Over the past few years, there has been a growing interest in tokenization as an alternative form of financing. While it’s not a new concept, its popularity has increased due to several factors, including technological advances – particularly during the Covid-19 pandemic – and regulatory changes. Here, we explain what tokenization is, how it works and why it could revolutionize finance as we know it.
What is tokenization in finance?
Tokenization is the process that converts traditional assets into digital tokens and makes them easier to transfer and manage.
In finance, tokenization is typically used for security, privacy, and scalability purposes, such as securing real-time payments and the financial information of customers.
However, it is important not to confuse tokenization with cryptocurrencies. Cryptocurrencies, such as Bitcoin and Ethereum, are the native asset of a blockchain that are used for peer-to-peer payments and can be exchanged for other cryptocurrencies or fiat money.
In contrast, tokenization is part of the platform that is built on an existing blockchain that not only secures payments, but also decentralizes marketplaces by creating new asset classes that can be traded on secondary markets, such as real estate, stocks, or art, either fractionalized or in full.
There are two main benefits to this: one is security; the other is liquidity. The term was first used in the financial sector but has since been adopted by other industries such as healthcare, real estate, and agriculture.
The history of tokenization can be traced back to about 2001, when smart cards were introduced as a way of storing value on a card instead of cash or checks. As technology advanced, so did the methods for storing assets digitally: from bar codes scanned at checkout counters to the magnetic stripes on credit cards today, which are increasingly being replaced by contactless payments.
Why is tokenization trending now?
Tokenization is a hot topic because many now regard it as the future of finance. The idea is that this new way of doing things will allow us to rethink how we use money and interact with each other financially, as well as create bigger opportunities in our financial lives.
It also allows users to keep track of digital assets without having access or control over them – making transactions safer than ever before, particularly in the post-pandemic era when concerns over cybersecurity are at record highs.
What are the advantages of tokenization?
For banks and financial institutions, the benefits are clear. Tokenization allows them to reduce costs, and improve efficiency and security to prevent fraud, while providing a better customer experience with more accurate data.
For end-users, tokenization provides increased trust in the financial system as it does not share card details, such as the 16-digit debit or credit card number, with merchants. It also better protects customer data from hackers.
However, the onus is on banks and financial institutions to ensure that their customers’ funds and data are safe at all times by using strong encryption protocols and storing them in secure locations.
One potential disadvantage of the technology is that not all legacy banks have the right infrastructure in place yet for tokenization systems, which can be expensive and complicated if they’re not already part of a lender’s core business processes, such as payments.
Regulatory issues also stand between banks and the successful implementation of tokenization. While it allows for borderless payments, many countries have different rules and it may take some time before there is a universal consensus globally, or even within individual countries.
What do banks need to do to start the tokenization process?
Banks need to prepare their infrastructure by putting a system in place that allows them to store the data of the assets they want to tokenize. They also need to identity a management system where all participants can register, verify their identities, and receive access rights for the tokenization process.
To prepare for tokenization, banks should create a strategy outlining how they plan to manage the entire process from start through to completion. They should also develop procedures specifically designed for this purpose so everyone involved knows what they’re doing at every step along the way – including how they’ll handle any issues or disputes that might arise during this multi-phase process.
Tokenization and CBDCs
Tokenization and CBDCs are both about digitizing money and share similar aims, such as making it possible for people to hold their money in digital form instead of fiat currency, encouraging financial inclusion, and providing security and privacy.
In some ways, CBDCs are simply another form of tokenization – but one that is currently considered more efficient than existing models because there is no need for intermediaries such as banks or credit card companies when transacting with them.
How will tokenization continue to grow in the future?
Asset tokenization is expected to grow into a US$16.1 trillion business opportunity by 2030, according to a research report by BCG and ADDX.
There are many use cases of tokenization, because almost any type of asset can be tokenized and traded using blockchain technology: real estate, gold bars and coins, oil reserves, healthcare data and agricultural commodities, among others.
Tokenization is already, for example, providing transformational financial solutions in the agricultural sector by allowing farmers to tokenize their crops and store them as collateral on their cell phones to secure finance.
In real estate transactions, homebuyers could choose to purchase tokens instead of making monthly mortgage payments – and they would own those tokens until they sell them later on at an agreed price set by a contract between a buyer and seller before the purchase took place.
While tokenization is already a game-changer for the global financial sector in terms of security, privacy, and scalability, it is also has the potential to democratize financial opportunities for everybody and transform how the world thinks about money – and uses it.
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