Derek Edward Schloss (TDW): Oved and Todd, great to have you as the first guests on The Digital Wrapper. Let’s start with your backgrounds. Oved, want to kick us off?
Michael Oved (Fluidity): Sounds great. I studied mathematics at Carnegie Mellon and then joined Virtu Financial in 2008, which at the time was a team of 40. We grew it to a massive trading powerhouse, now a household name, and one of the largest trading firms in the world. I built out the Asia portion of Virtu and turned that into a multimillion dollar business within the wider business, which helped us IPO¹ in 2015.
Derek Edward Schloss: What’d you do after the IPO?
Michael Oved: I took some time off, and kind of by accident, I met Joe Lubin² at a music festival in early 2016 and learned about Ethereum³. I started to really look at the space — everyone was talking about decentralized exchanges⁴ on message boards. I met with my Co-Founder Don Mosites, and we used our experience in financial markets and design to develop the Swap Protocol. That whitepaper went viral and put the decentralized trading platform we built, AirSwap, on the map.
Derek Edward Schloss: Todd, you’re the Founder/CEO of Propellr, a platform and integrated broker-dealer structuring, managing, and servicing digital assets/securities. What’s your background, and how’d you find yourself in the blockchain space structuring security token deals with Fluidity?
Todd Lippiatt (Factora): My first job out of school was on Wall Street as a programmer, doing front line mortgage analytics for Credit Suisse. Within 18 months, one of the analytics packages I wrote brought me down to the trading desk, and I ended up trading fixed income mortgages over a few firms, creating and trading a bunch of structured products. Fast-forwarding a few years, I got offered to be a direct lender in NYC for hedge funds, and managed to survive the financial crisis without really losing principal on any of the deals, which helped generate new business on the institutional side.
Derek Edward Schloss: Nicely done.
Todd Lippiatt: We ended up developing sort of a friends and family following, and the interesting part was, we would end up with a few hundred investors trying to close a loan for an “in-time” closing, and really became system constrained trying to reconcile wires and subscription docs and so forth. We looked at third party providers, and ended up getting frustrated with the suite of products that were actually available to accomplish this. So we built Propellr to solve our own problem, and built it to be an agnostic capital markets toolbox that could bring any private placement or public deal to market.
Derek Edward Schloss: What did you first think when Oved came and told you that he was building a decentralized trading platform on Ethereum?
Todd Lippiatt: When Oved came in and explained the Swap Protocol to me, I remember looking at him and saying, “Oh, you guys perfected digital escrow.” And he looked at me and said, “I don’t know what that means, but yeah okay.”
Derek Edward Schloss: That’s a great transition into the new partnership— Oved, you recently announced that Fluidity and Propellr were coming together to create Fluidity Factora. How did the partnership first start between you two?
Michael Oved: In October of last year, Fluidity and Propellr partnered on the tokenization of a luxury Manhattan condo development. Fluidity was the technology provider, and Propellr was the broker-dealer⁵. After we announced it, the deal exploded and we both started receiving so much inbound interest from projects that wanted to have their assets tokenized. But it was happening in a fragmented way — Propellr was receiving their own inbound interest, we were receiving our own inbound interest. So we just said, “you know, let’s just figure out how to do this together.” Todd and the Propellr team are extremely good at structured finance. They have experience we don’t have. And we’re extremely proficient at building blockchain technology. So we formally came together, and it’s been a natural fit.
Todd Lippiatt: Our mission in coming together is to upgrade financial infrastructure. We’re not trying to change it. A lot can be solved when you start removing the bottlenecks and eliminating the errors caused by human interaction with all that data. And thankfully, a lot of the pipes that were built during the ICO⁶ boom allow for the securities industry to start building on top of that infrastructure.
Derek Edward Schloss: That’s interesting. I don’t think I’ve ever thought about ICOs in that way.
Todd Lippiatt: The way I think about it — the reason we’re able to talk about security token liquidity at all is because there are already exchanges built to trade these things. Having parts of the system already in place makes it better and easier to build security token solutions than building it from scratch.
Derek Edward Schloss: That makes sense. Let’s talk about liquidity for a minute. Improved liquidity is always discussed as the flagship benefit for tokenized securities. Maybe it’s your backgrounds in finance, but I’ve noticed that you both seem to think about liquidity differently than others. Can you talk more about your approach, and how that affects the products you’re building?
Michael Oved: Just to give a very simple description, liquidity is the ability to find someone on the other side of the market, at a reasonable price, for the size that you’re looking for. It’s both the size of the “bid-ask” spread, which is the difference between what people are willing to sell and buy for, and also how deep those markets are.
Todd Lippiatt: To add to that — a little over a year ago when ICOs were going off like crazy, having a digital broker-dealer became a magnet for incoming phone calls from everybody that had legal counsel, who were skeptical about the status of these ICO deals. We turned them all down for various reasons, but towards the beginning of 2018, we started to see security token formation platforms release whitepapers and protocol projects discussing liquidity. Having dealt with illiquid products in the past, I found some of the claims to be misguided. A digital wrapper around securities will make some difference in terms of liquidity, but you need to go even further to solve the problem.
Derek Edward Schloss: This is where your educational whitepaper, The Two-Token Waterfall, comes in.
Michael Oved: In The Two-Token Waterfall, Todd and I cover some of the things that affect the liquidity of an asset. One is diversity of buyers and sellers — if there are more buyers and sellers with diversity, theoretically you’ll have a deeper book, and more liquidity.
Todd Lippiatt: Information asymmetry is another factor. If we’re in the market, especially for private securities, sellers always have more information than buyers do, because they’ve been in the trade longer. If you can level the information playing field between sellers and buyers, there should also be more liquidity.
Michael Oved: So basically the entire premise in our educational whitepaper is that transparency will encourage liquidity. To build on something that Todd said earlier, when you put a digital wrapper around something with no peer-through to the underlying assets, you won’t get that much liquidity. For example, if you take a venture fund’s equity and you tokenize it, but you don’t actually know what the venture fund is holding, or what the equity looks like behind the scenes, you’re not going to gain that much of an advantage. Our thesis is that if you can replicate the entire capital stack, for example for a real estate transaction, you can start pricing assets very easily.
Derek Edward Schloss: How does this transparency play out when you think about tokenizing commercial real estate?
Michael Oved: In a real estate deal, Token A would replicate “debt” and Token B replicates “equity.” Token A plus Token B equals the entire capital stack. If you have a price you think this property is worth, you can price both Token A and Token B. This ability to easily price the whole stack will encourage market makers to come in. It also encourages others to know what a fair price is to buy or sell it in the future. That transparency starts to tighten the bid-ask spread⁷, and that’s when you start to have a relatively liquid market.
Todd Lippiatt: As a precursor to this — if we only tokenize the equity, and the debt just existed out there, but not in token form, how does an equity holder know what that token is worth? If I have a million dollar property, the equity token is worth something different if the mortgage is $750k versus $900k. The equity token will be worth different values in different environments. This is why transparency of everything in the stack is so important — so you can actually do a full analysis of what any particular asset is worth within that stack.
Derek Edward Schloss: You just announced another security token deal for commercial real estate — FACTOR-805 in Brooklyn. Can you walk me through the structure of this deal?
Todd Lippiatt: The project we announced is the tokenization of a construction loan on a development in Brooklyn, with an expected completion around the end of this year. It has a token waterfall that has one level more than what we just talked about. It’s a really good case study to explain how structured debt actually works within the security token framework. Here’s what the priority waterfall looks like — first, the A1 token (debt) gets its interest payment, then the A2 token (debt) gets its interest payment. Then the A1 token gets its principal, then the A2 token gets its principal. Then B token (equity) is next in priority.
Derek Edward Schloss: Got it — so you’re adding another debt token to the waterfall.
Todd Lippiatt: Right. Instead of having the simple A (debt) token, there’s actually an A1 and an A2 token.
Derek Edward Schloss: Another unique feature of the FACTOR-805 deal is your incorporation of Dai⁸, an algorithmically stable cryptocurrency that holds its value roughly around one dollar. Holders of the security token you’re bringing to market will be able to receive their coupon distributions in Dai?
Michael Oved: Yes. There’s actually two separate end points for Dai — there’s accepting Dai from investors in order to actually purchase the security token, and then there’s the security token itself paying out coupons in Dai. We’ll have both integration points set up for this deal. This is the first time in blockchain history that a stable cryptocurrency is going to be used to pay distributions in a real-world tokenized asset.
Derek Edward Schloss: That’s pretty interesting.
Todd Lippiatt: From a systems standpoint, just to geek out a little bit, the interesting part is that we offer optional custody options, and those custody options can change at any time with notice. The traditional way to do it is that tokens stay on the broker-dealer’s centralized ledger and distribution is paid in fiat. However, customers who choose to take custody can receive fiat distributions if they want to, or our system will recognize they want distributions in Dai and send them Dai.
Derek Edward Schloss: So is it a fair statement to say that depending on my level of comfort in holding or accepting stablecoins⁹ like Dai, there are still options for me to participate in the security token deals that Fluidity Factora are bringing to market?
Todd Lippiatt: Yes, definitely. You can participate fully in fiat¹⁰, a fiat/Dai mix — really any variation.
Derek Edward Schloss: I think adding Dai into the structuring of these security token deals might make for some really interesting downstream implications.
Michael Oved: I actually think that people don’t fully appreciate how important stablecoins are for security tokens, and how well those are going to play together as this infrastructure gets filled out.
Derek Edward Schloss To piggyback on that, there’s this robust open financial ecosystem being built on Ethereum right now. How do you think Fluidity Factora and security tokens will benefit from open finance¹¹ in the future?
Michael Oved: ERC20¹² was the first level of standardization that allowed basically any protocol to interact with tokens. Decentralized trading platforms were able to call certain methods on the tokens that were uniform with one another, so if you wanted to add a new token to a decentralized exchange, it was pretty seamless to do something like that. Now you have all these tokens that are available, and they are pretty seamless to move around. Now we’re talking about having stablecoins, which are also seamless to move around. Standardization allows us to create an asset and program it with the ability to pay dividends in a currency that people are familiar with. From this, you can start building loan markets for security tokens, and allow people to start shorting security tokens. You can also lend an asset and earn interest. All of this gets us back to liquidity. To improve liquidity, you need to think about asset creation, asset distribution, and short selling markets. All three are needed to create a good bid-ask spread and improve liquidity for security tokens.
Todd Lippiatt: We look at the ecosystem for security tokens as almost an overlay of the legacy system. We want to partner with people who will solve different issues within that system so that we can have the full checks and balances. We’re going out and partnering with the best people who are solving particular pieces of the ecosystem, and if we can’t find those partners, we’re going to build it. That’s the way we’re approaching it.
Derek Edward Schloss: Harvard Business School recently put together a terrific case study on Fluidity, within the context of a growing security token ecosystem. How has the response been?
Michael Oved: We were honored to put together the case study, and have a professor who was interested in financial technology present it to his class. Unfortunately, I didn’t attend, but I heard it was surreal to see the students debate the merits and drawbacks of tokenization. Pushing into educational territory has been something our team has focused on, because in order to gain meaningful adoption of this technology, we need to educate the top minds as to how the backbone of the newly digital financial system will operate.
Derek Edward Schloss: What does 2019 look like for Fluidity?
Todd Lippiatt: Sleep deprivation.
Derek Edward Schloss: [Laughs] What do we still need to see before we get hockey stick growth in the security token space?
Michael Oved We need adoption, and I would go as far to say we need institutional adoption. We need best practices to be formed, and you need people to come in and say that what’s being done here is better than the way we’ve done things previously. The sky’s the limit with this technology. The number of assets around the world is staggering, even just in the United States alone. Staggering.
Derek Edward Schloss: Oved, Todd, on behalf of The Digital Wrapper, thanks for your time.
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¹ IPO is an abbreviation for Initial Public Offering, where a privately held company is transformed into a public company by offering and selling stock to the public.
² Joe Lubin is the Co-Founder of Ethereum and Founder of ConsenSys, a software foundry to develop software services and applications that operate on the Ethereum blockchain.
³ Ethereum is an open-source, blockchain-based, distributed computing platform and operating system featuring smart contract (scripting) functionality.
⁴ Decentralized exchanges are trading platforms that do not rely on a third party intermediary to hold the customer’s funds. Instead, trades occur directly between users (peer to peer) through an automated process.
⁵ Broker-dealers are organizations engaged in the business of trading securities, for its own account or on behalf of its customers. When executing trade orders on behalf of a customer, the organization is said to be acting as a broker. When executing trades for its own account, the organization is said to be acting as a dealer.
⁶ ICO is an abbreviation for Initial Coin Offering, a fundraising mechanism where individuals purchase digital tokens to help bootstrap new token-based networks. In the US, the SEC has released ICO comments to help provide guidance around compliant token-based offerings.
⁷ Bid-ask spread is the difference between the highest price a buyer is willing to pay for an asset, and the lowest price a seller is willing to sell it.
⁸ Dai is a decentralized, price-stable cryptocurrency based on Ethereum.
⁹ Stablecoins are cryptocurrency that demonstrate price stable characteristics.
¹⁰ Fiat is currency, without intrinsic value, that has been established or declared by government regulation to be legal tender.
¹¹ Open finance is a growing Ethereum ecosystem of decentralized finance apps and protocols.
¹² ERC20 is a common list of rules and standards for all Ethereum tokens to follow, empowering developers to predict how new tokens might function within the larger Ethereum ecosystem.
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