Tokens and Tokenization: Still a Gordian Knot for the Future of FinTech?

Tokens and Tokenization: Still a Gordian Knot for the Future of FinTech?

Carlos Fernandez-Herraiz (Grant Thornton, Spain), Sara Esclapes-Membrives (Grant Thornton, Spain) and Antonio Javier Prado-Dominguez (Universidade da Coruña, Spain)
Copyright: © 2020 |Pages: 27
DOI: 10.4018/978-1-7998-2440-4.ch002

Abstract

The authors have carried out an examination of the status of tokens and tokenization in financial markets with regulatory problems, which lack proposals for solutions based on a generalized consensus. Overall, it seems to authors that cutting the Gordian knot of tokenization and tokens is the essential need to achieve a consensual and efficient protocol of unequivocal attribution of legal responsibility to obtain satisfactory levels of transparency and reliability in all transactions. In particular, tokens that claim to be money appear to have a more complicated potential development than the rest, since there is a controversy between the pressures of the sector agents and the specific restrictions indicated by Knapp and Ingham and maintained by the states and regulators with respect to its exclusive regulatory capacity over money as a means of payment of a wide and reliable acceptance.
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Introduction

The emergence of communication protocols that structure information as chains of blocks of information linked in a cryptographic way represents a profound technological-instrumental innovation for the financial system. These protocols are generically referred to as blockchains. However, blockchain is only a part of a larger set, commonly known as distributed ledger technologies (DLT), whose aim is to enable a group of parties to manage a non-centralized database. Authors acknowledge the different definitions available for DLTs and blockchains however, in this document, both terms will be used interchangeably.

DLTs admit and foster the representation and transfer of previously existing goods and rights, the creation of new goods and rights and the natural experimentation and evolution on market mechanisms. Such possibilities entail the development of reward and punishment models associated with the positioning of market participants’ interests. A process that can be expected to be intense, but in some way similar to those already experienced in the past, as a consequence of other significant procedural advances in financial system.

Main, but not exclusively, DLTs are built with the aim of not depending on the role of a trusted intermediary or third party in the process of representation and transmission of value. The ability to maintain and transmit value as well as the ability to dispense with third parties could be considered as the two main aspects in the solution given by these technologies.

Regarding representation and transfer of value, blockchain makes possible to create units of account or complex financial products, digitally represent real assets or any right, and transfer them with great ease. These units of account are commonly known as “tokens”, and its transfer is simple since all the agents participating in a system fed by this technology have either the same duplicated information, or mechanisms to indirectly verify the good purpose and existence of the transactions executed in the network.

The first DLT arose to support a new means of digital payment, known as Bitcoin (considered a type of token), which was formulated as the first means of payment capable of overcoming the problem of double spending in the transfer of purchasing power by electronic means. Thus, the original Bitcoin white paper by Nakamoto (2008) allude to “digital cash”, proposing a system that supports the exchange of purchasing power with the same guarantees as a physical transaction, but dematerializing the means of payment and making remote transfer possible.

This leads to the second aspect of the solution given by distributed ledger technologies: absence of trusted third parties. The existence of the problem of double expenditure in the transmission of value is one of the main reasons that determine the role of trusted third parties in the payments function and, in general, in the transmission of value in the current financial system. Trusted third parties, or reliable intermediaries, fully process the registration, maintenance and updating of purchasing power records, securities registers or financial contract registers. They do so within the framework of a system of guarantees based on the regulation and control of their activity.

This process has been historically absorbed by financial institutions, due to feedback between convenience for users, regulatory barriers and competitive advantages for the banking institutions themselves. The coexistence between payment function and credit function allows institutions to expand their balance sheet and create money supply, based on their risk appetite and within the framework of regulatory compliance.

Due to the fact that DLTs are communication protocols that, in turn, lay on internet communication protocols, there should not be appreciable difference between transferring value using that protocol between users who are closer or more distant in geographical terms. This also implies another revolution compared to current value transfer systems. Today's payment systems are multi-local, so the transmission of purchasing power between different parties located around the world is not a trivial problem. Blockchain-based payment systems simplify this problem by sending units of account with the same simplicity as sending units of information. The challenge is how to articulate these units of account from an economic and legal point of view as well as the system that support them: blockchain, and this question inevitably invokes the concept of money.

Key Terms in this Chapter

Representative Tokens: Tokens that reflect, refer to or symbolize (tokenize) in a DLT environment an existing good or right in the physical world.

Asset Tokens: Tokens that have its own intrinsic and stand-alone value and, therefore, can be considered products.

Product Challenge: All legal challenges derived from representing new assets or any kind of value, good or service in a decentralized platform.

Tokenization: The creation of a token representing either a good or a right over an underlying asset whose properties are verified by blockchain. Tokenization is, in consequence, the process of converting the value of an asset, tangible or intangible, into tokens that can be recorded, exchanged and stored in a blockchain system.

Security Token Offering (STO): The issuance of tokens representing securities and following regulatory standards for traditional securities issuance.

Initial Exchange Offering (IEO): ICO released through a exchange, introducing KYC and AML considerations.

Market Challenge: All legal challenges derived from the way of issuing, distributing, and trading tokens in a decentralized platform.

Cryptocurrency: Tokens whose function resembles legal tender coins or means of payment, but in a blockchain environment.

Initial Coin Offering (ICO): Public and decentralized issuance of tokens.

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