Bitcoin and Ethereum are the top cryptocurrencies. However, there are various instances where investors do not feel comfortable trading them or other altcoins directly. Some investors may turn to derivative products such as ETFs, futures, options, etc. However, others may utilize tokenization as a way to lock and earn new cryptocurrencies.
What is Tokenization?
Tokenization is a process using cryptocurrency that allows the issuers of an asset class to tether the price of a cryptocurrency or denote it in the form of a virtual asset. Companies can tokenize their securities by issuing cryptocurrencies to represent their value.
It can mean that investors may be able to hold a fraction of the total market value of a security by purchasing cryptocurrencies that represent them. This feature of tokenization is called fractionalizing and it can also be applied to other sectors such as real estate.
What is Crypto Tokenization?
Cryptocurrencies like Bitcoin and Ethereum can be tokenized as well. There are various types of cryptocurrency tokenization but the underlying principle remains the same.
Investors have the option to lock their Bitcoin or Ethereum coins in a protocol such as a virtual machine or smart contract. In exchange, they are allowed to mint new cryptocurrencies that they can use to trade and perform other functions.
There are some cases, where these Bitcoin and Ethereum locking protocols require over-collateralization.
It means that the investors have to lock greater value of BTC or ETH than they are allowed to mint. Such mechanisms ensure protection for the new token issuers in case of any unexpected market movements. Several tokenized cryptocurrencies are issued against locked Bitcoin and Ethereum.
Types of Crypto Tokenization
Here are two main types of Bitcoin or Ethereum tokenization:
Custodial tokenization involves centralized custodians who lock away Bitcoin or Ethereum tokens in a cold storage wallet. The investors who are reserving their crypto coins have to trust the centralized exchange traders to keep their locked holdings secure.
Since the custodians are centralized the users have to complete the KYC/AML verification process to avail of these services. Once the coin reserves are successfully locked the protocol mints new tokens that the investors can use for various trades and other purposes.
BTCB is a tokenized Bitcoin that is locked on the Binance Smart Chain and it is a good example of custodial tokenization.
The process is automated, the investors have the option to lock their Bitcoin or Ethereum reserves in the decentralized protocols and return new tokenized virtual currencies in equal or allotted proportion.
Most non-custodial tokenization projects use the over-collateralization method to secure themselves against black swan events and other sharp market movements. In the event of a massive price fluctuation, the integrity of the system remains relatively stable and absorbs the pressure more effectively.
Ren Virtual Machine (RenVM) is a good example of this type of decentralized tokenization that issues renBTC.
Advantages of Crypto Tokenization
Tokenization allows traders, exporters, and global merchants to issue tokenized cryptocurrencies that become more accessible, compatible, liquid, and easier for remittance and international transactions.
There are countless virtual asset variants in the cryptocurrency markets. In this scenario, investors can use tokenization to access several cryptocurrencies at once like an index. At the same time, tokenization increased liquidity and accessibility.
Tokenization brings a lot of transparency for investors by publicizing all the information on the blockchain. In this manner, anyone can verify the authenticity of transactions and avoid the risk of fraud.
Tokenization of large market cap cryptocurrencies such as Bitcoin and Ethereum can reduce the transaction cost which can increase the profitability of the investors. At the same time, they also reduce the complexity of dealing with these cryptocurrencies and remove the need for any intermediaries.
Disadvantages of Crypto Tokenization
Tokenized cryptocurrencies often stand at a higher risk of security threats such as DeFi exploits and attacks on centralized custodian wallets. In the case of a centralized custodian, the investors have to take the chance that their service provider is going to remain in business.
Financial enterprises such as Bank of America have endorsed Tokenization as one of the best use cases of blockchain. However, this byproduct of blockchain still suffers from the lack of regulatory clarity.
Tokenization has affected both financial and non-financial sectors such as asset management and GameFi. There is a visible probability of tokenization becoming more popular in the near term with applications outside of the cryptocurrency market.