Security Tokens or: How I Learned to Stop Worrying and Love On-Chain Cashflows
Every week the Mosaic research team will delve into important topics within the cryptoasset space.
Security Tokens or: How I Learned to Stop Worrying and Love On-Chain Cashflows by Jason Yannos & Lanre Ige
This article will review the present hype for tokenized securities and assess both weaknesses and strengths of this emerging token category. Moreover, we will discuss the potential offered by certain types of tokens which display similarity to equity securities, but offer on-chain cashflows.
Introduction
There has been a lot of talk over the last few months about the promise of tokenized securities. Most conceptions of tokenised securities center on a token representing a digital claim of ownership of an off-chain asset. It is still early days and we are not yet convinced of whether this spreading virus is justified.
Take a quick stroll through crypto twitter and one will quickly realize that the narrative surrounding tokenized securities is extremely bullish. Many advocates of this thesis evangelize the fact that this new asset class will eliminate the need for middlemen in the issuance and exchange of securities, add increased liquidity, and even help with price discovery.
It would be naive to claim that traditional capital markets are anywhere close to perfect today; however, many of the claims suggested by this bullish thesis surrounding the tokenization of securities are worth diving deeply into in order to assess their true validity.
Structural Dynamics — Liquidity
One of the most popular themes of the securities token thesis is that the tokenization of securities will increase liquidity for investors. The less liquidity there is in an asset class the more inefficient the market is, as the number of buyers and sellers are mismatched. Market participants with access to information often find ample opportunities for arbitrage. Buyers and sellers, who often get ripped off paying large commissions to brokers and asset holders, rarely obtain a fair market value for their assets at the point of sales. These are all very common traits of equities that currently trade Over-The-Counter (OTC) and private securities.
On the other hand, markets with lots of liquidity function well as participants can quickly transact in and out of positions, bid and ask spreads are tight as opposed to wide preventing buyers and sellers from paying large commissions to brokers, and adequate price discovery exists where participants can buy or sell assets at fair market values.
Liquidity is essential to a well-functioning market; however, proponents of this thesis often assert that by tokenizing securities, market participants will be able to access ample amount of liquidity and an evolution of efficient markets. While removing friction in the capital markets and introducing instant settlement of securities is attractive there are many flaws with this argument that are often neglected by those who present solely the bullish case from the perspective of market dynamics.
The question we must first answer is where is this ample source of liquidity going to come from? Liquidity can simply be defined as the degree to which an asset can be bought or sold in a market without affecting the asset’s price. In other words, buyers and sellers of an asset must have the same liquidity preference to maintain a liquidity equilibrium and not drastically move the price in either direction.
While advocates of this argument assert that increased participation will lead to increased liquidity it is imperative to realize that increased liquidity does not make an asset immune to the behaviour surrounding market participants. Liquidity is fluid and often changes in very short periods of time, therefore the notion of increased liquidity and fair markets brought forth by security tokens is fairly questionable. No amount of liquidity has ever saved market participants in times of crisis where liquidity has gone to zero as liquidity is simply a function of the number of buyers and sellers at any point in time, not the total number of market participants perceived as present.
Despite the noise of increased liquidity and positive reception of the securities token thesis, the prudent market participant must understand that what is proposed is a misled technological solution to a legal problem. Proponents advocate that trading will be 24 hours a day 7 days a week under this new regime; however, the current capabilities of the NYSE, Nasdaq, and SP500 are not restricted due to technical limitations brought forth by hardware and software but are restricted from continuous trading due to current regulation.
Additionally, the cryptocurrency markets as a whole are currently extremely illiquid relative to public capital markets and this will not change in the near future. Factors contributing to this lack of liquidity in the cryptocurrency markets range from minimal participation, unpleasant user experiences related to trading on exchanges and storing tokens in wallets, exchange risk, and a lack of true utility at present to name a few. Cryptocurrency markets are simply in their infancy today and will continue to lack truly sustainable forms of liquidity in the foreseeable future therefore it is imperative to be mindful of this fact when evangelists make strong claims related to the massive benefits of the security token thesis.
Access
For any investor considering the value proposition presented forth by tokenized securities and the actual need for a token or a blockchain, it is worth looking back to the creation of crowdfunding platforms during 2015 and 2016.
Often cited by many securities token platforms is the fact that these protocols will bring access to illiquid asset classes like real estate and private equity through the creation of a token and fractional ownership; however, access to illiquid asset classes is already possible through many crowdfunding platforms. To simply name a few, realtyshares.com created a bridge for fractional ownership in real estate, equidateinc.com built a platform for the resale of private equity, and seedinvest.com helps investors invest in startups through crowdfunding. All of which exists today without the need for tokenization or a blockchain debunking one of the largest value propositions proposed by this emerging area of tokenization.
Cashflow generating tokens
Taking a step back, there are generally three contexts in which the term ‘security token’ (a tokenized security, in other words a token deemed as a security, etc.) is typically used:
- Tokens representing off-chain claims on assets
- Tokens which are unregistered securities
- Cashflow generating tokens
We’ve shown how tokenized securities like (1) aren’t as promising as they seem but there are certain examples of (3), decentralized tokens with cashflow generating properties that are interesting. There are several notable examples of (3) in the market: Binance Coin (BNB), MakerDAO (MKR), & DigixDAO (DGD), SiaFund. These tokens use either a token ‘burn’ function (MakerDAO & BNB) or a two-token model (SiaFund, DigixDAO) to generate cashflows to token holders.
Why is this interesting?
These four aforementioned tokens are interesting since they produce cashflows from the activities of the project to token holders. While tokenized securities would simply act as a certificate of a user’s claim on off-chain cashflows or assets, each of these tokens give on-chain cashflows which are, to varying degrees/somewhat: (1) verifiable and (2) trust-minimized.
In the case of Binance Coin, the cashflow from the quarterly burn is verifiable but in no way trust-minimized, nor is Binance a decentralized network. BNB token holders have to trust Binance to honor their token burn and discount arrangement, Binance does not have any explicit legal rights to honor the arrangement, nor are their smart contracts which Binance uses to codify said arrangement.
SiaFund and MakerDAO offer better examples of on-chain cashflow tokens. In both cases, the cashflows are verifiable on a blockchain and the token holder arrangement is codified into the smart contracts. For example, one can check on an Ethereum block explorer for the ‘SAI_TAP’ smart contract with the ETH address 0xc936749d2d0139174ee0271bd28325074fdbc654 and note the boom() function. This function takes a given net Dai (a stablecoin) balance which had been used to pay the fees on the Dai stablecoin system and then sells the Dai in return for MKR (the cashflow generating token) — which is then burned. Unlike tokenized securities, the claim a token holder has to the cashflow does not rely on a third-party to verify and honor said claim.
Moreover, given the open source nature of projects like MakerDAO, in the case over a token holder dispute or disagreement, any token holder or user has the ability to fork the codebase. It can be argued that the ‘right to fork’ is the ultimate governance failsafe for token holders within a decentralized community; this simply does not exist for tokenized securities. Forking a public blockchain for security tokens is futile if a token holder’s claim on a particular asset and cashflow relies on a centralized party.
Governance of MakerDAO is still in its early stages and not well documented, but even still root authentication to the Dai system is still controlled (and can be voted on) by MKR holders. We expect the governance process in MakerDAO to become more documented and easier to understand for MKR holders — eventually perhaps becoming similar to traditional shareholder voting, for example.
Modelling
Another strength of demarcating a subset of tokens which exhibit equity-like properties is that it allows them to be modelled under reliable and tried-and-test frameworks. One problem with the current state of affairs for cryptoasset valuations is that a lot of the frameworks proposed are overly complicated or rely on dubious theoretical grounds. These tokens can potentially be modelled similarly to a free cashflow to equity approach which is used in traditional finance for DCF and LBO modelling.
There have been credible attempts to value a cryptoasset like MKR — the annual return on investment is a function of the annual MKR ‘burn rate, which can be modelled. Such an approach seems much more sensible than trying to model MKR as a the ‘currency in the [Dai] protocol economy it supports’ and using the MV = PQ approach or any of its derivatives [1]. There has, as of late, been a movement away from ‘medium-of-exchange’ tokens (especially for application layer projects) — where a MV = PQ approach may have made some sense — due to their lack of defensibility. As the cryptoeconomics of more and more tokens begin to become more ‘cashflow’-centric, it’ll be easier to create credible models for these equity-like tokens.
Similar work has been done by CoinFi based off the hypothetical cashflow generated by the BNB token’s fee discount, token burn, and referral bonuses. Under their model, BNB is viewed as a “cashflow generating asset, where the cashflow comes in the form of transaction fees saved”.
The fervour over tokenized securities is a misnomer. However, inspecting the common arguments for them elucidates another interesting opportunity for cryptoasset investing — cashflow generating tokens. Thus far, a lot of the value proposition for tokens has centered around them acting as a medium of exchange within their own protocol; this is sometimes arguably a technical necessity such as with ETH, but in most cases the token proves unnecessary. Moreover, ‘governance’ is often used as another value proposition but on-chain governance is likely to have its problems (bribery, vote-memeing, etc.). In addition, the marginal governance impact for most token governance schemes (which are almost always plutocratic) is minimal and not necessarily a credible value proposition. Cashflow generating tokens, however, make sense on a technical level and from a valuation perspective. It may be wise for investors to view a token from a ‘Does this produce a cashflow?’ lens when evaluating its value proposition.
Problems/Future
Needless to say, these decentralized cashflow generating tokens present their own problems:
- Regulation
How should these cashflow tokens be regulated? They display security-like properties, but will often be ‘decentralized’ to a high degree — which seems to be an important criteria for the SEC now.
- Cashflow redistribution
What is the ideal way for cashflow to be redistributed to token holders? Are token burns equivalent to token payments?
- Accountability and Governance
What level of accountability is there in these decentralized token systems to ensure that the cashflow arrangement that token holders expect remains in place. To what extent should token holders also control governance of the system?
Conclusion
This article has shown the hype for tokenized securities is likely to be a misnomer; however, inspecting the arguments for them has helped reveal the potential for a certain subset of tokens which generate cashflows. These tokens offer much of the promise of tokenized securities whilst still being based on the core tenets of verifiability & decentralization which Bitcoin — the first cryptoasset — has drawn its success from.
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[1] This could be construed as ‘straw-manning’ to an extent. We doubt that proponents of MV = PQ would value MKR this way. This article is not a rebuttal of a MV = PQ approach to valuation necessarily.
End of weekly research report
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This article is intended for informational purposes only. The views expressed herein are not and should not be construed as legal or investment advice or recommendations. Recipients of this article should do their own due diligence, considering their specific financial circumstances, investment objectives, and risk tolerance before investing. The individuals contributing to this article have positions in some or all of the assets discussed. This article is neither an offer, nor the solicitation of an offer, to buy or sell any of the assets mentioned herein.
