Tokenization: what is it, and how does it impact financial services?

The process of digitalizing data using blockchain technology, which was the technology that made it possible to create cryptocurrencies, is causing another revolution: tokenization.

Because of this innovation, various asset markets have become more accessible, integrated, and extremely secure, allowing a huge number of new investors to enter.

The expected impact of negotiating tokens is immense. According to an estimate by MarketsandMarkets, asset tokenization will be responsible for expanding the market from US$ 2,3 billion in 2021, to US$ 5,6 billion by 2026.

In this article we will discuss what tokenization is, and how it works. We will also look in more detail at the expected consequences of democratizing tokenized asset transactions around the world, and the impact that will have on financial services.

What is tokenization?

The tokenization process consists of transforming an asset into a token. In other words, any good or right that has a financial value can be converted into a type of “symbol,” or token.

Tokenization is, therefore, the procedure for digital representation of an asset, whether that asset was originally digital or physical. A token may represent the whole asset, or just a fraction of the initial asset.

Once something has been tokenized, the “token” itself is public and can be verified. From that moment on, it is no longer possible to make any changes or conduct negotiations regarding the tokenized asset without its respective registration. Such transparency means excellent anti-fraud insurance.

How does tokenization work?

Creating a token is like issuing shares for an asset, property, or right. The asset is tokenized by end-to-end encryption using blockchain technology.

The programming language that registers the token is where the asset’s characteristics, the rules for identifying its owners, and the ways the asset can be traded in smart contracts are defined.

Tokens can be classified as fungible or non-fungible (NFTs, or non-fungible tokens), depending on the asset they represent:

• Fungible token: the represented asset may be replaced by another of the same type, quality, and quantity.
• Non-fungible token (NFT): in general, the represented asset has an exclusivity characteristic that has no direct equivalent with another asset.

The simplest examples of NFTs are those associated with works of art. For example, a painting by Picasso cannot be substituted for a painting by Van Gogh, and vice versa. Therefore, tokens that represent these assets, although they both correspond to very valuable works of art, are not direct, equivalent substitutes.

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Tokenization in different sectors

Since all assets that have economic value and that can be traded can be tokenized, it is reasonable to consider that it is just a matter of time until tokenization’s reach is broad. At the same time, tokenized assets open the way for new business models.

Some of the most common examples of sectors that can use tokenization include the real estate market, securities market (such as stocks and bonds), art and collectible works market, precious metals market, commodities market, etc.

In addition to traditional markets, asset tokenization also creates new opportunities for investments, such as negotiating rights to the future earnings of artists or athletes, for example.

In cases like this, the professional involved benefits from the possibility of “advancing” their income to the present time, and thus being able to invest in new training and materials, for example, contributing to their future success.

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Tokenization in the payments and banking market

The transition from using physical currency to digital currencies have been progressive and consistent in recent years around the world. Even in regions such as Latin America, where cash is still the most widely used means of payment, digital initiatives such as Pix have found surprising adherence.

This transition to digital currencies tends to accelerate with asset tokenization. Cryptocurrencies, in parallel with advances in Open Finance, will be increasingly used in negotiations using tokens. Over time, it is also expected that the tokens themselves will be used as a means of payment, in a type of modern bartering system.

Impacts of tokenization in the payments market

Currently, the tokenization method is already being used in the segment of means of payment to bring increased security for digital payment processing, keeping the user's sensitive information confidential. This is an even more efficient method than common cryptography as a barrier in antifraud solutions.

Some of the benefits brought to the banking and payments sector by tokenization include the following:

• Reduced use of physical currency, resulting in savings for countries;
• Greater security in financial transactions;
• Faster and simpler settlement;
• Reduced brokerage costs;
• Greater efficiency through the use of smart contracts.).

In addition, new financial products and services tend to emerge with the consolidation of asset tokenization, leading to expanded potential to raise funds, especially for small and medium companies, as well as financial inclusion of the still-unbanked population, especially in scenarios such as that of Latin America.

Today, for example, banks are already exploring the issuance of debt in blockchain structures in Europe. Tokenization is also expected to reduce currency exchange fees for transactions in which funds move between countries.

The Central Bank and tokenization in Brazil

In Brazil, the Central Bank has invested in initiatives that will help promote tokenization in the country. One of the Central Bank’s main projects that seems to be accelerating tokenization is the “Digital Real.”

The Digital Real, also known as the Brazilian CBDC, will be a digital currency: a token issued by the Central Bank that is linked to deposits received. The advantage of a CBDC over cryptocurrencies is that it will be backed by the Central Bank, which may intervene to prevent excessive volatility, as seen with bitcoin, for example.

The Central Bank’s efforts to create a digital currency are focused on stimulating tokenization of the Brazilian economy. At Febraban Tech 2022, the president of the institution, Roberto Campos Neto, said that tokenization “is here to stay,” increasing the efficacy and competitiveness of the financial system. He also said that the banking system is expected to gradually migrate to a tokenized system in which there will be “fewer accounts and more tokens.”

Tokenization is still highlighted in the current context

At Febraban Tech XNUMX, tokenization was one of the main highlights of the event, especially regarding the Digital Real. Fabio Araujo, coordinator of the project at the Central Bank, participated in a round table on the subject.

In addition to disclosing the expansion of proposed testing of the Digital Real, Araujo pointed out that tokenization for the sake of tokenization is not sufficient; this process must be done with the intent of addressing the needs of the system, and expanding and facilitating access to services.

Check out the panel “Real Digital and Brazil on the map of tokenizations” at Febraban Tech 2023:

Obstacles to tokenization: regulation is the current challenge

Currently the largest obstacle to tokenization, not only in Brazil but globally, is the deficient legal framework necessary to regulate tokenized transactions. The legislative gap regarding crypto assets is the lack of defined regulation, and naming entities with jurisdiction to oversee the process.

Until the challenge of regulation is overcome, tokenization initiatives might not advance, depending on the business model of the traded asset and its respective regulator.

However, once this difficulty is resolved, tokenization will lead to an explosion of new opportunities, mainly in the capital markets, in which it will be possible to tokenize companies, receivables, and securities.

In addition, the traditional market as we know it could be entirely transformed due to the agility, automation, decentralization, and transparency that blockchain technology provides.

The Regulatory Sandbox in Brazil

One action to help solve the difficulty of creating appropriate regulation for operations involving tokens is called the “Regulatory Sandbox,” organized by the Brazilian Securities Commission (CVM).

The Sandbox functions as a testing environment monitored by the CVM, in which previously authorized participants receive temporary permission to develop innovations in regulated activities.

In the Sandbox, the CVM, in collaboration with some of its regulated entities, closely observes what initiatives need to be taken to improve the regulatory framework of transactions involving tokens.

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Tokenization brings numerous advantages to society and financial services

Tokenization is the subject of the day all over the world, not only because it is a transformation that is currently under way, but also because it brings with it countless advantages. Democratizing access to investments in various segments is one of those advantages. With tokens, fractions of an asset can be traded, which allows investors with less purchasing power to have access to markets whose entry cost would be too high without tokens.

Another benefit is diversification of investment portfolios, because investors with very different profiles can have more asset options in which to invest their funds. By increasing the range of alternatives, the total risk of the portfolio tends to fall.

In the payment and financial services market, tokenization leads to expanded financial education content, as the population has more incentive to learn about new market segments and financial products that were inaccessible before.

Furthermore, we will have faster, safer, and more transparent transactions, since tokenization combined with blockchain keeps transaction information confidential, facilitating and driving use of the virtual environment for financial services.

Finally, we can cite the lower costs, because since we are talking about digital records in smart contracts, all settlement and back office services are simplified. This tends to reduce operating costs significantly, ensuring that those involved pay lower fees.

Dock has its finger on the pulse of market evolution!

Asset tokenization brings enormous potential to create new markets and business models. Companies that take advantage of this time while the regulation is taking shape to study opportunities for using tokens in their operations, will be ahead of the competition.

Dock is monitoring market innovations, especially with respect to the payment market, and it is closely following news on tokenization.

Through the Dock Oneplataform, companies from different sectors can use our Banking, Cards & Credit, Acquiring e Fraud Preventionsolutions. Learn more:

Tokenization: what you saw in this article

• Tokenization is the procedure for digital representation of an asset using blockchain technology.
• A token is registered in a programming language in which the asset’s characteristics, the rules for identifying its owners, and the ways that asset can be traded in smart contracts are defined.
• A token may represent the whole asset, or just a fraction of it. The represented asset may be fungible —it can be replaced with another of the same type, value, or quality— or not fungible (known as an NFT), which is the case of exclusive assets, such as works of art.
• Any asset that has economic value and can be traded can be tokenized, such as: real property, works of art, precious metals, commodities, collectible objects, copyrights, etc.
• In the banking and payments market, tokens decrease the cost of transactions, increase the security of confidential information, and improve competitiveness of the sector.
• The Central Bank of Brazil has invested in creating the Digital Real to stimulate tokenization in the Brazilian economy.
• The greatest obstacle to tokenization worldwide is the development of an adequate regulatory framework. The Brazilian Regulatory Sandbox, monitored by the CVM, is an important initiative by the regulator to find solutions to this challenge.
• Once the regulatory issue has been overcome, tokenization may be expanded in various segments, especially in financial services and products.
• Tokenization encourages the democratization of investments, allows safer and more transparent transactions, reduces risks, costs, and the bureaucracy of middlemen’s back office services.

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