Tokenization 101: What It Is and Why It Matters

R Tamara de Silva

1. Introduction to Tokenization

Tokenization refers to the process of converting real-world or intangible assets and rights into digital tokens on a blockchain or other distributed ledger. Each “token” represents a share, unit, or fraction of the underlying asset. For example:

• A single piece of property can be split into multiple fractional interests, each represented by a digital token.
• Artwork, collectibles, or music royalties can be transformed into a token, granting the holder certain ownership or revenue-sharing rights.
• Traditional securities (like stocks or bonds) can also be tokenized, enabling faster settlement times and potentially broader global investor access.

At its core, tokenization is about leveraging blockchain technology to make asset ownership more liquid, transparent, and efficient. It bridges physical or intangible assets with a digital representation that can be traded, tracked, or managed seamlessly on a distributed ledger.

2. Why Tokenization Adds Value

1. Enhanced Liquidity

Traditional assets—like real estate or private equity—are often illiquid, meaning they can take a long time to sell or convert into cash. By fractionalizing assets into tokens, a larger pool of potential buyers and sellers emerges. This increased market participation can improve liquidity and potentially lead to more accurate asset pricing.

2. Increased Accessibility

Tokenization can lower investment barriers. Instead of needing large sums to buy an entire property or a significant stake in a private company, investors can purchase fractional tokenized interests. This approach opens investment opportunities to a wider audience, including retail investors.

3. Faster, Cheaper Transactions

Traditional transfers of value (such as real estate transactions) often involve extensive paperwork, multiple intermediaries, and lengthy settlement periods. Blockchain-based token transfers can occur near-instantly, with fewer intermediaries and lower transaction costs.

4. Transparency and Traceability

A distributed ledger provides a tamper-resistant record of ownership and transaction history. This can reduce fraud, improve auditability, and build trust in markets where document forgery or uncertainty in chain of title have been historical challenges.

5. Programmability

Smart contracts—self-executing agreements encoded on a blockchain—make it possible to program rules directly into the token itself. For instance, automated royalty distributions or compliance checks (e.g., verifying an investor’s accreditation status) can happen without manual intervention.

6. Global Reach

A token on a public blockchain is accessible to anyone with an internet connection (subject to regulatory compliance). This global participation can offer a larger pool of investors and more significant market opportunities.

3. Real-World Use Cases and Industry Examples

While the benefits of tokenization are clear—such as enhanced liquidity and programmability—it’s often helpful to see these concepts in action. Below are some real-world scenarios where tokenization has already begun to make an impact:

1. Real Estate Fractionalization

   • Overview: Tokenized real estate allows investors to purchase fractional shares in a property lowering the barrier to entry and broadening the investor base. Read more about this use case here.
   • Practical Benefits: Owners or developers can tap into global capital markets more easily, while investors gain access to traditionally high-value assets without having to buy entire properties.
   • Legal Considerations: Depending on the jurisdiction, fractionalized real estate tokens may be deemed securities, triggering disclosure requirements and potential licensing obligations.

2. Art, Collectibles, and NFTs

   • Overview: Artists can mint Non-Fungible Tokens (NFTs) tied to artwork, videos, or collectibles, creating a unique digital certificate of authenticity on the blockchain.
   • Practical Benefits: NFTs provide verifiable provenance, helping combat forgery in the art world. Some marketplaces also enable automated royalties for secondary sales.
   • Legal Considerations: Intellectual property (IP) issues loom large—merely owning an NFT does not always confer copyright ownership. Ensure the scope of rights (e.g., display, commercialization) is clearly defined in the smart contract or associated documents.

3. Supply Chain Management

   • Overview: Companies can tokenize commodities or products to track them from origin to final destination, recording each step on a distributed ledger.
   • Practical Benefits: Enhanced traceability and transparency can reduce fraud, streamline quality assurance, and demonstrate compliance with ethical sourcing requirements.
   • Legal Considerations: Validating the authenticity of on-chain data may require partnership agreements with suppliers, plus compliance with customs or import/export regulations.

4. Decentralized Finance (DeFi)

   • Overview: DeFi protocols allow tokenized assets to be used as collateral for loans or to earn yields through liquidity pools.
   • Practical Benefits: Greater financial inclusion, as users can obtain loans or generate returns on assets without traditional banks.
   • Legal Considerations: Rapidly shifting regulatory scrutiny is common in DeFi, especially concerning consumer protection, AML/KYC, and securities laws for yield-bearing tokens.

5. Intellectual Property & Royalties

   • Overview: Musicians and filmmakers can tokenize royalty streams, letting fans or investors purchase fractional interests in future revenue.
   • Practical Benefits: Creators receive upfront funding, while token holders gain a share of ongoing royalties.
   • Legal Considerations: These tokens often resemble investment contracts, so they may require registration or fit within an applicable exemption under securities laws.

6. Tokenizing Investment Fund-read previous article about this here.

Legal Best Practices for Tokenization

While the tokenization model offers many promising benefits, it also comes with a complex legal landscape that varies across jurisdictions. Below are some key legal considerations and best practices for businesses, entrepreneurs, and legal professionals navigating tokenization.

The regulatory framework for digital assets is expected to undergo changes in 2025. 2025 could bring entirely new or updated regulations and guidance in multiple jurisdictions, which may directly affect how tokenized assets are issued, traded, and taxed. The guidance in this article reflects the current legal landscape. The importance of staying informed about pending legislative or regulatory proposals that may alter compliance requirements cannot be overstated.

1. Understand and Classify the Token

Tokens can serve different functions. Accurate classification is crucial because the type of token often determines the applicable laws and regulations.

1. Utility Tokens
   • Give holders access to a product or service—like an in-app currency or membership pass.
   • Not necessarily securities, but if the token is marketed or used primarily as an investment, it could be subject to securities laws.
2. Security Tokens
   • Represent ownership, profit participation, or other financial rights in an enterprise.
   • Often subject to securities laws (for example, in the U.S., passing the Howey test could deem them securities).
   • Must be issued and traded in compliance with relevant securities regulations (SEC rules, exemptions, disclosures).
3. Payment Tokens (Cryptocurrencies)
   • Intended to serve as a medium of exchange or store of value (e.g., Bitcoin, Ether).
   • May be subject to different or additional regulations (for instance, commodity laws under the U.S. CFTC, or anti-money laundering (AML) requirements from FinCEN).
4. Non-Fungible Tokens (NFTs)
   • Represent unique digital items—art, music, real estate deeds, collectibles, and more.
   • Key issues revolve around intellectual property (IP), authenticity, and the nature of rights granted to NFT holders (e.g., does the NFT come with a license to display or commercialize the underlying artwork?).

Best Practice: Before launching a tokenization project, consult with legal counsel to determine the token’s nature (utility, security, payment, or NFT). This classification informs compliance obligations and risk management.

2. Comply with Securities and Financial Regulations

a) Securities Laws

If a token is deemed a security, particularly if it confers investment, voting, dividend, or ownership rights, it should be issued under a valid regulatory framework:

• Registration Exemptions: In the U.S., issuers might rely on Reg D, Reg A+, or Reg S exemptions from the full public registration requirements.
• Disclosure Requirements: Even if exempt, disclosures regarding risks, use of proceeds, and company details are important to avoid liability for omissions or misstatements.

b) Anti-Money Laundering (AML) and Know-Your-Customer (KYC)

• In many jurisdictions, token issuers or exchanges must implement KYC/AML procedures to verify users’ identities and report suspicious transactions.
• The Financial Crimes Enforcement Network (FinCEN) in the U.S. may categorize token platforms as Money Services Businesses (MSBs), subjecting them to specific registration, reporting, and record-keeping requirements. This may change in the near future.

c) Commodity and Derivatives Regulations

• The Commodity Futures Trading Commission (CFTC) may treat some digital assets as commodities (e.g., Bitcoin).
• Platforms offering futures, swaps, or derivatives tied to digital assets must comply with CFTC rules.

d) Global Considerations

• Europe: The Markets in Crypto-Assets (MiCA) Regulation introduces a comprehensive framework for crypto-asset issuers and service providers, aiming for harmonized rules across EU member states.
• Asia: Jurisdictions like Singapore have enacted legislation (e.g., Payment Services Act) to regulate digital payment token services.
• NB: If tokenizing assets for international investors, determine the regulatory requirements of each jurisdiction where tokens will be offered or traded.

3. Draft Robust Offering Documents

Clarity in documentation can avert future disputes and mitigate liability:

1. Whitepapers or Private Placement Memoranda (PPM)
   • If marketing tokens, consider providing a whitepaper or a more formal PPM to outline the project’s purpose, token mechanics, and risks.
   • Be transparent about potential hazards: technology risks, liquidity risks, regulatory uncertainties, and business model viability.
2. Token Purchase Agreements
   • These should detail the rights and obligations of both issuer and purchaser, covering ownership, transfer restrictions, and dispute resolution.
   • Include disclaimers regarding the possibility of changing regulations, forks in the blockchain, or other unforeseen events.

4. Incorporate Smart Contracts with Care

Smart contracts can automate token issuance, transfer, and rights management. However:

1. Legal Enforceability
   • Determine if a smart contract meets contract formation requirements (offer, acceptance, consideration). In many jurisdictions, smart contracts can be enforceable if they embody those essential elements.
   • Ensure compliance with e-sign laws and any specific state or country requirements.
2. Code Audits and Testing
   • Technical glitches can cause serious legal and financial problems. Conduct thorough audits to detect vulnerabilities.
   • Confirm that the coded terms match the legal terms in the written contracts, avoiding discrepancies that might lead to litigation.
3. Governance Issues
   • For security tokens that grant voting or governance rights, clarify how those votes are tallied and executed through the smart contract.
   • Plan for protocol upgrades or changes to consensus mechanisms, and how such changes affect token holders.

5. Address Intellectual Property and Licensing

If tokenizing artwork, music, or other creative assets, consider:

1. Ownership vs. Licensing
   • Holding an NFT or token does not always confer full IP rights. Clarify whether the buyer receives a license to display or commercialize the asset.
   • In some cases, the buyer only owns a digital certificate of authenticity, not the underlying copyright.
2. Royalty Mechanisms
   • Smart contracts can automate secondary sale royalties for creators. If you choose to include royalty functionality, verify it does not conflict with local IP or resale laws.
   • Note that enforcement of on-chain royalties can be complicated if secondary marketplaces opt out of enforcing them.

6. Ensure Data Privacy and Security

In jurisdictions with strict data protection laws (e.g., GDPR in the EU, CCPA in California), tokenization platforms might:

1. Collect Personal Data during KYC/AML checks.
2. Store that data, possibly off-chain due to blockchain’s immutability (once on-chain, data cannot be altered or deleted).
3. Implement robust security measures to prevent breaches, given that sensitive data could be targeted by cybercriminals.

Best Practice: Maintain compliance with relevant privacy regulations, and consider using privacy-preserving technologies or off-chain solutions for any sensitive data.

7. Factor in Tax and Accounting

Tokenization can trigger complex tax and accounting challenges:

1. Taxable Events
   • Selling or transferring tokens at a gain or receiving dividends from security tokens can create taxable events.
   • The classification of tokens (commodity vs. security vs. currency) can alter tax treatment significantly.
2. Accounting Standards
   • Determining fair market value for illiquid or newly minted tokens can be difficult.
   • Regulatory authorities have published guidance, but many gray areas persist. Staying up to date and working with accountants experienced in digital assets is prudent.

8. Build a Compliance-First Culture

A proactive compliance strategy can prevent costly enforcement actions and protect a company’s reputation. In our practice, we run into many cases of businesses who pay the price for selecting law firms that do not establish and encourage compliance protocols, or worse yet, are not familiar with compliance. This can lead individuals and businesses to spend many multiples of what they paid their first law firm, to address a regulatory action. Here are some (non-exhaustive steps):

1. Early Regulatory Engagement
   • If uncertain about classification, consider seeking guidance from regulators (e.g., SEC no-action letters). The regulatory landscape that addresses tokenization evolve and change in the near future but in the meantime, do not wing it.
   • Maintain open lines of communication to address potential concerns before a public launch.
2. Ongoing Education
   • Blockchain regulations evolve relatively quicky. Appoint or consult with legal experts who closely monitor new laws and enforcement trends. Speak to more than one law firm whenever possible. If you are a lawyer starting to practice in this area, consult with lawyers who are more experienced to make sure you do not miss anything.
   • Regularly update tokenization workflows, offering documents, and compliance checklists to reflect the latest guidance.
3. Liability Mitigation
   • Obtain directors’ and officers’ (D&O) insurance that covers digital asset activities.
   • Draft indemnification agreements with partners to allocate risk if regulatory actions or lawsuits arise.

9. Ethical and Professional Responsibility

For lawyers advising on tokenization:

1. Model Rule 1.1 (Competence)
   • Stay current with blockchain-related developments.
   • If you lack technical expertise, collaborate with knowledgeable counsel or technology specialists.
2. Confidentiality and Conflicts
   • Model Rule 1.6: Public blockchains are transparent, so ensure client data is safeguarded.
   • Model Rule 1.7: Avoid conflicts of interest, especially in complex token offerings with multiple stakeholders.
3. Unauthorized Practice of Law
   • Cross-border offerings may raise jurisdictional issues.

Conclusion and Key Takeaways

Tokenization is already being used to change how assets are owned, traded, and managed.  It has the potential to democratize investment opportunities and unlocking new business models. However, the regulatory environment is complex and a new regulatory regime may take shape in 2025. Remember that proper due diligence, conducted by legal, financial, and technical professionals, is essential for compliant and successful tokenization projects.

• Best Practices involve:
  1. Thoroughly classifying the token.
  2. Complying with securities laws and financial regulations.
  3. Providing robust disclosure and contractual clarity.
  4. Auditing and legally reviewing smart contracts.
  5. Addressing data privacy, cybersecurity, tax, and accounting considerations.
  6. Maintaining a proactive, well-informed compliance culture.

By prioritizing legal compliance and technical rigor, businesses and investors can harness the liquidity, accessibility, and transparency benefits of tokenization while mitigating risks and uncertainty. If you are a corporate entity looking to tokenize real-world assets or an investor interested in exploring tokenized securities, take the time to understand legal best practices.

If your business is considering tokenization, our firm provides strategic legal guidance to help navigate compliance risks. Contact us for a consultation to help ensure your tokenization strategy aligns with current and future regulations

Further Reading and Resources

1. SEC Framework for “Investment Contract” Analysis of Digital Assets (2019)
2. CFTC Primer on Virtual Currencies (2017)
3. Financial Action Task Force (FATF) Guidance on Virtual Assets
4. Markets in Crypto-Assets (MiCA) Regulation (EU)
5. American Bar Association (ABA) Blockchain and Cryptocurrency Resources
6. Local Bar Association for state-level regulatory guidance

Disclaimer: The information provided in this guide is for general informational purposes only and does not constitute legal advice. Consult with qualified professionals to address your specific circumstances.