Assets on the blockchain — creating new markets
By Ksenia Beloglazova on The Capital
Personally, I like blockchain technology very much. The changes that the blockchain is going to bring to our life will be primarily associated with finances. All our life we deal with money somehow; in particular, we earn money, we spend money, we invest money, and we win or lose money. Therefore, blockchain is going to change one of the most important aspects of our lives and I am sure that the changes will be truly revolutionary. Still, before we start talking about what the transferring of the assets to blockchain will bring us in the future, I would like to shortly describe what has already happened.
First of all, blockchain has already given us the opportunity to legally receive investments, bypassing the securities market regulations. Obviously, I am talking about ICO and IEO. However, more than 85% of ICOs turned out to be unprofitable. Accordingly, ICO investors quickly realized that the securities market laws are not just bureaucratic procedures that impede business development and aimed at collecting additional taxes and commissions but they actually constitute an investor protection mechanism.
Secondly, blockchain has already given us the opportunity to transfer money around the world without control and for minimal fees. For example, Chinese businesses actively use it. Here we talk about USDT and some other stablecoins.
Finally, blockchain has already given us the opportunity to tokenize investment products and to offer them to millions of retail customers at a minimal cost. This process of real assets tokenization is just the beginning. It hasn’t become a widespread practice yet. Indeed, only an insignificant share of issuers offers their tokenized securities and a very small proportion of buyers purchases security tokens instead of traditional securities. Still, in my opinion, the investment product tokenization will significantly transform the stock market over time. Therefore, I would like to delve deeper into this issue.
I don’t think that traditional financial markets were worried because of the blockchain appearing. The securities market and the crypto market are simply not comparable. The securities market size is about $80 trillion vs. the crypto market size $250 billion. Still, the blockchain can greatly change financial markets due to its advantages:
1. Your assets on a really public blockchain cannot be seized without your leaving you unaware of this
2. No one can interfere with your transactions.
3. Transactions are irreversible.
I want to consider three questions: what should be tokenized, for whom and how to do this. So be patient, this article will be quite voluminous.
WHAT is to tokenize?
I wrote already in my previous articles “Trust Point” and “There can be only one” that the trust issue is currently the most sensitive issue of the entire cryptocurrency market. Indeed, there is a massive uncertainty concerning the crypto assets states policy. Moreover, the ICO bubbles, in which many courageous investors lost a lot of money, are still fresh in my memory. Therefore, the main issue that the security tokens potential buyers are concerned about is liquidity and reliability, which inevitably leads us into liquidity and reliability issues of the assets behind these security tokens.
We can recall here a Howard Marks ’s comment that one of his irrevocable rules is that no investment tool should promise more liquidity than its underlying asset. Otherwise, what will be a source of increasing liquidity? Since there is no such source, the growth of liquidity is usually illusory, fleeting and unreliable, and it works (like a financial pyramid) until the markets freeze, and the promise of liquidity passes the test of difficult times.
Based on this, the most attractive security tokens will be those that are traded on stock exchanges and have their own high liquidity as well as those which are based on cash or highly liquid assets that are traded on the stock exchanges.
Therefore, first of all, tokenization affected the most highly liquid assets: cash and cash equivalents. For example, we saw the emergence of stablecoins, which are secured by major world currencies and the emergence of cryptocurrency index funds that are secured by cryptocurrencies.
Lately, all the most striking examples of tokenization of real assets have been relating to real estate. That makes sense. Indeed, the issuer receives the necessary financing much cheaper and easier through real estate tokenization than through mortgage or bonds issuing. A security token buyer, in his turn, has an opportunity to invest in a high yield project with a low entry threshold and minimal risks.
There is also a demand for tokenized bonds of reliable issuers. Here the set of advantages is very similar. For the issuer, it’s the simplicity and the low cost of raising funds; for the buyer, it’s reliable investments with good returns and a low entry threshold.
In the case of tokenized real estate and tokenized bonds, the reliability issue seems to be resolved but the liquidity issue remains. Issuers of such security tokens are unlikely to bring them to crypto exchange to provide them with high liquidity since payments for the listing can significantly reduce the benefits that the tokenization offers. Still, in these cases, the liquidity level is not lower than in real estate or bonds direct investments. Moreover, a low entry actually minimizes this problem.
For all the other assets, their tokenization potential is still seriously hampered by the liquidity issue.
I think we will see good stock tokenization cases over time. I do not expect any big companies to tokenize their shares in the nearest future taking into account the current blockchain infrastructure development level. The current blockchain development level and the current blockchain confidence level (or rather, distrust) is incomparable to the confidence in the largest democratic countries. Thus, the appearance of leading companies’ tokenized securities is quite unlikely for now. Notwithstanding the above, the companies, the security tokens issuers, may eventually grow into stock market giants whose stocks will be already tokenized.
So, now we understand quite well what should be tokenized and what will be the underlying assets of security tokens. First of all, these are currencies, cryptocurrencies, commodities, real estate and bonds, then shares of companies and finally, any resources, any assets, even the rarest and most exotic ones.
WHO needs tokenization?
Here we have two sides, namely those who issue security tokens, and those who buy them.
Let’s start with the issuers. Basically, tokenization is a way to attract cheap capital on the security of underlying assets. In general, issuers have no other motives. Moreover, in cases when it comes to tokenized stocks of companies (mainly startups), issuers often have no other options to raise the capital. But this is the current situation. Soon enough, everything will change. I think that in the near future, investment units of banks, investment funds, and brokerage companies will be the main issuers of security tokens. They can tokenize part of their investment products and ensure compliance with the law regarding the security tokens buyers’ rights. At the same time, high competition for customers in the traditional investment products market will be the main engine of this tokenization process. Those hundreds of millions of potential retail investors from around the world that aren’t currently in the investment market (they can invest just a few thousand euros each) will become a great force and a very attractive target audience.
Let’s divide the potential security token buyers into three groups (I do not consider institutional investors in this article):
· developing countries residents that seek to avoid the depreciation of their savings due to incompetence and high level of corruption of their governments
· developed countries residents that seek to invest their savings with a high level of security
· ICO investors
Each group has its own motives for investing in crypto assets.
For developing countries residents, cryptocurrency assets are able to solve their most pressing problem — the problem of preserving their savings:
· The currency of the country of residence quickly depreciates due to inflation or hyperinflation.
· Investments in world reserve currencies (US dollar, euro) are difficult due to limited supply or currency control.
· The banking system is traditionally weak, corrupted, and often fraudulent.
· Financial and brokerage structures may associate with special services or organized crime.
· The purchase of foreign currency and securities is not often a confidential transaction. These actions are transparent to both regulatory authorities and criminal elements.
· The purchase and personal storage of gold is often prohibited or unsafe.
· Foreign currency , gold, securities is difficult or even impossible to take out of the country of residence
Consequently, the clients from developing countries are extremely active in the cryptocurrency market but they have very high requirements for the liquidity of acquired assets. First of all, they are interested in cryptocurrencies, stablecoins, and highly liquid tokens of cryptocurrency index funds.
Residents of the developed countries have completely different motives for investing in the cryptocurrency market. They are not worried about preserving their savings. That is why they are classical investors with the aim of increasing equity. They make investments in order to provide a higher standard of living for themselves and their families. Security tokens are also very attractive to them. Indeed, the following significant investment problems can be solved by investing in security tokens:
· High commissions of consultants and financial advisers taking a significant portion of the return on investment.
· High entry threshold for the most investment products that often does not allow to fully diversify the portfolio and to reduce the overall risk level.
In this regard, clients from developed countries are stepping up their activity in the digital securities market while expressing maximum demands to the reliability and profitability of digital investment products. The security tokens liquidity is also important for them, but this issue is not as acute as for the people in developing countries who need practically an absolute liquidity of the acquired digital assets.
A completely separate group of potential buyers of security tokens are the ICO investors, due to their objectives:
· The main goal of investing in ICOs (84%) is a speculation
· Then it is a support for a promising project that can change the cryptocurrency market (52%)
· Finally, to increase savings, to distribute investments among different projects, to find another highly profitable project that will allow to multiply the investments.
In any case, we are talking about a manifold increase in investment value that greatly narrows the list of digital assets that are attractive to the ICO investors. Attractive options for them are:
· Cryptocurrencies and their derivatives in the form of cryptocurrency index funds
· The STO projects in which the security tokens are sold. An investor receives the right to a share in the promising company’s capital.
As an intermediate result, we can say that the security token market is already big, groups of potential customers have already formed in it; and as the supply grows, the digital asset market expects an explosive growth. And we move on to the third key issue of this article.
HOW can assets be tokenized?
Answering this question, it is important to understand what assets are tokenized, for whom, and for what purpose. I have sorted it all out above, so now I’ll just summarize it.
Let’s start with tokenized cash, that is, stablecoins. In my opinion, stablecoins have two main areas of application: cross-border payments (I already wrote about business in countries with tight currency controls, e.g. China) and mediation in transactions between fiat currencies and cryptocurrency assets. Since stablecoins fulfill the function of money and they are trusted as money, this imposes several restrictions on stablecoin tokens:
1. They should be built on the reliable public open source blockchain. Any other blockchain, by definition does not have the level of trust necessary for money (here I do not consider alternatives as the Central banks’ cryptocurrencies).
2. The issue volume should correspond to the amount of assets that this stablecoin is backed up with. The stablecoin issuer should be audited regularly.
3. The issuer himself must be registered in a democratic jurisdiction with a high level of reliability.
That means, everything is simple: as in the case of money, we need the ability to remain anonymous, and we must trust the issuer, the country where it is registered, and the blockchain on which stablecoin is issued. In this regard, I think that in the near future the stablecoin market will be redistributed, since the current leader ( USDT ), in my opinion, does not fully comply with these rules.
When cryptocurrencies are a tokenized asset, for example, in the case of cryptocurrency index funds, it is very important to consider whom the created security token is intended for:
1. If potential buyers are retail customers from all over the world, then they need absolute liquidity, trust in the blockchain on which the security token is issued, and trust in the issuer. Accordingly, it is necessary:
a. An open source public blockchain.
b. A smart contract, which allows an unconditional selling of issued security tokens to fund at market price.
c. Transparency of underlying assets. We should be able to see at any time how many and what cryptocurrencies are in the fund’s assets.
d. Adequate level of trust in the jurisdiction in which the issuer is registered.
2. If institutional investors are the potential buyers, the set of requirements changes: trust in the issuer and guarantee of ownership of the asset come first. That is, neither the actions of hackers, nor randomness like losing a private key should lead to a loss of an asset. There should be a backdoor in the blockchain or in the smart contract allowing you to return the property in cases protected by law. Accordingly, it is necessary:
a. Public or private blockchain that guaranties the ownership
b. Asset audit
c. The issuer must be registered in a democratic country with a high level of trust.
When tokenizing real assets, exactly the same questions arise: for purpose the tokenization is carried out for (what are the objectives of the issuer) and who are the potential buyers.
Currently, the main reason for real assets tokenizing is to raise funds. It doesn’t matter under what pretext. It may be a real estate projects tokenization (often not built yet) or, for example, the sale of shares in a company (most often, a startup). The essence of all this is: STO is a simpler and cheaper way to raise funds comparing to traditional bank loans, issuing bonds or conducting an IPO.
In the future, I believe, the main financial goal for securities tokenization will be to receive the commission of the sale of these tokens to the end customers. The investment banks and brokerage firms will become the main issuers.
One the one hand, the issuers’ objectives actually define the requirements for security tokens. This set of requirements form a kind of additional functionality that the issuer defines during the issue. For example, this set of requirements may include functionality for regular payments (interest, dividends, etc.), for counting of votes (e.g., the sale of tokens, shares), for repayments, etc.
On the other hand, the customers form their own set of requirements for security tokens. Depending on what is the target audience, the following parameters: the level of trust in the blockchain, in the issuer, in the state in where the issuer is registered, the possible level of anonymity, the irreversibility of transactions, guarantees of ownership of the asset and the presence of a backdoor, — have different values. The backdoor, for example, may be important in the case of share tokens. Indeed, the cryptocurrency may be lost if the private key is lost but this should not happen to company shares.
Here I come to a key feature of the entire process of securities tokenization. The whole essence of cryptocurrency is in the fact that we do not need to trust the third parties. We can solely rely on cryptography, to be sure that all participants unconditionally comply with the rules. But in the case of security tokens, the confidence in the issuers becomes very important too. Moreover, in some cases, a backdoor is required. In such a case we need to be confident even in the platform that conducts the token issuance.
So, this leads to the question: What is the point of using blockchain for asset tokenization, if we still cannot get away from the problem of trust in the third parties, in this case from the need to trust issuers? There are two reasons that make the whole process of security tokens issuance justified and guarantee that the process will continue growing exponentially:
1. Raising funds through STO is much cheaper than traditional methods.
2. Huge markets are opening up for hundreds of millions of potential retail investors around the world.
I believe that it is the second point, namely, the attraction of hundreds of millions of retail investors around the world that will bring the main financial effect for the tokenized securities market; it will bring trillions of dollars to this market. And if so, then the credibility of the blockchain on which all this mega-tokenization will be carried out becomes the key issue.
It is also necessary to bear in mind that the security tokens infrastructure will evolve, the standards will change, but the investment products should stay valid.
And yet, in my opinion, there should be no security token binding to the platform that released it, since this increases the need for trust. Indeed, in this case, we need not only to constantly trust the current blockchain and the issuer but also the platform.
According to the above discussion, we can conclude that any security token that is intended for retail investors should be fully decentralized. That means it has to be issued on a public blockchain with open source code. Every owner should be able at any time to take his security tokens from the platform to his personal e-wallet, and the existence of the token itself must not depend on the existence of any platform in any way. This is in the spirit of blockchain, it minimizes the need for trust in the third party, and therefore it is right.
Back to trust in the blockchain. Let’s say it again: the most liquid, safest, open source, not redistributing its intrinsic value in favor of its developers. What is this? Maybe it is Bitcoin again? Not yet, Bitcoin does not support Turing-complete smart contracts. That makes its applicability to securities tokenization very limited. Therefore, here it becomes quite interesting. Which blockchain will become dominant for retail buyers? Will Ethereum Overcome Its scalability Issues? Or will a new blockchain appear and become a leader in this market? Or will a solution to this problem appear on top of Bitcoin? Let’s stop guessing, we’ll see everything soon. I bet on Bitcoin, though I use Ethereum now. Moreover, in order to fully elaborate on the securities market evolution, I am going to publish another article about how I see this market after some 10 years. Stay tuned on!
