Tokenization of Assets

I remember when I was a kid I would go play Street Fighter on these arcade machines at Denizli-Turkey. To do this, one had to insert a token that was exchanged for money at an ATM. A chip was equivalent to a certain amount of soles according to what the local established. This happens with the chips that one exchanges in casinos. In both examples, it can be seen that there is a consensus among all the participants in which a certain value is attributed to these tokens in order to use them for a certain purpose. And, in essence, this is what happens with the tokenization of assets, which is nothing more than the representation of an asset or a right in a digital asset.

The tokenization process is nothing new to humans and has been around long before Blockchain networks appeared. Tokens represent any form of economic value or right. For example, the “gift cards”, loyalty programs such as “bonus points” or the miles program, the tokens that are delivered in the wardrobes of the nightclubs, the bracelets to enter concerts, VIP areas or “all inclusive” hotels. ” are ways of representing something. They are tokens in the analog world. Even if one analyzes carefully, the DNI number is a token that represents the identity of a person. A seat in a registry item is a token that represents some right or registrable act.

Now, when we talk about the tokenization of assets, we refer to the transformation and digital representation of asset(s) or right(s) within a Blockchain. This digital process creates a block within the Blockchain where the unique properties of the asset or right that is being tokenized are registered. In other words, all the information regarding the object or right that is being tokenized is stored in the Blockchain. Once the token is created, it can be freely exchanged, stored and shared. Tokenization is ultimately the conversion of ownership rights to an asset or the transformation of title rights into a tradable ‘token’ within the Blockchain space.

Tokenize is to represent a right (personal or real, or over a tangible or intangible asset) in a private distributed registry ( Blockchain ) for legal purposes and public or semi-public for technological purposes, materializing said representation in unitary accounting entries called tokens. In addition, these tokens will always be linked to a specific account (called, in Blockchain jargon : wallet or purse) that will allow the possession and transfer of the tokens. Therefore, the tokens are essentially transferable and, generally, their rightful owner is the owner of the wallet that stores and controls them.

If you just read the previous two paragraphs and they sound like “Mandarin Chinese” don’t worry, until recently I was in the same situation. That is why I consider it extremely important to land examples of how asset tokenization can be used in our daily lives.

If you are a sports fan, like me, this example can help you understand what tokens are. Let’s imagine that your favorite football club issues a thousand fan tokens. Whoever buys these tokens will be entitled to discounts on tickets and official team merchandise. He also gives the right to meet privately once every 6 months with the players and buy plane tickets to accompany the team in all its away games, among other experiences and rewards. Surely you are wondering: Why do I need a token if I can do this with an ordinary promotion? Very good question, I, at some point, also asked myself.

The Blockchain allows to guarantee the traceability of the token. In other words, this technology makes it possible to create an electronic database that reflects in real time who the holders of that right are at any given time, and it establishes the rules so that said database can be modified each time the right is transmitted, thereby determining who is the new holder. This takes us from the “ Internet of information ” to the “ Internet of Value ”.”. If we think of a pdf file as a digital asset, once it is sent, control of the asset is lost, since anyone can send it, reuse it or delete it. Instead, with tokenization, ownership of the token can always be traced on the blockchain. This would allow, in the previous example, that when a fan, holder of the token, gets bored of its benefits, he can sell it to another fan. The token can be programmed in such a way that, for each transaction, the club can receive income from that sale, which completely changes the rules of the game.

Let’s take another example. Let’s imagine that you have a music band and instead of signing a contract with a record label you decide to issue tokens that represent 20% of the copyright in perpetuity on the music they compose. The fans who trusted the group from the beginning will be able to earn 20% of the royalties and every time they decide to sell their tokens to other fans, the band will also be able to receive an income from that sale. If the tokens were purchased at $2,000 each and then the pool ends up being the new “Nirvana,” fans could sell them for hundreds of thousands of dollars. Without a doubt a “ game changer ”.

There is no doubt that the disruptive capacity of Blockchain technology is found in tokenization. As noted in the book “The Token Economy” by Shermin Voshmgir: “ The ability to deploy tokens at low cost and with relatively little effort in a p2p infrastructure can be a game changer, because it makes it economically possible to represent many classes. of assets and of access rights in a digital way that was not possible in the past.” Blockchain asset tokenization can be applied to pretty much anything. The NBA can tokenize legendary moments and sell them as collectibles. Game developers are going to create video games where their players can “play to earn” (“ play to earn ”).”) the tokens of the same game to later be exchanged for real money or even exchange it for other tokens that are used for other video games. Companies will be able to issue debt to finance themselves through tokens. Likewise, shares, bonds and real estate may also be tokenized. Even the identities of people can be tokenized. This tokenization capacity opens the doors to an unprecedented digital transformation.

What differentiates this tokenization from other virtual representation processes (such as miles, for example) is that the token has an internal logic, which is subject to certain conditions. This is what we call Smart Contract , which is the code responsible not only for creating the tokens but also for managing the transactions that are made with the tokens. In layman’s terms, the Smart Contract acts like the cashier at the arcade store exchanging money for tokens. That is the relationship that exists between a token and a Smart Contract. In legal terms, the token is the digital object (the subject matter of the legal act) on which the Smart Contract computer code affects.

In short, the tokenization process refers to the issuance of tokens that are introduced as a block within a Blockchain and can be stored and transferred in the digital world. These tokens exist on the Blockchain , acting as a store of value and giving their holders rights to the assets they represent, while the real world assets backed by these tokens continue to exist “ off-chain ”. From a legal point of view, when we talk about ‘tokenization’ of assets we are talking about a complex, unilateral and receptive legal business normally made up of the legal business of issuance and that of digital representation itself.

After understanding that the tokenization of assets is nothing more than an extravagant way of talking about the securitization of assets and rights through the Blockchain , what corresponds to question ourselves is what is the legal nature of the tokens. It is worth asking if a token that represents a right to a discount of a certain product or service will have the same nature as a token that represents real estate or a movable value.

If the token is analyzed in isolation, we can conclude that the characteristics of a token are the following:

1. It is susceptible to economic valuation and will be part of a person’s assets, so it is considered as an asset;
2. Being able to move from “ wallet ” to “ wallet ” and being appropriated by the legal sphere of a subject, it will be considered as movable property;
3. Some tokens are fungible and some are not. For example, bitcoin or ether and, in general, the tokens that follow the ERC-20 standard are fungible goods; that is, it can be reciprocally substituted for another. However, there may also be non-fungible tokens, which follow the ERC-721 standard. The latter are the famous “ NFTs ”.
4. It is found within commercial traffic (unless it represents a prohibited asset).
5. It can be divisible or indivisible. It will be divisible when it can be divided into smaller fractions like bitcoin and its satoshis. It will be indivisible when tokens are linked to identity, such as certificates and titles. It wouldn’t make sense to have a fraction of a title or driver’s license.

However, stating the characteristics of the tokens does not really answer if the token is the subjective right that it is representing or if it is the digital token on which a property right rests. In my opinion, I would lean more towards the first position, since the legal nature of the token is very similar to a security, since it is a digital asset that contains a right. The token will be the representative title of the underlying right that is registered in the Blockchain. Due to the fact that our legislation does not contemplate the figure of the tokenization of assets, it must be analyzed case by case if the rights that are intended to be tokenized are susceptible to such a process.

An issue that is quite important when trying to determine the legal nature of the token is to see if there are particular elements of the assets or rights that are intended to be tokenized and see if this can alter the regulatory framework applicable to them. Generally, this happens when the token operates within the scope of regulated sectors or with great formalities or restrictions to carry out certain transactions. Although there is no international regulatory consensus on the classes of tokens and their legal nature, I consider that they can be classified into the following types:

A. Payment or exchange tokens : These are those that are used as an exchange mechanism in order to acquire goods or services or use it as a store of value. Bitcoin , ether , sol , doge would fall into this category , as well as stablecoins or stable currencies such as tether , which is normally backed by an asset in order not to be affected by market volatility.

B. Security Tokens or Investment Tokens: Those tokens whose underlying right grants rights over the capital of a company, its dividends or debt issuance. It is transferable and there is an expectation on the part of the acquirer to obtain an economic benefit, while on the side of the issuer it seeks financing. Although in Peru, this type of tokens do not fit within the definition of “transferable securities”, the Law for the Promotion of the Securities Market authorizes the Superintendency of the Securities Market to apply the principle of “primacy of reality” to define when we are dealing with a financial asset, whose purchase or subscription is publicized massively (for example, through the internet or social networks) by unsupervised persons or entities. Namely,

C. Utility Tokens or Utility Tokens : It is that token whose underlying right represents a specific use, normally of a good or a service. These are promotions, discounts, access. Its purpose is to retain the token holders. It is not a financial instrument, despite the fact that due to its technical characteristics it is essentially transferable. It is governed by civil and commercial law.

A legal challenge faced by the tokens is that, on occasion, the characteristics of the tokens themselves allow their use for more than one purpose and can even deviate from what was originally planned, since finally the laws of supply and demand for a given token can rise in value and eventually be traded on a secondary market. Users will therefore be able to speculate on its price and be treated as financial assets. This may raise the question if a Utility Token can be converted to a Security Token. Taking the Spanish practice as a reference, it is very important to see what the initial intention is in order to determine its legal nature, otherwise all the tokens could be “destroyed” by the behavior of the users and deviate from their original nature. For this, it is important that the issuer specifies in the White Paper what is the determining reason for creating that token. Likewise, this document must be aligned with the terms and conditions of use, as well as with all advertising material. In good account, the consistency in the duty of information will determine to a certain extent the legal nature of the token.

Another legal aspect that must be taken into consideration is the tokenization process of the asset or right. It begins with a feasibility study, where an exhaustive analysis of the asset or right that is intended to be tokenized is carried out. It is at this point that you must define whether tokenization is viable or not. A second step is to see what type of token we are going to use for the business or transaction that the client has in mind. Finally, certain clauses in the Smart Contract must be considered not only for the issuance of the token, but it is also important to clearly define the rules for transferring the tokens and the rights that they grant to their holders. It is important to understand that we are not facing a new type of contract, but rather a new tool for contracting with electronic means that allows the famous principle of “ pacta sunt servanda ” to be applied in depth (effectiveness or compliance cannot be left to the discretion of one of the parties).

One of the practical challenges that currently exists is the risk of double tokenization. In other words, it is extremely difficult to know if a tokenized asset has not been previously or subsequently tokenized in another Blockchain network in parallel form. Although the contract can establish an automatic resolution clause and a penalty for damages in case this is done, the truth is that it is an important point to consider. One possible solution is that in the case of assets that are registrable, an entry could be recorded in the registry entry stating that said asset has been tokenized in order to know when and in what network it was tokenized. However, non-registrable assets could not opt ​​for this solution. For these cases, the solution must be proposed by a private party, either a company that privately certifies or registers the tokenizations in order to provide security in commercial traffic.

In conclusion, the tokenization of assets is going to revolutionize the world, since practically everything can be tokenized. This will allow businessmen, consumers and investors to live in a more liquid, transparent and efficient world. On the other hand, we, the lawyers, face a number of legal challenges that we probably do not yet see. There is currently a regulatory framework that has not been designed with this new reality in mind, so our job will consist of navigating between the implementation of new technologies and a complex legal system. Therefore, all the legal elements related to all kinds of tokenization, the legal nature of the token and, above all, the sector of activity must be carefully analyzed so that, after said study,