How To Tokenize: The Realities of Asset Tokenization

Real World Asset Tokenization has garnered a lot of interest. Here's the process of how to tokenize an asset from start to finish.

By Vertalo Team

Ever since the introduction of blockchain technology for enterprise use-cases, we’ve seen so much interest in the tokenization of real world assets (RWA’s). Particularly, the interest has centered around what blockchain could do for the trading and transference of private assets. Setting aside the trading discussion, for this post we’ll dig into the actual process for how to tokenize a real-world asset to highlight the nuances and subtleties, and requirements issuers must be aware of when performing an asset tokenization.

Note that much of the criticism against existing cryptocurrencies stems from the fact that they are not backed by anything, so their value is entirely driven by market sentiment, hype, and investor activity.

If you have an asset that can back your tokens though, this effectively wipes out that criticism, since we have many different models and methods for asset valuation, based on the class, the nature of the investment, the asset itself, and the operators.

To begin, we first examine the asset itself. Nearly all of the tokenized real world assets that we’re seeing on chain meet the definition of a security, which means they’ll need to be treated according to securities regulations. Most of the assets we’ve tokenized, or intend to tokenize, fit in one of the following categories:

• Equity

• Debt

• Derivatives

• Collectibles*

• Real Estate

• IP Rights

• Litigation Finance

*there’s overlap here; the tokenized collectibles, for example, was preferred equity in an LLC that owned the collectible outright, but it’s important to highlight the various asset classes that we’re seeing garner interest in the market

Once the asset type is determined, this will help you understand how you need to treat the asset, which brings us to the next question - timing.

Is this an asset you’re raising against currently, or is this an asset that was previously capitalized and simply needs its underlying beneficial ownership reflected on chain?

Both will work fine, and indeed the top tokenization platforms in the world are architected to support the tokenization of an asset at any stage in its life cycle. Let’s examine both cases one at a time to go deeper into the nuances of each.

Security Token Offering

In this case, you intend to raise capital as part of the tokenization. This is a new or recapitalized asset that’s being offered as a primary offering and you’ll need to file an exemption to raise the capital. Most private fundraises are conducted via the Reg D 506(c) private placement. This means that investors must verify that they are in-fact accredited and able to invest in private securities.

Side note - we hold a very strong opinion against telling individuals or institutions how, when, or if they can spend their own money. Sports betting books, casinos, or poker tables have no requirement to check that you can in fact spend the money you want to put down. If banks want to exclude extending credit for risky activities like gambling, that’s fine, and we understand a ban on credit for those sorts of purchases. But your own cash? It’s yours! The minute you want to invest in a private placement, you have to verify your income and/or net worth via asset ownership less outstanding liabilities. We believe the moral thing to do would be to deregulate investor accreditation and open up private markets to all peoples, but we digress.

In order to qualify for securities offerings in the United States, you’ll have to complete the following:

• KYC/KYB & AML

• Accreditation

• Subscription Document Signing

• Funding

If you’re familiar with these processes, feel free to skip to the descriptions of issuance and tokenization down below.

KYC/KYB & AML

Know-Your-Customer or Know-Your-Business (the institutional version of KYC) & Anti-Money Laundering. These checks include making sure the person or investing entity is who they say they are. The Anti-Money Laundering check is to verify the investor or entity is not a terrorist or sanctioned individual prevented from investing. Often times AML checks and companies that provide this as a service have additional verifications, like whether the individual has criminal history. These checks are not something that would automatically preclude you from taking the investors cash, but may factor into the decision. Many of our customers, for example, choose to preclude those with violent criminal pasts or fraud convictions.

Another check that can be included is exposure or access to funds or treasuries, often referred to as a PEP or politically-exposed persons. Federal, state, or local government officials will usually trigger this, but it can also be applied to private individuals and companies as well. For example, Jeff Bezos would trigger a hit for PEP since he most likely has access, either directly or by directing someone who does, to treasuries for Amazon and Blue Origin. It’s not that you wouldn’t want to take investment from him, just a factor for you to be aware of when conducting investor onboarding.

Accreditation

We already commented on our disagreement with this as a practice, but the law currently states that individuals must be accredited to invest in private placements. The threshold for accreditation is defined either through income or net worth. For income, the definition is:

• An individual who has made $200,000 / year for the last two years, with a reasonable expectation for that level of earning to continue

• A married couple filing jointly that has made $300,000 / year for the last two years, with a reasonable expectation for that level of earning to continue

For net worth, the definition is as follows:

• Net worth over $1 million, excluding primary residence (individually or with spouse or partner)

There are also professional distinctions, like securities licenses, that can grant one accreditation status, but since nearly all accreditation occurs via income or net worth, we’ll leave these be. See the SEC’s definitions for more insight.

Subscription Document Signing

All private offerings will include terms in some sort of subscription document or private placement memorandum (PPM). Investors must sign and agree to the terms outlined in this document, which typically includes any preference or conversion in the case of liquidity event (like acquisition or going public), as well as guarantees, anti-dilution terms like ratchets, or other clauses that investors will want to know and understand.

Funding

The accepting of cash for securities is more tightly regulated than accepting money for widgets on Shopify, and this is due to Anti-Money Laundering provisions that require that banks moving capital run their own checks on the individual before allowing money to change hands. This is also a driver for using custodians for escrow purposes - the cash can easily be returned to investors should something be amiss.

It’s important to highlight here that for issuers seeking to create a customized experience, the order in which these steps are completed doesn’t actually matter from a legal standpoint. There’s nothing in the law that says you must KYC before signing a Subscription Document, for example. This means that we’ve seen every order of onboarding flow you might imagine, and the nature of the order of the steps is usually dictated by the asset itself, the investment minimum, and the intended audience. Large minimums and/or more traditional assets will sometimes require payment upfront, after which the KYC and other requisite steps can occur.

Issuance

Once the onboarding steps have been completed, the issuer is then able to issue the security. This is critical, since the establishment of shareholders rights only occurs upon issuance, not before. Not when the subscription document is signed, not when KYC is cleared, not even when cash hits the issuers bank or escrow account. This makes for a favorable scenario for the issuer, since they get to decide who becomes an investor in their asset.

This was the case for Exodus, who raised capital via a Reg A+ offering in May of ‘21. According to their filings with the SEC, as well as from those who were close to the project, Exodus was actually quite oversubscribed to the Tier II Reg A+ limit of $75M, which meant they got to decide who made it on their cap table, giving them some discernment and influence over who became a registered shareholder in their company.

This also reminds us of how, in the venture world, VC’s sign a subscription document but simply never fund their holding, which is unfortunately more common than most might believe. Those subscription documents are not enforceable in a court of law (at least not that we’ve ever seen) and no issuer would seek to enforce the terms of the sub doc anyways, but simply choose to walk away altogether. When dealing with venture: a deal isn’t done till the cold hard cash is sitting in your account, but this cuts both ways. Issuers can choose to exclude anyone from investing for any reason. If capital was collected from someone who was ultimately rejected from being issued shares, it would simply be returned to the investor. While this is not a sentiment that Vertalo, a former partner of ours put it this way, “If an investor is offering me an interest-free loan, I’m taking it! I’ll return the cash later if I have to.”

Finally, the asset must be issued, after which it can be enhanced on-chain through the tokenization. This process is simple, whereby the issuer verifies, either through a Transfer Agent or of their own accord (private offerings do not require TA’s, after all), that the asset has been issued, the date it was issued on, the value, and any other elements they feel necessary to relay.

Issuance vs. Tokenization

Now the distinction between issuance & tokenization is essential. Vertalo made an intentional decision to bifurcate the issuance and tokenization process, based on comments from the SEC and other regulators early on in this space.

Issuance does not not need to mean tokenization. There are several different classifications of digital securities (already preparing a post on this, subscribe so you won’t miss out!) and tokenization does not need to mean issuance. Vertalo has been carefully architected to support both use cases. There are several steps in this process:

1. Issue the security first in a digital dematerialized fashion

2. Deploy smart contracts that are compliant with securities law that govern the security

3. Mint and distribute tokens to shareholders,“enhancing” the reflection of the security to include the token

Because the issuance and tokenization are separate and distinct steps, this opens up interesting options, like a partially tokenized cap table for example, that issuers can make use of. Many investors don’t understand blockchain, public key infrastructure (PKI) or private key management, and even the mentioning of the word “blockchain” is enough to scare them away. They’ve read the horror stories about lost passwords or destroyed private keys and don’t even want to go there.

Even people close to us, who have been subject to our blockchain evangelism for years, were skeptical of buying Bitcoin or other crypto assets until they were comfortable with a custodian who would take the storage risk on for themselves. We know that bearer instruments and securities function very differently, but investors usually aren’t aware of the control provisions required of issuers, making it easy to conflate blockchain with “Bitcoin”, “lost assets”, “risk”, or even, “proceed with caution”.

By separating the issuance and tokenization function, if investors are skittish or antagonistic towards tokenization or blockchain for any reason, the issuer simply has the ability not to tokenize their specific holding. In theory, this could extend beyond the simple delineation of tokenized vs. non-tokenized and into cross-chain functionality across token holders on a singular cap table (e.g. half the cap table tokenized on Ethereum trading on ATS #1, the other half tokenized on Avalanche trading on ATS #2) but we have yet to encounter a solid business case for this sort of behavior. The marketing & sex appeal would be compelling though.

Deploying Smart Contracts

When tokenizing an asset, once it has been issued, you have to deploy smart contracts on chain to govern the token itself. Vertalo uses the Vertalo Securities Protocol, but there are many that will suffice, including ERC 777, ERC 1400, ERC 1404, or the DS Protocol. The thing these protocols all share is that they are restricted token standards, meaning they can solve for the clawback, escheatment, recovery, or reassignment required of all securities.

The smart contract deployment is a singular action, since once created, the smart contract can be used to mint any number of tokens against any number of shareholders.

“By separating the issuance and tokenization function, if investors are skittish or unfavorable towards tokenization or blockchain for any reason, the issuer simply has the ability not to tokenize their specific holding. In theory, this could extend beyond the simple delineation of tokenized vs. non-tokenized and into cross-chain functionality across token holders on a singular cap table (e.g. half the cap table tokenized on Ethereum trading on ATS #1, the other half tokenized on Avalanche trading on ATS #2) but we have yet to encounter a solid business case for this sort of behavior. The marketing & sex appeal would be compelling though.”

Minting & Token Distribution

Once the contract has been deployed, the tokens need to be minted and distributed to investors. If you’re using self-sovereign wallets like MetaMask, you’ll need to have investors register their wallet before transferring tokens. Just like a DeFi participant receiving tokens in an Airdrop, your investors will have to sign a transaction in real-time to verify that they own the wallet where tokens are to be distributed. While this infrastructure is relatively straightforward, it’s a critical step in the process to guarantee tokens are going to the intended recipient, since unlike bank accounts, blockchain wallets are pseudonymous.

This also presents as a unique challenge when trying to use stablecoins in private market transactions like dividend distributions. The pseudonymous nature of blockchain wallets mean enhanced monitoring and verifications, like KYT (Know-Your-Transaction) or KYW (Know-Your-Wallet), become necessary.

If investors are unsure or uncomfortable with blockchain technology, token distribution may present as a challenge, both from a business standpoint (investors simply won’t purchase your asset) but additionally from a user experience standpoint (they may still want to purchase but not know how). This is one area where Vertalo has gone above and beyond through the creation of Keyless Custodial Wallets. We previously wrote about the Transfer Controller function within the securities-compliance in our piece, “The Case Against Bearer Instruments (as Securities)” where we touch on the Transfer Controller function and its ability to maintain compliance with securities laws, but Keyless Wallets are a unique and powerful byproduct of this development.

By creating smart contracts governed by a Transfer Controller function, one can also produce blockchain wallets, on-chain, publicly viewable, that are subject to the Transfer Control method, that do not have private keys. They are literally keyless. They are subject to the Transfer Controller in a hierarchical primary-secondary relationship, and are limitless in number, meaning an operator could create as many wallets as they like to support an issuance with a large number of non-savvy blockchain users. The same way that Coinbase made buying Bitcoin easy with an email and a password (which has allowed them to amass a staggering 100M users globally), Vertalo has made accessing blockchain based securities possible through a simple brokerage environment based on the issuer and/or broker’s relationship to the investor.

No private keys, no wallet infrastructure, no investors being turned away because of blockchain. Investors get access to the benefits of blockchain-based securities without needing to understand the underlying technology.

Imagine if AOL had told its customers, “We have this amazing new technology called the internet, it’s gonna completely change your life! Real quick - watch this 2 minute video on how the command line works to access it!” Draws a smile every we mention it, but that’s what most of the blockchain industry expects of newcomers, and it usually includes explainer videos and walk-through tutorials. The message is always the same - learn about private keys, download MetaMask, and take on risk yourself.

We just don’t see that approach as one that can drive mass adoption. We have to architect for user experience.

Previously Issued Asset

In this case, we assume the asset was already capitalized, all the requisite investor qualifications were completed, and the issuance of the asset was recorded. The timing of when this asset was issued doesn’t matter much, the only time boundary for consideration would be the seasoning of the asset. We’ll assume this asset has fully seasoned.

When the asset has already seasoned, the transformation from analog to digital format, reflected via security token on-chain, is really just a way to change how the asset is reflected. You’re not making any material change to security itself, just the method whereby you record its ownership. These securities are often referred as “digitally enhanced securities” since they have an on-chain reflection of the security itself. We’ll write more on the differences between digital asset securities and digitally enhanced dematerialized securities in another post.

Most shareholder ledgers are maintained digitally today, whether that be with your online broker, a cap table service like Carta, a simple Excel spreadsheet, or a digital Transfer Agent like Vertalo. The tokenization digitizes the ownership to include an on-chain representation of the security.

Staging

To tokenize a previously issued asset, issuers typically go through a staging process whereby their existing cap table and data are brought into an environment that can support blockchain infrastructure. There are only a handful of digitally enabled Transfer Agents worldwide that can support this process, Vertalo being one of them.

The staging process may include a migration and digital transformation as the issuer moves off the traditional Transfer Agent and onto a digitally-enabled one. This typically includes a board resolution where the issuer declares they have hired the new Transfer Agent and fired the previous one. These declarations are filed with the DTCC, and usually bring 30 day termination terms with the existing Transfer Agent. Unfortunately this can make getting the data out of the traditional Transfer Agent difficult, since the entity being fired isn’t always thrilled to support a departing client, but that just means the new Transfer Agent must be prepared to stage unique formats, solve for unknowns with regards to the existing cap table, and handle the ETL (extraction, transforming, loading) process with grace.

Once the data has been staged and imported properly, the tokenization can occur in the two step process highlighted above (Deployment > Minting) to all or part of the cap table as the issuer desires.

If this seems overly simplistic…

…that’s because the process is actually straightforward and relatively uncomplicated. One of the important things we often tell those seeking to tokenize assets is the fact that the tokenization itself is a singular watershed moment, and in some ways it’s almost anti-climactic. The thing you’re tokenizing is really the cap table of ownership.

Having performed hundreds of these tokenizations personally, it’s both satisfying seeing the contract address and minted tokens, but also a bit of a letdown once it’s done, that includes a “Well now what??”, realization. It’s the before & after that truly make the difference.

Ok, so what comes after? Well a non-exhaustive list might look like this:

• Ledger management, including

  • Transfers between shareholders

  • Maintaining the association of identity & pseudonymous token ownership

  • Potential recoverability & transfer of securities if access is lost

• Reporting & compliance (rare for private assets, but not unheard of)

• Investor & equity management, especially where multiple share classes are concerned. You could have options, warrants, preferred, common, etc. All could theoretically be tokenized, but must be treated as securities

The tokenization is truly the easy part. It’s what you do with the asset once tokenized, and how you handle the myriad of use-cases where securities are concerned, that issuers, brokers, banks, and financial institutions need to take care of when approaching asset tokenization. From what we can tell, as far as the SEC is concerned, “Oops, we didn’t know that!” is not a valid excuse for securities violations.

Chain of Choice

The last thing we’ll highlight before signing off is that many come to us with the latest and greatest blockchain asking if we can support tokenization on that chain. Broadly, the answer is yes, if the programming language of that chain is Turing complete, then transfer controls and securities law compliance can be encoded within the smart contracts and that chain could support securities without issue.

But that’s really not the right question to ask - the question here is - what business benefit do you get by tokenizing the asset on this new chain?

In our post, “The 4 Unique ATS Models of Trading Secondaries” we detail one of the critical considerations for how trading blockchain-based securities on an ATS behave with the following:

If the brokers take custody of the asset, and it’s a security token on-chain, they have to have blockchain infrastructure to support the proper custody and ledger management of the asset itself. This has been a huge hindrance to the growth and adoption of the digital asset securities industry, since many large brokerages, like all large companies, struggle to adopt new technology and build with/around it. It is growing though, as companies like Fidelity, NYDIG, Nasdaq, BlackRock, and others, are building digital asset strategies and engaging with the opportunity in this space.

If you intend for your asset to trade on an ATS, and that ATS is custodial under the 15c3-3 customer protection rule, but you opt for the newest and sexiest blockchain to tokenize the asset on without confirming the ATS supports that chain, you’re rolling the dice that the ATS will be able and/or willing to support custody of the securities on that blockchain. As best we can tell, the only blockchains supported by ATS’s domestically in the US are Ethereum, Tezos, Avalanche, and Algorand, although issuers have tokenized securities on other chains like Stellar, Polygon, or Solana.

With regards to the chain - always remember that the assets we’re dealing with are blockchain-based securities, so the talking points you hear in the crypto world about network costs, throughput, transactions per second, decentralization, etc. are all not nearly as applicable.

Network costs - definitely. But the rest? No one is trading blockchain-based securities that could be considered in any way as “high frequency” (nor will they for a long time, lots of building to do before that’s even possible, much less desirable) so the throughput and TPS don’t really matter since settlement happens at the executing broker-dealer.

The decentralization of the chain is also not a necessary consideration, since these are controlled, not sovereign, instruments subject to transfer restrictions, lockup periods, jurisdictional geofencing, and many other controls. If we were dealing with bearer assets designed to trade in a sovereign manner 24/7 globally, we could talk about these and many others points, but we’re not, so that conversation is rendered moot.

Side note - most throw the word “decentralized” around without understanding the nature of middleware-type API layers like Infura or Ankr, who render any element of decentralization obsolete and instead create a distributed ledger environment not dissimilar from AWS. Nothing wrong with that, most of the software world runs on AWS, but we’re not calling it “decentralized” because it’s not, it’s distributed.

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Conclusion

Asset tokenization is really pretty straightforward, and the steps in the process only hinge on where you are in the lifecycle of the asset you’re issuing. In its most simple format, one effectively issues tokens against a share ledger which was subject to a securities filing or exemption.

It’s the preparation and staging beforehand, and the data management afterwards, that are the real concern. The nature of blockchain-based securities means much consideration must be taken to maintain compliance, but once those boxes have been checked, issuers can operate with confidence.

Real world asset tokenization brings with it the potential to unlock trillions of dollars worth of assets for greater liquidity and broader capital markets activity.

It just has to be done right.

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Disclaimer: None of this information is nor should it be considered as professional, legal, investment, or any other sort of advice or recommendation. The information presented herein is done so for informational, entertainment, & educational purposes only. Please consult an attorney or licensed investment professional before taking any investment, legal, business or professional action.