The State of Security Tokens 2022 — Security Tokens as Collateral
Security Tokens as Collateral
The digital assets universe has brought to light new automated borrowing and lending opportunities — specifically those that do not rely on third parties like banks and alternative lenders. While there are more centralized options like BlockFi and Celsius, protocols like Aave and Compound use their own strategies regarding staking pools and collateralization percentages to facilitate peer-to-peer loans — or pool-to-peer loans. One of the questions surrounding these protocols involves the volatility of cryptocurrencies.
Many existing loans are overcollateralized so as to combat any sharp price volatility in the underlying crypto asset. This works for now, but it is also limiting. Why put up 1.5 ETH just to borrow 1 ETH when traditional markets would enable one to borrow 5 ETH on 1 ETH collateral?
Since security tokens are designed to be backed by real underlying assets with intrinsic value, they present themselves as a superior collateral to cryptocurrencies. In theory, the price of each security token should reflect the underlying asset’s perceived value. So something like a token based on a real estate portfolio shouldn’t necessarily fluctuate beyond the real estate portfolio’s performance and positioning.
Nonetheless, the marketable value of a security token is driven by supply and demand, so these assets are still susceptible to heavy price fluctuations, especially as order books remain thin. Looking forward into the industry, it is very likely that security tokens will overtake other digital assets as collateral pieces as the secondary marketplace ecosystem matures.
From a primary standpoint non-tradable tokens can be used as collateral right away with limited to no worries about price fluctuations. To stick with the real estate example, a single-property security token that is not currently trading on secondary markets could be used for a loan the same way one’s house could be used for a mortgage. The main difference between the two types is the decentralized method by which one could access a loan rather than working through a bank.
Lending Improvements
What makes security tokens so powerful from a collateral perspective is the newfound ability to mark alternative assets to market. Previously, assets like properties, art, funds, and other “one-off” examples were only priced and re-valued periodically, usually when a situation called for it such as a property sale. This makes the asset a subpar piece of collateral as either:
- The lender will provide worst terms given the illiquidity and difficulty of transfer in regards to the underlying asset, or
- The borrower will take advantage of the asymmetry associated with the underlying asset.
When assets are priced in real-time, as is the case with security tokens, both parties involved (borrower and lender) have access to the same transparent data and market pricing. This should, in theory, create a more fluid lending market, and even enable unprecedented assets to be used as collateral. The transfer of ownership is seamless with a security token compared to a “paper asset” since lending terms can be coded into the protocol for automatic execution, and this ease will likely be a driving factor in the eyes of an alternative lender.
Rather than needing to take possession of a full asset or following through with legal agreements to fulfill any fractional ownership stipulations (i.e. partial shares in a property), security tokens can be automated to change hands from borrower to lender in any proportion in the case of a default or a penalty.
Employee Shares
As a pressing topic when it comes to alternative assets used as a collateral, employee shares and options are one of the most applicable. In an Employee Stock Ownership Plan (ESOP), employees gain access to upside in their own companies — just like early investors and shareholders would. It’s possible for ESOP shares to be held in 401k and comparable retirement or tax-sheltered funds. Given this, “It is theoretically possible for you to borrow directly from the plan in an arrangement similar to a 401(k) loan. However, this is not true of all plans. It is, furthermore, unusual for ESOP plans to contain significant cash assets with which to make employee loans, as they by definition contain mostly shares of stock.”
The tokenization of ESOP Shares (just like the tokenization of publicly-traded stock), is one possible solution to bring more beneficial terms and financial flexibility to employees of all kinds. Taking the same approach as mentioned earlier, tokenized shares can be easily transferred from borrower to lender in the event of a default or need for a full possession transfer.
Even outside of ESOP plans, private company shares — known as “Pre-IPO Shares’’ — are prime targets for tokenization. Many startups and young companies offer equity in the firm as a major portion of compensation. Though this trend may be changing as startups become more well-capitalized, employees can have anywhere from five to eight figures worth of company shares as private firms move from Series A to Series B to Series C, etc.
While these shares vest over time, they previously were only liquidatable upon a formal exit, such as an acquisition or an IPO. This is a hindrance on some employees as they could be sitting on millions of dollars worth of company shares that aren’t yet actionable. Even without the secondary trading aspect, the benefits that tokenization brings to private shares doubles when using the shares as collateral to borrow against.
With this solution, early employees won’t even need to sell shares of stock to access liquid cash. Employees can post their tokenized shares as collateral to traditional lenders, alternatives lenders, or even DeFi protocols and gain much-needed liquidity. At the end of the day, these shares shouldn’t even trade hands from employee to lender barring a default or similar negative occurrence.
DeFi Staking Protocols & STO Synergies
As reported in September 2021, “In a proposal on Thursday on MakerDAO’s governance forums, French multinational banking giant Société Générale (SocGen) submitted an application for the decentralized finance (DeFi) lending platform to accept on-chain bond tokens issued by the bank as collateral for a stablecoin DAI loan.” This proposal is arguably one of the largest institutional pushes towards the DeFi space, and the fact that a tokenized asset is the underlying collateral is very bullish for the mission that’s been discussed in this section.
Pending a successful pilot program between SocGen and MakerDAO, this could be the first domino to fall regarding on-chain loans via security tokens. Next targets would include Aave, Compound, and Uniswap, in addition to more activity on IX Swap. As mentioned earlier, as security tokens trade more in-line with their underlying assets’ book values or trade per common stock metrics, expect security token-based DeFi lending to take a strong hold and rise to the top as superior collateral assets relative to existing digital assets.
Next week’s edition will cover Ratings & Rating Agencies for Security Tokens.
