Tokenizing commodities is a killer use case for DeFi. Commodities are physical goods such as precious metals or physical art traded on exchanges. Commodity tokenization refers to creating digital tokens representing a commodity’s ownership. This process allows for fractional ownership of commodities and enables investors to buy and sell commodities in smaller quantities. This Cryptopolitan explores the benefits of commodities tokenization and why it is a killer use case for DeFi.
What is commodity tokenization?
Commodity tokenization converts a physical asset, such as gold or silver, into a tradeable digital token on a blockchain. In other words, it involves creating a digital representation of the underlying commodity on a blockchain, representing asset ownership.
You achieve commodity tokenization through smart contracts, i.e., self-executing programs that automate transferring ownership and other actions related to the commodity token. For example, a smart contract can represent ownership of a specific amount of gold, and the token traded on a decentralized exchange (DEX) like Uniswap or SushiSwap.
How does DeFi asset tokenization work?
DeFi is a financial system that uses blockchain technology to provide traditional financial services or products built on top of a decentralized and uncontrolled blockchain infrastructure. This system uses automated programs to perform the conventional banking functions of traditional finance (TradeFi). DeFi can replace TradeFi, where control is distributed among stakeholders and gives users greater asset control.
To tokenize an asset in DeFi, one must first create a smart contract that defines how to represent it on the blockchain. The smart contract will specify the number of tokens created and what each represents. Once the smart contract is complete, it is deployed on the blockchain and becomes immutable.
After deploying the smart contract, users can purchase tokens representing ownership in the underlying asset. These tokens can be traded on decentralized exchanges like Uniswap or Sushiswap, allowing for more efficient and transparent buying and selling of the underlying assets.
Advantages of commodity tokenization
Commodity tokenization offers several advantages over traditional forms of commodity investing; these include:
Fractional ownership
Commodity tokenization allows for fractional ownership, meaning investors can buy and sell small amounts of the commodity without purchasing an entire physical asset. Tokenization makes investing in commodities more accessible to a broader range of investors, including those who may not have the resources to invest in physical gold or silver.
Easier transferability
Unlike physical assets requiring physical delivery, you can transfer commodity tokens instantaneously and cheaply. Investors can quickly and easily move their holdings between different wallets and exchanges without worrying about the logistics of physically transferring the asset.
Reduced counterparty risk
Commodity tokenization also reduces counterparty risk, as investors can hold the underlying asset directly rather than through a third-party custodian. Investors are not reliant on the financial health of a third-party custodian and are instead in control of their assets.
Lower transaction fees
Commodity tokenization can also lead to lower transaction fees. Traditional commodity trading involves several intermediaries who take a cut of the transaction. In contrast, commodity tokenization allows for peer-to-peer transactions, which they can execute at a lower cost.
A killer use-case for DeFi
According to a report by Citi, “Money, Tokens, and Games,” blockchain technology is at an inflection point, and the tokenization of financial and real-world assets could be blockchain’s killer use-case. According to the analysis, tokenization in private markets will increase dramatically, reaching a value of up to $4 trillion by 2030, an increase of over 80 times.
The benefits of tokenization will encourage demand-side adoption, particularly for private funds and securities, by replacing expensive reconciliations and settlement failures with better operational efficiency, fractionalization, and accessibility to different market players.
Commodity tokenization can enhance DeFi in several ways. For example, DeFi protocols can create complex financial instruments that allow investors to hedge their positions, borrow against their assets, or access leverage. Additionally, DeFi can create new forms of collateralized lending, where investors can borrow against their commodity tokens without selling them.
Collateralization of tokenized commodities
Collateralization is pledging an asset as security for a loan or other financial obligation. When an asset is collateralized, it is held as security by the lender or creditor, who can seize it if the borrower defaults on the loan or obligation.
In tokenized commodities, collateralization involves using the tokenized asset as collateral for a loan or other financial transaction. Collateralization enables investors to access liquidity without selling their underlying assets while providing lenders with high security and collateralization.
Collateralization of tokenized securities works by using smart contracts to automate the process of pledging and releasing collateral; when investors want to borrow against their tokenized security, they can use a smart contract to pledge the security as collateral. The smart contract holds the commodity as collateral and releases it to the investor once they repay the loan or obligation.
Collateralization can reduce counterparty risk for lenders and creditors. By pledging a tokenized security as collateral, lenders can be confident that they will be able to recover their assets in the event of default.
Collateralization can also increase the efficiency of the securities market by enabling investors to access liquidity more efficiently. The process reduces transaction costs and improves the overall liquidity of the market.
Benefits of combining DeFi and commodity tokenization
DeFi offers several advantages when it comes to commodity tokenization. First, DeFi allows for peer-to-peer transactions, meaning investors can buy and sell commodity tokens without relying on a centralized exchange. Decentralization reduces the risk of exchange hacks or shutdowns, a significant concern in traditional finance.
DeFi offers a high degree of transparency and security. By using smart contracts to automate transferring ownership and performing other actions related to the commodity token, investors can be confident that their assets are secure and that transactions get executed as intended.
DeFi enables investors to earn a yield passive income on their commodity tokens through various liquidity provision strategies, such as staking or providing liquidity to decentralized exchanges. Such methods provide an additional source of income for investors, making commodity investing even more attractive.
Real-world use cases of asset tokenization
Blockchain asset tokenization helps parties develop custom solutions for their respective industries. Asset tokenization is becoming more critical as blockchain technology gains momentum allowing these industries to create smart solutions. Here are some famous use cases for asset tokenization on blockchain:
Real Estate: Tokenizing real estate assets can help investors buy fractional ownership in properties that were previously out of reach due to high costs or regulatory barriers. They help democratize access to real estate investments and provide liquidity to traditionally illiquid assets.
Art: Tokenizing art can help democratize access to art investments and provide liquidity to traditionally illiquid assets.
Commodities: Tokenizing commodities like gold or oil can help investors buy fractional ownership of these assets without physically storing them.
Intellectual Property: Tokenizing intellectual property like patents or copyrights can help creators monetize their work more quickly by selling fractional ownership.
Collectibles: Tokenizing collectibles like sports memorabilia or rare coins can help collectors buy fractional ownership of these assets without physically storing them.
Supply Chain Management: Asset tokenization can track goods through the supply chain, providing greater transparency and traceability.
Gaming: Tokenizing in-game items like weapons or skins can help players buy and sell these items more quickly.
Carbon Credits: Tokenizing carbon credits can help companies offset their carbon footprint by buying fractional ownership in carbon credits.
Music Royalties: Tokenizing music royalties can help artists monetize their work more efficiently by selling fractional ownership in their royalties.
Real Estate Investment Trusts (REITs): Asset tokenization can create REITs that allow investors to buy fractional ownership in a portfolio of real estate assets.
These are just a few examples of how asset tokenization is used in today’s real world.
Components required to scale commodity tokenization
Several components must be in place to scale the tokenization of commodities. These include:
Fully digitized workflow
A fully digitized workflow is essential for the efficient and cost-effective tokenization of commodities. The process involves digitizing the entire process, from the token issuance to the transfer of ownership. By using smart contracts and other digital tools, investors can easily buy and sell commodity tokens, and issuers can manage the tokenization process more efficiently.
Support from traditional finance layers
Support from traditional finance layers, such as banks and financial institutions, is necessary. These institutions can provide the infrastructure and expertise needed to manage the tokenization process and access a broader pool of investors.
Technology-neutral laws
To facilitate the growth of commodity tokenization, laws, and regulations must be technology-neutral. The legal framework should be flexible enough to accommodate emerging technologies, including blockchain and smart contracts. Technology-neutral rules will help to reduce uncertainty and encourage innovation in the commodity tokenization market.
Standardized taxonomy
A standardized taxonomy is essential for the efficient and transparent trading of commodity tokens. Standardizing taxonomy involves creating a common language and set of commodity definitions, which can reduce confusion and facilitate more accurate pricing. Standardized taxonomy can also improve liquidity by enabling investors to compare and trade different commodities more easily.
Built-for-purpose legislation and regulation
The legal framework should be designed for commodity tokenization rather than trying to shoehorn existing regulations into this new and emerging market. By building legislation and regulations for this purpose, we can ensure that the commodity tokenization market is safe, transparent, and efficient.
Challenges of commodity tokenization
While commodity tokenization offers many advantages, it also presents several challenges.
Regulatory challenges
One of the primary challenges of commodity tokenization is regulatory uncertainty. The tokenization of financial and real-world assets raises several legal considerations, including:
Compliance with securities laws
Governments may regard tokens as securities depending on the asset’s characteristics and the relevant legislation in the jurisdiction. As a result, all applicable laws and ordinances, such as those governing registration, disclosure, and anti-fraud provisions, must be followed during the issue and trading of the tokens.
Property law
tokenizing real-world assets raises questions about property ownership and transfer. The tokenization process must address the legal rights and obligations of owning and transferring the underlying asset.
Taxes
Issuers and investors may be affected by the tokenization of financial and physical assets by capital gains, sales, and indirect taxes.
Security concerns
While smart contracts can reduce the risk of fraud and manipulation, there is still the risk of smart contract bugs or hacks. Additionally, there is a risk of theft or loss of private keys, which could result in the loss of an investor’s assets. As commodity tokenization is a relatively new field, best practices for security are still evolving, and investors must be cautious when investing in commodity tokens.
Scalability issues
Commodity tokenization may also face scalability issues. As more investors participate in the market, the number of transactions on the blockchain could increase significantly, leading to higher transaction fees and longer confirmation times. Scalability issues could limit the growth of the commodity tokenization market and make it less attractive to investors.
Conclusion
Commodity tokenization is a game-changing development in finance and a killer use case for DeFi. Tokenizing commodities such as gold and silver brings several advantages, including increased liquidity, accessibility, and reduced counterparty risk. Moreover, combining commodity tokenization and DeFi creates new opportunities for yield farming, staking, and other liquidity provision strategies, making it an exciting option for investors.
As the DeFi ecosystem develops, more cutting-edge and intriguing use cases will emerge. Commodity tokenization is an area ripe for study and innovation, whether you’re a trader looking for new opportunities, an investor hoping to diversify your portfolio, or a developer looking to build the next major DeFi platform.
