On Saturday, April 13, 2024 (Eastern Daylight Time), the price of Paxos Gold (PAXG), which is linked to gold at $1,000 per ounce, soared to $2,923 per coin, 20% higher than the previous day's gold spot price of $2,342.9. Since one Paxos Gold is issued backed by 1 ounce of actual gold, the price should normally be the same. However, a strange phenomenon occurred where the token price exceeded the price of the collateral asset.
The cause lies in the nature of the tokenized market, which is open 24 hours a day, 365 days a year. While the gold spot market closes on weekdays, during the weekend, after Iran attacked the Israeli mainland, the demand for gold, considered a safe asset, shifted to the tokenized market, such as the London Bullion Market Association (LBMA), instead of the gold spot market. Since people couldn't buy physical gold, the increase in buying gold tokens led to a price disparity. Although the price later normalized, this incident demonstrated that tokenization could distort the price of physical assets.
The tokenization market, which allows physical and financial assets to be easily traded in small amounts 24/7, is considered a future innovation. However, concerns have been raised that, as seen in the case of Paxos Gold, price distortions may occur or excessive demand could lead to bubble formations. The Financial Stability Board (FSB) noted in its August 2023 report that "the risk of a bubble could increase if the tokenization system becomes widespread."
◇ The volatility of tokenized physical asset prices is significant
The phenomenon where prices rise when assets are tokenized is easily observable. A wooden house measuring 100 square meters (about 30 pyeong) located on the western beach of Waianae on the island of Oahu, Hawaii, saw its price increase by 76% just four months after being tokenized. According to the real estate platform Zillow, this house was valued at $670,000 (about 930 million won) in February, but, after being tokenized by the real estate tokenization company Lofty, its price surged to a maximum of $1.18 million (about 1.643 billion won).
Lofty buys real estate properties and then tokenizes the ownership to sell to the public. It distributes the revenue generated from the rental business of the properties to token holders. By purchasing and holding tokens, investors can earn rental income proportional to the amount held under the guise of interest.
Lofty purchased the house for $670,000 and then divided the ownership into 14,727 tokens, selling each at $50. This meant the house was instantly valued at $730,000 ($50 × 14,727 tokens). The difference of $60,000 constituted the fees and taxes incurred during the process of purchasing and tokenizing the property.
Due to the advantage of yielding a higher return than bank deposits and being able to invest in small amounts, more people began to buy tokens. The token price rose from $50 to $80 just two months after being released in May. The house price reached $1.18 million ($80 × 14,727 tokens). Subsequently, the token price decreased to between $54 and $63, but was traded at $58.9 on the 29th of last month.
This demonstrates how bubbles can arise and price volatility can intensify when physical assets are tokenized. During the process of Lofty selling homes as tokens, the costs and fees incurred were reflected in the home prices, leading to the formation of an initial bubble. The advantage of allowing for small real estate investments then resulted in excessive demand, creating a secondary bubble. High-value real estate is not frequently traded, which leads to less price volatility; however, the ease of buying and selling as tokens has caused home prices to fluctuate.
◇ Overflowing liquidity... the bubble potential increases
Some are concerned that the nature of the tokenization market, intertwined with the recent increase in liquidity, could lead to the emergence of bubbles. As enormous amounts of money flood the market, these funds could flow into the tokenized market beyond stocks and real estate, leading to excessive demand that drives up asset prices significantly. The global liquidity indicator, M2 money supply, reached a record high of $22.12 trillion last month.
Previously, President Trump signed a bill (OBBA) that raises the federal government's debt ceiling by $5 trillion, going beyond a monetary stimulus policy, and has also regulated the complementary leverage ratio (SLR) to supply liquidity to the markets. He has publicly called for an interest rate cut, even mentioning the resignation of Jerome Powell, Chair of the Federal Reserve. As a result, the Standard and Poor's (S&P) 500 index and the Nasdaq index have been repeatedly hitting record highs, and the price of Bitcoin even once surpassed $120,000.
The problem is that if liquidity dries up, the inflated prices could plummet, leading to significant investment losses. This is something already experienced four years ago during the COVID-19 pandemic. The excess liquidity, which persisted through a 'zero interest rate' period lasting nearly two years from 2020, not only propelled the Nasdaq index to record highs but also flowed into the cryptocurrency market and even non-fungible tokens (NFTs), creating a bubble. An NFT created from the first Twitter message left by Twitter co-founder Jack Dorsey was sold for 340 million won (1,630 Ether) simply because of its rarity, but it became worthless, fetching only a top bid of $270 at auction in 2022.
The Financial Stability Board (FSB), an international organization, pointed out that if the tokenization market rapidly expands by October 2024, the high "collateral turnover rate" could lead to an excessive leverage effect as the same asset is recycled as collateral multiple times. This means purchasing real estate tokens and then using these tokens as collateral to secure funding for buying other assets. Although there may be no issues while liquidity is abundant and asset prices rise, if liquidity diminishes and prices fall, this re-collateralization structure could collapse in a chain reaction.