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Asset Backed Tokens

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Any financial asset can be recorded as a token, either directly, where the
token is the financial asset, or as a depository receipt, where the token is a
claim on a custodian for the financial asset. You may think of a share or a
bond as a physical object, but financial assets are nothing but agreements
between parties, usually an issuer and the owner of the asset. For
example, a share of a company is a legal agreement between the issuer
company and the owner of the share; a bond is a legal agreement between
the issuer and the holder of the bond; a loan is a legal agreement between
the borrower and lender. Money itself is an agreement between two
parties. Deposits in a bank account are an agreement between the bank
and the depositor, with many provisions including daily transaction
limits, daily withdrawal limits, interest, etc. A banknote is an agreement
between the central bank and the bearer.
These agreements can all be represented as tokens recorded on
blockchains or distributed ledgers.
Asset backed digital tokens take a number of forms:
1. Depository receipt tokens
2. Title tokens
3. Contract tokens
Depository Receipt Tokens
Depository receipts are tokens that are claims on a specific entity for an
underlying item. You can think of them as a digital version of a
goldsmith’s receipt for gold stored in their vault, or like a digital version
of a cloakroom ticket or left-luggage ticket. The tokens represent
ownership of the underlying item held in trust by a custodian. The receipt
ownership of the underlying item held in trust by a custodian. The receipt
could be for real world physical objects, such as gold, or for a financial
asset, such as a share of a company. When a token holder wants to
redeem a token, they go to the issuer with the token to claim back the
underlying asset. The issuer then destroys the token once they have
returned the underlying asset.
Title Tokens
Title tokens are a slightly different concept. They are the digital document
that represents proof of ownership of an asset, for example a digital title
document to a car or house. Unlike a depository receipt token, the item is
not necessarily under someone else’s custody.
How Do Asset Backed Digital Tokens Work?
Let’s take the example of Goldchain Inc, a fictitious entity. It stores
physical gold bullion in its vault on behalf of itself and its account holders
who have bought some of that gold. It issues digital tokens called
GoldchainOz to the account holders when they buy that gold. Each token
represents 1 oz of the gold bullion stored. These gold tokens are recorded
on a blockchain. They may be recorded in smart contract on the public
Ethereum blockchain, or on a private Ethereum blockchain, as assets on
any number of other public blockchains or private blockchains such as
Corda. It doesn’t really matter for these illustrative purposes. What
matters is the ability for a customer of Goldchain Inc to withdraw the
tokens and keep them in a wallet where they, and only they, have the
private keys.
Let’s assume you want to acquire 1 oz of their gold bullion. So:
1. You create an account with Goldchain Inc by going to their website.
2. You make a bank transfer of fiat funds to Goldchain’s bank account
to fund your account.
3. After a period of time (hours or days depending on how long your
bank transfer takes to get to Goldchain’s bank), Goldchain sends you
an email indicating they have checked their bank account and have
received your funds. You can now buy gold tokens.
4. You log in again and click ‘buy’ for 1 oz of gold at $1,500 per oz.
5. The money in your Goldchain account drops by $1,500, and you see
you have 1 ‘GoldchainOz’ token in your account. In the background,
Goldchain reclassifies 1 oz of gold in its books from ‘Gold owned by
Goldchain Inc’ to ‘Customer assets’. Goldchain has sold some gold to
you, but instead of shipping the physical gold to your home it has
issued you a token representing that gold. The gold token is still
under the control of Goldchain Inc because you haven’t yet
withdrawn it to a wallet entirely under your control.
6. If you wish to have the gold token completely under your control,
you can withdraw the GoldchainOz token to your independent
address. Goldchain will send a transaction to the blockchain
transferring one GoldchainOz token from their address to your
7. You can keep the token, give it to your friends, sell it, or do whatever
you want with it. Let’s say you transfer it to Alice.
8. Eventually Alice wants to redeem the token real gold, if that is an
option, or sell it for USD. She can do so by creating an account at
Goldchain Inc, transferring the gold token from her blockchain
address to their blockchain address, and requesting delivery of gold,
or selling the token back to Goldchain Inc, assuming these options
are available.
If Goldchain Inc, who controls the warehouse, is a central point of failure
and control, what is the value in using tokens? Why doesn’t Goldchain
Inc just use an Excel spreadsheet?
Firstly, the use of cryptography in blockchain technology makes the
tokens very hard to fake, and this creates more transparency over the
number of tokens issued and held by customers. The warehouse can
number of tokens issued and held by customers. The warehouse can
prove that there are not more tokens than they have gold in their vault.
An auditor would periodically match the amount of physical gold to the
number of tokens outstanding.
Secondly, existing processes of passing title documents or receipts may be
manual, time consuming or operationally challenging. Transfer of digital
tokens may be more efficient, and increasingly so as new software and
hardware is developed to manage digital assets.
Finally, in a peer-to-peer system, the warehouse itself doesn’t have to be
online and participate in transactions between customers. All it has to do
is issue and redeem the digital tokens. The trading of the tokens can
occur on whatever digital asset exchange or exchanges are chosen rather
than being managed centrally by the warehouse. The settlement of the
tokens is recorded on the chosen blockchain.
This leads to a segregation of responsibilities and opens up the possibility
of competition for each element of the end to end ‘trade lifecycle’. The
warehouse’s job is to store gold, issue tokens representing that gold, and
transfer gold to any party legitimately redeeming the token, as it would
have done under a paper-based system of old. Trading, settlement,
liquidity, collateralisation, and other functions unrelated to storage can
be done elsewhere without the warehouse having to update their records
or manage those functions. The title documents or receipts, by virtue of
being on a blockchain, can be trusted as genuine and uncounterfeitable,
and the ownership or liens on any particular lump of gold can be made
more transparent, potentially reducing the confusion relating to who has
what claim on which piece of gold.
Asset backed tokens are easy to transfer. Blockchains enable predictable
and secure record keeping. The key risk is that the issuer must remain
solvent. If the gold is stolen from the vault, or if the issuer becomes
solvent. If the gold is stolen from the vault, or if the issuer becomes
bankrupt, whether from fraud or otherwise, asset backed tokens can
become valueless.

Contract Tokens
Contract tokens represent a contractual obligation between the issuer of
the token and the bearer of the token, or between two parties who jointly
agree to hold the token. For example, a token could represent a share of a
company or an interest rate swap between two parties. Shares can be
issued by a company in the form of a token, and the owner of the token is
the shareholder. Two parties who agree on an interest rate swap enter
into an agreement which is represented by the token.
Contract tokens are slightly different from depository receipts. In the case
of a contract token, the token is the share; whereas with a depository
receipt, the token is a claim on a custodian who is safekeeping the share.
Utility Tokens
The holder of a utility token can redeem the token from a specific entity
for a product or service rather than for an asset. Sale of utility tokens is a
popular ICO strategy.
Utility tokens represent a liability of the issuing company. Eventually,
when the product or service becomes available, a token holder can
redeem their token for that product or service. In this respect, ICOs that
issue utility tokens are performing a pre-sale.

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