Asset-Backed Tokens: The Litmus Test

The growing popularity of Asset-Backed Tokens is bringing a host of new issuers looking at tokenizing a wide range of assets.  As we have seen, Asset-Backed Tokens have the advantage combining secure and pseudonymous ownership of assets with micro-divisibility and a high degree of trading and physical liquidity.

We have recently witnessed efforts to tokenise both financial assets such as cash (Tether – USDT), securities (Jibrel Network Token – JNT and CryDR) and funds (Brickblock – BBK); and real assets such as diamonds (D1 Coin – D1), gold (DigixGold - DGX), property (Atlant – ATL] and art (ArtCoin – ACF).  We are also seeing efforts to tokenise digital assets such as IP (MAVO – MVT) and music (Gramatik – GRMTK).  While this development will offer an exciting new array of investment alternatives to crypto investors and traders, the fact remains that many of the teams developing the Asset-Backed Tokens are approaching their projects from the blockchain technology perspective, and not from the traditional asset management perspective, and thus may lack some of the basic requirements of an asset management operation.

The blockchain benefits that accrue to Asset-Backed Tokens are undoubtedly attractive for crypto investors, but what makes these tokens attractive also requires them to have a real world infrastructure to acquire, store, safe-keep, audit and redeem physical assets.  The Asset-Backed Token market is in its infancy, and there has yet to be a set of standardised rules to govern the legitimacy of these tokens.

To help fill this gap, we can identify four basic requirements of asset backed tokens that can act as an effective Litmus Test to gauge their legitimacy, namely: Transparency, Veracity, Custody and Convertibility.

Transparency may seem like a given in a blockchain-powered market, but the level of transparency used to govern traditional tokens is insufficient in the context of Asset-Backed Tokens.  The blockchain is a digital ledger that records every transaction that occurs relating to a cryptocurrency. These ledgers contain information, such as the parties involved, a timestamp and other transaction details and is available to the public, and hence transparent. But cryptocurrencies like Bitcoin only require a record of investment transactions, since there is no underlying intrinsic value to the coin to record.  However, when creating Asset-Backed Tokens, a “double-ledger” system is required, one to record the token holders’ transactions, the other to act as a digital ledger for the assets. This second ledger records the history of each asset purchase and sale, as well the itemisation and valuation of each asset.

Veracity is a close cousin of transparency, since it attests to the truth of the assets that are recorded on the blockchain asset ledger.  Unlike cryptocurrencies and utility tokens, the value of Asset-Backed Tokens depends on the underlying assets. It is imperative that investors have proof that the underlying assets exist and that they are legally attributable to the token holders.  Issuers therefore must maintain up-to-date and verifiable records of the assets, and these must be audited by an independent party to confirm their existence and value.  For example, an issuer can issue a token backed by something as fundamental at U.S. Dollars, but if the issuer does not publish an updated account of how many U.S. Dollars are held, where they are stored or banked, and whether they are free and clear of any encumbrances, then the token holder has no way of knowing whether his tokens are really backed by assets.

Custody is another characteristic requirement of Asset-Backed Tokens that is not necessary for traditional cryptocurrencies and utility tokens.  The assets underpinning Asset-Backed Tokens are real world assets and thus need to be physically or digitally safeguarded, contractually owned, and possibly insured against theft and loss. Furthermore, the assets need to be held in escrow or in trust for and on behalf of the token owners, and thus in custody.  The custodian needs to be an independent party, preferably regulated, with a sound reputation and track record, and sufficiently capitalised.  The custodian will work closely with the auditor to ensure that the assets are accounted for and valued correctly on a regular basis.

Convertibility is the final characteristic of an Asset-Backed Token, since the token holder should be able to convert the token into the asset, or have some means of “cashing out” under any circumstances and without limitations.  As much as this sounds like common sense, seamless convertibility is currently in low supply in the crypto-market. Despite some Asset-Backed Tokens having very large trading liquidity on exchanges, they can have little or no real physical liquidity, mainly due to restrictive clauses pertaining to maximum daily volume or value that can be cashed out.

Asset-Backed Tokens hold great promise to attract traditional investors into the crypto-markets and to provide existing crypto-traders with a stable alternative to more volatile cryptocurrencies and utility tokens.  As much as Asset-Backed Tokens sound like secure investments, however, crypto investors would be well served to apply the Litmus Test of the four “best practice” characteristics of Asset-Backed Tokens – Transparency, Veracity, Custody and Convertibility – prior to investing. Few of the existing Asset-Backed Tokens can pass these four tests, though we expect that as the crypto-market matures and more sophisticated investors start to discern between tokens with better governance, these characteristics will become standard market practice.

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Hogi Hyun is a Director at D1 Mint

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The views expressed in this article are those of the author and do not necessarily reflect the views of AlphaWeek or its publisher, The Sortino Group