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General information only. This article does not consider your objectives, financial situation or needs and is not a recommendation to acquire, hold or dispose of any digital asset. Digital assets can be volatile and may fall in value.
It’s all well and good to say that gold is becoming digitised using blockchain technology.
But even for those entrenched in the industry, understanding the mechanics of this process can be challenging to wrap your head around.
So how exactly does tokenisation transform something physical into something digital?
Tokenising gold: The process
Different tokenised gold issuers may use different processes, but, for the most part, gold can be represented digitally through a broadly similar process.
Physical backing. The underlying issuer (for example, Tether Gold), typically acquires physical gold bullion and stores the assets in a vault. These reserves may be subject to third-party attestation reports released monthly or quarterly.
Minting. A corresponding supply of tokens is then minted on a blockchain, with the issuer aiming for each token to be backed 1:1 by the underlying reserves. These tokens can take on varying denominations – with the most common being 1 token = the value of 1 troy ounce of gold. If investors continue purchasing more gold than is stored in the vault, the token issuer may need to increase its physical reserves to match circulating supply.
Fractionalisation. Because tokenised gold is typically fungible, users can buy fractions of a token, meaning they don’t need to purchase an entire troy ounce to gain price exposure to the asset.
Trade. Tokenised gold can then be traded on supported decentralised and centralised exchanges, while some issuers will allow investors to purchase tokens directly. This may allow gold-backed tokens to be traded for fiat currency (like AUD), cryptocurrencies, or even other tokenised assets. Typically, smart contracts can execute balance transfers and record ownership transfers automatically.
Redemption. Finally, some projects, like Tether Gold, support a redemption program. In this instance, eligible users may be able to redeem a corresponding number of tokenised gold assets for physical gold if they meet certain terms. These issuers may be able to sell the bullion or arrange delivery, although this is dependent on each issuer’s individual requirements and logistics.
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Key Takeaway
You can conceptually think of gold tokenisation as a cloaking room. Let’s say you’re attending a concert for your favourite band. Upon arrival, you hand over your heavy coat (the gold) and are issued a small ticket linked to it (the token). The ticket is smaller and easier to manage than the cumbersome item of clothing – so you can dance along to the music without needing to worry about it. Yet, when you want to leave the venue, the ticket can be redeemed to get your coat back.
Redeeming tokenised gold can come with additional complexities – after all, it isn't a coat to ward off a cold Melbourne winter. Users must navigate issuer terms and eligibility requirements that don’t typically come with a cloaking room. But still, the underlying concept is similar.
The power of smart contracts
In a sentence, tokenisation leverages technology known as ‘smart contracts’ to digitally represent an underlying asset on a blockchain.
We can think of smart contracts like computer programs that execute under certain conditions. This can reduce reliance on a central authority (like a bank) to authorise transactions – for example, the issuance and swapping of gold-backed tokens on a marketplace.
Smart contracts act as the bridge between the underlying asset and its digital representation (which in this instance, is a crypto token). It helps connect investors with token issuers, other traders and even physical storage solutions, automating parts of the process.
These programs are a big part of what may make tokenised gold distinct from other access methods, and what largely separates it from an ETF or another, digitised gold vehicles. Some of the functionality may include:
Public verification of token balances on a blockchain, rather than waiting for a custodian audit. In some instances, tokenised gold issuers serialise their physical holdings and associate serial numbers with token holdings – adding an additional level of transparency.
Smart contracts support the transfer of assets with less reliance on an intermediary. This may reduce some operational steps and improve efficiency – for example, some of the larger tokenised gold issuers state that they do not currently charge annual management fees. Of course, different platforms and products will have different fee structures.
Additionally, some tokenised gold products can be traded 24/7, assuming the trading platform of choice facilitates the necessary liquidity.
The programmable nature of smart contract allows users to participate in DeFi rather than have their gold assets remain in an ETF or vault. For example, experienced users may lend XAUt to an eligible liquidity pool, potentially generating yield separate from the price movements of the underlying gold. Of course, this can introduce additional DeFi, smart contract, liquidity and counterparty risks which are worth considering.
Gold: A 24/7 market?
Commodities aren’t typically traded round-the-clock, instead following the common 24 hours, five-days a week schedule and closing for most of the weekend.
So, how does tokenised gold continue to value its underlying asset if the rest of the market is closed?
Well, the answer is simpler than you might think.
For most of the week, most commodities volume flows through futures exchanges like Commodity Exchange Inc (COMEX) or the Chicago Mercantile Exchange.
But, over the weekend, when these markets are closed, some tokenised gold markets may continue trading. Investors may react positively or negatively to weekend events, potentially pushing the price of gold-backed tokens up or down and providing a source of price discovery before commodity markets re-open on Sunday.
Key Takeaway
"In terms of publicly visible price formation, onchain markets are responsible for virtually 100% of weekend price discovery,” - Iggy Ioppe, ex-CIO Credit Suisse
Summary
Tokenisation, blockchain and smart contracts: to a complete beginner, these concepts can appear complex and intimidating.
Yes, the technology that underpins decentralised finance can be a mouthful – but investors do not need to understand every detail of how coding languages like Solidity are used to craft smart contracts on Ethereum.
For example, every time you tap your phone on an EFTPOS machine, most aren’t considering the radio frequencies used by NFC technology.
However, grasping the basics can help to understanding why adoption has accelerated in the mid-2020s. This context can help identify the historical pain points of gold ownership, demonstrating the potential use cases and risks that tokenised gold may present for users both now and in the future.