Bitcoin is hovering just beneath $60,000. Traders doubt, weigh and measure, with uncertainty ever gnawing. Crypto and DeFi have certainly gone mainstream, but so has the speculation. In the height of speculative frenzy, fundamentals tend to fall out of focus. And in the case of DeFi, it is all too easy to forget that financial systems exist to finance economic activities rather than other types of financing.
Previous articles of the present column have pointed out the importance of financing real assets based on real economic activities. The other side of the same equation is attracting traditional capital, which will naturally gravitate towards investment vehicles with actual underlying economic production. This is by no means an easy challenge. Economic interests and claims in the real world are encapsulated in nuanced legal terms, which do not carry over automatically on the blockchain. Capturing entire legal contracts on the blockchain is impractical, and hence drawing out the key terms of the transactions is crucial, a skill not commonly found in the DeFi world.
The current lack of protocols or projects to address this issue attests to the difficulty of the task. However, one has recently launched as a promising solution — Ink Finance (www.inkfinance.xyz).
Not just a new protocol
Ink Finance does not operate like a typical DeFi or blockchain project. It is not even a protocol per se, but an entire suite of banking and financial engineering modules. While not necessarily obvious to crypto natives, bankers will find its logic highly intuitive. It is at heart a financial governance system, which bankers (and sophisticated investors) deal with every day in the form of transaction documents as they run a deal. Ink Finance applies its technical framework to govern these financial affairs, by replicating some of the legal terms of the asset itself in order to enforce them. The device is called Ink Envelope, which organizes and encodes the terms into smart contracts. In doing so, it marries the blockchain spirit with real financial transactions — the code is law, and the law pertains to real economic claims. In doing so, Ink Finance spawns the issuance of crypto investment vehicles to finance non-crypto ecosystems — i.e. real-world assets.[TT1]
The Ink Finance Governance Module addresses the technical issues facing a DAO with a no-code experience. It offers a plug-and-play DAO construction and operation platform so that clients can directly use Ink to govern their off-domain business. This will appeal to bankers and financiers, who are famously clumsy in hiring and managing technical staff. Sitting atop the governance module, Ink Finance Products Module offers a full-blown suite of financial engineering tools to build equity rights, bonds, notes, funds, etc.
If it all works according to plan, any banker-minded asset owners could structure transactions to tap into DeFi liquidity. Ink DAOs enforce that only asset-backed tokens (bonds, rights, ETFs, etc.) will trade and clear with proper custody. Decentralized technology enforces the integrity and rigor of governance. It links users with liquidity looking for good investments to issuers to raise funds backed by real-world assets.
In many ways, Ink Finance caters for businesses in the “Web2” world, which may dominate their sector, could issue their own tokens with credibility, but are daunted by blockchain technology. However, it can theoretically work with any type of real-world asset. For example, those with existing carbon credits could use Ink Finance to wrap them into a structure to be tokenized. If one thinks more aggressively, entire renewable energy projects, reforestation efforts could be wrapped with Ink Finance to issue green tokens instead of green bonds. As any debt capital markets banker can testify, bond issuance is a lengthy and cumbersome process that becomes cost-prohibitive for smaller ventures raising less than $50 million. For small scale innovative sustainability projects, especially those in emerging markets, green tokens offer an appealing alternative.
The pressing need to exit
Technology, when applied correctly, always improves operational efficiency. This not only benefits smaller ventures seeking to raise smaller sums due to its “democratizing” effects. Ironically, it may even be more relevant to big capital with pressing needs to exit big investments with big gains.
It is no news that companies are staying private longer, and with bigger valuations. For example, ByteDance, the Chinese technology behemoth that owns TikTok, remains private at a valuation of $140 billion[1]. According to a recent Morgan Stanley report, “the median age of a company doing an IPO was 7.9 years old from 1976 to 1997 and 10.8 years old from 1998 to 2019. This is a 37 percent increase. If we extend the first period through the dot-com boom, the median age has increased closer to 50 percent from 1976–2000 to 2001–2019.”[2]
One can easily surmise the reasons — ample liquidity, wealth concentration driving private capital markets, globalized capital flows, etc. Less obvious is the pressure of this trend on entrepreneurs, venture capitalists and their LPs.
Disclosure requirements and 24/7 social media presence have effectively shone a gigantic spotlight on corporate activities. A wrong tweet by the CEO could spark a selloff in the company’s stock. This is on top of the constant demand to deliver short term results for public equity investors. The pressure of running a public company, especially in the US, is palpable. The IPO process itself has become more burdensome and more costly with more regulation over time. Hence many entrepreneurs prefer to stay private as long as possible, and only pursue the IPO when they feel absolutely necessary.
These incentives force a bizarre adverse selection — only really successful companies will consider the IPO exit, but to remain successful they often need to raise money again and again from private markets, creating ever higher rounds of valuation. This only exacerbates the need to launch an even more successful IPO, as later private round investors expect high multiples for their investments to justify the late stage valuation. A last moment mistake could destroy billions of dollars in valuation, and take off many points in fund returns, as WeWork has agonizingly demonstrated.
The pressure also makes taut nerves for venture capitalists. Funds often last 7 to 10 years, and will need to unwind, delivering a return for LPs, and also literally returning capital to LPs. VCs may face tremendous pressure from LPs to close out investments, and they in turn pressure portfolio companies to sell or pursue an IPO. While private capital has been much more plentiful than before, at the end of the day, private investors need to exit.
And hereby comes the paradox. Private securities are by nature more bespoke and less liquid. Public securities are by nature more liquid and less strategic. The golden balance is just enough liquidity to create exits for private investors, but also just enough standardization so that entrepreneurs do not face the same pressure as they would in public markets. The answer is tokenization.
Tokens are not public securities and token investors would not demand the same level of scrutiny on the company as public equity investors would. However, they would still want some assurance on the relationship between the token and the activities of the company, especially if the token investors are traditional capital players. Striking this balance has always been a challenge, as nobody could capture the right investment terms on the blockchain. Ink Finance could provide a solution. Tokens and smart contracts are by nature far more flexible in implementing voting rights, governance conditions, dividends, etc. The Ink Finance governance module and Envelope could well encode these terms appropriately.
Unlike equity markets, tokenization does not need to stop at the level of portfolio companies. Stakes in venture capital funds could also be tokenized, as long as Ink Finance could truly capture the nuance of the investment agreements. No LP would decline the opportunity to explore an exit. Tokens, powered by blockchain technology, could be easily divided into smaller units to tap into DeFi liquidity, but no smaller than necessary to preserve the idiosyncrasies of the investment.
More importantly, with appropriate structuring and custodianship hopefully empowered by Ink Finance, such tokens can remain private securities. They capture, reflect and correspond to privately structured investment agreements as well as vehicles. This will need to be carefully thought out before launch to avoid any unpleasant confrontations with the SEC, and will likely involve the governing law of friendlier jurisdictions such as Switzerland or Singapore.
And if token investors worry about volatility and risk management, DeFi derivative suites such as CLEAR have emerged for this purpose. In fact, the tokenization of real-world assets will form a positive symbiosis with DeFi derivatives, as both the need and object of risk management become more sharply focused.
Closing thoughts
Speculation alone does not make a financial system. Financing makes a financial system. Fortunately, this point is not lost in the DeFi world. The launch of Ink Finance represents an important step in bridging the world of the real economic activities to the blockchain and hence to the world of DeFi.
It is too early to tell if tokenization will meaningfully overtake securitization, but hope has glimmered. The resilience of this technology can coexist with jurisdictions and governing laws, but will also hopefully deliver the world from the evils of a financial system hijacked by fiscally irresponsible actors.
[1] CB Insights, How TikTok’s Owner Became The World’s Most Valuable Unicorn
[2] Morgan Stanley, Counterpoint Global Insights: Public to Private Equity in the United States: A Long-Term Look, August 4, 2020, https://www.morganstanley.com/im/publication/insights/articles/articles_publictoprivateequityintheusalongtermlook_us.pdf
