I was on vacation when I received a message from David Sacks last summer, but I knew this was a call I wanted to take as soon as possible. My article Traditional Asset Tokenization had resonated with him because he shared the same vision of ownership claims on real world assets being represented by blockchain tokens.
Many of the world’s assets, such as real estate, fine art, and private equity funds, are characterized by low levels of liquidity. Ownership claims on these assets trade infrequently and are subject to high transactions costs when they change hands. Investors that bear these costs rationally discount the value of illiquid assets as compensation.
A groundswell of interest has developed around the idea of representing these ownership claims with tokens because they can reduce transactional friction. If lower friction leads to increased market depth then this will mitigate the illiquidity discount.
My conversation with David centered around regulatory compliance, one of the major challenges I highlighted in the article. He explained that he had begun work with a small team on what would become Harbor. I was immediately intrigued.
I’ve been thinking about the intersection of technology and regulations for many years because I’ve spent my entire career around highly regulated industries. First, in wine, regulated by the TTB, then in drones, regulated by the FAA, and most recently in securities, regulated by the SEC and numerous other entities. Although these industries are completely different, the common thread is that participants are continually seeking solutions that reduce the regulatory burden.
The case for tokenized securities often revolves around relaxing frictions to trade, and one of the most complex frictions is adhering to regulations. It is complex for at least two reasons:
(1) Regulations can vary along multiple dimensions such as asset type, investor type, buyer jurisdiction, seller jurisdiction, and issuer jurisdiction. Each of these dimensions has numerous regulatory permutations and multiple regulatory agencies that govern trade.
(2) Regulatory compliance is typically documented through a series of separate ledgers, each constructed by entities that facilitate issuance and/or secondary market trade. It is only through reconciliation of these ledgers that ownership and compliance is legally validated. In this environment, maintaining compliance adds latency and cost to trade, segments markets, and reduces liquidity.
What makes a blockchain token different from other forms of securitization? Lots of things, but a key feature is that they are programmable. What this means is that many elements of the contracting environment can be hardwired into the architecture of the security. The implications of programmable securities affect a variety of aspects of contracting, one of which is how market participants can verify compliance.
When securities are tokenized, compliance can be automated. This is what Harbor is working to solve. Automated compliance means that regulated trade will no longer be restricted to walled gardens. Security tokens will be able to trade anywhere, including decentralized exchanges. Markets can be integrated and liquidity will be pooled. This is a big deal.
When I discuss crypto-securities with potential issuers and investors, regulatory risk is always a concern, particularly with regards to secondary market trade. My standard reply has been “solutions are coming.” Harbor’s compliance protocol represents one of these solutions and will allow market participants to manage regulatory risk.
The first application will likely be in asset classes like real estate, where illiquidity is most pronounced. However, security tokens of all types will eventually employ automated compliance to manage regulatory risk and attract investors in regulated markets. The team at Harbor has a big vision, and I’m honored to be an advisor to this ambitious group.