There has been a lot of “buzz” about tokenization. Is it just hype? Or should you actually care?
First, what is Tokenization? Simply put, in the financial context, tokenization of assets refers to the process of issuing a digital token that runs on a blockchain. This token is a digital representation of an asset – tangible or intangible – and its value is derived from the value of the asset it represents, like the process of traditional securitization1, but with a digital “twist”.
Before we delve into the more complex and sophisticated uses of tokenization (which we’ll discuss in future blogs), let’s look at a simple example of how tokenization could be the appropriate solution to an existing problem.
The Challenges
In an effort to appeal to young investors – Millennials and Gen Z – Fidelity recently announced that it is offering fractional shares trading for stocks and ETFs. The on-line traditional brokerage house Charles Swab announced similar offerings in October 2019. Fractional shares offerings are not something new. FinTech startups, such as Stash, have been offering, since 2015, fractional investment in a stock for as little as $5. FinTech startups have long recognized the different needs and challenges of young investors. Owning a share of Google ($1,518.15, as of 2/20/2020) or Amazon ($2,153.1, as of 2/20/2020) or even Apple ($320.1, as of 2/20/2020), may not be in the budget of a young millennial, especially if they would like to hold a diversified portfolio. Understanding this challenge, Stash has been offering millennials fractional share “ownership” of a few dollars of Google or Amazon or any other share that they might be interested in but cannot afford buying a whole share. As Stash and other FinTech companies have been gaining popularity with young investors, traditional brokers (e.g., Fidelity, Charles Schwab) have been taking notes and following suit.
But on the exchange (e.g., NYSE, Nasdaq) you can only buy one unit of a share. The exchange will not allow a trade of a fractional share. So, how do these brokers offer a fractional share to clients? How does this work?
Indeed, traditional exchanges only offer whole unit share trading. Therefore, the broker, who offers the fractional share trading, has to buy the unit share on the exchange. This unit share will represent a “pool of investors”, each holding a fraction of that unit. Legally, the owner of the unit share is the broker, not the individual investors who “bought” a fraction of a unit. The broker could create a financial instrument which will define the legal rights and ownership of each investor. However, no broker has provided such information and we have no details on how and if clients actually have any rights to a fractional unit of a share. If they have created a financial instrument to represent the investors rights in the pool, then that adds another layer of complexity to the offering.
Other Issues with Factional Shares
There are other problems with this configuration. Since the broker is buying the unit share, then most likely, clients will not be able to get the best price (and embedded fees might be included in the discounted price.) In most cases, the trade will not happen in real-time. Although Fidelity claims to offer real-time fractional trading, it has not provided information on how this might work. Remember that fractional units of a share cannot be traded on the exchange. Hence, Fidelity will buy one unit of share and create a “pool” (or a financial instrument) behind the scenes.
The complexity discussed above is the reason why people have been advocating for stock splits2 which in turn, has called for companies whose stock price has gone too high to split its stock in the name of increased liquidity (i.e., high trading volume).
The Solution — Tokenization
Tokenization, however, can solve this complexity without having companies split their stocks. But how?
Think for a moment. Bitcoin is very popular among the younger generation. But how could they afford to buy bitcoin if it is traded in the thousands of dollars (BTC price $9,715.08, as of 2/20/2020)? How could Robinhood, a FinTech broker, offer bitcoin trading without offering fractional trading for bitcoin? The reason is because fractionalization is already embedded in any digital asset (bitcoin or otherwise) that runs on a blockchain. This is one of the main (and appealing) features of a digital asset.
If you look into the daily transactions of bitcoin that happen on any crypto exchange, you will notice that all transactions are of fractional units of a bitcoin and as little as 0.0001 of one bitcoin. This is possible because with digital representation (i.e., computerized), fractionalization of a unit is infinite. This is true for bitcoin or for any asset that is (or will) be tokenized.
Now, think what could happen when you tokenize a Google or Amazon share. The same thing that applies to Bitcoin trading will apply here. Therefore, tokenization is the most appropriate solution for the problem presented above – how could young investors afford (diversified) investing under their budget constraints?
If assets are tokenized, investors are able to:
- trade and own, in real-time, fractional units, given the constraints of their budget
- own a fraction of a unit, without the added complexity of the broker and its legal implications
- get the best price directly from the exchange (or a tokenization platform)
- avoid additional embedded fees
In this scenario, higher liquidity is achieved without companies worrying about stock splits or brokers worrying about fractional shares and its financial complexities and legal implications. Tokenization seems to be the best solution to satisfy all parties concerned: investors, companies and brokers (or other financial institutions.)
We will discuss other tokenization benefits and applications in future blogs. In the meantime, if you’d like to learn more, GFMI offers several Digital Assets courses, including “From Cashless to Tokenized Economy.”
1For an overview on how securitization transactions are structured visit GFMI’s article on CLOs – https://www.gfmi.com/articles/collateralized-loan-obligations/
2 A stock split is a corporate action which increases the number of the company’s shares outstanding by dividing each unit share. For example, a $100 share can be split into 2 shares of $50 or 4 shares of $25 or any faction that the company deems necessary and appropriate. You can think of a “stock split” as “fractionalization”. In this case, however, the newly fractioned stocks are traded on a stock exchange; hence, increasing liquidity.
