Tokenization: An Innovation Whose Time has Come
TOKENIZATION: AN INNOVATION WHOSE TIME HAS COME
Image Source: McKinsey & Company
It is now ten years since we shared our investment thesis with you and five years since we sat down and wrote Blockchain Competitive Advantage to help entrepreneurs, investors, corporate executives and government officials take advantage of one of the most important innovations of our time - blockchain or distributed ledger technology.
Now in 2023, our alma mater McKinsey & Company has just issued its new whitepaper Tokenization: A Digital Asset Deja Vu which lays out the process, benefits and challenges of tokenization and concludes that the time may now be upon us for broad adoption of tokenization across the financial sector. The short and easy to read paper can be downloaded from our website by clicking this link and downloading item 17. Tokenization is one of the innovations that is built on top of Blockchain.
We thought it would be appropriate to recap the perspectives we have shared for ten years now (and which we have worked on for more than twenty). Because of course we know that all of the world's assets will be digitalized and that paper and people will eventually exit stage right allowing for real time, very low cost, and easy access to digital ownership. When it happens this new innovation will allow us to prove what we own, and if we wish, buy or sell on fully digital platforms; just as we do with our communications and content. The challenge is primarily that all of the world's financial infrastructure will need to be upgraded to get there, but then we just successfully upgraded the world's communications and content sharing infrastructure (or most of it) so we know we can do it.
This time the benefits are much larger, as is the value creation which can benefit investors. Financial commerce is so much bigger than the other industries that we have digitized to date.
What is Tokenization?
In our webinar What is Tokenization? we lay out the detail and we recommend readers watch the recording for half and hour or so if they want to deepen their knowledge but here are the essentials again:
Tokenization is an innovation that enables the digitalization of the ownership record for any asset, including not only financial assets (e.g. Public Equities, Real Estate, Funds of all types, Private Equity investments, and so on) but also assets that we don't usually record ownership (e.g. most art, collectibles and personal possessions).
Blockchain is the technology upon which to build tokenization - and most of the at scale use cases today of tokenization like digital monies and stablecoins, are blockchain based.
Because the ownership record moves from paper (think share certificate, fund investment agreement, or pink slip) to digital certificate, it in turn provides the opportunity to move the information of the ownership of an asset over digital communication networks including on mobile devices.
The token, that results from the process of tokenization, does not in itself have any value. It is the asset that the token records your ownership in that has value - from zero to very large. So when someone asks you if you want to buy a token, you have to ask what is the asset ownership this token represents?
This in turn implies that you need a categorization of the asset classes that tokens can represent ownership in:
If a token records ownership of an asset, and you ask what asset do I own, you will find that there are an infinite number of answers that may come back, so know how to classify those answers.
At Blockchain Coinvestors we have a simple 8 category classification for currently investable tokens.
We only invest in four of those categories (the ones that have the ability to create new value) and only in the formation and seed rounds - we don't buy and sell publicly listed crypto tokens.
You can watch the recording of our webinar Investing in Early Stage Tokens to understand how we think about this.
The tokenization process can be broken down into steps and once we digitize asset ownership we will need digitally capable providers of traditional services that are required in asset ownership industries. McKinsey uses the following four major process steps, but there are many more possible depending upon the specifics of the asset class and tokenization process:
Asset sourcing,
Token issuance and custody,
Token distribution and trading,
Asset servicing and data reconciliation.
Because a token is software, we can append other code into the token to make it do more than record ownership:
We can bundle in code that combines, for example, a loyalty program, a referral program, a usage benefit program, and so on into the token such that when a token owner completes a behavior, they receive a reward of some type.
This is perhaps the hardest concept to get your head around - unlike a pink slip that only says you own your car, a tokenized pink slip can include any other benefit program that, for example, the car OEM wants to provide to you when you first take ownership of your car, and for all of the years that you own it.
While we expect many assets to continue to have paper based ownership records for decades, and many assets will be hybrid with dual paper based, and tokenized ownership certificates possible, the digitized variant benefits will be superior.
What are the Direct Benefits of Tokenization?
The benefits of tokenization are many. To start with the obvious and most direct benefits, take a look at this exhibit from the McKinsey report:
Just as digital communications like email and texting made our communications almost real time, free and very easy, so digital financial assets once tokenized also provide consumer benefits of lower cost, faster settlement, and an easier and more democratized access. Which is of course what every financial provider wants to deliver to their end users - all corporations seek to provide their end consumers with tangible improvements in benefits over time in competitive markets. It is only in monopolies and oligopolies that corporations forget to deliver consumer benefits to end users - which is why most industries have regulators to ensure improvements in consumer benefits get delivered over time.
What Other Innovations Does Tokenization Make Possible?
Furthermore, in the world of digital assets there are additional benefits that may be the most valuable part of the creation process of tokenization. Consider what happened when we first digitized public equities onto first generation digital formats:
In the 1980's we moved public equities from paper based share certificates and open outcry on people based trading floors, to digital records of ownership and computer based trading.
Straight away we captured benefits of lower cost trading (although it is still far from free), faster settlement times (although it still takes days to settle a public equity trade) and easier access (although almost every qualified investor still needs to go through intermediaries to trade public equities which incurs significant costs and most of the world's 8 billion people still have no direct access to public equity investing).
However, what was much more dramatic, and what drove most of the subsequent value creation in the world of public equity investing were the following changes that the version 1 digitalization of public equities enabled:
Once we had digital trading in public equities we were able to extend trading hours (although for most investors we don't have 24/7 trading yet).
We were also able to move to lower lot sizes (now fractional share trading) allowing for more investors to come into the market.
We were able to usher in a world of high frequency trading with its benefits, and risks - in turn liquidity massively increased and price discovery became better.
Perhaps most importantly we were able to create derivative products that also greatly expanded the investor set, trading volumes and investor benefits.
Today, public equities once again need to level up the technology that underpins the asset class, and leading public equity exchanges around the world are moving to tokenized approaches - most of the world's leading stock exchanges are preparing digital exchanges as we speak. Tokenization of public equities will usher in a new world of almost real time, close to free and globally 24/7 accessible public equity marketplaces with enormous end user benefits.
But of course it is the paper based assets going through their first experiences with digitalization where the initial changes and end user benefits will appear most dramatic. Massive asset classes like real estate, fund investing and private equity will be fundamentally transformed.
What Are The Challenges?
The challenges are the same as when we introduced the Internet and began to digitize communications and content. Past is a prologue. McKinsey outlines four, and they will suffice for the purposes of this newsletter:
Technology and infrastructure unpreparedness
Limited short-term business case and high cost to implement
Market immaturity
Regulatory uncertainty
It has taken more than thirty years for us to digitize the world's communications and content, and perhaps we are only 50% through that task. But to be clear - it was the greatest wealth and value creation event the world has ever seen and it drove most of the public equity alpha of recent years. The world's most valuable companies (and even all the world's less valuable companies) are totally reliant upon the Internet today.
What Did We Learn From the Internet?
So what else did investors learn from the Internet and the digitization of communications and content now that we are tokenizing the worlds' monies, commodities and asset classes?
The value was captured early by venture investors in the most successful infrastructure providers and use cases and their founders - with names like Alibaba, Alphabet, Amazon, Apple, Meta, Microsoft, Netflix, Tencent and so on.
The returns were a power curve, not a normal distribution, such that massive diversification was a requirement, not a nice to have.
A new breed of pure play Internet investors rose to be the highest performing funds in the world - mostly in the early and mid stage venture space.
At the beginning it was possible for most of us to be LP's and coinvestors with these best in breed Internet investment firms, but access diminished over time.
It was a smart strategy to selectively follow on invest, but only when the best investors in the category were doing the same.
Those of us that did have Internet investment exposure in the 90's and 00's, and followed the above best practices, received superior returns.
Because the US passed pro-innovation regulation early in the 1990's, it won the value capture battle against other nations.
We believe that these are also the best practices of blockchain investing, and by extension are also the best practices for investing in tokenization infrastructure and service providers who will themselves capture most of the value from this worldwide transformation now in its formative stages.
What Will Be Different This Time Around?
There are some important differences this time around. Both on the positive and negative sides:
On the positive side, since we have already digitized communications and content, these innovations will diffuse faster globally.
Also on the positive side, this time the whole world will want to innovate and capture the value - so this is a global, not only North American driven transformation.
However, on the negative side, the legacy paper and people based providers make so much money out of the inefficient ways of doing business that they maintain today, that some of them will actively resist changing.
Fortunately, among them, the more innovative players like, for example, Blackrock, Citibank, Fidelity, MasterCard, PayPal, Visa to name just a few who have made recent announcements, will join the ranks of disruptors like Alipay, Coinbase, Kraken, Securitze, Uphold and so on in driving tokenization.
Many investors have lost a lot of money recently because they did not know what a token was, and did not understand the asset they were buying ownership in. It is a cliche in investing that if you invest with no due diligence and no understanding of the investment you lose money - caveat emptor.
And on a final mixed note, while most of the world's financial centers are already passing pro-innovation regulation, it appears that this time around, the US will not be the first mover, but perhaps an early adopter instead (it is not conceivable to us that the world's leading financial services nation will be a laggard once this tokenization transformation really gets going).
There is more to say about how this will be different, but the key point is that by now the investors reading this newsletter will have realized that they have seen this before. What should you have done the first time around, and how can you now take advantage of that historical experience and/or insight?
How Are We Investing into This Transformation?
For our part, we saw this ten years ago and pivoted our investing 100% to take advantage of it. At Blockchain Coinvestors we have systematically, and in a disciplined way, applied the best practices of Internet investing to Blockchain (and tokenization) investing. We are already investors in many of the of the world's leading tokenization platforms and providers - at least the new to the world ones.
Our latest fund of funds has a very simple value proposition.
A SINGLE INVESTMENT ACCESSES GLOBAL, DIVERSIFIED EXPOSURE TO LEADING EARLY STAGE BLOCKCHAIN VENTURE INVESTMENTS ON AN INSTITUTIONAL PLATFORM
If you believe like McKinsey (and ourselves) that tokenization is an innovation whose time may have come, then please ask for our fund materials. Tokenization is only one of the powerful innovations resting upon blockchain technology, but it is going to be a massive value driver over the next two or three decades and you want to have exposure early - not once everyone sees it in plain view.
Contact us at ir@blockchaincoinvestors.com to learn more.
Thank you for reading.
The Blockchain Coinvestors Partners.
ABOUT BLOCKCHAIN COINVESTORS
Blockchain Coinvestors is the best way to invest in blockchain businesses. Our vision is that digital monies, commodities, and assets are inevitable and all of the world’s financial infrastructure must be upgraded. Our mission is to provide broad coverage of early stage blockchain investments and access to emerging blockchain unicorns. Blockchain Coinvestors’ investment strategies are now in their 10th year and are backed by 400+ investors globally. To date we have invested in 40+ pure play blockchain venture capital funds in the Americas, Asia, and Europe and in a combined portfolio of 750+ blockchain companies and projects including 75+ blockchain unicorns. Blockchain Coinvestors’ first fund of funds ranks in the top decile amongst all funds in its category on both Pitchbook and Preqin. Headquartered in San Francisco with a presence in London, New York, Grand Cayman, Zug and Zurich, the alternative investment management firm was co-founded by Alison Davis and Matthew Le Merle.
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