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Although gold has proved its worth as a store of value and a safe haven for thousands of years, one criticism keeps resurfacing: a gold bar sits passively in a vault and generates no interest or dividends. New technology appears set to change that. By tokenizing gold, a gold bar can become more than a passive store of value: it can be traded more easily, used as collateral and deployed to generate returns.
Major banks and investors are investing heavily in this new technology. The market for tokenized real-world assets is now worth tens of billions of dollars, while gold is also increasingly finding its way onto the blockchain. Can tokenization eliminate gold’s greatest disadvantage without undermining its strengths?
Gold held in a vault does not generate interest for a retail investor, which is why this wealth could be described as ‘dead capital’. The Peruvian economist Hernando de Soto described how so-called ‘dead capital’ can paralyse an economy. Under normal circumstances, savings can be lent out and used for investments, thereby contributing to economic growth. Assets that exist but cannot easily be deployed within the financial system, by contrast, remain largely passive.
De Soto regarded ‘dead capital’ as a problem, particularly in developing countries. Homes and businesses in these countries often have considerable value, but weak property rights and bureaucracy make it difficult to use them as collateral to obtain credit or expand a business.
Although physical gold is registered property, retail investors still find it difficult to deploy it actively within the financial system. Large institutions such as central banks and bullion banks can already use their gold reserves for gold leasing, thereby generating interest income. For the average investor, however, a gold bar usually remains idle in a vault, and lending out gold is not readily accessible.
Blockchain technology can lower that barrier. Tokenizing gold makes it easier to use as collateral or within applications that generate returns. Whereas investors traditionally had to choose between earning interest on a savings account or bond and holding gold, tokenization may partly change that trade-off. This could reduce the opportunity cost of gold, making it relatively more attractive to hold.
An important principle of tokenization is that every token is fully backed by physical gold. It is therefore not a new form of paper gold, but rather the digitization of physical ownership.
A major provider such as Paxos, the issuer of the PAX Gold token, stores the physical gold in highly secure LBMA vaults in London. Paxos is a regulated trust company in New York, which means that the gold is legally segregated from the company. If the company goes bankrupt, creditors cannot make claims against the physical reserves. Your right to the gold therefore remains intact.
A token is then linked to this physical gold. With PAX Gold, one token represents one troy ounce of physical gold. If you sell the token or transfer it to someone else via the blockchain, the gold remains in the same vault. Only the ownership changes. Through the PAX Gold website, token holders can see exactly which bar, or which portion of a bar, they own, including its weight, purity and the vault in which it is stored.
Under the gold standard, more currency was put into circulation than was actually backed by gold. The question, therefore, is how someone can be prevented from issuing more tokens than there is physical gold in the vault.
This is where the Chainlink protocol comes in. Chainlink verifies the so-called proof of reserve in a decentralized manner. It continuously scans the vault data, which are supplied and checked by external accounting firms, and compares them with the number of outstanding tokens. If a discrepancy arises, for example because PAX Gold is hacked or attempts to issue more tokens than the amount of gold available, those new tokens are automatically rendered unusable and worthless. Because the verification process is fully automated, there is no central party that can influence it.
Because tokenization companies generate revenue from creating and redeeming tokens and from transaction fees on the blockchain, they generally do not charge token holders storage fees. Tokenized gold is also highly liquid: it can be traded and transferred 24 hours a day, seven days a week. And because tokens can be divided into many decimal places, investors can participate with any amount.
Because the gold has been digitized, it can also be used within DeFi, the decentralized financial ecosystem on the blockchain. Examples include using gold as collateral for a loan or lending it to other parties in exchange for interest. This makes it one of the few ways in which a retail investor can generate a return on physical gold.
Tokenization also has disadvantages. PAX Gold is backed by a central party that can freeze specific tokens in exceptional circumstances, for example when ordered to do so by a court or regulator. In addition, Chainlink relies on data from external accounting firms for its verification process. The protocol would simply fail to detect fraud or an error by those auditors.
Furthermore, physical delivery of the underlying gold is only available to holders of a complete 400-ounce bar (nearly 12.5 kg of gold), a threshold that is realistically attainable only for large institutional investors. Although the physical gold is legally segregated from the company, bankruptcy proceedings could still mean that it takes some time before the value of your gold is actually paid out to you.
Nevertheless, tokenization also has limitations. Physical delivery is not feasible for most investors; tokenization remains dependent on external vault audits, and tokens can be frozen in exceptional circumstances. The question, therefore, is whether tokenization can improve gold without undermining its unique characteristics.
The answer is nuanced. Tokenization digitizes physical gold in a legitimate way. Protocols such as Chainlink verify the backing. In addition, tokenization offers new opportunities to generate returns. The trade-off is that you become more dependent on other parties than you would be if you stored the gold yourself or had it registered directly in your name.
Above all, however, tokenization offers something that did not previously exist: a choice. Whereas retail investors seeking interest income previously had to rely on a savings account or a bond, gold can now also be included in that decision. And that is a positive development.
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