Asset-backed tokens: the final frontier for financial professionals
Financial professionals have been using computers and the internet to improve their productivity for more than two decades. But it seems that for each productivity gain that is made, two more bureaucratic formalities are put in place. And that’s why many financial professionals have taken a keen interest in digital tokens, which offer much more than a simple productivity gain- they provide a potential paradigm shift. There are a lot of promises being made about the future of this technology, but how can it be harnessed and used effectively right now?
Before that question can be answered we should first give some context. Consider the simple hypothetical case of Mark, the manager of a private vault which stores gold. Customer Clarice gives her gold to Mark, and Mark gives Clarice a receipt. This receipt is much easier to transport than the gold, and it certainly takes up less space! If Clarice decides she needs cash more than she needs her gold, she could sell her receipt to Dave. Then Dave could go to the vault with the receipt, and give this receipt to Mark. After checking to make sure the receipt is valid, Mark would give the gold that Clarice originally deposited to Dave.
In the real world, this process is complex and fraught with risk. Mark might be required by law to match Clarice’s identity to the receipt, making it difficult for Dave to redeem Clarice’s gold. And Dave needs some way to verify that the receipt Clarice is trying to sell him is not fraudulent. You might have banks in different jurisdictions involved, and those banks have the ability to cause real problems during the course of the deal. Mark could solve these and other problems by simply offering the receipt in the form of a digital token, which would only require that each participant use compatible software.
A more abstract example could be a company which decides to finance a new project through the sale of a derivative. The derivative is based on the company’s equity, and provides some dividend rights. Or it could provide no dividend or voting rights at all; it could behave like common stock. Such a derivative product can be really hard to sell to the investing public. Not because it is illegal to do so, but because it takes a lot of effort to explain what it is to a lot of different parties. You have to coordinate the offer with brokers, exchanges, lawyers, banks, and so on. But what if all you had to do was fill out the legal paperwork, and then click a few buttons to create a token that represents that derivative?
With a digital token representing this derivative it would be very easy for the company to give the ability to buy and sell the derivative to the investor. The owners of these derivatives could easily trade them “over the counter” (OTC) by moving digital tokens that represent the underlying derivatives to anyone using compatible software. The people who are buying the tokens would probably never need to take delivery of the actual derivative contract; the paperwork would never need to leave the company’s legal office.
If we consider these and similar scenarios where we want to take some of the friction out of markets for physical or abstract assets, what would a well-rounded and general set of business requirements for a digital token project look like?
- Let any retail investor with a smartphone discover, buy and sell financial derivative products with a somewhat liquid cryptocurrency.
- The costs for moving the token are the responsibility of the retail investor.
- These transaction costs should be stable and predictable, and should be perceived by the person paying the fee to be “low”. Or at least significantly lower than traditional broker fees.
- When tokens are transferred, the updated ownership information (who holds how many of each token) should be available to both sender and receiver immediately, in real time.
- That change in token ownership should be irreversible. This means that our business rules are clear: all sales are final, no returns or exchanges are accepted.
- Custodians should not be required. This means that the risks and costs associated with custodianship can be avoided.
- We want to use a token format that everyone else is using, or can easily start using. Creating a database and issuing our own tokens means that achieving interoperability with other tokens and digital money, like Bitcoin, will be very expensive and time consuming to achieve.
It’s also important to think about what is *not* important in this context:
- Censorship resistance. These are financial products that are already regulated, being offered by companies that already comply with regulations. Asking retail investors to pay for more “trust minimized security” than is absolutely necessary means that they will achieve lower returns than they expect.
- Technical protection against attacks on the token’s network by a well-funded adversary, like a large company or a government. Companies pay taxes and in return expect governments to provide public infrastructure and protect their business interests. Even though tokens are a relatively new concept, it should be normal for a company to expect the government it pays taxes to to provide for the ultimate security of the networks they are using.
For retail investors, one of the biggest challenges in a world awash in tokens is determining the quality of those tokens. Most likely, they will look to trusted brands to offer these products in an environment where low quality and imitation token products have been filtered out. This probably means you will soon see “App Stores” which offer pre-screened, high quality, legally compliant (in your jurisdiction) tokens.
With all of this in mind, let’s address the important question: how can professionals harness and use this technology effectively, right now? The reality is that even though there are thousands of blockchain projects out there, there very few viable options. And because it’s so easy to get rich by marketing a new “blockchain” technology, there is a huge amount of marketing noise. And that means it’s really difficult to find the signal. But if you think about what you really want to achieve and then start searching the haystack for your needle, the most appropriate technology choice for asset-backed tokens at the moment is probably Stellar.
Why Stellar? At the moment it meets all of the aforementioned business requirements. And importantly, Stellar is designed to let you model exactly these sort of “asset backed” scenarios.
What are the risks to using Stellar? There are two serious risks: the first is the weak “Proof of Stake” security model. Unlike Bitcoin’s Proof of Work system, a well funded adversary could easily overpower the Stellar network, disrupting transfers and destroying confidence in your financial product’s token. If the Stellar network becomes interesting enough to attack, someone will attack it. Your only hope in the near term is that Stellar is too boring to be attacked by such an adversary, and in the longer term that the government you pay tax to will help defend your Stellar infrastructure.
The second is the risk of the price of its native currency unit, the Lumen, rising. This would in turn cause transaction costs to rise. At some threshold, this would invalidate our “low” transaction cost business requirement. Because of its market dynamics, the Lumen price can be manipulated very easily by even moderately wealthy private persons. And the Stellar foundation ultimately controls the supply of Lumens, allowing it to act as a sort of central bank. Is this organization qualified to act as a central bank? That’s a question that has to be answered by anyone who is considering offering tokens on the Stellar network.
Why not Ethereum or Bitcoin? Both fail the “low, stable and predictable” transaction cost requirement for this application. Both provide more censorship resistance and/or technical capability than is necessary to meet a financial product’s business requirements, and this cost will be passed along to the user. Instead of expecting the network to provide all of the security required, we should expect (and demand) some of this security to come from the government that is already policing the financial products being offered. There is of course much more to discuss when it comes to the technology, but this is out of the scope of this article. Ethereum and token fans can start by reading this blog post: https://blog.stellarx.com/the-great-filter-why-you-shouldnt-ico-on-ethereum/
But what about this newer/better/faster/cheaper technology my friend told me about, it’s got *buzzwords* and I bought a lot of its tokens/started mining it!?
There might be some newer and better technology out there, which helps better manage the risks mentioned above, but I don’t know about it. Stellar has been around for a little while, and it works in a way that people expect it to. I would not recommend using any technology that has not been around for at least a few years, has clear and extensive documentation, and has broad support. I think it’s reasonable to assume that if you offer your financial product via a token on the Stellar network, you should be able to expect it to perform reasonably well for 1.5 to 2 years. After that, plan to re-assess your technology decision.
Oh, so should I buy a bunch of Stellar Lumens and hope they go up in price?!
No, absolutely not. Unlike Bitcoin, which has perfect scarcity, Stellar Lumens in and of themselves should be considered near worthless. And that’s the whole point. Lumens are nothing more than a way to move your tokens around and provide interoperability with most custodial exchanges, while providing a modest security framework. If the price of Lumens is erratic, and especially if the price is considered “too high”, then the ultimate value proposition of using Stellar as the rails for an asset-backed token will be destroyed.
Technology discussions aside, it’s not a good idea to “bet the farm” and invest your entire R&D or marketing budget into a token project. But any firm that does start a project now, even a very small project, will soon be light-years ahead of larger competitors with bottomless budgets who talk endlessly but never take action. It takes time to wrap your mind around this paradigm shift; being able to competently form a business strategy in 2025 starts by taking the technology seriously and getting a “hands on start” in 2018.
A simple mobile application where your clients can use tokens is enough to learn an enormous amount, and with very little risk. As technology and the regulatory environment matures, those who will have started now will be experts in a year. When the next big wave of excitement hits, you’ll know exactly what is real and what is hot air, and how to proceed with confidence with your product strategy. There are highly nuanced risks and enormous opportunities that lie just ahead.