Security Tokens (Part 5: Single Asset Securitisation)
In the first three parts (Part 1, Part 2, Part 3) we discussed how security tokens (or tokenised securities if you prefer) are different from traditional securities. In Part 4 we discussed the two most important strategic frameworks of the recent years, namely Disruption and Blue Ocean, how they apply here, and for what kind of products security tokens will be a good choice. In this post and those that follow we will go through those opportunities one-by-one.
After having discussed the different dimension of how Security Tokens (or tokenised securities; we are not making the distinction here) are different from classic securities, and after having looked at the two most important recent strategic frameworks (Distruption, Blue Ocean) we have identified a number of areas where we believe Security Tokens will make a difference soon. Here we will look at the first one of those, single asset securitisation, in particular of real estate.
Financing assets in the current system
Before we go there let’s look quickly at the history of securitisation. It is generally used as the process of collecting cash flows from a certain pool of assets and turning that into tradeable securities. We would like to use a slightly wider definition here in that instead of attaching to the cash flows generated by an asset we might also try to carve up the ownership of the asset itself, which in turn might allow us to create tokens that behave like securities and/or financial instruments, but that applicable law does not consider as such. In the US this is notoriously hard to achieve as the Howey test is extremely wide in what it considers an investment contract, but in other jurisdictions, including the EU, it might be possible to structure investments in physical assets such as art and real-estate in a way that they are not considered financial instruments.
Coming back to securitisation, the major asset classes in this context areresidential real estate (ie loans to individuals and small landlords), commercial real estate (ie loans to owners of commercial real estate portfolios, including office buildings, shopping centres, and also large residential developments), consumer loans (mostly credit cards), auto loans (to both individuals and fleet operators) as well as equipment loans including shipping and aircraft.
Note that the above all relate to loans extended against the assets, but in all cases the equity interest resides elsewhere. There are a few examples of securitisation deals where the entire cash flow of an asset is included in a securitisation deal, for example the famous [Bowie bonds, securitising the royalty stream of David Bowie’s songs][bowie]. Deals that include the equity components do exist however, it is just that they are not generally referred to as securitisations, but rather as funds. Being a fund might, does not have to, imply a different legal structure from a securitisation, and also funds are generally actively managed, whilst securitisations are either static (ie the portfolio is known from the outset), or if they are dynamic then generally only to replace assets that get repaid, and on an algorithmic basis without much active intervention.
Typical securitisation deal have a relatively complex liability side allowing to separate it into a risky and a mostly (default-) risk free part. The details are relatively complex, but essentially there are some investors taking the first-loss risk, say the first 25% (the so-called “equity investors” because this similar to bank equity), and someone else is only losing money if and when the losses exceed those 25% (the so-called “senior investors” as this similar to bank senior debt). As opposed to banks the securitisation vehicles are structured in a way that they do not pay corporate tax, so it is a very tax efficient way to support a lending business.
Let’s piece this together and have a look how this all works together in the real world, because it is actually quite a finely tuned system. Let’s say we have a shopping center that is up and running, so its cash flows are predictable, and let’s assume that the enterprise value of the object (ie the value of the asset assuming it is financed without debt) is at $1,000m. At this stage a real-estate fund might get interested, but for them the return on the unlevered asset — say 5–7% — is too low. What they can do is to lever up the investment which for those kind of deals typically happens not at the fund level but at the company level. So the company owning the shopping centre might borrow $700m with the centre pledged as security, and the fund buys the equity of that company for $300m in cash. After interest cost that might allow them to achieve a return of 10–15% in line with their return expectations.
The $700m in loans was probably provided by a number of banks, in chunks between $50m and $250m. Some of those banks will keep those loans on their balance sheet, and others will contribute those loans into a securitisation deal. This securitisation deal in turn will issue equity tranches that go to fund investors, similar to those that invested in a equity of the shopping centre, but with more of a macro view. It will also issue senior tranches that goes to investors who simply want to park some cash at a slightly higher yield in a very safe (usually AAA-rated asset).
Single-asset financing using security tokens
As we have seen above, the current process of financing assets is rather complex and relies and generally relies on aggregators such as funds, banks, or securitisation vehicles. Note that financing is used here in the wider sense of raising equity and raising debt. One key reason for this aggregation is that each of the activities in this value chain come with a fair amount of fixed cost where “fixed: means that it scales with the number of investment vehicles.
The worst of those fixed costs is making payments. The cost of making payments differs a lot between jurisdictions: in some they are free or nearly free (a few cents, possibly low single digits), but especially for international payments we can talking single or even double digit dollars per payment. More important is the cost of handling exceptions, eg if a payment is being returned because of wrong account information, or because the account has been closed. Another important cost is investor communication, especially if investors are expected to take certain governance decision because in this case every single investor has to be authenticated. In a tokenised world all payments and all communication and voting can go through the token with allows to massively reduce those costs, making much smaller investment amounts viable. So if before the minimum viable investment in terms of back-office costs was $1,000, in a blockchain world the minimum viable investment might be $100 or even lower. For those keeping track, this refers to the Payment, Communication, and Authentication dimensions at the outset of this discussion.
The other important dimensions here are those of Custody, Clearing, and Ease of Settlement. Regulations permitting it is much easier for investors to hold assets cross-border, and there is no need for being linked to a specific depositary or custodian in order to hold an asset. The consequence of this is that — again, regulations permitting — every investor can transact securely with any other investor around the world, and hold any asset regardless of where in the world it is located.
For those paying attention we however made one important implicit assumption which is that operations on blockchains are virtually free: there is no point saving a dollar in real world transaction costs if we pay the same every time we interact with the blockchain. This is clearly not the case in today’s world, but here is not the place or time to discuss this, so for the time being I would just ask you to park this issue and we will revisit it in a later post.
So in a tokenised world it is possible for individuals to hold hundreds or even thousands of investments in their individual investment portfolio. This leads to another issue of course which is the cognitive load of the investors in question: even professional investors doing this full time will find it hard to track portfolios with thousands of positions, but retail investors who do this on the side will certainly not manage. What it does allow however is for a new breed of fund managers: instead of making the investment decisions and holding the assets on behalf of their clients they are advisors, who recommend investments, or macro portfolio structures to their clients and/or arrangers who source deals for their clients). It is also now possible for clients to get a second opinion meaning that investors can have multiple advisors who make recommendations with respect to their investment portfolio, and the investor decides about the actual portfolio composition using some decision algorithm that is overlaid with those recommendations.
Also the application of leverage can become very different in a tokenised world (and again, applicable regulations and tax laws might complicated things). As discussed above, leverage is often applied at the level of the individual investment, if it is applied at all. In a blockchain world it is much easier to apply leverage at the token level: just stick them all in a smart contract, and use this smart contract as a collateral contract for borrowing tokens, along the lines of what Maker DAO is doing.
Taking this together with the ability to execute cross border investment with ease this means that capital and investment flows can be much more extensive: people can invest in countries to which they never had previously access, and/or in asset classes that were previously too small to be investible in the public markets. At the same time investors can adapt their risk/return profile to their own specific risk appetite.
Only the sky, and the relevant regulator, is the limit as to the way that this can change the way asset management is organised. For example, people can choose to invest into their local community, say for building a cinema, or a pub, or a new shopping centre. Or people can invest in their neighbors’ assets, say a solar roof, possibly benefiting from subsidies for green technologies that they neighbors otherwise would not be able to get for the lack of funds. With the right technology in place repayment could be guaranteed by the electricty that those panels produce, and that at least partly could be sold to the grid in case the neighbors default.
People could also choose to invest internationally. For example, a wind turbine or solar panels in a developing country could be directly financed through tokenisation, and the users of the generated electricity could make their payments into a smart contract that in turn distributes them to the investors, at a neglible transaction cost, whereever they are located.
I’ll stop here because ultimately this is all speculation, and whilst a lot of things will be possible in the brave new world of tokenisation-based financing, each of the use cases will require a dedicated team making an enormous effort to put all pieces into place. Blockchain and tokenisation might be the enabling technology for all of this, but ultimately execution is not a technology problem; in many respects the technology part is the easy bit because blockchain has pretty much solved it already.
Importantly however — and that circles back to the strategy discussion that
we had before — there is a good chance token-based financing will first
operate in the blue ocean of markets that are currently underserved or not
served at all: if it is already possible today to get financing for a
project at halfway decent rates then tokenization might not be the first
priority. It is the projects that not currently get financing but where
there is a community of investors that would finance them if only they could
that will be the first ones to kick of security tokens in this space.
This concludes Part 5 of this series. The next installment, Part 5b is here.
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 2018).
Image credit: Pexel
