Tokenisation: Introducing a new asset class - the Royalty Token

Tokenisation has led to the creation of a number of different token types. These mainly consist of equities, bonds and the fractional ownership of assets, with a particular focus on property, which I’ve mentioned in part two of this series. However, there are a whole host of instruments that are securities but have yet to be traded on any exchange. In this article I’d like to introduce one of these instruments, the new Royalty Token.

Investopedia defines a royalty as:

“A payment to an owner for the ongoing use of their asset or property, such as patents, copyrighted works, franchises, or natural resources. The legal owner of the property, patent, copyrighted work, or franchise receives a royalty payment from licensees or franchisees who wish to make use of it to generate revenue. In most cases, royalties are designed to compensate the owner for the asset's use, and they are legally binding.”

The concept of a royalty payment is nothing new - they have been used in the music and film industries for decades now. Yet most people don’t consider that a royalty is actually a security. It gives the owner certain rights, and although previously it has not been possible to trade these rights in their current form, blockchain technology enables the creation of a token representing that right. The token itself could then be traded on a stock exchange that accepts security tokens.

Royalty tokens will overlay the securities/license agreement, creating divisible units. The overall license will typically reference a percentage of the gross or net revenues obtained using the owner's property; that percentage is then broken down into a number of units, much like the shares in a company are split, representing the different ownership. The use of royalties is common in situations where an inventor or original owner chooses to sell his or her product to a third party in exchange for royalties from the future revenues the product may generate. Royalty interests are the legal rights to collect future streams of royalty payments.

In the past, the only way to access these rights was to buy them as a commercial contract, but now they can effectively be packaged into a security offering and traded.

Because there are different types of royalties, the different uses, benefits and rights allocated to each owner of the royalty would need to be clearly defined. To provide more context, here’s a brief example of some royalties that could be created and potentially listed on a tokenised stock exchange (again courtesy of Investopedia): 

”Computer manufacturers pay Microsoft royalties for the use of the Windows operating system in the computers they manufacture. Payment may be non-renewable resource royalties, patent royalties, trademark royalties, franchises, copyrighted materials, book publishing royalties, music royalties, and art royalties. Well-known fashion designers can charge royalties for the use of their names and designs by other companies.”

Don McLean was once asked what the lyrics meant in American Pie and his response was, “It means I’ll never have to work again”. He knew that the royalty payments he would receive for his song would be able to give him a comfortable lifestyle on a perpetual basis.

Third parties pay authors, musical artists and production professionals for the use of their produced, copyrighted material. In the oil and gas industries, companies provide royalties to landowners for permission to extract natural resources from the landowners' property.

It will soon be possible to tokenise royalty payments in the energy sector, whether it is oil and gas, or through electricity produced from a solar farm, or waste from an energy plant. In these instances, the right to receive revenue can effectively be commercialised and structured into a contract. The price of oil might fluctuate, as might the level of production and demand, yet it will be possible to simultaneously create a royalty token that gives the token holder the ability to receive a right of income based on the oil company’s output. The price of that token will rise and fall depending on various factors including the price of oil, the level of production, the amount of sales and foreign exchange rates, etc. As a result, it will be possible to offer an investment-grade speculative product on an exchange that is different from equities and bonds.

The main advantage to the issuer is that equity in their business is not given away. Rather, it’s a purely commercial transaction in which the issuer can receive monies in advance in order to pay for upgrades to key business areas such as sites and equipment. Unlike a variable coupon bond there is no redemption period (i.e. the investment is ongoing rather than maturing on a fixed date), meaning it works in perpetuity. This can be advantageous to both parties, insofar as there are no conditions that place an obligation to repay or an expiration date. Effectively, it is a continuing obligation for the life of the issuing entity. If, however, the company wants to stop the arrangement, it will be obliged to repurchase those tokens on the market and buy back its own income rights.

Tokenisation makes this possible because the contractual arrangements are held by a custodian of the contract, while the beneficial owners of that contract own the tokens. Those tokens will likely fluctuate in value, and can be bought or sold in a secondary market. As the price rises and falls, the token holders can easily enter or exit the contractual agreement - something that was previously extremely difficult to do. The presence of multiple counterparties makes the creation of an active secondary market possible, with buyers interested in acquiring more income-bearing royalties, and sellers wanting to trade out of their position.

Not only can tokenisation make markets more accessible and efficient, it provides the ability to fractionalise and seamlessly trade tangible objects such as property, vehicles or art, thereby opening up previously unimaginable possibilities. In addition, tokenisation provides us with the opportunity to create new tradable asset classes. Replacing the middleman with decentralised technology provides ease of access and affordability to all shapes and sizes of investors - which indeed must be the definition of the democratisation of asset ownership.

This is the third article in a three part series on tokenisation. Our first article focused on the rationale behind tokenising securities, while the second examined the democratisation of asset ownership.