Security token skepticism
In the last few months, it seems that security tokens have become the in-vogue thing to advocate. Reading the various pieces of thought leadership, tokenizing securities will do everything from open the markets up to a greater number of investors, massively reduce costs, and allow people to invest in every asset imaginable. What always seems to be lacking however are any specifics on how these security tokens are going to be technically implemented, and why the technology will allow them to do things that regular securities, and the technologies that facilitate them, cannot. In this post I’ll seek to walk through each of the supposed benefits and highlight what I believe to be the stumbling blocks that I see few people raising in this particular hype cycle.
In short, I believe the thesis that people are following on security tokens make the same mistakes that many enterprise blockchain projects make: that is, once everything is on the blockchain, then everything will be perfect. Everything will be perfectly reconciled, immediately transferable, and we’ll have a large utopian ecosystem that works perfectly. The questions are, how do you get it onto a blockchain? And if it doesn’t need a blockchain, why haven’t the changes been made to this point and why would a blockchain change that?
While a future state of tokenized securities may come about, I am skeptical of the current proposed evolution achieving the benefits some advocates claim.
The current state of enterprise technology
Enterprise technology, including that for securities, is clunky and disconnected. This is news to no-one, particularly any IT department within any major organization. These architectural issues introduce data quality issues, maintenance costs, slow down processes due to batch vs real time operating methods, and many other issues that are too numerous to mention. So why is it like this, and why don’t enterprises fix it? In short, it’s to do with three things: priorities, timelines, and budgets.
Almost every enterprise divides their organization into departments with specific mandates, and budgets to achieve those mandates. These mandates give each department specific priorities, and timelines in which to achieve those priorities with a budget that is typically allocated annually. This leads to very strong governance and efficiency in operating, however it does lead to a challenge when looking long term: that is, the further out the benefit of any organizational change, the less likely it is that current management is going to be rewarded for prioritizing such a change.
In the context of technology infrastructure, this dynamic leads to technology that is built or deployed in a way that it will give the quickest return or savings in a timeframe that can be justified to upper management when allocating budget. This very rarely means establishing a giant data warehouse integrating all data across the enterprise in one integrated environment with perfect data reconciliation. So while such a project could be done, it rarely happens: and note, that it is not for technical reasons that it isn’t done.
Note that at this stage, we’re just discussing challenges within one organization. If we’re looking across an industry these problems are magnified. In any economic ecosystem, enterprises play different roles. In the securities ecosystem, there are broker dealers, custodians, asset managers, securities depositories and various other administrative roles. Consider the challenges of coordinating technology between separate departments mentioned above: now consider competitors and enterprises who have entirely different business models coordinating their technology through the ecosystem.
The reason it’s important to understand this is that almost every proposed blockchain solution could be achieved using upgraded, legacy technology. Consequently, it assumes that such a solution could be implemented at a cheaper cost in a faster timeline because they are using a different type of data structure. This isn’t how technology transformations work.
This calculation also doesn’t matter if it is a private vs a public blockchain: there are countless back office systems that will need to be integrated into any new platform. That cost will need to be evaluated against the benefits of the transformation. Who will be the first to sign their budget off on that transformation, and what will be the benefit to them individually, as the owner of a department’s budget?
Consequently, 24/7 trading, rapid settlement, fractional ownership: none of this is a limitation of today’s technology. Consequently, it is difficult to claim that that is a benefit of using blockchains.
With that background, I’m going to walk through two other proposed benefits — cost and liquidity — and explain what I believe to be the preconditions for token-based securities eventuate, if they are to.
Cost reduction
The ‘lower cost’ thesis goes something like this: putting securities on the blockchain will enable reconciliations and accounting calculations in real time and lower costs due to digitizing everything from the legal language to KYC.
What I’ve never seen in this thesis is how any of this is actually done, nor consideration of the additional costs created by this structure. In short: we’re making the same leaps about blockchains for security tokens that enterprises have been making about blockchains for years.
Companies holding bitcoin and cryptocurrencies right now have reconciliation issues — and this is the most basic asset to manage. It is difficult to ensure that what is on the blockchain aligns to your general ledger, because again: systems integration is difficult. Let’s say we could perfectly integrate, we don’t want to have fully transparent securities trading: no fund is going to want people to be able to see their holdings, so we’re going to need to obscure that in some way. How is that going to be done? How complex is that obfuscation? Who verifies that what is happening behind the scenes in an obscured environment is accurate? How do we know that they are trustworthy?
Every additional piece of complexity does two things. One, very simply, increases blockchain transaction costs. The more complexity in a smart contract, the more gas or transaction fees you need. Secondly, and possibly more significantly, more complexity increases the potential for errors: and remember that errors on blockchains are incredibly difficult to fix. Who is going to do the testing of the code? Who is going to verify that it in fact meets the plain text description of how your person on the street understands the security to perform?
Add into this the challenge of getting enterprises to agree on a standard data format — note that to this point they have chosen not to do so using current technology that is more than capable of doing so — it is unclear why a blockchain would be the missing link that fixes these problems.
Increased liquidity
This always seems to be an odd benefit to me, as this is neither a technology issue nor a enterprise governance issue: liquidity is almost always deliberately limited by the issuer. I in fact can’t think of a case where it isn’t.
As an example, much noise has been made about this with the ICO space, where claims abound that ICOs have demonstrated a lack of efficiency in the fundraising market. Similarly, claims have been made that token based blockchains could enable people to invest in illiquid products such as venture capital funds. There are pretty major assumptions being made here, and in both cases it assumes that venture capitalists, with all the lawyers at hand that they need, don’t know how to structure an investment properly into a startup, and don’t know how to best leverage investments into their funds. I find that an unrealistic assumption.
Private investments are almost always about more than just money. If all a VC provides is money, and not relationships, business guidance and support, I’d say they’re a pretty subpar VC. Similarly with strategic investors into private companies: those companies almost always have right of first refusal if an investor wishes to sell their shares, as they wish to ensure that the owners of the company are aligned with its vision.
Liquidity does not help build a business’ core operations. There is a reason VCs don’t want the founders of a company which they’re funding focusing on the price of their stock, versus building a sustainable product. There is a reason why companies wait as long as they possibly can before going public. The minute you are public, you are open to the whims of Benjamin Graham’s Mr Market, the irrational market movements that focus on short term emotions and not long term growth. Be wary of any project that wants to enable its owners to sell on a whim.
Countless companies ICOd who did so simply after their business could not get VC funding: so really, the only thing ICOs demonstrated is that there is no shortage of people that will give money away because of hype, regardless of whether or not there is anything of substance.
Like Bitcoin, this is a network play
All of this does not mean that security tokens will never work. The dialog, however, is off, and is reminiscent of the ‘blockchain not bitcoin’ dialog that we’ve had for the last few years.
Public blockchains enable a public network of censorship resistant value transfer, but they are self contained. You cannot take the technology and fit it into the current paradigm, because the technical problems that you’re aiming to solve by using a blockchain are a result of the current paradigm. As we saw with bitcoin, while many organizations have looked to use private blockchains to benefit from the supposed benefits and struggled, bitcoin has slowly progressed, gaining mainstream adoption, and slowly becoming an asset with recognized mainstream value. In other words, it didn’t fit into the current paradigm: it created a new one, on the back of innovators and early adopters. Note that it still has some way to go before we can begin to say that there’s total market adoption and that it can demonstrate a significant benefit over current assets.
In the same way, for token-based securities to have a significant advantage over current securities, it will need to create a new paradigm, totally distinct and separate from the current one. To do that, it will need a widely adopted network on which to run, and innovators and early adopters who are not part of the current securities paradigm, who gain significant benefit from using this technology versus the current infrastructure. As laid out above, it is unclear exactly who that is.
Either way, however, at the very least we need a widely adopted network on which such security tokens can be built, which means focusing on building the base layer network — ie, the initial application of value transfer such as bitcoin — before building layer 2 applications such as security tokens. A blockchain is an incredibly inefficient infrastructure designed to solve a very specific problem, being the double spend problem between anonymous parties. If parties are known, or that value transfer mechanism isn’t widely adopted, there is typically better infrastructure to use.
Without significant adoption of the base layer by consumers and institutions, I struggle to see how we will leapfrog that to layer 2 applications when there is no clear market need, other than people wishing to cash in on the hype, and no clear market benefit.
In the same way that the dot com boom built web-based businesses before there was a market and sufficient consumers connected to the web, developing security tokens before building the base layer is trying to force a network into a market that I’m skeptical has differentiated value. Networks need to grow organically, and they cannot do that without establishing layer 1 first.
