About Disclosures and Information Asymmetry in Security Tokens
When we think about the foundational building blocks that need to be built in the next phase of security tokens, disclosures makes the top of the list. Information disclosures, or the lack thereof, is arguably the biggest roadblock in the evolution of crypto-securities and one that can make the difference between an efficient or an inefficient market. Professor Stephen McKeon often refers to the term “Disclosures Marketplace” as this component of security tokens that should enable transparency of public material information relevant to crypto-securities. While conceptually trivial, implementing effective token disclosures in a decentralized ecosystem is far from trivial. Today, I would like to explore some ideas in this area.
The relevance of disclosures in security tokens goes beyond transparency and regulation and goes to the core dynamics of the market. If we don’t have access to relevant information about a crypto-security, how can we know whether we are paying a fair price for it or not? In utility tokens, price is dictated by the core mechanics of the protocol and trading momentum, but those mechanics are barely relevant in crypto-securities. The market behavior of security tokens is tightly associated with information about the tokenized entity. Poor or unreliable information flows lead to inefficiencies in the market. Economists refer to this term as Information Asymmetry and can be effectively considered one of the biggest risks in the evolution of security tokens.
Akerlof, Lemons and Asymmetric Information in Security Tokens
A rather self-evident concept, information asymmetry has revolutionized market economics since 1970s. As an adjective, asymmetric information , refers to situations, in which some agent in a trade possesses information while other agents involved in the same trade do not. The study of information asymmetry in financial markets has produced important contributions to economics such as Modigliani-Miller theorem that states that the market value of a company is not related to its financial structure and rather to its perceived earning power and risks. Therefore, information disclosures and incentives between employees and shareholder are more important than the financial model of an asset.
American economist and 2001 Nobel prize winner George Akerlof is one of the top authorities in information asymmetric markets. In a 1970 paper titled “The Market for Lemons”, Akerlof considers the example of a seller who has private information about the quality of a used car. A buyer would like to acquire a car, but is keen on paying a “fair” price for it. To make things more concrete, suppose that there are nine different cars, each car having “fair” values, 100$, 200$… 900$ respectively. As the buyer cannot observe quality, owners of low quality cars will always claim they are selling a high-quality product worth 900$. A fair price will then reflect the average quality of the market, in this case 500$. However, under such circumstances, sellers whose cars are worth more than 500$ find such price too low, hence exiting the market. The average price must then drop to 300$, inducing more exits, and so forth. Consequently, at the exception of worst-quality cars worth 100$, no seller is willing to sell a car that a buyer is willing to buy!
Extrapolating some of Akerlof’s ideas to security tokens, we can clearly see how information asymmetry can become a roadblock in the evolution of the market. Markets in which asymmetric information prevails are conducive to bad behaviors such as insider trading or market manipulation in which a small subset of the population with a disproportional access to information take advantage of retail investors. Furthermore, together with exchanges/liquidity pools and liquidity protocols, disclosures is one of the key pillars that will influence the price of crypto-securities.
A Decentralized EDGAR for Security Tokens
In The United States, the Securities and Exchange Commission(SEC) has established very clear guidelines for the disclosures of public securities. From the Securities Act of 1933 and the Securities Exchange Act of 1934 to recent regulations such as Sarbanes–Oxley Act of 2002, US public securities are required to be compliant with very strict disclosure mechanisms. In 1984, the SEC introduced the Electronic Data Gathering, Analysis, and Retrieval system(EDGAR), as the main mechanism to collect and search information relevant to investments in public securities. Obviously, EDGAR is completely centralized under the oversight of the SEC which uses the rule of law as a powerful incentive mechanism to keep the different market participants honest. In the global, decentralized and programmable ecosystem of security tokens, we have the opportunity to reimagining disclosures. We need a decentralized EDGAR or to be cooler: DEDGAR 😊.
In the current state of the security tokens market, the basic disclosures available are processed by the token issuance platforms in a centralized manner. While that model might make some sense in this early state of the market it has some very tangible limitations and very serious risks. For starters, in the centralized model, market participants need to trust the issuance platform to assert that validity of any information disclosed by the token issuers which is nearly impossible at a high scale. Making security token issuance platforms or exchanges the custodian of disclosure information relevant to security tokens doesn’t address the information asymmetry in the market; quite the opposite. Finally, security tokens offers a unique advantage to reimagine disclosures for modern securities: programmability. A DEDGAR model should provide a programmable, trustless, decentralized disclosure mechanisms and tools that can be accessed by all participants in the security token market.
A Programmable Disclosures Protocol
When I think about security token disclosures in its most basic form, I keep going back to the idea of a new protocol to enable this capabilities across the different layers of the security token market. At a high level, there are three relevant parties that interact with disclosures in the lifecycle of a security token:
· Publishers: Token issuers or entities that publish material, public information about crypto-securities.
· Consumers: Token holders, exchanges and other participants that make decisions about crypto-securities based on disclosed information.
· Validators: A non-trivial role, Validators are participants that can assert the veracity of disclosed datasets.
Using those three roles, we can architect the basics of a disclosure protocol for security tokens. The security token smart contract itself will include mechanics for publishing and validating disclosure documents. Exchanges, security token issuance platforms and other entities can act as validators of that information. The disclosure dynamics can be seen as an extension of tokenization protocols such as Securitize’s DS Protocol and, maybe, there is an opportunity for even tokenizing those interactions to incorporate the right incentives.
In a nascent market such as security tokens, disclosures are one of the elements required to legitimize the space in the eyes of large investors. I feel that the nature and importance of disclosures will challenge some of the centralized models in the current generation of security token platforms. Hopefully some of the ideas in this article will help to imagine a better path.