What is Tokenization? A Practical Explanation
Tokenization has been a hot topic for a while now, steadily raising its awareness within the general public. However, it is fair to say that an average user’s perception and knowledge regarding tokenizing assets is merely on the surface level.
As the prevalence of this process is growing stronger in a variety of industries and niches, it stands to reason that expanding our understanding of what is tokenization is instrumental. Being an expert company working with tokens, we put together a comprehensive guide on this topic.
In our article, you will find plenty of valuable information on what this process is and how it works, the difference between encryption, its history, benefits, and much more. If you have any questions about tokenizing your assets, be sure to contact Limeup for more information.
What is tokenization?
In the most essential breakdown, tokenization refers to hiding or replacing sensitive data or information with elements that are not sensitive and are generated randomly by a system. These non-sensitive elements are widely known as tokens.
The purpose of this replacement process is to make sure that the link in between the actual values of the data and the values of a token couldn’t be tracked or deciphered. Unlike encryption, the tokenization process provides a link to the real data within a token but leaves no option to uncover what that data really is. We will talk more about this distinction later in the article.
Explanation of the tokenization process.
By now it should be becoming clearer that the main purpose of tokenization and the reason behind why it is becoming all the rage these days is its promise of security and privacy protection. Even in an instance of the token landing in unauthorized hands and perpetuating unwarranted access, the information kept inside it won’t be possible to access or intercept.
Since its inception into the public domain there have been several most commonly recognized use cases for tokenization. Perhaps the biggest one is real estate tokenization which involves splitting down assets to create fractional ownership of the property. Thus ultimately helping a typically illiquid market increase its liquidity.
Another remarkable niche where tokenization is planting its roots is artwork. In recent years it was hard to avoid discussions around Non-Fungible Tokens or otherwise known as NFTs. These tokens transform conventional ownership rights for an intellectual property in realms like painting and photography. Now, using NFTs artists can claim authentic ownership of a piece of art they have created.
Of course, it is also worth mentioning that some amount of controversy will inevitably follow new and emerging technologies with tokenization being no exception. There are also challenges and limitations to consider when it comes to tokenizing data for various purposes such as legal regulations and complex compliances.
Still, let’s put these notes more into a perspective. Research from Fortune Business Insights states that the market for tokenization was valued at $2.81 billion in 2023 and is projected to grow to a staggering $9.82 billion by the year 2030. This estimation suggests that the compound annual growth rate (CAGR) of the tokenized market is currently sitting at an impressive 19.6%.
This growth tendency just goes to show that tokenization is catching on with the public and is here to stay. Hence why it is important to get to the bottom of this phenomenon and how it works to stay in the loop.
Types of tokens
In order to understand what kinds of tokens exist, we need to first level up on what types of tokenization are out there. After all, it is not a one-size-fits-all process and there are different principles and purposes at the heart of each type.
One vital aspect we need to keep in mind is that not all types of tokens operate on a blockchain-based technology. While it is the most common approach, at least in the eyes of the public, it is not always the case.
Types of tokens.
Blockchain-based tokens are typically built on a decentralized platform such as Ethereum, IBM, Hyperledger Fabric, etc. At the same time, the other type leverages centralized entities to create, manage, and transfer tokens, for example, in-game reward tokens.
With that in mind, let’s take a closer look at the examples of tokenization in the context of real-life usage of tokens, i.e. what types of them exist:
- Access tokens. Possibly the most common type of tokens which we touched upon in our previous chapter. Essentially, access tokens carry the credentials of the person to later allow for authorization or authentication within a system. Access tokens are frequently used in API (Application Programming Interface) security so as to control who gets to enter the services.
- Security tokens. These are most often associated with the real estate and property fractionalization topic we covered. Security tokens are meant to represent one’s ownership over something warranted by a token which can include but not be limited to equity, commodity, shares, and so on. This type of token is regulated by legal entities, however.
- NLP tokens. Natural Language Processing tokens are quite unique in their purpose because they are meant to separate textual information into smaller pieces so that a computer or a machine is capable of reading it. Based off the preconditioned requirements and algorithms for the analysis, sentences are specifically split to be able to get processed.
- NFT tokens. As we mentioned above, Non-Fungible Tokens are blockchain-based and are aimed at representing the digital ownership of a person over intellectual property or other unique items. With NFTs, an artist or a creator can prove their authenticity in regards to the tangible items like artwork, as well as non-tangible things including digital content.
- Utility tokens. In a broader sense of this term, utility encompasses any item a person can purchase or access a service using this kind of token. They do not represent ownership rights but rather allow for access to certain services or features. For example, utility tokens may be an in-app currency that lets you make a payment to upgrade your subscription to a premium level.
- Governance tokens. Lastly, the type of token worth exploring is the governance one. They delegate the power to the bearer to make decisions in terms of development and allocation processes. In other words, it enables a person to vote on matters that concern the system behind why the token was issued in the first place.
History of tokenization
When looking back at how the modern state of tokenization came to be we can trace it back to the beginning of the 2000s. The company that goes by the name TrustCommerce proposed the concept of tokenization as a revolutionary way to protect the sensitive data of their client.
As a method to mitigate risks of leaks in case of data breaches, the company developed a platform known as TC Citadel that would transform the payment card data into what we know call a token. That way, the customers would safely make transactions without the need to store any information about the card and be rest assured.
While these are the roots of data security tokenization in today’s context, the actual concept of tokens predates this time. You only need to think of casinos and chips that a player receives in exchange for their money which serve as a sort of currency in the establishment to get a grasp of its extensive history.
You can tell that the tokenization process has been underway for many decades now, and looking at it from the perspective of 2024, it is becoming more accepted and used across the board. With the development of the blockchain-based technology almost any asset that carries a value is possible to be tokenized to purchase, sell, trade, and invest in.
The early rise of cryptocurrencies and blockchain platforms like Mastercoin and Colored Coins proved to be with a turmoil and a set of challenges. However, the arrival of Ethereum’s decentralized system in 2015 set into motion a wholly new approach to tokenizing assets of any complexity and scale with the mass utilization of smart contracts.
There were many noteworthy milestones coming along the way that marked how the process operates today. Like we mentioned, smart contracts now opened the gates to allow for verification, transfer and management of ownership rights without the need for third parties.
Over time, what was once a legal and regulatory landscape that is hard to navigate became more transparent in certain regions of the world. In places like Europe institutions have set the stage to legitimize the use of tokens for real-world assets inviting the opportunity for investors to seek this process confidently.
In the end, the growth of this industry is undeniable and there is no doubt that the regulatory frameworks are evolving to suit the needs of this market to facilitate its further expansion.
How does tokenization work?
In its most basic form, tokenization entails the process of converting sensitive data into an appropriate type of a token that is represented as a randomized alphanumeric ID. This token consequently carries no attachment or connection to the account of the owner.
That data can be credit or debit card information, social security number, or any other personal identifiers. The nature of the token allows it to be indecipherable and holds no meaning or value so in case the data is breached, the personal information contained within it cannot be accessed.
The process of how tokenization works.
To wrap your head around how tokenization works we need to talk about the platform for tokenization. This platform is responsible for the process of issuing and managing tokens as they are securely stored in the data base. A concept of data mapping is introduced to help link the data and any related information with its substitute token in the same data base.
Software development services can be employed to aid businesses in integrating tokenization systems, payment gateways, and other features into the platform’s software, web, and mobile applications. Partnering with professional providers can warrant a secure and compliant platform development for sustainable and scalable operation.
Speaking of how the stored data on the token is retrieved we come back to the mapping table or a data base where the relevant information is located. When the token needs to be used during a transaction or other activity, the system retrieves the corresponding data in order to be processed and de-tokenizes the ID to confirm the payment.
In a nutshell, the tokenization system is fairly easy to comprehend when you witness the full picture of the process. The main takeaway is that it offers complete security with the token being readable only through a payment processor being useful to a single merchant.
Benefits of tokenization
Now that you are more aware of the tokenization definition, its history of coming into the spotlight, and how this process works, you might be asking yourself a question of what kinds of advantages it brings to the forefront. Indeed, it may not be as obvious to the naked eye what makes tokenized assets so attractive to the investors that it pushes the market so rapidly.
Main benefits of tokenization.
In the following section we will review five of the most prominent benefits of this system focusing on the essential gains you can obtain. As with any topic there is more to talk about and some points are intertwined with one another so let’s get started.
Increased liquidity
In industries like real estate, where it is notoriously well-known that illiquidity is present, processes like tokenization pave the way for improvement in this area. But what is liquidity, you may ask? To put it simply, this term is referring to how easily and quickly an asset can be bought or sold correlating with the price of its value.
Through tokenizing assets, the market is able to open the doors for more investors to join the trade by improving the liquidity. This means that the investors are no longer required to allocate a certain amount of money to trade assets and instead can invest as much or as little as they deem fit in order to get started.
Cost efficiency
The point that drives savings of the costs for investors is the automation of the processes. Blockchain-based technology allows for an opportunity to eliminate any middlemen and third parties that extend the time it takes to get started as well as act as a financial burden leading this to be one of the major benefits of tokenization.
In the place of the before mentioned third parties, such as lawyers, smart contracts come into play. These are self-executing contracts that enable issuing tokens when the specified criteria and conditions are met. As a result, the investor mitigates the need to pay extra costs to legal counselors, escrow services, and other notaries.
Improved transparency and security
One of the primary concerns investors have is the hardship related to finding information about the sale and ownership history of the assets they plan to buy. With tokenization the issue of transparency is automatically reduced to a minimum as the nature of the blockchain is fundamentally public which allows entities to openly track and audit the asset before settling on any financial decision.
Specifically the immutability of the records regarding the transactions is what drives the reduction of the risks related to fraudulent activities across. This is especially significant within industries with high-value assets including art, property, and other luxuries.
The clean and transparent record-keeping enables entities that are behind the execution of Know Your Customer (KYC) compliances to monitor and prevent money laundering and other fraud-related procedures from occurring.
The 3 components of KYC.
Streamlined payment processing
A notable example of tokenization being a beneficial choice for investors is the way it offers a streamlined payment process. In a traditional system investors are paid out dividends from the assets after a lengthy and time-consuming procedure of checking for the correctness of information about the receiver by third parties.
In the tokenized system the process is significantly accelerated only requiring the information about the digital wallet of the receiver, as it is detailed in the smart contract. Such a system is resulting in almost immediate payment processing with an added bonus of immutability of the record about the completed transaction.
Accessibility
The decentralized nature of the blockchain-based tokenization system comes with an extensive set of advantages not only for high-end investors but those on the lower-end side. Assets that were once unreachable for the latter group, like private equity and property, can now be accessible for a larger pool of opportunities.
With tokenization being similar to a crowdfunding system with the exception that the investors gain a financial return on their purchases, the interested parties are now eligible for the highest-upside assets with a minimal rate of investment. On a larger scale, this approach promotes exposure to this market and draws more investors to the table which ultimately benefits the industry.
Tokenization vs encryption
In the digitalized world where the security of personal information and data is everything people tend to confuse tokenization with encryption and vice versa. Certainly, their concepts and primary focus are similar. However, when looking at the encryption and tokenization meaning within the context, it becomes obvious that these terms are not interchangeable and cannot be used to mean the same thing.
Difference between Tokenization and Encryption.
So, what is the difference between these methods and how can you tell one from the other? Let’s take a look at each of them separately to help you better understand.
Tokenization:
- Sensitive data is obfuscated through a randomly generated token value.
- Supports structured data such as payment card number, social security number, etc.
- Data exchange is enabled through a direct access to a token vault mapping token values.
- Original data never leaves the organization, increasing security strength.
- The original format and length of the output remain the same with no detriment to the security.
Encryption:
- Plain text is transformed into cipher text by an encryption algorithm with a key.
- Supports structured data as well as unstructured data fields including entire files.
- Data exchange to a third party receiver using an encryption key.
- Original data in the encrypted form leaves the organization.
- Preserving the original format and length of the output comes with security strength diminishing.
Getting to the bottom of the differences in encryption vs tokenization will enable you to make informed decisions regarding which method is going to suit your business the most. Each option carries its own set of advantages and disadvantages and will ultimately depend on your goal and requirements.
In any case, both encryption and tokenization will be a good choice to help you adhere to HIPAA-HITECH, PCI DSS, EU GDPR, and other types of regulations and compliances. Depending on your specific instance, each of these methods can be used simultaneously for a greater level of security.
Tokenizing is the best fit for structured data with a greater level of security measures with risk mitigation in case of any breaches. While encryption will be of good service if you need to secure large amounts of unstructured data within the lower end of compliance requirements.
Main takeaways
Tokenization has come a long way from being an enigmatic concept that investors from various industries were wary of to a widespread and increasingly popular process of securing assets. Nowadays, the awareness and recognition around this system are still new in the eyes of the general public and many are curious to get to the bottom of this approach.
As experts in this field, we put together a valuable guide to help you uncover the tokenization meaning, the main processes and principles it operates on, the token types and the benefits, as well as other crucial insights. With the knowledge of how tokenization protects sensitive data behind randomly generated values, you can be well informed on the right choices to make for your business.
If you are looking for a reliable tokenization partner with over a decade of experience in the industry, contact Limeup. Our experts can help you with the most complex projects and guide your business to success.