Tokenized Assets: The Needle To Pop The Bubble or Just More Hot Air?
A blog post from our CEO, Eric Allred, earlier this year…
I recently listened to a masterful TED2018 talk done by Kate Raworth. She highlighted as humans we’ve come to expect, demand, and depend upon constant, never-ending growth.
Financially, politically, and socially we are addicted to it. The financial system is designed to pursue the highest rate of return for money; politicians want to raise tax revenues, but not raise taxes.
We have economies that need to grow even though the people aren’t thriving.
Since the 1930s Gross Domestic Product (GDP), the total value of goods produced and services provided in a country during one year, has become the focus for policymakers. Growth is always the solution. Or is it?
At what cost are we willing to go as humans to achieve this growth? How much leverage are we willing to use? How much risk are we willing to take on? Who ultimately bears that cost?
How can crypto assets, token economies, and a shift in the paradigm around value creation and distribution help to alleviate this?
Tokenizing Physical Assets
Tokenization of assets has become an increasingly talked about application of distributed ledger technology; this enables us to bring liquidity to previously illiquid asset classes.
Liquidity refers to how quickly you can convert the asset to cash; it is also the ability to buy or sell a security without affecting the asset’s price.
Tokenization also has the potential to reduce some of the liquidity risks for companies and banks in the marketplace too.
What does it mean to “tokenize” an asset?
Tokenization is the process of converting rights of an asset into a digital token on a blockchain.
Our world is full of assets.
… oil, stock, real estate, metals, etc.
These assets can be hard to subdivide, difficult to physically transport, and easy to counterfeit (some more easily than others).
That’s inconvenient.
**Insert 1980s and the genesis of the derivatives market.**
Derivatives are an arrangement or instrument (future, option, etc.) whose value derives from and is dependent on the value of an underlying asset.
In its most basic form, a derivative is a trade between two counter-parties whose outcome derives from something. Inherently, they are an effective way to redistribute risk around the markets to those parties better equipped to absorb them.
Do you own your home? Your insurance policy for your home is a standardized form of a derivative.
You enter into a contract with your insurance company; they agree to pay a certain amount of money for a list of potential realized damages. In exchange for that protection, you shift that risk of loss to them in a swap for paying a sum of money based on the value of your home via the policy each year.
As you can see, some are simple. Some are also much more complex. Some are standardized (insurance), and others are bespoke.
Financial markets are in place to help with the allocation of capital and proper risk management at a relatively low transaction cost.
So derivatives, in theory, should be a good thing. They are a tool to support the financial markets. People want protection from outcomes they can’t foresee or control. They want the ability to take a calculated and sensible risk. This instrument for risk mitigation enables them to grow their business, and positively impact the economy. That’s a good thing.
Due to a lack of divisibility, difficulty in transportation, etc. it makes sense that we would use “paper” to represent part or all of an asset’s physical value given the challenges we stated above.
But, we’re human, and there’s a reason we can’t have nice things.
Global Derivatives Market Bubble
Experts have estimated that the 2018 global derivatives market notional value (the total value of a leveraged position’s assets) is thought to be close to 1.2 quadrillion. Yes, quadrillion. The word you always goofily used as a child that you couldn’t imagine materializing.
The world’s GDP is estimated between 50 and 60 trillion.
This means the global derivatives market has grown to 20 times the size of the global GDP.
Growth, growth, growth!
How did we get here?
- Derivatives can be incredibly complex instruments
- There is a lack of regulation (both from understanding and a resource perspective)
- OTC trades happen between private parties and are mostly in a “black box”
- Traders aren’t incentivized to go against the crowd
- Traders are incentivized to take big risks; their bonuses are paid before the real ramifications of the trade is realized
Most importantly, since 2008, a decade later, the derivatives bubble has continued to balloon from 600 trillion to what some experts believe to be as high as 1.2 quadrillion.
We don’t want to learn from our mistakes.
Some will argue that it’s not a “real money” value and that most of the products are not explosive. They would only force a crisis in the case of an “unlikely event.”
However, in my opinion we are underestimating this unrealized risk. There should be an equal amount of attention on the increasing correlation developing between asset classes due to globalization and the growth of multi-national companies. Following that is an increasing use of leverage to continually produce additional returns.
Don’t have a smarter bet? Make a bigger one!
Growth, growth, growth!
This increasing correlations means fewer places to hide when the markets do start to meltdown and that “unlikely event” does come to fruition.
The gold market to me seems like a likely place for some of this chaos to take place in the not too distant future.
The paper to physical ratio is ultimately out of whack with a COMEX gold ratio exceeding 100:1, massive synthetic supply absorbs physical asset price appreciation, and 99% of trades on the London OTC are settled in cash, meaning delivery of the physical asset occurs less than 1% of the time.
To be fair, transporting gold to settle trades would incredibly inefficient.
What happens when that “unlikely event” does occur? We are likely to see one of the most substantial short squeezes in history.
Who owns the physical gold in times of crisis? Those that physically hold it, your ETF allows you to own shares of “value creation units,” but not the underlying asset. So in the times of crisis and panic, you have nothing.
What happens if there is no physical gold left to buy? Destruction of the fractionally-reserved gold banking system as we know it.
The refugee asset argument prompts one of my favorite investment cases for crypto assets; they have a low correlation to global assets and help to further diversify a portfolio.
Below Chris Burniske’s write-up, “Bitcoin: Ringing The Bell For A New Asset Class”; supports this.
Bitcoin also makes a fantastic store of value against these “unlikely events” and unlike that Gold ETF, you can actually have ownership of the underlying asset, transport it, and custody it with little to no effort.
Conclusion
Tokenized assets allow us to reduce the leverage and inflated value composing the derivatives market. They create the opportunity to allow financial markets to act as they were intended to.
Tokenized assets present a digital representation that is:
- Easy to transport
- Are very divisible
- Difficult to forge or counterfeit
- Provide more transparency for the derivative products that are built (think fully transparent tokenized MBS)
- Near instantaneous settlement
So it seems that we may no longer have the need for cash-settled derivative markets for certain asset classes and should not need them for future ones.
Unfortunately, depending on who is leading the charge they also have the ability to further exacerbate the current bubble and impending financial crisis.
Will these new tokenized assets become the needle that pops the bubble or are they just more hot air?
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