Tokenizing Real world Assets: Real Value to DeFi
We often say ‘that asset has great value’ but exactly do we mean by this? When does an asset have great value? Assets, be it financial assets like stocks, bonds, commodities or cryptocurrencies, or actual everyday assets like a real estate, a car, a book, or a pen, have a certain value attached to them. For financial real world assets, this value is true for everybody. A stock of a company will have the same value to you or to me. However, a house’s value is dependent on who lives in it, how long they have lived there, and other memories attached to the house, etc. In short, the value changes between people. The differences (and as we will soon see the similarities) between the two groups doesn’t end there.
Since financial assets have a, let’s call it, ‘universal value,’ it’s easier to represent them. It can be represented as a number of dollars, euros, or another currency. Since they have ‘universal value’ these assets can be easily stored, transferred, and traded between parties. But how exactly is it done? How can one person buy and sell, say a company’s shares, with another in a different location? It’s not as if the buyer is knocking on the door of the seller and delivering the share certificate. This transaction is done through an intermediary, and more importantly, in a digital manner.
The process of converting a physical share or bond certificate into a digital form is called ‘dematerialization.’ Similarly, the account in which these electronic shares and bonds are deposited is called dematerialized accounts. These accounts are maintained by a brokerage, using which you can buy and sell shares, or bonds. Do cryptocurrencies have a similar mechanism?
When cryptocurrencies were introduced to the world back in the early 2010s, beginning with Bitcoin, a new era of asset representation began. No more were accounts operated by separate brokerages needing to hold digital certificates of real world assets. All that was required were wallets. These wallets could store, hold, and transfer digital currencies between people. What’s more, these currencies can be transferred between people across the globe, using no third parties and very little fees.
So, what made cryptocurrencies so easily transferable? Well, broadly speaking it was two aspects, the ability to tokenize and the ability to transact. Both of these were a function of blockchain technology.
The interesting thing with Bitcoin is, it’s the first real world asset to have been represented via a digital token in its original form. There was no physical coin that you could hold representing one Bitcoin. It wasn’t something you left in your pocket or dropped on the sidewalk. It was always represented in an electronic form. Unlike shares, bonds, or gold, which were originally physical before being dematerialized. Bitcoin was a true first in the modern age of finance.
A ‘digital first’ asset
What made Bitcoin become this ‘digital-first’ as far as financial real world assets go is blockchain technology. Through blockchain, it was possible to monitor the supply of Bitcoin, its transfer between wallets, and its price. Since each Bitcoin has a unique ID, which is created based on the IDs of the Bitcoins produced immediately before it. This ensures that no Bitcoins can be inserted into the blockchain because it would disrupt the IDs of the coins after it. Other key infrastructural points that support the system are the network, the miners, the transaction fees, the wallets, the addresses, and the private keys. All these ensure that Bitcoin can be created, stored, and transacted efficiently without a central intermediary. In short, Bitcoin and blockchain created the foundation for the decentralized financial system.
Now, with cryptocurrencies like Bitcoin and Ethereum already in place and working well, much of the ‘plumbing’ of this system was already built. This presented an immense potential for the Decentralized Finance (DeFi) world.
Building the real world system
DeFi has built some of the most innovative tools in this new financial ecosystem through the work of financial architects. We’ve previously written about stablecoins, lending, insurance models, liquidity pools, and more, but throughout all of this, the base has remained the same – digitization of assets.
What Demat accounts did to traditional real world assets like stocks and bonds, tokenization did to cryptocurrencies. Put simply, tokenization allowed an asset to be represented digitally. This ‘representation’ does not end with simple price quotes. It’s a gateway to every bit of information required. For cryptocurrencies, everything from unique IDs, ownership details, transfer history, price changes, volume fluctuations, all this and more is stored within one simple token, but the ‘representation’ does not end there.
Like we said earlier, there are two types of real world assets based on ‘universal value,’ assets like stocks and cryptos and assets like Real Estate and cars. Another way to differentiate them is through their digital form. Stocks can be represented in Demat accounts, and digital currencies can be represented in wallets, but what about Real Estate? Is it possible for a piece of land or an office building to be represented digitally? Well, let’s find out.
Real world problem
The premise should be the same, shouldn’t it? Real Estate has a value, it can be bought and sold, it has an owner who can change. Finished buildings can also earn regular returns in the form of rent, similar to dividend payments and liquidity interest for stocks and cryptos. Why can’t they be digitized? Don’t they follow the same rules?
Well, at face value, all the boxes are checked. Both Real Estate and stocks or cryptos have growth and income characteristics. They are transferable, and have a value attached to them, but the difference lies in their liquidity. What’s liquidity?
Fun fact, the reason why finance has so many terms related to fluids, like liquidity, float capital, and dilution comes from a legendary market manipulator of the 17th century. A livestock trader named Daniel Drew (1797 – 1879) would sell his cattle by literally inflating them. While on his way to Manhattan to sell them, he would force-feed his cattle salt. By the time they got to the Harlem River, his cattle would drink huge volumes of water out of thirst. This water would fatten them up, and since cattle were sold by the pound, Drew would pocket a larger profit.
Back to Real Estate and liquidity. When we say something is not very liquid, we mean it cannot be easily sold for cash. Why cash? Because with cash, you can buy anything almost immediately. Simply put, cash is the most liquid real world asset, and every other asset’s liquidity is measured by how quickly it can be converted to cash.
Using that barometer, stocks and bonds can be converted to cash in your bank account within a few days. Similarly, digital currencies can be converted to cash even more quickly. The reason for this difference between stocks and digital currencies is because the latter has a decentralized system of checks, without any third party approval like a regulator or bank account. Plus crypto markets are open 24/7 while redeeming held shares or bonds are only allowed during market hours. So, in the order of liquidity, we have the cash right at the top, followed by digital currencies, stocks, and then bonds.
Where on this list does Real Estate lie? Think back to the definition of liquidity, and the example of the rest of the real world assets and ask yourself, how quickly can I convert a piece of land into cash? Well, I think you have your answer.
Real Estate, an actual piece of land or a physical building, takes a while to convert to cash. There are permits and licenses that need to be squared off, zonal, and government approval to be checked, banks and insurance agencies contacted, and this is before a buyer is found! All these hurdles prevent a piece of land to be converted into cash quickly.
A question you might have here is, doesn’t the Real Estate owner receive periodic rent? And isn’t that rent in cash? So, there’s some liquidity, right? That’s a good question, and yes, that does add some liquidity, but not enough. Let’s look at this in the form of an example.
Adam is an investor in a Real Estate project. The project sets up office buildings for companies to use and collects rent from them distributing it to the various investors. Unlike shares and bonds, Real Estate investments are quite steep. In this case, Adam invests $100,000 into the project and receives rent of $8,000 every year. That’s an 8% return in cash, a highly liquid asset, so isn’t this ‘liquid’? While the $8,000 is liquid, Adam’s initial investment of $100,000 is not. This invested amount is locked into the Real Estate contract.
Here, for Adam to actually ‘unlock’ his $100,000, he’ll have to sell his investment. To sell, he’ll have to transfer ownership to an interested party. This is where the problem arises.
No getting out easy
If Adam wants to transfer his investment in the real estate project, meaning he wants to sell it back to the owners or another investor, the process is difficult. The management will have to value the property, determine Adam’s proportional ownership, verify the same, and change the distribution payout channel, all for just one seller. Instead of this long and tedious process, the company will offer Adam two options to opt-out.
- Adam has to wait for the company to sell the building. In this case, everyone’s shares will be sold, not just Adam’s. Everyone receives their investment back, plus any appreciation. If the company is having a hard time redeeming Adam’s shares, imagine how long they’d take to redeem everyone’s. In short, this option will be long and drawn-out.
- If Adam needs to get out quickly, the company can buy him out. However, the amount at which the company will buy him out will likely be reduced because they are unlikely to have cash-on-hand for redemptions. Also, such redemption would have a limit. The company wouldn’t want a lot of investors to redeem at once. In short, this option is limited and at a reduced price.
Whichever option Adam takes (or is forced to take) he either sacrifices time or his part of his investment. Because of the fees and friction associated with such transfers of ownership, coupled with the high value of the investment, Real Estate investments are not a liquid asset. This illiquidity of Real Estate prevents a lot of financial functions that we have come to expect from stocks, bonds, and digital currencies to be developed for the asset class. This is what the next stage of blockchain technology and DeFi is trying to solve. To bring real-world assets like Real Estate on the blockchain.
Real Estate, the problem in detail
Why is Real Estate such a big deal in the first place? Well, let’s start with the sheer size of it. According to a 2018 study by Savills, a Real Estate services provider, the global Real Estate market is worth $228 trillion, divided mainly between residential Real Estate (73%), commercial Real Estate (14%), and agricultural land and forestry Real Estate (11%).
This massive Real Estate market is only second to the debt market, which is valued at just over $250 trillion according to the Institute of International Finance. No other market, not even equities, gold, and cryptocurrencies combined can come close to the two giants that are debt and Real Estate.
Here’s how they stack up against each other.
Data source: All of the world’s money and markets in one visualization, VisualCapitalist
The other reason for Real Estate to be considered a big deal is the limitation of it. Unless Elon Musk occupies Mars or another planet, we’ve just got one Earth to live in. What this means is, land is limited. To put this in financial terms, Real Estate like gold and Bitcoin has a ‘hard cap’ meaning only so much of it can be supplied. Once it reaches its cap, you can’t just make more land, the same way you can’t just mine more gold or Bitcoin. That’s also why debt, equities, and even currency will outpace Real Estate eventually.
Land and property may be the second biggest asset class in the world now, but it’s not like more land can just be printed. Currency can be endlessly printed by central banks. Stocks and bonds can also be endlessly issued by companies. Real Estate unlike currency, stocks, and bonds is not bottomless.
Everyone needs Real Estate, more so than we need any other asset. We all need a house to live in, offices to go to work, and farmland to grow food. There’s a very real and clear use-case with Real Estate assets.
All this and more details the importance of Real Estate as an asset class that cannot be ignored and underlines why the next generation of finance has to put it at the forefront.
Tokenizing the future
To put real-world assets like Real Estate on the blockchain, the first step is to tokenize them. The process of tokenization simply means to digitally represent an asset in the form of a token. This token will contain all relevant information about the asset.
Real Estate tokens will contain all the legal documentation, the ownership deeds, and more price of the property. The important bit is, the process of tokenization helps break up the problem of illiquidity because one larger property can be divided into many tokens. Further, since all the regulations and ownership transfer are encoded within the token, breaking up the asset becomes easier.
In the previous example, if the Real Estate investment were to be tokenized, instead of Adam having one large $100,000 investment, he has $100,00 in 100 tokens, which represent his ownership. Each token has a value of $1,000, amounting to $100,000. These tokens are put on the blockchain, which allows the investment company to track its price and ownership change. Adam can put these tokens into his private wallet. Here, the wallet can be his own private wallet or a qualified custodian’s wallet which holds every investor’s investment.
Tokens and data transparency
Let’s bring in the company here, we’ll call it Real Estate Corp. The company receives investments from several investors like Adam and issues them tokens. Like any other asset, the value of the investment, and hence the tokens, changes. This value is determined by various pieces of data, which are monitored by oracles.
These data points can be internal, like property value appraisal conducted by third parties, income generated from users, occupancy on a periodic basis, expenses, insurance, capitalization table, etc. Further other external data points can also be added like the development of the city and the domestic economy, the crime rate within the neighborhood, damages due to the weather, regulation, and more. The best part is because all this data is on the blockchain, it’s transparent. Each investor can verify the value of their investment easily, by simply checking the change in price of the tokens which is reflective of each of the factors mentioned above.
What happens when each token has all the data points represented in it and its value changes according to the data points? Well, as we’ve seen in financial assets in the past when you have such represented assets, there’s always a market for them. This opens up a market where the tokens of Real Estate Corp, let’s call them RECs, can be traded. So, Adam or any other investor holding these tokens can put them up for sale if they want.
An in-built system
Let’s say, Ron, an accredited investor, would like to buy Adam’s tokens. An accredited investor, according to the US Securities and Exchange Commission (SEC), is someone who is financially sophisticated and does not need regulatory protection.
Basically, only accredited investors can participate in certain transactions, because it involves high risk. For general transactions parties have to prove they are accredited investors, but in a blockchain system, such proof is in-built. This means that Ron does not need to prove that he is an accredited investor. This will already be flagged in his wallet and his ID. Moreover, non-accredited investors’ transactions with Adam for the REC tokens will not go-through, meaning financial checks and balances are already in place.
Getting back to the example. Ron would like to buy Adam’s tokens. Here, Adam can choose how many tokens he’d like to sell. He can sell a part of them and keep the rest. Adam decides to sell 50 tokens, which cost him $50,000 i.e. 50*$1,000. But looking at the data points, he thinks the value has doubled. This may be because the property was developed, the facilities fixed, the occupancy increased, etc. For these reasons, each REC tokens’ value is higher. Adam fixes a price of $2,000 per token, taking his 50 tokens to a total price of $100,000.
Ron doesn’t mind paying $100,000, because he thinks it’s a good investment and the property’s value will rise further. He pays the $100,000 and receives the tokens. Adam now has liquid cash of $100,000, and 50 tokens worth $100,000, and Ron has his 50 tokens as well. Simple, right?
No notification required
One question you might have is, what about the company, won’t Real Estate Corp need to be notified? Well, not really. The only thing that Real Estate Corp cares about is the tokens, regardless of who holds them. Since blockchain technology allows both ownership and custody to change during transactions, when Adam sold 50 tokens to Ron, the ownership changed hands. Real Estate Corp will still make the payments out to all 100 tokens, but since 50 are held with Adam and 50 with Ron, they’ll get divided between the two. No intermediaries, no fees, no friction. Even Real Estate Corp does not have to be involved in this transaction. Although they’d be aware of it since it was taking place on the transparent blockchain.
Think about what this means from an administrative and cost perspective. Real Estate Corp doesn’t have to change any distribution streams, even the destination addresses are changed automatically. This decreases the costs of re-papering, documentation, filing, manual appraisal, and more.
Compare this to how a Real Estate investment would be sold between two parties. All the regulators have to be notified separately. Investors’ accreditation will have to be approved before they can participate in transactions. Secondary market transactions without going through the legal, regulatory, company intermediaries are impossible not to mention long and tedious. After transfers, the company has to make several changes to the distribution channels, often adding several costs to the process. By migrating this process to the blockchain, using and employing digital assets, and oracles, everything is not only automated but streamlined and made more efficient.
Real-world assets on the blockchain are not just a one-stop-shop solution. To make this transfer possible, a host of supporting infrastructure elements is present. These elements not just create a market where assets are merely bought and sold. They create a market that has regulatory checks, data transparency, transaction efficiency, and more. Here are a few of the integral elements.
Accurate and reliable data is the building block of a valuation and appraisal process. After all, if you don’t have the right data, how can you price an asset? Oracles help create streams of data that are constantly updated. This data pertains to the value of the property, the occupancy rates, the rent mode, the economic output of the city, the periodic expenses, the insurance payouts, and more. All of these flow to verify data and to make sure it’s accurate.
In the secondary market, transfer agents help transfer not only the asset, in its digital form, but also all the ownership. These agents help switch ownership from the seller to the buyer. Similar to cryptocurrencies and digital wallets, assets can be transferred only if it’s actually present in the account. This prevents the problem of ‘double spending’ where one coin is spent twice through two different transactions. Transfer agents can also have an in-built verification process to only allow certain classes of investors to participate in transactions. Like we’ve seen in the above example of ‘Ron the accredited investor,’ transfer agents can have qualifying criteria based on the receiving address of the buyer or seller. These in turn can be approved by regulatory bodies.
Everything about the investment, including price history, ownership history, dividend payments, validity, etc can be put in the token. This serves as a complete picture of the investment. Since the token is operated on the blockchain, its every movement is recorded and built into its code. At what price it’s moved at, which parities transacted it, the investor class of the parties, the dividends it received, everything is encoded. This leaves nothing to chance or error. Further, since tokens are digital and stored in the wallet, they can easily be verified and transacted between parties.
These are just the basic elements. Over and above this you can add stablecoins to maintain the value of your investment, smart contracts to automate them, decentralized insurance to protect these investments, and more.
Liquidity in action
We started talking about Real Estate because of the problem of illiquidity, but with the help of blockchain technology, this problem is not only addressed but developed on. We’ve seen, through the process of tokenization, how liquidity can be infused through the creation of a secondary market.
How does this help exactly? Apart from the ease of transfer like we’ve seen above, how does liquidity actually help an asset and its market? Think about it this way, if you know you could buy and sell Real Estate as quickly as you could buy and sell stocks, what could you use it for?
Like with all financial assets we’ve seen in the past, liquidity creates multiple used-cases. Since shares, cryptocurrencies, and even commodities are so liquid, they can be used for more than just investment growth. They can be used to generate income, to insure against risk, for transactions, but the most important use-case has got to be lending.
Real Estate tokens in use
As we’ve seen above, global debt is bigger than equity, cryptocurrencies, and commodities combined and marginally bigger than Real Estate. With tokenization of real-world assets like Real Estate, these assets can be used as debt. How so? Isn’t debt a completely different asset class? Well, not really, debt is simply borrowed assets. These assets can be stocks, crypto, or cash. For an asset to be used as ‘debt,’ it must have three features.
- Value: If the borrower is unable to pay back the borrowed sum, the asset should have resale value to make the lender whole
- Storable: During the borrowing period, the asset should be stored either with the lending party, or a compliant third party till the sum is paid back
- Liquidity: The asset should be liquid, meaning it should be able to be sold quickly for cash by the lending party
Think about how these three qualities apply to Real Estate before and after tokenization. Before tokenization, Real Estate assets were valuable, but not easily storable or liquid. After tokenization, all three boxes are checked. Real Estate investments, even ones that are large, can be tokenized, stored in a wallet, and used as debt. Because of oracles, the value is accurate and reflects a whole range of internal and external factors. Since there are transfer agents, checks and balances can be placed. These checks can include the lock-in period of the investment, class of investors, type of transfers, amount of collateral of assets, and more. Through the tokens, all documentation, regulations, and legal norms can be satisfied and constantly updated in a digital form.
Real-world real use
Real Estate is the first step of real-world asset tokenization. Owing to the asset class’ high illiquidity, and vast size, the logical progression to a usable liquid asset, works. However, there’s so much more to the tokenization of real-world assets. This principle can be applied to bonds, hedge funds, art, even to physical commodities like gold and silver. Once these assets are tokenized, they no longer pose a liquidity problem.
These assets, once out of the liquidity deadlock, can be used for so much more. By combining their value with the ability to store and transact they can be used for lending, borrowing, regular income generation, insurance against risks, collateral for invoicing, and more. Every essential financial function can be unlocked even with assets that are traditionally bought and sold in bulk and have long holding periods. What’s more, this is done with minimal costs. With no intermediary, not even the issuer, required to be a party to every transaction. And the regulatory checks already checked off, both fees and friction are eliminated.
Every asset, no matter large or small, can be tokenized. They can then be put on the blockchain and transacted in complete transparency. The supporting infrastructure, in the form of oracles and transfer agents, is being made more efficient by the day. Finally, more and more simple and everyday financial functions are being developed for these tokens. Decentralized finance is building a real use-case for real-world assets, the first of its kind.