How To Tokenize: The Realities of Asset Tokenization

The introduction of blockchain technology for enterprise use-cases, has brought about the interest to tokenize real world assets (RWA’s). Particularly, the interest has centered around what blockchain could do for the trading and the transference of private assets. Setting aside the trading discussion, in this article we’ll dig into the actual process of tokenizing a real-world asset, and will highlight the nuances and subtleties, and requirements issuers must be aware of when performing an asset tokenization.

To begin, we first examine the asset itself. Nearly all of the tokenized real world assets on chain satisfy the definition of a security, which means they’ll need to be treated according to securities regulations. Many of these assets fit in one of the following categories:

1. Equity
2. Debt
3. Derivatives
4. Collectibles
5. Real Estate
6. IP Rights
7. Litigation Finance

Once the asset type is determined, this will help you understand how you need to treat the asset, which brings us to the next question - timing.

Is this an asset you’re raising against currently, or is this an asset that was previously capitalized and simply needs its underlying beneficial ownership reflected on-chain?

Both can be tokenized, and indeed the top tokenization platforms in the world are architected to support the tokenization of an asset at any stage in its life cycle. Let’s examine both cases one at a time to go deeper into the nuances of each.

In this case, you intend to raise capital as part of the tokenization. This is a new or recapitalized asset that’s being offered as a primary offering and you’ll need to file an exemption or registration to raise the capital. Most private fundraises are conducted via the Reg D exemption, specifically the 506(c) private placement, though there are others such as Reg CF and Reg A. Each regulation has its own guidelines, which include or exclude certain types of investors, for example, Reg D 506(c) offerings require investors to be accredited, at a minimum.

In order to qualify for private securities offerings in the United States, you’ll have to complete the following:

1. KYC/KYB & AML
2. Accreditation (depending on reg type)
3. Subscription Document Signing
4. Funding

If you’re familiar with these processes, feel free to skip to the descriptions of issuance and tokenization down below.

Know-Your-Customer or Know-Your-Business (the institutional version of KYC) & Anti-Money Laundering. These checks include making sure the person or investing entity is who they say they are. The Anti-Money Laundering check is to verify the investor or entity is not a terrorist or sanctioned individual prevented from investing. Oftentimes, AML checks and companies that provide this as a service have additional verifications, like whether the individual has criminal history. These checks are not something that would automatically preclude you from taking the investors cash, but may factor into the decision of whether or not you accept their capital and allow them on to your cap table. Many of our customers, for example, choose to preclude those with violent criminal pasts or fraud convictions.

Another check that can be included is exposure or access to funds or treasuries, often referred to as a PEP or politically-exposed persons. Federal, state, or local government officials will usually trigger this, but it can also be applied to private individuals and companies as well. For example, Jeff Bezos would trigger a hit for PEP since he most likely has access, either directly or by directing someone who does, to treasuries for Amazon and Blue Origin. It’s not that you wouldn’t want to take investment from him, just a factor for you to be aware of when conducting investor due diligence.

Accreditation status is determined based on an individual meeting or exceeding certain wealth or income thresholds. There are also rules based on certain professions. See the SEC’s definitions for more insight.

All private offerings will include terms in some sort of subscription document or private placement memorandum (PPM). Investors must sign and agree to the terms outlined in this document, which typically includes any preference or conversion in the case of liquidity event (like acquisition or going public), as well as guarantees, anti-dilution terms like ratchets, or other clauses that investors will want to know and understand.

The accepting of cash for securities is more tightly regulated than accepting money for widgets on Shopify, and this is due to Anti-Money Laundering provisions that require that banks moving capital run their own checks on the individual before allowing money to change hands. This is also a driver for using custodians for escrow purposes - the cash can easily be returned to investors should something be amiss.

Once the onboarding steps have been completed, the issuer is then able to issue the security. This is critical, since the establishment of shareholders rights only occurs upon issuance, not before. Not when the subscription document is signed, not when KYC is cleared, not even when cash hits the issuer's bank or escrow account. This makes for a favorable scenario for the issuer, since they get to decide who becomes an investor in their asset.

Finally, the asset must be issued traditionally or digitally - as a token. This process is simple, whereby the issuer verifies, either through a Transfer Agent or of their own accord (private offerings do not require TA’s, after all), that the asset has been issued, the date it was issued on, the value, and any other elements they feel necessary to relay.

Now the distinction between issuance & tokenization is essential.

Issuance does not need to mean tokenization. There are several different classifications of digital securities and tokenization does not need to mean issuance. There are several steps in this process:

1. Issue the security first in a digital dematerialized fashion
2. Deploy smart contracts that are compliant with securities law that govern the security
3. Mint and distribute tokens to shareholders,“enhancing” the reflection of the security to include the token

When tokenizing an asset, once it has been issued, you have to deploy smart contracts on-chain to govern the token itself. The smart contract deployment is a singular action, since once created, the smart contract can be used to mint any number of tokens against any number of shareholders. The smart contract can also restrict token movement and contain token transfers to specific actions performed by specific third parties, meaning it can solve for the clawback, escheatment, recovery, or reassignment required of all securities.

Once the contract has been deployed, the tokens need to be minted and distributed to investors. If you’re using self-sovereign wallets like MetaMask, you’ll need to have investors register their wallet before transferring tokens. Just like a DeFi participant receiving tokens in an Airdrop, your investors will have to sign a transaction in real-time to verify that they own the wallet where tokens are to be distributed. While this infrastructure is relatively straightforward, it’s a critical step in the process to guarantee tokens are going to the intended recipient, since unlike bank accounts, blockchain wallets are pseudonymous.

By creating smart contracts governed by a Transfer Controller function, one can also produce blockchain wallets, on-chain, publicly viewable, that are subject to the Transfer Control method, that do not have private keys. The wallets are literally keyless. They are subject to the Transfer Controller in a hierarchical primary-secondary relationship, and are limitless in number, meaning an operator could create as many wallets as they like to support an issuance with a large number of non-savvy blockchain users. The same way that Coinbase made buying Bitcoin easy with an email and a password (which has allowed them to amass a staggering 100M users globally), companies like Vertalo are making blockchain based securities possible through a simple brokerage environment based on the issuer and/or broker’s relationship to the investor.

This approach is able to take into account both securities regulations and user experience - so no private keys, no wallet infrastructure, and no investors being turned away because of inexperience or discomfort with blockchain technology. Investors can still get access to the benefits of blockchain-based securities without needing to understand the underlying technology.

Imagine if AOL had told its customers, “We have this amazing new technology called the internet, it’s gonna completely change your life! Real quick - watch this 2 minute video on how the command line works to access it!” That’s what much of the blockchain industry currently sounds like to newcomers, and it’s off putting to new entrants and large financial institutions.

In this case, we assume the asset was already capitalized, all the requisite investor qualifications were completed, and the issuance of the asset was recorded. The timing of when this asset was issued doesn’t matter much, the only time boundary for consideration would be the seasoning of the asset. We’ll assume this asset has fully seasoned.

When the asset has already seasoned, the transformation from analog to digital format, reflected via security token on-chain, is really just a way to change how the asset is reflected. You’re not making any material change to security itself, just the method whereby you record its ownership. These securities are often referred to as “digitally enhanced securities” since in the eyes of the regulators, the on-chain token is simply a reflection of the security itself, but the security is the version recorded in the privately managed database.

Most shareholder ledgers are maintained digitally today, whether that be with your online broker, a cap table service like Carta, a simple Excel spreadsheet, or a digital Transfer Agent like Vertalo. The tokenization digitizes the ownership to include an on-chain representation of the security.

To tokenize a previously issued asset, issuers typically go through a staging process whereby their existing cap table and data are brought into an environment that can support blockchain infrastructure. There are only a handful of digitally enabled Transfer Agents worldwide that can support this process.

The staging process may include a migration and digital transformation as the issuer moves off the traditional Transfer Agent and onto a digitally-enabled one. This typically includes a board resolution where the issuer declares they have hired the new Transfer Agent and fired the previous one. These declarations are filed with the DTCC, and usually bring 30 day termination terms with the existing Transfer Agent. Unfortunately this can make getting the data out of the traditional Transfer Agent difficult, since the entity being fired isn’t always thrilled to support a departing client, but that just means the new Transfer Agent must be prepared to stage unique formats, solve for unknowns with regards to the existing cap table, and handle the ETL (extraction, transforming, loading) process with grace.

Once the data has been staged and imported properly, the tokenization can occur in the two step process highlighted above (Deployment, Minting) to all or part of the cap table as the issuer desires.

…that’s because the process is actually straightforward and relatively uncomplicated. The tokenization of a cap table of ownership is truly the easy part. It’s what you do with the asset once tokenized, and how you handle the myriad of use-cases where securities are concerned, that issuers, brokers, banks, and financial institutions need to take care of when approaching asset tokenization.

Asset tokenization is really pretty straightforward, and the steps in the process only hinge on where you are in the lifecycle of the asset you’re issuing. In its most simple format, one effectively issues tokens against a share ledger which was subject to a securities registration or exemption.

It’s the preparation and staging beforehand, and the data management afterwards, that are the real concern. The nature of blockchain-based securities means much consideration must be taken to maintain compliance, but once those boxes have been checked, issuers can operate with confidence using this new technology and shared ledger to their, and their shareholders’, benefit.

Real world asset tokenization brings with it the potential to unlock trillions of dollars worth of assets for greater liquidity and broader capital markets activity. It just has to be done right.

Disclaimer: None of this information is nor should it be considered as professional, legal, investment, or any other sort of advice or recommendation. The information presented herein is done so for informational, entertainment, & educational purposes only. Please consult an attorney or licensed investment professional before taking any investment, legal, business or professional action.