A Practical Tale of Decentralized Finance — Part 1

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.

Blockchain, Decentralized Ledgers, Smart Contracts, ICO, Security Tokens. While Bitcoin, the originally cryptocurrency, has been around for over 10 years, we are just now starting to see the more mainstream proliferation of additional Decentralized Ledger Technologies.

The technology is starting to find its way into industries such as shipping, oil and gas, real estate, agriculture and manufacturing.

In this series of articles, we will discuss the current, and future use of what we will call Decentralized Finance — DeFi. We will look at how the financial industry currently runs, and how Decentralized Technologies will replicate, replace, and later completely alter the processes and players.

The financial industry touches so many parts of the economy — entrepreneurs, banks, funds, retirement plans, individual investors, institutional investors. And there are so many parts of the financial sector — equity, debt, investment management, money flow.

We will attempt to explain a bit of how the system currently works, the players, where money is being made and lost, the flow. From there we can hit each part and look at how it has evolved from the past until now, and where we see Decentralized Technologies replicating, replacing, and improving on the current system.

We’ll do this by introducing several players in our financial drama:

James — A successful real estate developer who is looking to raise money for a new real estate fund.

Alice — An investor with some liquid assets she is looking to invest. She would like some potential upside, and is ok with tying up her money for a few years, if the annual rate of return she receives is sufficient.

Brian — Another investor with some liquid assets he is looking to invest. He would be happy earning just some interest above and beyond bank interest.

Frank — A young fund manager who is trying to create new investment funds. He is technologically very adept, and would prefer to not have a large team.

Here is how the drama might play out in the next 2–5 years.

James might put together a great business plan. In the past he has always raised money for his real estate projects on a project by project basis, which has led to several administrative headaches. It also means he has to create a separate business plan for each project, and go to essentially the same investors each time, and sell them on the merits of the investment opportunity. The investors, which include Alice, basically invest with him on each project because they trust his ability as a manager.

In addition to having to raise money for each project, James also has the issue of having to pay distributions for each project separately. He might generate great profits from one project, but less stellar for another. HIs investors might be thrilled with the former, but disappointed in the latter. Of course, they may remember either his huge successes, or his average performances, and use that to determine their investment in future projects.

James has the idea to create a real estate fund — essentially a private equity fund — that would raise money to invest in several projects. The idea would be to have the fund operate essentially in perpetuity, so James could roll the profits from the growth or sale in one project over to another project. His investors would continue to receive distributions.

Alice likes the idea of diversification in her real estate investment. However, she doesn’t like the fact that there is no end date or even full liquidation strategy for her money. Even if one real estate project is sold, she doesn’t get her investment back…it is rolled into the next project. James would have to sell the entire portfolio for all the investors in the fund to realize the growth.

Currently, most private equity, hedge fund, and real estate investments do not allow the investors to cash out easily. This is done so that the managers of the fund are not tasked with completing some sort of valuation. They also don’t have to “re-paper” the investment. Each investor is given a ridiculous amount of paper that represents the contract they are undergoing with the manager. That contract includes all sorts of regulatory language, which makes it very difficult to sell the equity. Again, this is done purposely, since it would be expensive to go through the “re-papering” process, and it would divert time from the manager’s schedule.

Therefore, private investments, while potentially lucrative, and highly illiquid.

Another reason the private investments are illiquid is the effort needed to find a willing buyer, and have that buyer complete enough due diligence to warrant a fair price. The manager doesn’t want to take the time to justify the investment, since he has already raised the money. If

Let’s say Alice invests in a project called Re-James. Re-James is a retail project similar to other project James has successfully completed in the past, and is located in Houston,Texas. Alice invested $100,000, but decided she needs some cash to pay for her daughter’s wedding. The project is currently paying distributions of 5%, but will probably pay more in the next year, since a new tenant is arriving soon. The value of the real estate has also grown.

Alice would need to find a willing buyer, and thinks it should be worth $130,000. However, it is difficult for her to locate all the people that might be willing to buy, and be accredited investors who have the net worth and liquidity. Even if she found the right people, they would have to examine the investment. They would want to understand the distribution history, the history of the James, the tenant contracts, the land value. This all takes time and money.

James does not have the time to meet with the new potential investors, especially since he won’t be receiving any benefit if Alice were to sell for a higher value. It would also take time from a lawyer, and possibly a broker/dealer to enact a trade of the equity from Alice to another investor.

Because of all this, the contract might state that if Alice were to want to sell her share, she has to sell back to James’ company at a discount.

Here is where we begin to see a way that Decentralized Finance has the potential to help.

Maybe James raises the money for his real estate private equity fund, with the idea that it is essentially perpetual. We’ll call the new company JREF In addition to the ream of paperwork he gives his investors, he looks to create a Security Token to represent their investment cryptographically on a Blockchain. The Security Token is a Smart Contract, which contains all the regulation and legal terms of the paper contract. Once deployed on a Blockchain (probably Ethereum at the moment), it is immutable.

James might choose a company like Securitize, Securrency, or Polymath to help him create the Security Token. They would do so in a way that it could later be sold on an exchange.

James might also use a company like Abacus to administer the distributions to his investors. Abacus can administer distribution and management of ownership whether the investment utilizes a Security Token or not, but the Abacus is fully prepared to manage Security Tokens.

Since the tokens are deployed to a Blockchain and administered by Abacus, James can choose to make the terms transparent. He can also choose to have the tokens available to be traded on an exchange like OpenFinance.

OpenFinance and other Decentralized Exchanges (DEX’s) use a protocol called 0x, so that once the token is designed and deployed, it can be easily exchanged.

Now we’re getting somewhere…

Alice can now offer her Security Tokens in JREF for sale on OpenFinance. OpenFinance makes sure that all investors comply with local regulations, so if they want to buy a Security Token, they are free to do so.

Now Brian enters the picture. Brian has been approved by OpenFinance, and is looking for investments that will earn him some return with lower risk than some of his other investments. He has decided real estate is the place for his money, and likes a relatively stable market. He sees the listing for JREF. He notices a good 5–6% return, and that it is located in a growing section of the country — Houston. Alice has made her Tokens available, and Brian offers $62,000 for half of her tokens. Alice takes the offer.

The transaction is completed instantaneously, and Brian now owns half of the Security Tokens once owned by Alice. OpenFinance takes care of all the legal requirements regarding the transfer of ownership, and Abacus starts making sure part of the distributions go to Brian now.

James has no knowledge of the transaction, and doesn’t need to. It doesn’t matter at all to him that Alice sold some of her shares, and he is not out any time or cost.

Already Decentralized Finance has created more economic value. Alice has been able to sell her shares for more than she paid, Brian has made an investment that will give him income, and James hasn’t had to lift a finger to make it happen.

Now we see what happens when we give everyone even more options. Check out Part 2 — Decentralized Debt.