A sleeping $7.7T giant waiting to be tokenized

2018 is clearly shaping up to be the year of security tokens, as the battle cry of TOKENIZE THE WORLD clamors across the landscape. The team here at OpenFinance Network, the world’s leading security token trading platform, is actively working with our network of partners, including Harbor, Securitize and Polymath, to spearhead the effort of disrupting the financial markets.

But we’re only at the tip of the iceberg with security tokens. There lies a sleeping giant under the surface, in the form of the $7.7 trillion dollar alternative asset market class, that is just waiting to be tokenized.

$7.7 trillion giant waiting to be tokenized

The alternative asset industry is broadly defined as investment vehicles that exist outside the traditional asset space of public equities, bonds and cash. Typical assets that fall under the “alternative” category include real estate, hedge funds, private equity, venture capital, and crowdfunded assets (including Regulation D, Regulation S, Regulation A+, and Regulation CF).

The alternative asset market faces many challenges to growth, from exorbitant fee structures, wildly inefficient clearing & settlement processes, and locked up liquidity. In past articles, we have discussed the potential benefits of blockchain technology for the industry in reducing back-office costs by eliminating various reconciliation processes, reducing capital tied up in the settlement cycle, and unleashing the liquidity potential within the asset class.

Bridging the gap between Off-Chain and On-Chain Capital Markets

While some may see “traditional” alternative assets vs. “crypto” alternatives (security tokens) as two different beasts, they are really the same underlying instrument — fractional ownership of a financial security that enables investors to participate in the economic benefits of the asset. The distinction comes from how their books and records are maintained, either in a traditional database system with a centralized entity (transfer agent, fund administrator) or on a distributed, peer-to-peer database system (blockchain).

We see a natural convergence of the off-chain and on-chain capital markets as the adoption of blockchain technology expands. From initially seeking to reduce back-office costs to accessing broader capital markets, the strengths of blockchain technology will ultimately create an environment for “Smart Securities” that is not only more efficient and liquid, but will also provide increased access and improved service to the investing public at large.

In fact, we strongly believe that in three years’ time, we will see a massive shift from traditional off-chain electronic book-entry, to a recording of ownership entirely on the distributed ledger.

The true opportunity hence lies in the cross-market bridging opportunities between Traditional Securities and Digital Securities, or rather, the on-boarding of Traditional Securities to a distributed ledger system. This shift towards a more liquid format will unlock the massive growth potential within the broader $7.7T alternative asset markets.

But how do we get there?

Security Tokens: Protocols, Issuance and Trading

First and foremost, compliance is key in any tokenized security issuance. Working with security token protocol frameworks (such as Securitize’s DS Protocol, Harbor’s R-Token, Polymath’s ST-20, or OpenFinance Network’s S3) can ensure that the primary and secondary market activities are conducted under full compliance. The ideal security token protocol will also be compatible and interoperable with security token trading platforms such as OpenFinance Network.

Within the campaigns we see coming to market today, there are two broad buckets that all tokens fall into: New Issuance and Asset Tokenization.

New Issuance covers capital raises for new funds, be they venture, hedge or crypto funds. Examples of this include Blockchain Capital, Science Fund, Protos Fund, Spice VC, 22x and others. New issuances can also be “venture” raises for new or existing companies, such as Lottery.com, Cyber Miles or others.

Asset Tokenization entails taking an existing asset (such as real estate) and “tokenizing” it… meaning moving the books & records of the underlying asset onto distributed ledger. Examples include Morgan Creeks’s Anexio campaign and Harbor’s upcoming real estate fund campaigns. Real estate is a popular instrument for this type of process as it lends itself well to fractional ownership of an underlying asset.

Regardless, so long as the primary offering is conducted under a compliant exemption or registration (Regulation D, Regulation S, Regulation A+, or Regulation CF), and uses a compliant security token protocol, it is eligible to trade on a security token trading platform such as OpenFinance Network.

Decentralized “Street Name” Trading

Now that we’ve covered security token issuance and asset tokenization, we can look next to the issue of scaling: how do we apply this new technology on a wider scale to the alternative asset industry? For that, we turn to the topics of custody and “street name” trading.

When you buy public equities, such as Google (GOOG) or Amazon (AMZN) stock, through a brokerage firm, most firms will automatically place your securities into “street name”. A street name is when securities are held in the name of a broker, custodian, bank, or some other nominee as opposed to being held in the investor’s name. Public equities are largely held in street name because it makes transferring the securities easier, especially in the world of electronic trading. Before the introduction of electronic trading, all shares were held in a paper certificated form, either as registered shares (where the company maintains a register of owners of shares as well as issuing share certificates), or as bearer shares where ownership was transferred simply by handing the bearer share certificate to the new owner. By holding securities in street name, it eliminates the step of physically transferring the securities to the investors and significantly speeds up the trade settlement. Public equities today are held in electronic form, making the need for physical transfers obsolete, but holding securities in street name still facilitates speedy trading.

Alternative assets don’t have the mechanism or infrastructure in place to support street name trading. Within the OpenFinance Network though, these assets can be held in “distributed custody” by the network and its consortium of broker-dealers, custodians and banks in a method compliant with the Uniform Commercial Code (UCC). While the street name mechanism does have its flaws, we see blockchain as addressing some of the underlying issues of property rights, settlement and needless counterparty risk. In public equities one of the largest direct holders is Depository Trust Co. (DTC), a depository that holds securities for some 600 broker-dealers and banks (via its nominee Cede & Co.), but in a distributed ledger model the assets can be held by the broader consortium to minimize these issues. The act of placing an asset into distributed custody (also commonly referred to as “tokenization of assets”) allows for these “real” assets to be traded on blockchain with instant settlement times.

The distributed custody mechanism provides a bridge for certificate and traditional book-entry records to access a new form of distributed ledger book-entry recordkeeping and all the benefits that come with it. However, this is just an intermediate step to connect the worlds of traditional capital markets and crypto capital markets. The next step after that is in a full-scale migration towards distributed ledger.

Distributed Ledger Book Entry

As the benefits of distributed ledger technology become more evident to market incumbents, there will be a full migration toward a distributed ledger book-entry recordkeeping mechanism for the issuance and trading of all alternative assets.

We expect that in three years’ time we will see a massive shift from traditional off-chain electronic book-entry to a recording of ownership entirely on the distributed ledger. We refer to this new process as “ledger-entry” to distinguish not only between the location where the “book-entry” data is located but also to the newfound functionality and capabilities that this new system entails.

Leveraging a decentralized securities depository system, the industry can perform the full scope of the securities transaction lifecycle entirely on blockchain. An investor passport mechanism can allow for broker-dealers and online portals to securely perform all the necessary AML/KYC checks, along with accreditation and/or suitability reviews. A global asset registry can provide full transparency to the registered securities to boost investors’ confidence in the issuance. Direct integrations with financial institutions such as broker-dealers, custodians and transfer agents can enable trusted intermediaries to play their necessary roles within the broader ecosystem in a frictionless format.

Today’s $7.7T alternative asset industry has a once-in-a-generation opportunity with blockchain technology to reimagine and modernize its infrastructure to address long-standing operational challenges and continue its rapid growth trajectory.

However, there is a need for a driving force with the experience and capabilities to enable the integration of a financial industry distributed ledger framework and protocol with the existing financial market infrastructures in a manner that is consistent with existing regulations and that further lowers risks and costs for all market participants.

Keep an eye out for our next post on “Security Tokens and First Principles: Going from Zero to One.” We’ll discuss the innovative new opportunities at hand in the crypto capital markets.

For more information on the OFN, see our website www.openfinance.io or stay updated with our OpenFinance Network communications:

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Juan M. Hernandez is the Founder and CEO of OpenFinance Network, the trading platform for security tokens and other alternative assets. Juan is a serial entrepreneur, technologist, and polymath experienced in financial markets, exchanges, and blockchain technology. He holds a CS degree from Northwestern University and an MBA from the Kellogg Graduate School of Management.

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