Security Tokens (Part 4: Disrupting the Blue Ocean)
In the previous three parts (Part 1, Part 2, Part 3) we have discussed how security tokens (or tokenised securities if you prefer) are different from traditional securities. Now we change tack and start looking at the different markets where security tokens might be successfully deployed. In this part we mostly look at applicable strategic frameworks. More detailed applications will be discussed in Part 5 and later posts.
After having discussed the dimensions in which security tokens are different we now want to change tack and analyse the implications of this, ie we are discussing in which situations tokenised securities are superior to classic securities. Of course as fellow MBAs and (ex) strategy consultants know, this analysis absolutely requires a framework. So without further ado, let’s dive into the framework discussion.
Disrupting the Blue Ocean
If there is one strategy framework that epitomizes the revolution that coming from the Silicon valley has taken over the world then it is the framework of Disruption or Disruptive Technologies which was first presented in Clayton Christensen’s 1997 book “The Innovator’s Dilemma” and that has been refined in his and others’ publications ever since.
The other big strategy framework of the last 20 years is the Blue Ocean Strategyframework which is based on W. Chan Kim and Renée Mauborgne’s 2004 book of the same name which also been developed further in numerous follow on books and publications, and has even lead to the foundation of the Blue Ocean Strategy Institute which is associated to the INSEAD business school in Fontainebleau.
Blue Ocean Strategy
Let’s start with the Blue Ocean strategy: the basic premise here is that firms more often than not compete in the red ocean where dog eats dog (or rather fish eats fish) instead of calmly lunching on the big shoals of herring in the large blue ocean where no other competitors can be found. Or, in slightly less prosaic language: according to the Blue Ocean theory, firms often do better focusing on the current non-customers than on their competitors’ customers, as targeting the former increases the overall market size, whilst preying on the latter simple solicits a competitive response that ultimately makes everyone worse off.
Now in principle this is a good story — who would not prefer to swim in the deep blue ocean rather than fighting with other predators in dirty red water? Well, not so fast: maybe there is a reason why everyone is feeding in the red part of the ocean, because this is where the fish are. Maybe the blue ocean is blue and not red because there is simply no prey to be found and predators who go there simply starve? Or again in a less prosaic language: converting non-customers is hard, and sometimes they stubbornly refuse to convert. To quote Keynes: “non-customers can remain stubborn longer than you can remain in business”.
Companies mentioned in the book as having sucessfully explored blue oceans are for example Netjets who created the category of fractional jet ownership, Southwest Airlines who pioneered the low cost point-to-point airline model, and the Cirque du Soleil who created a scaleable and modern high end circus experience. All those companies competed with companies in their wider market segment, but they also increased the overall market size. For example both Netjets and Southwest Airlines increased the money spent on travel at their respective end of the market.
Not all start-up companies pursue blue ocean strategies. A classic example is the clustering of businesses in certain areas, as evidenced eg in the City of London where streets are named after the products that were sold there in the middle ages, or in the cluster of electronic shops around Tottenham Court Road back in the time when electronics were still sold in brick and mortar shops and not over the Internet. The clustering typically happens because a new seller finds it more convenient to set up shop close to the incumbent sellers as this is where the customers are. So in fact by occupying a “blue ocean” spot close from every competitor our electronics retailer probably does his potential customers, and therefore himself, a disservice: they would much prefer him to be located in the cluster, even if they happen to live next door to him, because they value the diversity of choices in the cluster more than they dislike the cost of travel there.
Analysis of the clustering effect however is subtle. To show why, let’s look at electronics in the pre-Amazon age: those are big ticket items which costumers don’t buy very often. Because those items are expensive, buyers need to choose carefully, and they therefore value a larger selection of items, and a bigger variety of advice. On the other hand they probably care less about travel time and cost as long as both are reasonable. So this might mean that there is a single centre per city for those items, as Tottenham Court Road once was, but every major city has a centre because not all of the UK is willing to travel to London for buying electronics. Let’s compare this to say bakeries in France: every French person is by law required to buy baguette at least once a day, and it is not unheard of that people buy a demi-baguette before every meal instead of eating stale bread. This means that bakeries need to be much closer to the customer and are therefore much more evenly distributed. As a baker, occupying the “blue oceans” where customers can’t buy bread locally is often a good strategy. Also arguably baguette is a commodity that can be bought in any bakery, even though not all French people would agree to that statement.
What we can conclude here is that if you can deliver a product that is superior across all major dimensions then you should operate in red ocean territory because you will steal the incumbent’s customers — this is the story of the iPhone completely changing the dynamics in the mobile phones market. You should also operate in red ocean territory if the cluster you consider joining lacks diversity, so when you join there is a benefit for customers because they will have more choice and variety. That is the story of Android phones who are a lower-cost-but-mostly-equivalent alternative to the iPhone. One might think that the emergence of Android was bad for Apple, but in reality it was not. The iPhone was always a premium product with extremely high margins that was meant to be not affordable for a large portion of potential customers. Android covers those who can not or do not want to afford a premium product, and only Android’s emergence made that now smart phones are ubiquitous, which in turn lead to the emergence of many smart-phone reliant services such as Uber that in an iPhone-only world might not be profitable or even possible.
Disruption
After having looked at Blue Oceans let us now look at Disruption. The term “Disruption”, as used in the Clayten Christensen sense (and therefore capitalised in what follows, to indicate that it is not used in the every-day sense), is a very specific term that describes how the baton is passed in an industry from one generation to the next. Not every declining industry is being disrupted.
To go more into the details, Disruption describes a multi-step process how innovation works its way through the system. The sequencing is as follows: in a first step, there is an innovation in relation to an existing product. Importantly this innovation does not uniformly improve that product. Instead, it improves it along one set of dimensions, and it makes it worse along another set. One of the original example used in Christensen’s book are hard disks: innovation allowed to make them smaller, eg reduce the diameter from 3.5" to 2.5", and also cheaper. However, this reduction in size also reduced the storage capacity making it unattractive for the current customer base.
The second step in the disruptive process is that the innovated product is sold to new customers for whom the previous product was not suitable. For example a reduction in size in hard disks allowed building laptops. At the outset, laptops were an addition to desktop computers, so the new smaller disks are sold to people who would have not bought the bigger ones anyway (do you feel the Blue Ocean breeze here?). In the incumbent market the innovated product however has little to no impact at this stage because of the deterioration along the other dimension(s). For example for hard disks, desktop computers would still use the larger disks because they had more capacity, were faster and (at least on a per-capacity basis) cheaper.
In the third step (which technically is a period of time, not a discrete step) the innovated product is sold to the customers that value it, creating profits for the producers which in turn allows them to invest into improving the product, so over time it gets better and better. Of course the not innovated product (eg the larger disk) also gets better, but typically at a smaller rate, simply because it has been around longer.
The fourth step is where the actual Disruption that has given that process its name happens: there is a cross-over point where the innovated product is good enough for the users of the legacy product. Note that this does not mean that the innovated product has fully caught up — “good enough” simply means good enough. At this stage the users of the legacy product switch over to the innovated one: it is significantly better across some dimensions (eg size, cost) and good enough along the other ones, therefore there is not reason to remain tied to the legacy product, and therefore the legacy product disappears. Disruption has happened.
One aspect we have so far ignored, and that is central to the theory of Disruption, is that the disruptor and the disruptee are generally different companies. A significant part of Christensen’s work is dedicated to explaining how incumbent companies for organisational-behaviour-reasons typically do not succeed in creating the product that will ultimately disrupt them. For example, companies will have little interest in a product that is not suitable for their clients, and that therefore the existing salesforce can’t handle. Also there is often a general failure of imagination how such an inferior product could possibly replace the company’s flagship product.
Tokenised Securities
After this excursion into disrupted blue oceans, let’s come back to our topic at hand: tokenised securities, seen as subset of all securities, tokenised or not. “Securities” in this context is interpreted in it widest possibly sense as investment contracts that are sharing the ownership of any kind of asset, regardless of whether or not this particular contract would be considered a security or financial instrument under applicable law. An important example of a “security” under our definition but not under most jurisdictions’ legal definition would be income producing real estate.
The first decision to make is whether to use tokenisation in a red-ocean or a blue-ocean context. We have seen above that there are two reasons why we’d like to operate in the red ocean of the existing customer base: either we are so much better than the incumbents across all major dimensions that we will simply take over and push them out of business, or because the red ocean is not very deeply red, and could benefit from some diversity in terms of product or service offering.
The first condition — being better than the incumbents across all major dimensions and pushing them out of business — is exceedingly rare. As Christensen showed, the more viable part to Disruption and pushing the incumbents out of business is typically via entering adjacent blue oceans first, and use the business in those areas to improve the product until it is good enough for the incumbents’ users. Even the example we used above as being better across the board had a component of this: before the iPhone, Jobs developed the iPod Touch to put in place and test major iPhone design components (in particular the touch interface) in a lower risk setting. Only once all the important lessons were learned (and Apple’s customers paid for Apple’s lessons in this respect) would Jobs move on to the iPhone.
So the first question we need to ask ourselves whether there are red ocean areas where tokenisation is so much better across all dimensions than the current alternatives that there is a good possibility that by entering this particular market the current incumbents simply will be pushed out. For most current use cases the system works well enough, and in fact blockchain based methods might not be suitable. For example many of the major public chains still have serious constraints as to the throughput they can manage and settlement eg of the large publicly traded stocks would simply not fit within those volume constraints. Private chains can naturally run at much higher speeds, and there are some that could cope from a volume point of view. The reason we exclude them in this analysis is that from a customer point of view a private chain does not look much different from a centralised data base.
Note: this is a very crude statement and the reality is more differentiated. Discussion of the different kinds of private and proof-of-authority chains (in particular consortium chains) however is for another post.
The second issue of course, and this is arguably the most important one in the short term, is that current securities regulations are not written with blockchain in mind, and that eg for securities traded on major exchanges use of a centralised depositary is mandatory in many jurisdictions.
When doing the analysis for LexByte we could think of one existing market segment where tokenisation is strictly superior to what the current system can offer and where disruption could be iPhone-style instead of following the usual multi-step process. As we are currently contemplating to raise funds to execute on that idea and because it is an area with a significant first mover advantage we will keep schtum about it for the time being.
The second question then is what the blue ocean areas are in which the dimensions where tokenisation is different enable business that serve “non-customers”, ie customers not currently being served. This currently is an area under active investigation by many different teams. We will discuss this in more detail in an upcoming post, so for the time being I will only throw out a number of market segments here, without further discussion, and without any claim as to completeness:
- single asset securitisation, especially in the real estate space
- equity-based crowdfunding
- product-based crowdfunding
- certain cross border investments
Interestingly many of those segments are of the kind where a certain diversity of service providers matter, which makes it a good area for fast-follower strategies.
This concludes Part 4 of this series of posts. You can continue with Part 5
Stefan Loesch a managing partner at LexByte, an advisory firm specialising on tokenised investments. He has more than 20 years experience in financial markets, and his previous roles include advisory at J.P. Morgan and McKinsey and quant development at Paribas. He is the author of “A Guide to Financial Regulation for Fintech Executives” (Wiley 2019).
Image credit: Pexel
