A Practical Tale of Decentralized Finance — Part 3: Funds and Derivatives

This article is not in any way to be taken as financial advice. It is simply my opinion of how financial systems may work in the near future.

Also, I am not a computer scientist, technologist, programmer, etc. The following is my assessment from a practical standpoint…how I think the system will work. If the current technology does not allow for the exact narrative I play out, please understand this is where I think it can go.

In Part 1 of this series, we introduced capital into the system by having Alice invest in a real estate fund, and have her ownership denoted in a non-fungible Security Token. She had the ability with this token to trade it on an exchange — an act that was previously not feasible. This added the benefit of liquidity to private investments.

In Part 2, we looked that the advent of Decentralized Debt. Alice was able to use her Security Token — JREF — as collateral on a loan. The loan was underwritten and contracted in a Decentralized market, so Alice and her lender never met.

Now we will add to the velocity of money by introducing funds and derivatives using the decentralized platforms, and the flexibility that Security Tokens may offer.

Frank is a fund manager, and is looking to build a new fund. He realizes that he can build the fund much faster and cheaper by utilizing Security Tokens. The fund can also be more transparent for his investors, and be more flexible. The Frank Fund (TFF) will focus on Texas Real Estate

Frank might utilize a protocol like Set Protocol to look at the tokens that are available on different exchanges, and build the fund he wants from the tokens. Based on the parameters Frank sets for the fund, it turns out JREF fits into his investment policy nicely. He goes to the exchange and purchases some of Alice’s JREF tokens, along with several other Security Tokens that fit his parameters.

Now TFF has to have investors, so Frank issues Security Tokens to represent ownership in his fund. Those tokens are, of course, available to be traded after a certain lockup period, and the whole cycle can begin again.

In addition to finding good assets that are represented by Security Tokens, Frank also wants to limit some downside in his fund. He knows that, for example, the value of real estate in Texas is affected by the price of oil, and that if the price of oil decreases significantly, the Security Tokens would lose value. Therefore, as a hedge, Frank might utilize a prediction market tool like Augur. Frank can create a market for “betting” on the price of oil in a decentralized fashion. Frank places a “wager” that if the price of oil dips below $40, he wins and is paid. Although the Security Tokens in the fund would be negatively affected, his wager would make up some of the loss. He could bundle this additional token into the TFF token, so his investors are somewhat protected.

In all these scenarios, it is important to note that the only time the participants may have met each other was when Alice initially invested in the JREF token, which was based on the real estate fund that James was creating. Beyond that, none of the participants had to meet, know each other, or even know each others’ names.

That, of course, isn’t revolutionary. I can deposit my money into a bank via an ATM or an app on my phone. The bank makes millions of dollars in loans daily, while barely knowing the borrowers beyond some entries into an application. Those loans are packaged and sold as securities to other funds, which are then traded.

One of the main differences here the ability to cut out some of the middlemen — banks, attorneys, centralized exchanges — which all account for increased costs and decreased liquidity and marketability. Therefore, under this Decentralized Finance scenario, there is an increase in the velocity of money with a decrease in costs.

However, lowering those costs comes with risks. All those middlemen were getting paid for a reason. They provided a level of trust. We trust that when we deposit money into the bank, that it will be there when we need to use it. We don’t really care too much about how the bank invests it, except if they become insolvent.

We trust the fund managers and centralized exchanges to weed out the bad actors, so we can feel comfortable that at least we’re not “investing” in some scam. We trust the attorneys to write or approve the agreements when we’re trying to buy, sell, or transfer ownership, equity, or debt.

The move to a Decentralized system requires a move to trust software and code. We need to trust that when there is a Security Token available on an exchange, and the underlying investment is paying a 6% distribution, that I can buy that token, that the exchange of money and ownership will officially occur, and I will begin receiving the payments rather than the previous owner.

Many of these processes happen now in an electronic format. However, we place people in lobbies, behind desks, on the other end of 800-numbers, so we feel there is someone “watching the store.” Bitcoin has proven to us that we can trust software and code, if properly constructed and continuously monitored, to maintain a somewhat complicated system with little intervention.

The coming few years will be a big test to see how much trust we have in the code-based systems. How much do we want to continue to pay fees so that we feel we can have someone to blame when things don’t go our way? How much freedom are we prepared to give ourselves, with less of a safety net?

These systems are going to be built, and regulations will likely allow for more free trade, since there will be a demand. In the not-too-distant past, many of us were hesitant to even give our credit card numbers over the internet to purchase a book. It is now a rare day that I don’t have an Amazon package delivered to my house.

The promise of Decentralized Finance is not a world without government or banks. I feel like it is a world where we can have greater choices and efficiency with our money, with new fees paid to different “watchers.” It provides capital to very good business managers, and allows for higher returns, with greater risks. By transferring several job functions to software code, we open up new job functions in other areas.

Of course, this is all my best guess as to how Decentralized Finance will play out. It might not work at all, which will make this series look ridiculous. I am looking forward to the beginnings of usage of Security Tokens. Once investors, fund managers, and technologists finally dip their toes in the water, I think we’ll see the growth in efficiency, capital, and overall token market value.