Tokenized commodities, explained
Tokenized commodities represent fractional ownership of real-world assets using digital tokens on a blockchain while preserving their tangible value.
Tokenized commodities are digital versions of real-world items like gold, oil or crops recorded on a blockchain. Each token represents a part or whole of a commodity, making it easier to divide and trade. This simplifies buying and selling small portions for investors, provides more liquidity, and offers access to markets that are usually hard to trade in.
Imagine you have a giant pizza that’s too big for one person to eat alone. Instead of giving the whole pizza to one person, you cut it into slices. Now, each person can buy and enjoy the right amount that suits their appetite.
Tokenizing physical commodities works similarly. A commodity, like gold or oil, is the giant pizza. Instead of buying the entire commodity (which can be very expensive and impractical), it is divided into smaller pieces called tokens. Each token represents a small portion of the commodity.
Process of tokenization
Have you ever considered possessing a small portion of an oil barrel or a fraction of a gold bar? These are tokenized commodities, where blockchain technology meets traditional assets.
Tokenized commodities become digital tokens, opening up new channels for trading and access for investors. Here are the steps involved in the tokenization process:
- Create the tokens: Create tokens representing the commodity. One way to accomplish this is to establish the property owner’s identity as a legal entity. The tokens enable holders to have a share in the value of the commodity.
- Execution of smart contracts: Smart contracts implement the distribution, monitoring and payment of rewards derived from digital tokens. Once initiated, these programs operate without human interference.
- Token distribution and sale: Tokens are distributed to investors via smart contracts through private sales, public sales or a combination of a whitelist model. Whitelisting is a setup that allows only preapproved or trusted users, entities or actions to operate.
- Asset management: After the sale of tokens, the new holders can participate in managing the underlying commodity. The smart contracts specify the extent of control and the process for tokenholders to make decisions.
- Trading on secondary markets: After launch, tokens can be exchanged on secondary markets, creating liquidity. Unlike traditional commodity investors who might find it difficult to sell properties, tokenholders can sell their shares more readily.
Types of tokenized commodities
Blockchain technology can help tokenize various commodities, including energy resources, real estate, precious metals and agricultural goods.
Let’s explore various kinds of tokenized commodities:
- Precious metals: Tokenizing precious metals such as platinum, gold and silver enables investors to hold tiny fractions without physical storage. This facilitates portfolio diversification and hedging while also increasing accessibility to these assets.
- Energy resources: Tokenizing energy refers to converting actual energy sources, such as solar or wind power, into digital units on a digital platform. This facilitates new energy-related use cases, such as exchanging surplus solar energy among neighbors, simplifying renewable energy credits and improving grid management.
- Agricultural resources: Blockchain enables the tokenization of agricultural resources, creating secure records representing a product exchanged on a digital ledger. This brings efficiency, safety, openness and cost reduction to commodity trading for retail investors.
- Real estate: Investors could tokenize a property by splitting it into smaller pieces and using smart contracts to automate operations. The records are stored on a secure digital system. The owner can prove their ownership using a private key. Anyone interested in buying, renting or financing can easily check the property’s history utilizing this system. Past transactions regarding the property, including any outstanding debts, are shown as transparent, unchangeable records.
Tokenized commodities vs. commodity-backed cryptocurrencies
Commodity-backed cryptocurrencies are digital assets designed to be more stable than volatile cryptocurrencies. This stability is achieved by linking their value to tangible commodities such as real estate, gold or oil.
A company or organization holds the actual goods and issues tokens representing a specific amount of that commodity. The token’s value fluctuates in line with the cost of the underlying commodity.
For example, the commodity-backed cryptocurrencies Tether Gold (XAUT) and Pax Gold (PAXG) are both backed by actual gold. Similarly, other cryptocurrencies could be backed by commodities such as oil reserves or other precious goods.
The table below explains how tokenized commodities differ from commodity-backed cryptocurrencies:
Benefits of commodities tokenization
Tokenizing commodities has clarified ownership, enabled fractional ownership, simplified trading and boosted market activity.
Let’s understand the advantages of tokenized commodities using the example of gold-backed tokens.
- Increased liquidity: One significant advantage of tokenized commodities is increased liquidity. By converting commodities like gold into digital tokens, these assets become easily tradable on blockchain platforms. This allows investors to buy and sell fractions of commodities without using middlemen, reducing the cost and duration of transactions.
- Fractional ownership: Fractional ownership is another important advantage of tokenized commodities. It allows more investors, who might not have the funds to buy complete units, to access commodities. This makes commodities more accessible for investors, allowing them to diversify their portfolios.
- Better security and transparency: Tokenization uses a blockchain that acts like a digital notebook that records every transaction. This notebook can’t be changed, ensuring transparency and security, as everyone can see who owns what.
- Easier trading: Traditional methods of trading commodities can be time-consuming and complex. Digital tokens allow users to trade conveniently at any time and from any location, making the investment process more straightforward.
Risks of tokenized commodities
While promising, tokenized commodities face challenges. Rules aren’t always clear, as existing ones may not cover them completely. The technology behind tokenized commodities must be appropriately tested to handle the complexity of creating and trading these tokens.
Continuing the example of gold-backed tokens, let’s dive into the risks associated with tokenized commodities.
- Liquidity: Tokenization serves little purpose if the secondary market isn’t large enough to handle transaction volume. Building market depth requires trust between institutional investors using blockchain technology and traditional market players.
- Standardization and interoperability: Smooth integration of tokenized commodities with existing financial systems requires standardization and interoperability. Compatible token standards, smart contracts and data formats across various blockchain platforms and commodity markets are necessary for efficient transaction settlement and asset transfer.
- Cybersecurity: Protecting the integrity of tokens, private keys and sensitive transaction data requires strong security measures, such as encryption and two-factor authentication (2FA). Continuous monitoring is needed to guard against theft, hacking and exploitation.
- Regulatory challenges: Tokenized physical commodities are subject to laws governing securities, commodity trading and financial markets. To comply with these laws, strong governance must be established to prevent fraud, market manipulation and regulatory breaches.