Rob Behnke
October 11th, 2023
In an era where technological innovation continually reshapes the financial landscape, the convergence of traditional assets and blockchain technology presents new avenues for exploration and potential.The concept of asset tokenization, heralded by the digital revolution, is reshaping how we perceive and interact with real-world assets (RWA), transcending the confines of physical ownership. From collectible art and sprawling real estate holdings to essential commodities, the tokenization of real-world assets is on the rise.
Traditional financial institutions are now seeking to unlock the potential of issuing, trading, and managing tokenized assets on blockchain platforms. This intersection of traditional finance (TradFi) and blockchain innovation has the power to reshape investment paradigms and redefine the role of banks and financial institutions in the continuously changing global economy.
Asset tokenization tracks ownership of digital, financial, or real-world assets on the blockchain. Blockchain platforms provide the ability to track ownership on-chain and simplify the process of issuing, trading, and managing digital assets.
The blockchain’s original purpose was to track ownership of digital assets. Bitcoin and similar blockchains maintain ledgers that record the transfers of fungible digital assets. Since most cryptocurrency is fungible, they weren’t designed to track ownership of a unique asset.
Smart contract platforms like Ethereum have the ability to generate other types of tokens as well via smart contracts. A token contract defines the name of the token and the various ways in which it can be used.
Non-fungible token (NFT) standards such as ERC-721 enable ownership of non-fungible assets to be tracked on the blockchain. While these are commonly used for tracking ownership of digital art such as pictures in the Bored Apes Yacht Club (BAYC) collection, they can also be used to track other types of digital, financial, and real-world assets.
NFTs are issued by creating a smart contract that defines the token and its functions. Since platforms like Ethereum are publicly accessible, anyone can create these contracts and track ownership of various assets on the blockchain.
The ERC-721 standard is a common method of implementing NFTs on the Ethereum blockchain. This standard defines some of the core functions that the NFT contract should implement.
In addition to these core functions, an organization can also implement additional functions for an NFT. For example, financial implements tracked as NFTs could have specific functionality tailored to the unique asset.
Once the NFT smart contract has been written, it can be deployed to the blockchain. Once there, the contract manages all interactions using the tokenized asset.
After the token contract is implemented on the blockchain, a financial institution can implement a web frontend for it or use an existing one designed for managing NFTs. These frontends enable users to view, manage, and trade the NFTs that they own.
A Web2 frontend for a token contract works similarly to a traditional website. The main difference is the API used by the website and where the backend code is hosted. For a token contract, the web frontend will interact with the smart contract to perform the desired actions.
With tokenized assets, the blockchain is responsible for tracking ownership of the asset. Anyone can view the current ownership status of the asset, and transfers between users are performed using the built-in mechanisms provided by the blockchain.
Asset tokenization is a promising application of blockchain technology. However, financial institutions and other organizations exploring asset tokenization face a few potential challenges.
NFTs have become popular for tracking ownership of digital and real-world assets. One of the main reasons for this is that the blockchain provides all of the required infrastructure and functionality needed to maintain a ledger to record ownership of the assets and the ability to securely transfer them.
The main assumption about NFTs is that they actually track ownership of a particular asset. Historically, there have been several cases of NFTs alleging to track asset ownership actually turning out to be fakes that conveyed no real ownership. Multiple artists have been defrauded by NFTs claiming to track ownership of their work.
Blockchain-based systems have the ability to securely track ownership of a digital token, but they rely on the token issuer to validate that the token actually proves ownership of an asset.
Financial institutions that wish to tokenize financial assets on the blockchain will need to develop mechanisms to prove the authenticity of a particular token and that it actually conveys ownership of an asset.
One of the main barriers in the blockchain and cryptocurrency space is a lack of regulatory clarity. In many cases, various jurisdictions are still working through the process of defining and updating laws and regulations to govern this new space.
With the movement of traditional financial instruments into the blockchain comes new regulatory considerations and challenges for financial institutions. Government agencies are still working to determine who has responsibility for regulating various areas of the cryptocurrency space and how to apply existing laws to them.
Asset tokenization relies on the creation of smart contracts to manage these tokens. On a platform like Ethereum, a new token can be easily created by writing and deploying a smart contract that implements the desired functionality.
Numerous standards exist for implementing ERC-721 or similar token contracts designed to track ownership of non-fungible digital assets. By using these examples, it’s possible to write a token contract that records ownership of a particular asset.
However, it’s likely that financial institutions will need to customize these contracts to implement the desired functionality. By doing so, they introduce the risk of new vulnerabilities that can expose these contracts to attack.
The decentralized finance (DeFi) space is known for implementing complex and valuable protocols. However, it’s also known for massive, expensive hacks. Asset tokenization poses significant risks if not implemented carefully.
Blockchains use private keys to manage ownership of digital assets. Every blockchain transaction is digitally signed using a private key, and users are responsible for protecting their private keys against theft and potential abuse.
By moving into asset tokenization, financial institutions also face the challenge of managing the private keys for blockchain accounts. While banks can manage these keys for their users, they also have the risk that an attacker who gains access to these keys can perform irreversible thefts of the users’ digital assets.
For financial institutions, asset tokenization is a promising method of streamlining and modernizing financial systems. Blockchain technology enables transparent tracking of asset ownership and the ability to perform much faster transfers than traditional financial systems such as SWIFT. By making the move into asset tokenization, financial institutions also have the potential to expand the range of assets that they can hold, manage, and trade on behalf of their customers.
However, when exploring asset tokenization, it’s also important to consider and manage the associated risks. In addition to navigating a complex regulatory landscape, financial organizations also need to consider the challenges of proving the legitimacy of tokenized assets and protecting token contracts against potential exploitation by cyber threat actors.
For help in understanding how to safeguard digital assets, get in touch with Halborn’s blockchain security experts today.