MIT DCI Working Group on Tokenized Securities
Tokens Unlikely to Democratize Access
MIT Media Lab’s Digital Currency Initiative (DCI) conducts research to support the development of digital currency and blockchain technology. Together with collaborators, DCI works with interdisciplinary groups of faculty, students, as well as research scientists. These teams author research papers, run pilot use cases of the technology, and develop relevant open-source software.
Over the past few months, I was fortunate to be part of one such cross-functional team within DCI’s Working Group Program with Fidelity Labs as our sponsor. The project began as a comprehensive industry study on Stablecoins, Decentralized Exchanges (DEXs) and Security Tokens. Preliminary research allowed us to focus our scope to the relatively understudied field of tokenized securities. While Stablecoins and DEXs have been well-researched, for all of their hype, security tokens have received little academic attention.
~Checkout the list of all working group research topics for 2018–19 here~
Which of the “blockchain benefits” are truly realized by tokenizing an asset? Who are the real beneficiaries? Is it individuals or institutions who benefit from tokenization in the near term? Is there demand for a single tokenized asset? We wanted to investigate a complex asset with significant inefficiencies and potential for massive improvements. Real estate was an obvious choice. It is a notoriously illiquid asset class and ripe for overhaul.
Henry Elder, President of International Blockchain Real Estate Association, commented on the long overdue need for evolution in the real estate industry: “My family has 4 generations of real estate experience and I realized that everything is done the same way as it was 4 generations ago. This is clearly not sustainable in the long run.”
Real estate exhibits several shortcomings that blockchain purports to address via novel forms of fundraising, more liquid markets, tamper proof ownership history, and streamlined payments. While there has been considerable interest in tokenizing real estate, whether these blockchain benefits can be realized for is yet to be proven.
Fidelity Labs and DCI encouraged us to dig deeper and go beyond identifying the industry landscape. We conducted an extensive literature review and interviewed key stakeholders in the real estate ecosystem. Our work focuses on issues around access, liquidity and transparency in real estate and how blockchain technology could potentially solve some of the pain points.
One of our key takeaways was around the question of providing retail investors access to commercial real estate (CRE) investment opportunities. Currently, retail investors have access to this market via real estate investment trusts (REIT). Total CRE market value as estimated by National Association of REITs is between $15–17 trillion. While, public REITs’ market capitalization is only around $1.2 trillion. Retail investors have been historically locked out of institutional quality lucrative CRE assets (~93%). Crowdfunding platforms (since the passage of JOBS act) have tried to bridge this gap but have failed to take off. The biggest reason being adverse selection i.e. assets that were unable to raise capital through traditional means of financing end up on these platforms. High quality assets already have access to cheaper, strategically aligned and less burdensome means of capital.
Does tokenization provide retail investors increased access to commercial real estate (CRE)?
TL;DR— Not in the short term.
We believe tokenization of CRE asset class can potentially democratize access in the future. However, for the time being it is more of a lip service than reality. If we look at majority of the tokenized real estate examples today, we will notice they have been issued under Rule 506(c) of Reg D which restricts access only to accredited investors. Even though we have the technology to implement a new paradigm, regulation hasn’t changed. It is important to note that securities regulation is typically technology agnostic. Anything that represents a security (whether a piece of paper, a record in a database, or a token on a blockchain) that is bought or sold falls by legal definition under securities law. Thus, “tokenized security” is just a technology implementation (token) of legal concept (securities).
Even if these token issuances were exempt from securities regulation, there are open questions around:
Quality of asset — What is the incentive for owners to tokenize non-inferior assets? Are they going to earn higher returns?
Demand — Is there an appetite to invest in a random building? Will the owners of well known assets such as the Empire State Building ever going to open it up for public investment?
Governance — From an issuer perspective, do they want to deal with a few investors or thousands of small investors? Will token holders be able to vote their rights in a property? Enforcement of those rights with a fractionalized, passive ownership base is yet another hurdle.
Education — Do retail investors better understand the risk profiles and valuation than sophisticated institutional investors?
While there are more questions than answers, we believe that fractionalization of real estate assets has a huge potential to solve liquidity issues that the industry is mired with. Being able to buy/sell a piece of property reduces the initial capital requirement and can increase the overall investment appetite. However, it will take a longer time horizon for these benefits to trickle to retail investors.
Additionally, even though tokenizing the underlying securities have undeniable benefits, exponential value will only be realized when the entire investment value chain and the physical asset itself is on chain. Significant disruption can be achieved when we have solutions integrating land titles, asset identity, automated payments to and from various stakeholders, compliant smart contracts, property data and history, and lease agreements among other things. We believe the adoption cycle will move from tokenized securities to investment value chain and eventually to tokenizing the underlying asset.
More on the research and perspectives of various players including issuers, property managers, academics, investors, REITs and blockchain startups will be available soon in our research paper. Stay tuned! Or follow me on twitter @manasilvora for updates.
Being part of this working group has been a great hands on learning experience. DCI conducts cutting edge research and encourages everyone to rethink from the ground up. I would like to thank MIT DCI, Eilon Shalev, Jurica Bulovic (Fidelity Labs), Jason Ward (Fidelity Labs) and my teams members Hugo, Kenta and Julie for this incredible opportunity.