Tokens (Don’t) Rule Everything Around Me — Thoughts On Security Tokens

I’ve been watching with a bit of bemusement as the crypto world hype cycle has moved from utility tokens to security tokens, but am somewhat skeptical myself. Having read a few bull cases, I thought I might lay out the bear case in the hopes of encouraging a more sophisticated discussion around what blockchain technology can and can’t do.

It seems to me to be an axiom of blockchain technology that its native use cases all involve self-contained value, and that where value is not contained on-chain, the technology lacks value.

For example, digital gold is a good use case for tokens. If you hold a Bitcoin, all the information necessary to understand what it is and to determine its value is contained within the token.

Other tokens can have this property as well. Whether you think Crypto Kitties are dumb or cool (I’m in the cool camp), you can read any token and know which kitten it is, what it’s properties are, etc.

Utility tokens represent a third, and perhaps more interesting, example. A file coin may or may not have value, but it’s state is self-contained, and as far as we know you will be able to verify at time of use that your files are stored on the network.

In all of these cases, the property of trustlessness drives value.

In practice, the real world still matters. You could, for example, sue someone for stealing your Bitcoin or kitten (the monster!), but ultimately if they’ve sold that asset before you do, the anonymous recipient cannot (easily) have that value clawed back. We can trust the state of the chain and the information it provides when considering a potential transaction with an untrusted party.

By contrast, digital securities are fundamentally about creating abstract representations of off-chain value. The problem here is that truth is not self-contained, so you must trust that the mapping of real to abstract value is being maintained.

For example, let’s imagine you securitize a company’s stock. Traditionally, we value companies based on models such as DCF. But you can’t do this analysis by looking at the blockchain. You could imagine companies theoretically putting this information on the blockchain (in practice this seems dubious), but you still have the problem of needing to trust that the information is complete and accurate.

This is why I’m dubious of the claim that blockhchain technology increases liquidity of securities. Liquidity is more than just a function of the technical ability to trade. It (at least) requires the parties trading have the confidence to agree on a price for the asset.

So, to make blockchain equity work, you need trusted third party institutions that will assure the equity issuer is playing by a set of rules buyers and sellers can trust (including 3rd party market manipulators), and who will punish market participants who violate these rules, which also implies a specific jurisdiction. You effectively have to reinvent the SEC.

Note, this ignore issues of governments wanting to know who buyers/sellers are for tax purposes, anti-money laundering, etc. I believe this makes it highly unlikely we’ll achieve the theoretical (but real and interesting) benefit of global access to otherwise unavailable investment opportunities.

As another example, let’s imagine how you might securitize real estate. This, incidentally, is a use case I think is really interesting. Real estate is an asset that should be relatively easy to make liquid because so much information is public. It’s not a commodity, but close. I think we could see some real innovation here, but the question is whether it happens on the blockchain.

Today you can securitize real estate in some ways with companies like Reality Shares, Point, public REITs, etc. But you want to do it with blockchain. Liquidity is not a huge problem because buyers and seller roughly have the information they need to transact, but when we buy a token, how do we know that it represents 1/1000th of the home.

There is a blockchain entry asserting this, but there’s a title filed with the county that is the source of truth, there’s a loan with a bank tied to a stream of payments the home owner(s) must pay in the future, and there are unknowns such as liability for activities on property (what happens when somebody slips and falls).

These problem are all solvable, which is why I’m bullish on securitization of real estate, but solutions all fundamentally involve trusting the government to enable and enforce whatever contracts govern ownership and stewardship of the property. The token itself is an abstraction that derives value not just from the asset itself, but from the institutions that assure that abstraction maps to the value we wish to “own.”

As well, you would almost certainly need these blockchains to be mutable. Two quick examples. In the case of eminent domain, if an anonymous holder of an asset refuse to sign a transaction transferring ownership of an asset to the government, the government would need to be able to force a transaction. In the case where someone stole a private key and transferred tokens to an anonymous address (remember DAO), the owner would need the ability to fix the chain to reflect their actual (legal) ownership of the asset.

This isn’t to say that you couldn’t use a blockchain as a database to store a capitalization table for assets. Of course you could. Databases are flexible like that. The real question is, why would you?

If the novel properties of blockchains are provable possession (a physical concept) vs ownership (a jurisdictional/legal concept), immutability, and trustlessness, and none of these properties are present in a securities context, what are we really gaining by using this technology?