Security Tokens (Part 5b: Single asset securitisation examples)
I was busy with our assessment of and response to the FCA consultation on crypto tokens (Question 1, Question 3, Questions 4–6, Questions 7–9) which prevented me from working on this series. However, that is now done and we are back on track.
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 the previous post Part 5 we discussed single-asset real-estate investments, and before moving on to other applications I want to expand on some of the examples.
After having discussed single asset securitisation at a higher level above, I want to discuss a number of specific cases to make the applications more concrete. As discussed, the applications are mostly in the wider real estate space which not only includes real estate proper but also infrastructure.
The examples we will be looking at are the following
- Local commercial real estate
- Local rental objects
- Partial ownership of occupier
- Local infrastructure in the developing world
- Diaspora investment
Finally we will also look at leverage.
Local commercial real estate
The first use case we want to consider is that of an office building or a small mall in a secondary town, say at an asset valuation between 500k and 5m, maybe 10m. As this is a secondary town the real estate prices are not that high, and also the needs in terms of size are more limited, so whilst this is not a crucial piece in the local landscape it might be important enough to make a difference and for the mayor to care.
Because it is a secondary town this particular object will not be on the radar of many of the large national or international real estate investors — if at all, only a few specialsts investors will be looking at it. If you are not familiar with the area then analysing the object comes at a higher cost, so those larger investors will only look at it if the yield if sufficiently above that of a comparable object in a better known location.
Local investors however know the market very well — they know whether there is an abundance or dearth of office or retail space, they know what the good locations are, and with a little effort they’ll be able to dig out all kind of benchmarks to understand whether or not the proposed valuation is attractive. Moreover, if it fits in the overall municipal strategy the town hall might be able to provide some inducement local development. Even if it is only of financial nature it might still be better for the area (and often politically more acceptable) if subsidies are not paid to some far-away investor, but to local people who want to do something for their community. Even more importantly, in a local community the inducements do not have to be of a strictly financial nature. For example the mayor could organise an annual ball or a New Year’s reception for “investors in the local economy” which people might value more than simply a higher coupon, or investors might qualify for free parking at the mall, or discount vouchers.
All of this can be done without a blockchain, but not necessarily efficiently. Let’s say the object yields 7% unlevered (we’ll deal with levered investments) below, and say we want a ticket size of 15k, yielding about 1k per annum. That does not leave an enormous margin for operating costs, especially not those of the manual kind, say because addresses and bank account details have not been updated (and one should not underestimate the cost of updating those details either unless it is done in a self-service web-based system with virtually zero error rate and little need for support). On chain, there is no need for maintaining any of those details: all communication (both broadcast-style / open and bilateral secure) can be done via the token, including voting if need be (say for a virtual annual general meeting). All financial transactions can be done on-chain as well, so there is no need for bank account details, and in particular no risk of returned payments that are extremely costly to deal with.
Note: KYC and AML considerations as well as securities or company laws can make it necessary to keep up-to-date details of all token holders. That obviously poses issues for ERC20-style tokens that can be transferred to any Ethereum address. There are various possibilities of doing so. One solution would be a whitelist of eligible address, but that has an number of privacy and UX related drawbacks. Another solution would be to freeze all token benefits (in particular the right to receive dividends) until the new owner passes passes the necessary identity checks. Ultimately this is a structural issue that the whole token world needs to address, and I am confident that it will be sorted out in time.
Where tokens really shine however is all those supplementary inducements and services that we have discussed above. For example the wallet containing the token could — via NFC or QR code — serve as an entry ticket to the parking, the ball, or the New Year’s gala. Alternatively, the private key associated to the token address could be used register a number plate for parking, or two guests for the New Year’s gala. If there are security or privacy concerns about using the private key protecting the assets for such mundane task the investors could designate an alternative key for those by simply signing a single revokable attestation with their primary key.
Also, a blockchain based system allows to introduce advanced management features: for example, maybe not every token holder should be allowed free parking, but only those that have been holding the token for a while. So the system could be designed in a way that token holders only get free parking three months after they have purchased the tokens. Or, even more sophisticated, token holders could be reimbursed for all their parking fees once they have held onto their tokens for three months, six months, or a year.
In summary, tokenisation of local commercial assets could they allow for targeting local investors directly, even if they can only afford smaller ticket sizes, and they could receive inducements and benefits that would otherwise not be practical or cost-efficient to deliver.
Local rental objects
In the previous section we discussed local commercial objects, and everything we discussed there does also apply to single and multi-tenant rental objects: if locally real estate is tight it might be easier for local investors to assess this — and the attractiveness of any particular object — than this would be the case for outside investors. This is particularly true for relatively small objects — say a single flat, or a 2–4 family house — where the size of the investment would normally make any fractionalisation of that investment inefficient.
To look at a few particular use cases, let’s for example consider a house where the local housing market is very tight, which in turn makes it hard for a local company to recruit key staff. Those companies might willing to either invest in property themselves, but maybe only as anchor investor in multiple properties, with other co-investors chipping in an increasing the pie. They could also subsidise the object in exchange for a right-to-rent that they can pass on to an employee, or they could provide the landlord with an uptake guarantee in case the property is empty. None of this is impossible in the world of classic finance, but blockchain-based technology might just remove the friction to the extent that what was not attractive before suddenly takes off — I like to call this the “iPhone effect” where a product that was by no means new and revolutionary rolled up and created an entire market, simply because it just got all the features right enough so that the market friction disappeared and the PDA-phone market that had been languishing for a while suddenly took off.
Partial ownership of occupier
In the residential market there is another issue which is that from an economic perspective owning a property is often not ideal: in many cases the ownership of their house will be the only major investment that this particular person has, and especially for young owners this investment is often extremely levered because they are at the very beginning of paying back their mortgage.
Now houses are safe as houses, but not safer. Firstly there is a risk of a catastrophic loss. Many events can be insured against, but insurance cover can lapse eg in the case of strong negligence. Also, some events like natural catastrophes, terrorist attacks, or war might simply be uninsurable, at any premium. On top of this there are the more low-key but by no means unimportant risks, a key one of those being local economic activity. Let’s say there is a recession, and one or two of the major local employers go bust. This typically has strong knock-on effects of the local economy, and this means that many people might default on their mortgages or move away. This in turn leads to reduction in house prices, both on the purchase and on the rental side. Unfortunately for an owner-occupier this might be exactly the time when they need to sell or rent out their house because they have lost their job and are looking for employment elsewhere.
It is important to understand that in the above scenario leverage can dramatically increase the effect: say prices only go down 10–20%, which is not unheard of during a local event like this, especially when people are forced sellers. For someone owning their house outright this is annoying, but maybe not such a big deal — 10–20% is manageable. However, if the house is subject to a mortgage of 50% then a 10–20% drop suddenly becomes a 20–40% drop which start getting very substantial if this is your only asset.
Compare this scenario where the occupier owns a substantive part of their property — say 30–51% — but instead of having a mortgage they have a number of “investors” to whom they pay a pro-rata rent (we assume unlevered investments only for the time being; leverage is discussed in more detail below). For someone just getting on the property ladder those outside investors might be say 90%, and they might include parents, employers, or other related parties. Instead of paying back the mortgage, the occupier could then either buy back parts of their own property from those other investors, or they could invest in other people’s properties instead, ideally not in the local property market to reduce the correlation effect discussed above.
Note: depending on the jurisdiction there might be negative tax implications from the above deal because the rental income is taxed whilst the rental payment is not tax deductible. This is ultimately due to an implicit subsidy for owner-occupiers in many tax systems. There are a number of ways of structuring around this, but they are beyond the scope of this text.
For developed markets with a good banking system that option might or might not be the most attractive option for property owners, especially if the tax issue discussed above have not been taken care of. For developing markets however this could be a game changer as local communities (or the diasporas of those communities; see below) could finance the development of their own area. In this case, equity participation might not be the right instrument, but some kind of community-raised debt financing might be more appropriate, in which case this essentially is the original model of the British building societies, the German Bausparkassen, and the French credit mutuelles. Using blockchain technology this model could remerge especially in communities that otherwise would not have the resources managing it.
Local infrastructure in the developing world
Having discussed mutual lending and investment in relation to residential property in developing market in the previous section I now want to move on to the related topic of infrastructure investment, maybe a solar farm, or a well or an irrigation system, or a processing plant that would allow the local community to capture more of the profits along the agricultural value chain, and that might also create non-agricultural jobs locally which could prevent some of the migration from the communities into the cities.
Local people with some money to spare (or diaspora; see below) could pool resources to invest into local assets, which in turn might or might not give them a say in how those assets are run, or might give them preferential access to those assets in question, eg to have their own products processed first when there is a processing queue (and every efficient plant has a processing queue, otherwise it will go idle from time to time which can be very costly). Other local people might simply invest for the financial benefits that it gives them. In this case they might have no use for the benefits of preferential processing capacity, and to compensate them for this they might either receive token-based entitlement vouchers that they can then sell to people in need of processing capacity, or they could be investors in a different share class that would entitle the holders to a higher share in the profits in lieu of the benefits in kind.
Here again — blockchain does not suddenly create an opportunity to do something that was hitherto impossible, it simply might make things easier and reduce friction. For example, mobile Internet is ubiquitous and accessible through very cheap and equally ubiquitous devices. Once the investments and their associated rights (to products and services as well as to dividends) are tokenised, the software to deal with those (wallets, exchanges etc) is mostly available and often only requires minimal adaptation, and using tokens on a public chain as opposed to some proprietary system can make it easier to connect the structures in different locations, and/or to create some higher level integrations.
Note: eagle-eyed observers might have noticed one problem with using blockchain-based solutions where the keys are held in mobile wallets: if the mobile is lost or destroyed then the key might be destroyed, causing unacceptable losses. This is a wider topic however that we will address in a separate chapter on custody-related issues.
Diaspora investment
Thus far we have discussed local people investing into their local communities, but in many parts of the world there is an even more important source of funding: the diasporas. Community members living and earning overseas, and often earning amounts that are very substantial when considered in the context of the local community. The primary way that diasporas nowadays are getting involved in local communities is via remittances: they provide resources to their relatives who are still living locally, and those relatives might simply use those resources to top up their current spending, or they might use it for investments, typically in property, or into their own local business.
Firstly if the local community is already organising itself around a partially tokenised economy remittances can become much easier and cheaper: any local economy must use one (or multiple) currencies as a means of exchange, be it a stable coin or a bona fide crypto asset like Ethereum or Bitcoin. Those can easily be bought abroad and simply transferred to the intended recipients via the blockchain, at a de minimis, or at least at an acceptable cost
Note: on many currently leading public proof of work chains, notably Ethereum, transaction costs can be an issue, especially for smaller transactions or low-value events. Future technologies like sharding and second layer networks might address this, as could be the usage of publicly accessible consortium changes. This is subject of another chapter.
Apart from cheaper remittances, blockchain technology and tokenisation allows diasporas a deeper involvement in their communities of origin, and in particular it allows them to invest in those communities for their own benefit as opposed investing for or in the name of relatives and friends. Everything being equal this should substantively increase the amount of investment available for those communities, eg from people who no longer have close relatives there but still feel connected and want to contribute, or from people who feel they need some savings for themselves, but are happy to invest those savings in their communities of origin as opposed to in their host communities. Again, like in the case of local investments, one could think of all kind of non-monetary incentives that would allow diaspora investors to raise their social status in their community of origin.
Leverage
One topic that we have mentioned a few times before but that we we said we’ll treat later was the issue of leverage, ie borrowing against investments. This issue is particularly important in the context of real estate, both commercial and non-commercial residential.
For commercial real estate that is held by real estate investors (as opposed to by occupiers / users) leverage is a means of increasing returns and therefore making their time and investment worthwhile. The proper reasoning here is quite subtle as one needs to discuss the limitations of the famous Miller Modigliani proposition which is beyond the scope of Finance 101 and also beyond the scope of this discussion. So for the interest of brevity we will just posit here that some investors — especially those skilled at assessing risk — prefer leverage investments allowing them to earn larger percentage returns on a smaller capital base.
For owner-occupiers and asset owning companies the issue is different and more of a lifecycle decision: people or companies want to enjoy the use of an asset before they are in a position to afford it. Sometimes renting the asset is an option but this is not always possible and/or the same. In this case people or companies can borrow money and buy the asset, paying back the borrowed money plus interest over time. For people this allows them to bring future earnings forward, allowing them to earn property earlier in life than they could without it. For companies it is simple: many of them are resource-constraint in terms of growth and allowing them to borrow against their safe assets like real estate allows them to grow faster than they otherwise could.
Whereever possible banks try to lend against real assets as opposed to against uncertain future cash flows as it is in many cases much easier to estimate the value of those assets, and it is also possible to foreclose. Future cash flows might not materialise, and in particular with individuals it can be very hard to ultimately attach to cash flows if the circumstances change. In most countries there is a land register that holds the golden record of all debt associated with a certain plot of land and the real estate built on it. This makes foreclosure easier as it allows a lender to prove that they have a claim, and how it ranks in comparison to other lenders on the same asset, if any. This in turn reduces uncertainty and risk around disclosure which in turn should be reflected in lower lending rates.
For tokenised assets there is another way of obtaining financing: instead of borrowing against the asset itself it is possible to borrow against the tokenised representation of the asset, or rather against the investor’s share of it. This of course is nothing new: it is alway possible to borrow against securities. The difference however that in a blockchain-based environment it is much easier to attach to the assets and their respective flows. Typically if borrowing against a token then this token will be held in an escrow smart contract that tracks the (re)payments of the loan. In the classic case people need to reconcile bank statements to understand whether or not payments have been made. The escrow smart contract can take care of this itself, at least if all payments are routed through it. The escrow smart contract also receives dividends and payments going the other way, so in case of default the creditor can also attach to those payments.
It should be noted however that this area is still under heavy research and development, in particular from the legal point of view. Those legal issues then must also be reflected in the smart contract world. For example on-chain lending against tokens in escrow might be more risky than having a claim registered in the official mortgage registry. On the technical side it is important to understand how exactly the escrow contract should interfere or not with the ownership rights of the token. For example in the standard ERC20 world, as far as the token issuer is concerned the escrow contract is the owner of that particular token. So for example if the issuer relies on digital signatures to identify and authenticate the beneficial owners, eg for voting purposes, then either the escrow contract must forward those actions, or the issuer must understand that the token holder is an escrow contract and must have a way of identifying the beneficial owner.
This concludes Part 5b of this series. Stay tuned for Part 6!
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
