Tokenisation of real estate: what are the barriers?

To succeed, tokenisation must be trusted by investors and comply with the formalities of land law, as well as the rigour of financial regulation. In the second article in this three-part series, Ian Wilkinson, Ian McKenzie, Karima Lachgar and Catherine Hammon explore these challenges. Tokenisation refers to the process of representing an asset on a blockchain, with tokens issued to represent a specified aspect of ownership of the asset – potentially ownership of the legal title, or a right to a share in its value. Tokens can represent the whole asset or a fraction of it. The potential benefits of blockchain-based tokenisation of real estate were explored in the first article in this series, including opening up real estate assets to more potential investors and injecting efficiency and automation into transactions. However, despite well-known projects testing the suitability of blockchain for real estate tokenisation, it has not yet taken off. This article explores the perceived commercial and regulatory challenges that may be getting in the way. Not the Wild West A primary commercial barrier may be unfamiliarity with blockchain technology. Although the first blockchain system Bitcoin is over a decade old, commercial acceptance of this technology is still relatively low. Media stories about blockchain and crypto assets swing from extremes of hype, celebrity endorsements and tales of huge gains to hacks, collapses and Ponzi schemes. Against this background, tokenisation might not seem a suitable partner for an asset class relied on for stability and a steady return on investment. But it is important to distinguish between different uses of blockchain. First, tokens representing value come in many forms, typically with much less hype and volatility where they are underpinned by a real-world asset. Secondly, many blockchain applications are not focused on investment and returns but leverage its potential to deliver security, transparency and automation to offer efficiency of process, traceability or authentication, all of which can support the trust that investors have in the real-world asset. As regards actors in the field, there is a reputable industry of blockchain consultancies and developers, from big tech names to specialist software houses. In addition, corollary services such as exchanges and custodians are increasingly regulated, while institutional interest in crypto investment has driven rigour and regulatory attention. This is no longer uncharted Wild West territory. Asset or information? A background concern has been uncertainty around the legal status of crypto assets. Can a digital construct, formed out of data, overcome the English law principle that pure information cannot be owned? Past debate has largely settled into a consensus that crypto assets do constitute a form of property in law to which rights and obligations can attach. This view is supported by a 2019 expert opinion of the UK Jurisdiction Taskforce. Although the point has not been definitively ruled on by the courts, a number of judgments have endorsed this analysis. More recently, the UK Law Commission agreed that crypto assets are capable of constituting property, but found scope for clarification, recommending a new form of property for “data objects”, including crypto assets. Land law formalities Tokenisation of a real estate asset would need to adhere to the requirements for land law transactions, some of which continue to reflect longstanding practices from pre-digital times and assume that transactions are completed in person and with wet ink. Many of the formalities relate to dealings in legal title to land. The best way to combine traditional formalities with innovative structures may therefore be to split legal title and beneficial ownership or to offer rights to a share in something other than the title, such as a right to a share in profits. This layered approach may be necessary, in any case, to enable fractionalisation, given the upper limit under English law of four legal owners of a title to land. Formalities may also constrain automation. As discussed last time, “smart contracts” can be used to automate aspects of blockchain-based interactions. The Law Commission has concluded that smart contracts are capable of meeting the legal requirement for the formation of an enforceable contract. However, it also noted that smart contracts may not be suited to areas of law where there is a high degree of formality. Specifically, it expressed doubt that compliance with the requirements for execution of a deed could be achieved using smart contracts. Creating regulated investments The temptation with a completely new innovation such as blockchain may be to assume it is too new or too different to be regulated. This is rarely the case, even though regulation might not have been specifically designed for it. Most jurisdictions take a technology-neutral approach to financial regulation, and form is less important than substance. A key decision for tokenisation will be to define precisely what rights a token carries. If it has features akin to a share, debenture or unit in a collective investment trust, for example, it is very likely to be subject to financial regulation. Accordingly, the issuer may be subject to certain prudential, conduct of business, and governance requirements. For the reasons explained above, land law formalities may point a tokenisation project in this direction. Care will also be needed to understand whether the business or individuals concerned need regulatory authorisation or approvals to market, sell or trade the tokens. A case-by-case analysis of regulatory risk will be needed for each jurisdiction where the token will be available. The ramifications of falling within the regulatory perimeter of financial services will be discussed in more detail in the third article in this series. Collectable land tokens The discussion so far has assumed that a token would be focused on investment. But tokenisation of assets is sometimes aimed at creating “collectables”, rather than units in an investment scheme. Non-fungible tokens, or NFTs, offer a blockchain-based way to create uniqueness and authenticity around digital content. Some NFTs are akin to a limited run of prints of a painting. They do not carry any right to the real thing, share in its value, or licence of copyright, but are an “authentic” derived offering for which there is a distinct market. There have already been projects offering NFTs of a property alongside the sale of the real-world asset. This is unlikely to be the primary focus for tokenisation of real estate. But it might offer an alternative way to raise funds for some types of building – tokens could offer digital souvenirs of famous landmarks in a city, or collectables of architecture, for example. Depending on the terms of the token, it may also be a simpler structure from a financial regulatory perspective (although as noted above, a case-by-case analysis is needed for each jurisdiction). Environmental issues The potential environmental barrier to adoption of tokenisation has already been materially reduced. Ethereum is the most widely used public blockchain infrastructure for applications such as tokenisation (and was used, for example, for the Land Registry’s Digital Street tokenisation trial). It recently changed its protocol for recording transactions. This is estimated to have reduced its energy consumption by around 99.95%. Blockchain applications can also be built on a private system that does not have a heavy carbon footprint. Environmental concerns over the vast energy consumption of some blockchain systems are, therefore, now largely avoidable for tokenisation. Due diligence The scale of a typical investment in real estate means that purchaser due diligence is essential to understand the legal, physical and financial profile of the asset and associated risks. That information typically sits with multiple stakeholders and organisations. Some will be publicly available, often for a fee. Other information may be made available by the vendor following liaison with facility managers, asset managers, letting agents, fund managers, and so on. Gathering the information is typically a significant task in itself. Various initiatives are underway to restructure information held across multiple platforms in multiple formats, to be more readily combined and digestible. Application programming interfaces create the potential to pipe data out of one system into another. Knowledge graphs offer an advanced approach to data analysis that can find connections and relationships across diverse, unstructured data. Artificial intelligence tools can automate document reviews and search for key provisions. Meanwhile, blockchain offers a way to make information very transparent but very difficult to tamper with. The potential is clear to increase the efficiency of due diligence – and deliver wider transparency about the performance of an asset – with a combination of data flows, automated analytics and a blockchain register. Such a resource would also inject efficiency (both in terms of cost, which can be significant, and time) into the preparation of regulatory prospectuses. A token that carries a right of access to such a rich bank of asset information would be a significant innovation. The way ahead Tokenisation of real estate needs to navigate financial regulation and the formalities of land law. But a number of other challenges have been largely resolved, such as the legal status of crypto assets and environmental concerns. There remains huge potential to leverage the characteristics of blockchain to deliver efficiency around asset information and democratisation of investment opportunities. The remaining challenges are primarily unfamiliarity and cautious scepticism about blockchain as a form of digital infrastructure, as well as the up-front investment needed to deliver the benefits of tokenisation. In the third article in this series, we will offer a route map for the way forward. Ian Wilkinson is international sector leader for the built environment; Ian McKenzie is head of blockchain and tech in the built environment; Karima Lachgar a banking and finance partner; and Catherine Hammon is digital transformation knowledge lawyer at Osborne Clarke Photo by Jonathan Raa/NurPhoto/Shutterstock (13381986b)