Blockchain: Is asset tokenization the next big deal?

November 2020 – The use of blockchains in the environment of tangible assets is still in its infancy. However, smart tokens could significantly change the market, especially with regard to the real estate market. In the following interview, Dr. Cyrus de la Rubia, Chief Economist at Hamburg Commercial Bank, sheds some light on this hitherto little-known business.

The article was published as a guest commentary in the Frankfurter Allgemeinen Zeitung on 22.01.2021 (german only).

Bitcoin coin on green pink background

The financial industry has only just become acquainted with blockchains; now tokens, which are supposedly much easier to understand, are being talked up as the next big thing. Could you briefly explain what's behind this?

If someone tells you that the concept of tokenization is easy to understand, it's either because they doesn't want to scare you off with complicated explanations, or that they may not have understood the concept themselves. Tokenization is no walk in the park, but it is worth understanding, due to its considerable innovation potential for the financial sector and other industries. This is because – to anticipate one result – asset tokenization allows tangible assets such as real estate to be divided into small units, made available to small investors, and to be traded with minimal transaction costs. And much of this can happen without intermediaries.

This may sound rather like an 'all-purpose miracle device'...

...but it's a little trickier to understand. I can't avoid this if we want to talk more about the background. Asset tokenization is often based on the Ethereum blockchain – two terms that already require explanation: blockchain and Ethereum. Lets start with the blockchain: this is a database in which the entered pieces of data are linked to one other using cryptographic techniques in a way that makes it difficult or impossible to manipulate them. This is all the more true if this blockchain is organized in a decentralized manner; in other words, if an identical copy of the database is located on many thousands of servers, as is the case with the Ethereum blockchain. The Ethereum blockchain is a database that essentially anyone can access.

Really? Anyone?

Yes, anyone can add data there in the form of information, programs or digital contracts. Once this data has been added, it can no longer be removed or manipulated. This is ensured by what are called 'miners', who cryptographically seal the blocks containing the recorded data in a way that prevents anyone from changing them. To do this, a miner must allocate computing power to solve a cryptographic puzzle before other miners. Those who solve the puzzle first receive a reward in the form of Ether, the Ethereum blockchain's transaction currency.

"Tokenization is no walk in the park, but it is worth understanding, due to its considerable innovation potential for the financial sector and other industries."

Dr. Cyrus de la Rubia, Chief economist at the Hamburg Commercial Bank

And where do the tokens come in?

What I just described doesn't have much to do with tokens yet. However, tokens can be created via 'smart contracts'. A smart contract is nothing more than a piece of software that can be stored on the Ethereum blockchain in the case discussed here. This software functions like an if-then condition, and has an independent address on the Ethereum blockchain. This allows for example, a piece of real estate to be tokenized. In this case, the if-then condition is: If a certain amount of Ether – the cryptocurrency on the Ethereum blockchain – flows to the address of the seller's smart contract, then the sender of the Ether's address receives a correspondingly defined amount of tokens, which in turn represent an ownership share in the piece of real estate. Possession of a token, which is assigned to the individual blockchain addresses of the holders on the blockchain, entitles the holder to receive a share of the rental income. The transfer of the rental income can also be automated by means of a smart contract, for example by applying following if-then condition: If it is the 15th day of the month, then a portion of the rent is paid to the token holders' Ethereum addresses.

That sounds impressive. And doesn't exactly bode well for real estate managers' future business prospects.

The charm of this approach is that the processes run automatically and therefore require little administrative effort. Taken to the extreme, one could even imagine that no intermediaries will be necessary anymore, because the contracts cannot be corrupted and are self-fulfilling. The property manager will no be longer a human being, but just a piece of software. In addition, this creates new prospects for low net-worth private investors. Tokens can essentially be sold in any small value. This allows investors who wouldn't be able to participate in a large insurance tower under normal circumstances to acquire a fraction of this property or a corresponding rental claim with, for example, 500 euros. Many tokens can now be traded on decentralized blockchain based exchanges, meaning that shares can be traded here without high transaction costs. The high degree of divisibility also makes it possible to diversify even a rather small property portfolio at a low cost.

image tokenisierung

So what's still holding it back in practice?

The world of real estate and tenants is not as pure as programmers usually imagine. The magic words of 'blockchain', 'token' and 'smart contract' do not mean that tenants are automatically always in a position to pay their rent, that real estate management and repair work takes care of itself and that notary publics, who usually ensure the transfer of the land register when selling a property, are immediately out of a job. These obstacles are not insurmountable, however. For example, it is essentially possible to use sensors to continuously check whether electrical devices such as stairwell lamps or elevators are functioning and, in the event of an error message, to contact a corresponding contractor from an address pool. Here, too, it could be an advantage if the contractor is connected to the blockchain and can see the error message immediately. It would be just as interesting, if not more, to transfer land registers to the blockchain. This would be a logical step, as the Ethereum blockchain is almost impossible to manipulate and data entries therefore enjoy a high degree of credibility without the need for a notary public. This could make real estate transactions significantly cheaper. However, notary publics will probably still be playing a significant role in more complex commercial property transactions 20 years from now.

That may well be the case, but you are making careful use of the subjunctive. What else prevents the blockchain from making a major breakthrough in the asset industry?

Despite all the euphoria, we shouldn't allow ourselves to get carried away, at least for the time being. Not everything that can be mapped to the blockchain is useful per se. It's important to weigh up the pros and cons here, especially since the technology is still immature in many areas and also offers a target for attack. The Ethereum blockchain's biggest weakness is its lack of scaling. There are also other problems. For example, the information collected by sensors must be transmitted to the smart contract via oracles. Unlike the Ethereum blockchain, these oracles can be manipulated. Solutions must be found here to prevent misuse. And let's not forget the legal stumbling blocks. The federal government has made some progress in this regard and has recently introduced a bill to give electronic or tokenized securities the same status as traditional securities. Switzerland is even further ahead in this regard, but most EU countries are lagging behind. This could present an obstacle when it comes to international transactions.

You've evaluated the opportunities, and also mentioned the risks. Hand on heart, how much potential is there is for tokens?

In spite of all the doubts, think back for a moment to the Internet. It used to be that you'd sit there while the modem buzzed and – if you were lucky – actually established a connection and loaded a page in the time it took to make a coffee. Today, people move around the net with a naturalness that would have been unthinkable in the 1990s. The law has been, and continues to be, increasingly adapted to the new reality, and people no longer question whether such an abstract thing can function at all. They simply use it. The same thing can happen with blockchain and token technology. Rather than dismissing the technology as a fixed idea or perceiving it as a threat, it is therefore important for legislators and companies to stay on the ball and seize the opportunities inherent in these technologies.

Four questions and answers on the power of the blockchain

How are Bitcoins unique?

Bitcoin is a form of electronic peer-to-peer cash that can be transferred between computers without the need for a trustworthy intermediary, such as a bank. Its emission is not subject to the control of a single, centralized institution. Whole bitcoins, or its smaller units, known as Satoshis, can be transferred securely via the Bitcoin blockchain.

How is the digital money sent from A to B without counterfeiting occurring?

The secret of cryptocurrency lies in the fact that all transactions that take place in the Bitcoin blockchain are stored. Forever. Since the launch of the Bitcoin cryptocurrency on January 3, 2009, every single transaction has been stored. Today, when a new transaction is set to be carried out from a particular address, referring to the entire transaction history can quickly confirm whether the address is trustworthy. On a technical level, the security of the blockchain is created through "miners", who are rewarded for confirming the correctness of transactions involving (newly created) Bitcoins.

How significant is Bitcoin today?

Every "block" of the blockchain includes 1,500 to 2,500 carried out transactions. At this point in time, a new block is added every ten minutes. By mid-September 2020, around 650,000 blocks had been created worldwide.

What is the future of the blockchain?

A new generation of blockchains has now been developed which offers even greater benefits. One of the most prominent new blockchains is Ethereum – considered the Swiss army knife of the crypto industry. It is significantly more flexible than its predecessor. While the Bitcoin blockchain is only able to transfer Bitcoins, the Ethereum blockchain also transports data, information and what is known as smart contracts. It is these smart contracts that hold the greatest potential for innovation. Put simply, they are software solutions for any type of if-then transaction, such as rental or leasing deals.