What is needed to bring tokenisation mainstream? The final article in this series offers a route map for implementation
Existing initiatives offer insight into the crucial business case for tokenisation, highlighting where challenges and upfront cost need to be embraced to deliver anticipated benefits. The final article in the series on tokenisation draws on three examples from our experience advising clients in this field: a tourism-focused real estate investment business aimed at the German retail market, new investor groups for real estate funds, and a metaverse-related initiative in France.
Our first example concerns tokenised funding for a tourism-focused real estate investment business aimed at the German retail market.
A special purpose vehicle (SPV) was created to hold ownership of holiday rental accommodation in a Mediterranean destination. Investors were given the opportunity to lend money to the venture. The loans were tokenised, carrying a right to payment of interest (with both a fixed and variable component) and repayment of the funds at the end of the loan term. The tokens were issued in small denominations, to accommodate small-scale retail funders.
Funds raised were invested in acquiring rental property to be offered to tourists. Rental income from the properties creates the revenue stream to service the loans. At the end of the loan term, the issuer will have the option to sell the holiday properties, in which case token holders will receive a bonus payment if a profit is made.
The tokens can be sold, but only on a peer-to-peer basis (privately traded) – there is no secondary market for them.
This structure needed to comply with financial regulation for debt securities in Germany (where the tokens were marketed) and was set up in consultation with the German financial regulator. Tax considerations were also important.
A token not a share
Our second example concerns opening access to new investor groups for real estate funds.
Company law in many jurisdictions requires formalities such as paper share certificates and registration of ownership. This can effectively block tokenisation of shares in an SPV. But could a token instead grant a share in the profits (or losses) of a business without amounting to a share – a “token-based profit participation right”? Such a structure is currently under discussion with the German financial regulator.
A token-based profit participation right could be useful in various ways. For example, an asset manager in Germany needs to retain a 10.1% stake – potentially a very significant investment – in a real estate SPV that is acquired by a fund to ensure the structure does not trigger German real estate purchase tax.
However, using a token-based profit participation right (or a tokenised debt instrument), it could be possible to set up a secondary fund to cover the cost of the asset manager’s stake. With tokens in small denominations, this could be offered to the retail market (assuming the main fund would have been financed by banks and professional/institutional investors), creating an alternative to syndicating the asset manager’s investment to banks.
Entering the metaverse
Our third example concerns a metaverse-related initiative in France.
This project offers the opportunity to purchase plots of virtual land, based on postcodes from the real world and existing in parallel to it. Each parcel is represented by a blockchain-based non-fungible token (NFT), which records and authenticates unique ownership of the specific digital parcel.
The parcel of digital land can be developed by the NFT owner or rented out to someone else seeking a presence in that area. Third parties are also able to supply services to the occupiers of NFT plots, and the owner receives a stream of revenue based on the amount of activity in their area. The NFTs can be traded.
This digital world is linked back to the real world because the sellers of services can also take the relationships back into real life. Potentially, replica real estate could be created in the metaverse to mirror the real world, and services such as architecture or interior design could be trialled on the digital building before being commissioned for the real-world building.
There are many more layers to this project, leveraging the potential for automation and decentralisation that blockchain can deliver and including its own currency for transactions within its closed metaverse.
What themes emerge from these three examples of tokenisation of real estate?
Financial regulatory hurdle
Financial regulation is critical to the viability of tokenisation projects.
For example, in the UK, if tokenisation is structured as fractional interests that produce a pooled return for investors, they may amount to units in a collective investment scheme. In that case, the manager will need to be authorised by the UK financial regulator. There will also be restrictions on marketing the tokens – which are likely to be problematic if the target market is individual investors.
Getting the structure right at the outset is key to ensuring a business model for tokenisation does not inadvertently breach regulation. The structure of the tokenisation initiative and plans for marketing and distributing tokens will need careful analysis. It will also be necessary to consider whether the token issuer is subject to ongoing prudential, conduct of business, and governance requirements.
Regulatory and legal analysis needs to be an integral part of the design process for tokenisation from the outset to avoid the expense and disruption of discovering either that the business model comes up against a regulatory hurdle or that the technology needs to be rebuilt to achieve compliance. Depending on the project, the regulatory analysis may include financial regulation, tax, data privacy, wider data and digital regulation, consumer law, and so on.
For a tokenisation project that can be designed to meet financial regulatory requirements, the positives of regulation are significant and should not be overlooked.
A strong regulatory foundation gives confidence to investors. In a field such as blockchain, with a mixed reputation, regulatory compliance can be presented as an indicator of credibility and seriousness. It also ensures investor and consumer protection, which can be highlighted as a benefit for token holders.
Financial services regulators are very active in examining the potential of blockchain and crypto assets specifically. There is a constantly evolving effort to understand what is needed to facilitate the digitalisation of financial services more generally.
At EU level, a regulatory framework designed for crypto assets is part-way through the legislative process. EU authorities are running a “distributed ledger technology pilot regime” to assess using blockchain for trading and securities settlement, in part to support tokenisation. Electronic securities reforms will clarify the regulatory regime around digital financial instruments and remove some paper-based formalities.
In the UK, the Financial Conduct Authority’s (FCA) "sandbox" regularly accepts blockchain-based initiatives into its cohorts, enabling start-ups to understand the expectations of the regulator while it deepens its understanding of new technologies. It is also developing a financial market infrastructure sandbox.
More generally, the FCA Cryptoassets Taskforce is reviewing how the current regulatory framework could be reformed to address crypto assets.
It remains to be seen how far these various broader initiatives will support tokenisation of real estate.
Focus on retail investors
All three of tokenisation examples are intended to be offered to retail investors.
As discussed previously, access to retail capital may be an end in itself. As well as the benefit of a bigger funding pool, fractionalised tokens enable much smaller investment opportunities, lowering the entry point.
A second consideration – particularly important at a pioneering stage – is that retail investors may have a higher appetite for risk than institutional investors. Successful retail tokenisation initiatives could, therefore, have the knock-on effect of driving adoption by professional and institutional investors.
Of course, retail financial products are regulated differently to those sold to professional and institutional investors, with a strong focus on consumer protection. Products marketed to both professional and retail investors would need dual compliance (and, as noted, depending on the design of the tokenisation initiative, in some jurisdictions regulation may be very onerous around marketing to the retail environment).
It is important to ensure the business case for a tokenisation project can absorb this cost (for example, for some proposals the higher level of fees that could be charged to retail investors will offset higher compliance costs).
Ripe for transformation
One of the reasons that blockchain has not yet become a mainstream technology is that it is often not different enough to what is already in place to overcome the cost and disruption of change.
The real estate sector remains largely analogue and traditional in its dealings. Looking beyond tokenisation for investment purposes, digitalisation could deliver smoother, cheaper and faster transactions: blockchain is well suited as the digital infrastructure for such a transformation. It was conceived to support interactions between many stakeholders, potentially without trusted intermediaries.
As previously highlighted, real estate tokens could be supported by automated information flows, delivering significant improvements to due diligence, reporting processes and data analysis about the underlying assets.
Moreover, blockchain is well suited to supporting identity verification, offering a transparent database that is also very secure. Many of the formalities of land law that deter tokenisation of title are focused on protecting parties from fraud – notarisation, witnessed signatures, requiring transactions in writing, and so on. Blockchain could support a complete rethink of traditional formalities, replacing them with protections better suited to the digital age.
Particularly in turbulent economic times, real estate is seen as a secure and stable asset class. Combining it with the digital accessibility and flexibility of blockchain could be a transformative move, particularly if data flows and the database functionality of blockchain are combined to deliver real-time transparency about the underlying asset. Tokenisation offers the opportunity to boost transparency and certainty while addressing liquidity. Although tokenisation for the retail market can face regulatory difficulties in some jurisdictions, this may not be a bar to it taking off for professional investors.
It may be that industry collaboration across the full range of stakeholders, including banks, is needed to drive forward these opportunities, spreading the upfront costs and growing adoption in order to reach the tipping point where these structures and transactions become standardised and less expensive to set up. Such a consortium could also lobby for legislative change where needed to reduce barriers and regulatory costs. In the meantime, individual tokenisation initiatives are helping to shape and refine what is possible.
Realising the full potential of tokenisation will take a great deal of effort, investment and co-ordination across providers to build an integrated offering. Stakeholders will need to open up data silos. But with so much potential in applying tokenisation to real estate, there is much to play for.