Tokenize This: Week 54 ~ Tokenized Collateral Management
Precision and near-instantaneous transfers will enhance collateral management — it’s a necessity.
What happens behind the scenes at banks and institutions goes way deeper than the lay person would assume. I personally love touting the ability for security tokens to act as superior forms of collateral in DeFi protocols like Aave and Compound, but that’s merely one case here for tokenization. That’s a great retail-level case — retail (and any) investors can buy fractional shares in real estate through security tokens, stake those security tokens into these DeFi protocols, and earn yield on that staking activity.
What makes security tokens a potentially superior form of collateral relative to a general cryptocurrency is the intrinsic value associated with the underlying asset. Many staking pools and lending protocols require overcollaterization to hedge against massive volatility of the utility tokens like AAVE, UNI, and other ERC-20s. Many of these cases require a 150% overcollateralization rate, and we’ve even seen cases on MakerDAO that imply coverage rates as high as 172%.
In theory, a piece of real estate should not fluctuate the same way a utility cryptocurrency would, and therefore the security token representing that real estate should not be treated the same as a utility token. In the future, this could alleviate the overcollateralization guidelines that govern many DeFi protocols, and bring the Loan-to-Value (LTV) ratio up to more usable and feasible levels (i.e. even 50–50).
Nonetheless, tokenization of existing liquid and illiquid assets can bring newfound economics of scale to current banking operations through collateral management. Let’s dive into the plumbing that happens behind the scenes and determine where tokenization fits into everyday (literally everyday) operations in Week 54’s edition ~ Tokenized Collateral Management.
Value Adds:
- More efficient transfers of collateral and assets from party to party
- Near instantaneous settlement for more precise accounting and record keeping
- Wider range of assets may be used for collateral management and settlement purposes (i.e. real estate, private equity assets)
- Greater transparency and ability to meet regulatory guidelines (reserve ratios, for example)
Collateral Management is most commonly used by banks, broker-dealers, investment firms, and other associated parties to reduce risk and improve their own credit profiles. This is especially applicable to parties that partake in various credit & debt investments, as it would make sense to reduce exposure to certain investments like higher-yield and/or unsecured bonds.
So how would these parties reduce their risk if they’re holding onto a 14% coupon corporate bond (probably lowly-rated by Moody’s or S&P)? They could sell a small portion off and/or exchange a portion of that bond with another institution in a credit swap. This would essentially dilute Firm A’s position in the 14% bond while adding perhaps a higher quality product to its own balance sheet, and therefore improving its own credit profile.
Credit Swaps were made popular during the 2000s, and contributed to the 2008 meltdown when it came to Credit Default Swaps geared towards Mortgage-Backed Securities and the residential housing market.
But that should not give credit swaps a negative connotation — in fact, it should help emphasize the need for better and more precise practices when it comes to swaps and collateral management. And this is where security tokens come into play.
Rather than using a theoretical concept, let’s look to industry partner Arca and their US Treasury Fund. At first glance, it seemed like Arca was simply testing the tokenization technology with US Treasuries, as they’re already super liquid and transparent assets. However, the real play was what can be done with a product like this. And that’s when the realization sets in — revamping the backend of the existing banking operations.
Cash, treasuries, and other government and high-quality debt products are the most common assets used in collateral management — because they are the most liquid and most stable (all crypto jokes aside 😉). Still, the process of sending cash wires or trading/pledging treasuries from Bank A to Bank B in order to meet liquidity requirements, reserve ratios, and credit covenants takes way too much time in the existing legacy structure relative to the pace that people actually move at.
This is where Arca pioneered a next-level method of collateral management. Tokenized treasuries can be sent in a matter of minutes (or seconds) and can be used for parties involved to precisely manage their books, records, and desired transactions. The price of the ArCoin token has been quite stable at $1.00 NAV through Arca’s management of the fund that holds the treasury assets, and therefore the price risk is quite low. Given that, this can be used on a greater scale for collateral and credit management, and will probably find other significant use cases within the financial services infrastructure.
While this product and similar ones will be priority for integration, the future financial services landscape for collateral management practices may even include tokenized real estate, tokenized private shares, tokenized private investment fund interests, tokenized corporate debt, and more. Since these assets are typically illiquid and difficult to move, they are rarely (if ever) used in the pledging and management process.
This may be a whole new world through tokenization, pending a success story with ArCoin and similar comfortable products.
New edition coming next Wednesday 3/16/22!
Disclaimer: This is not financial or investment advice and should not be interpreted as such. Please do your own research on investments and financial decisions before partaking in any ideas or ventures depicted in this publication.
