Elevated Returns is known for tokenizing USD $18M of the St. Regis Aspen Resort, thereby giving stakeholders in “Aspen Digital” ownership in the luxury resort proportional to their token holdings.
Elevated Returns’ Aspen Digital offering was conducted on Ethereum. However, in collaboration with TQ and Securitize, a platform for compliantly digitizing securities on blockchains, Elevated Returns will conduct its future asset tokenization offerings on Tezos.
In this piece, I give a brief overview of advantages of tokenizing real assets, present shortcomings of issuing tokenized assets on some blockchains, and explain at a high-level how Tezos solves these problems and why it is the best platform to underpin such assets.
Assets like real estate and luxury art have high barriers to entry to participate in their respective markets. Unlike stocks and bonds which are traded on public exchanges, real estate and luxury art are socially exclusive, require large amounts of upfront capital (prohibitively expensive minimums), and are usually illiquid (extended holding periods, high transaction costs).
Blockchain-based tokens have a variety of use-cases (I won’t opine on their value here). They can be used as in-app currencies, means to incentivize specific actions, or to manage DAOs. However, as is most pertinent to this piece, tokens can also digitally represent the value of real, tangible assets.
Tokenization democratizes access to assets and enables more efficient markets by facilitating fractional ownership, unlocking global, anytime liquidity, and using smart contracts to create novel financial instruments and automate business processes.
Exchanges provide access to supported assets for those authorized to transact, either electronically or in-person. For more exclusive assets like real estate and luxury art, such exchanges exist in several, albeit limited, forms. For most people, access to these exchanges, such as an auction house, is restricted due to higher barriers to entry than those of an asset like a stock which may be bought and sold from one’s smartphone.
Some of these barriers are geographic. For example, it’s non-trivial for someone living in Chiang Mai, Thailand to invest in San Francisco real estate, and vice versa. However, a more restrictive barrier to entry is the high minimums required to purchase the entirety of these types of assets and/or participate in their markets.
Many people don’t have the option to participate in commercial or residential real estate markets because they cannot afford their respective properties. The same goes for luxury art — very few have the ability to take part in a Christie’s auction in Manhattan and participate in the potential value creation of tangible assets in this market.
As stated above, tokens may digitally represent the value of real assets. Tokenization facilitates fractional ownership to give authorized entities the ability to own very small parts of a whole asset. For example, by enabling one to invest USD $5 in a USD $50M asset, many from all over the world may have the option to participate in the potential appreciation of previously exclusive asset classes with prohibitively expensive minimums.
Blockchain-based tokens may be transacted 24/7/365, rather than strictly between the hours of 9:30 am and 4 pm EST, Monday through Friday. Global, anytime markets more effectively support price discovery via open access, which improves the prospect of increased liquidity.
Additionally, using smart contracts (i.e. decentralized and automated escrow), asset issuers can automate the observability, verifiability, and privity of regulatory best practices, such as KYC/AML checks or investor accreditation. The ERC-1404 token standard built by TokenSoft showcases how smart contracts can be used to automate the enforcement of complex compliance requirements.
Similarly, smart contracts can programmatically issue dividends or other payouts according to specified terms to those in control of an asset’s token, thereby lowering the administrative costs of such tasks and other business processes.
Lastly, tokenization eases the development of novel financial instruments such as globally accessible synthetic assets. Synthetic assets are assets designed to track the value of a single asset, or multiple assets, without having to hold an asset directly.
“These new securities are formed by combining securities (such as bonds) and derivatives (options and futures) in a wide variety of ways. Very complex term structures for payments (ie, what payments get made when, the rate of interest, etc.) can now be built into standardized contracts and traded with low transaction costs, due to computerized analysis of these complex term structures. Synthetic assets allow us to arbitrage the different term structures desired by different customers, and they allow us to construct contracts that mimic other contracts, minus certain liabilities.” -Nick Szabo (source)
Smart contracts can be used to rearrange and combine various tokenized assets to create novel financial products not possible before. However, certain aspects of some blockchains’ designs make them less suitable for tokenized/synthetic assets than others.
Shortcomings of Some Blockchains
As previously mentioned, smart contracts can be thought of as decentralized and automated escrow accounts. They can hold real value, sometimes hundreds of millions of dollars worth, and can be appealing targets for hackers. For obvious reasons, strong security techniques must be utilized to protect smart contracts and their contents.
Many platforms (aka “blockchains”) sacrifice smart contract security for ease of development. Although this is an effective means to attract less-capable developers to build on such platforms, it is a dangerous trade-off for use-cases of real value where smart contracts may someday contain billions of dollars of assets. Mainstream adoption of smart contracts and their platforms are unlikely to emerge with at-risk smart contract implementations that sacrifice security.
Beyond smart contract security, excessive costs to coordinate and execute software upgrades make it arduous for many blockchains’ stakeholders to implement new innovations while maintaining the network effects that give their stakes value.
For example, disagreements over how to handle hacked funds have produced heated debates within the Ethereum community, thereby disrupting its network effect. A previous episode did the same and literally split the network in two. The former debate rages on today, and only time, combined with informal and unenforceable decision-making processes, will tell how it will be resolved.
Not only is it difficult to coordinate decisions in a decentralized network with diverse stakeholders from all around the world, but it is also difficult to implement those agreed upon decisions and execute a software upgrade in a network with thousands of network/node operators. Even if a proposed upgrade is non-contentious and informally agreed upon by stakeholders, most blockchains require that network operators manually update the software running on their nodes before a specified block height to upgrade the associated networks.
Coordinating a blockchain’s upgrade in a distributed group of network operators who may not be acquainted with one another is a laborious and costly endeavor. Assuming this technology gains mainstream adoption, one can imagine a future with >100x more network operators than there are today. If a portion of those operators aren’t on Twitter or constantly aware of a network’s status, it will be extremely difficult for them to coordinate and execute network upgrades. Barring Bitcoin (though this is up for debate), an absence of mechanisms that facilitate the coordination and execution of upgrades puts the network effects that give blockchains value at greater risk of disruption and deterioration.
Many existing platforms lack mechanisms that effectively facilitate their steady evolutions so that they can adopt new technologies and retain the network effects that give them value. For asset issuers, it is likely in their best interests to tokenize their assets on a blockchain where stakeholders can more efficiently conduct upgrades to keep the platform technologically relevant and strengthen its network effect over time.
Tezos’ design supports an evergreen time horizon that is attractive to institutions, developers, and others who prefer to mitigate the possibilities of investment losses (time, money, reputation, etc.) building on platforms that carry greater risks of obsolescence.
Tezos empowers its stakeholders to more effectively solve the shortcomings described above, among others, and those that have yet to present themselves.
Smart Contract Security
First, a critical consideration of all platforms is smart contract security. The domain-specific language for writing smart contracts on Tezos, Michelson, is designed to facilitate formal verification to support the creation of more secure smart contracts. Formal verification is a technique used to prove properties of programs such as smart contracts. It is utilized in industry by high-frequency traders, nuclear, aeronautical, and automotive engineers, and others for mission-critical tasks that require strong proofs of correctness. Applications where real value is at risk, such as those on blockchains, should strive to be as secure as possible through the use of formal methods and other techniques.
Mainstream adoption of smart contracts is unlikely to emerge with poorly designed, at-risk smart contract implementations. Michelson is designed to improve smart contract security, which will help instill confidence in users and foster real adoption by various parties. In the future, it may be a requirement for the properties of any smart contract to be formally verified — Tezos smart contracts more easily support this technique.
Below are some resources for those interested in learning more about Tezos smart contracts:
- This repository contains a formalization of Michelson using the Coq proof assistant.
- This repository contains a tutorial series to get started with Michelson.
- This piece provides an overview of LIGO: an imperative language that compiles to Michelson, featuring a Pascal-like syntax and a simple type system.
- This piece provides an overview of SmartPy and SmartPy.io, an intuitive and effective language and development platform for Tezos smart contracts.
Platform longevity is likely an important factor for asset issuers, developers, and others to consider when deciding which blockchain to invest time, money, and other resources towards. There are different aspects of Tezos that make it built to last, at the center of which is a formal process, or governance mechanism, for stakeholders to make decisions about the protocol, including the protocol’s decision making process itself.
This section will not examine Proof-of-Work (PoW) vs. Proof-of-Stake (PoS) consensus. Although relevant to platform longevity, such an analysis warrants its own review and will not be covered in this piece. Check out this piece by my colleague Jacob Arluck for an overview of Tezos’ current consensus mechanism.
Cryptocurrencies largely derive value from network effects. Anyone can “fork” an open-source protocol to develop a version that differs from the one it originates from. When upgrading a platform, stakeholders with different preferred paths can separately proceed with the versions they think are most valuable. Because cryptocurrencies obtain value based on network effects, forks fragment communities and hurt the value of the networks in which they occur. As such, mechanisms that disincentivize forks to better retain network effects when conducting a platform upgrade are in stakeholders’ financial best interest.
The Tezos Position Paper cites the “‘hard fork’ problem,” commonly referred to as “fork-based governance,” as a primary motivation for Tezos. Typically, when talented researchers and engineers discover an innovation that may add value to a platform and decide to implement a change to the protocol, a fork produces an old version of its blockchain and a new one.
When a fork occurs, how do stakeholders decide which version is the “real” one and more valuable than the other? Which one should developers build on or issuers tokenize their assets on? Which version of an asset that exists on both chains should be recognized as “real” and transacted in the future? These are largely social questions and support the argument that innovating a blockchain while maintaining its network effect is a coordination game. Tezos offers a potential solution to fork-based governance via a mechanism that lowers the coordination and execution costs of conducting upgrades so as to strongly disincentivize stakeholder fragmentation.
Stakeholders in a decentralized network are incentivized to preserve and grow the network effect that gives their stakes value. Retaining a network effect when conducting an upgrade requires stakeholders to reach a Schelling point (i.e. social consensus) on the version of the protocol that is considered most valuable or “real.” In decentralized networks with both known and unknown stakeholders from all over the world, achieving this consensus entails significant coordination.
Tezos presents a mechanism that empowers all stakeholders to more efficiently coordinate to reach social consensus on protocol upgrades. In doing so, stakeholders can more effectively conduct a decision-making process that takes all stakeholders’ preferences into account so as to better preserve and strengthen the network effect that gives Tezos value.
Lastly, it is important to highlight that Tezos’ current governance mechanism can be modified. It is too early in this blockchain experiment for anyone to know for sure how to most effectively govern a decentralized network. The ability to upgrade the Tezos governance mechanism itself allows for more effective processes to be adopted if/when they are discovered in the future.
Stakeholders are financially incentivized to adopt technology that is deemed valuable by the market. Its governance mechanism facilitates Tezos as a more upgradable platform than other blockchains that lack such evolutionary processes. For example, Nomadic Labs, in collaboration with the French research center (CEA), Cryptium Labs, and Arthur Breitman, is working on a variant of Tendermint consensus to add finality to Tezos. Additionally, Nomadic is also working on zero-knowledge cryptography to add the option for shielded transactions on Tezos. These are just two examples of technologies that may be implemented to Tezos via its governance mechanism.
However, conducting an upgrade requires more than achieving social consensus. Even if stakeholders reach agreement on the preferred version of the protocol, they must still execute the change to upgrade the blockchain to what was agreed upon.
For most blockchains, network operators are required to manually update the software running on their nodes to execute an upgrade. Self-amendment is the mechanism by which a protocol upgrade is automatically executed. Once social consensus is reached via the Tezos governance process, the software running on nodes is automatically updated to the newly approved protocol, thereby upgrading the network and avoiding a fork that may have occurred due to an inability to manually intervene.
The ability to self-amend more easily facilitates the decentralization of the Tezos network at scale by lowering the friction of upgrading it. Platforms lacking mechanisms that lower the coordination and execution costs of conducting software upgrades will have difficulties scaling (with regards to the number of nodes, not transaction throughput) and staying technologically up-to-date while avoiding the disruption of their network effects.
Tezos’ formal process to coordinate social consensus about changes to the protocol and its removal of the need to coordinate the execution of protocol upgrades are two leading factors that make Tezos a more upgradeable platform than others. For asset issuers as well as developers, upgradability is likely a serious consideration as they must be confident that the platform supporting their assets or applications is technologically advanced with strong network effects, not only in 3 years from now but also in 30+ years.
Tezos offers a mechanism to fund the development of core protocol improvements and other public goods. If a software upgrade is approved via the Tezos governance mechanism, the new implementation can mint Tezos tokens (XTZ) and issue them to the developer (individual or team) behind the upgrade. This mechanism increases the total supply of XTZ and is called “inflation funding.” Inflation funding is a potential solution to the free-rider problem, which open-source projects are particularly prone to.
Assuming the adoption of a new privacy-preserving feature would increase the price of XTZ by 10%, rational stakeholders should adopt such an implementation so long as the minting of new tokens inflates the total supply of XTZ by <10%. This example would benefit existing stakeholders and compensate the developer of the implementation.
Inflation funding in Tezos allows developers to attach invoices to protocol upgrades and stakeholders to set on-chain bounties they deem valuable. Additionally, on-chain bounties can be automatically distributed to recipients when an upgrade satisfies its properties; escrow is automated and the developer captures the reward straight from the protocol itself.
Inflation funding is not reliant on any single stakeholder to fund development — the protocol incentivizes the development of itself. Inflation funding contributes to platform longevity as it presents a sustainable source of funding that is not reliant on token price appreciation, an entity’s war chest, or private investment.
As cryptocurrency stakeholders have experienced the last ~15 months, markets don’t always move up and to the right. Many core protocol and application developers had the luxury of devoting full-time efforts to projects when their stakes were appreciating by orders of magnitude. When markets go south for prolonged periods of time and developers have more difficulty financially supporting themselves, they turn to other sources of funding.
A number of entities that support the development of specific smart contract platforms have significant amounts of capital to do so. Regardless of their sizes, the war chests these entities control are still composed of finite amounts of resources — they will be depleted eventually, it’s only a matter of time. How will core protocol development be funded once these entities no longer have the capital to do so? Fred Ehrsam, a co-founder of Coinbase, examines the financing of protocol development in his August 2017 piece, “Funding the Evolution of Blockchains.”
“A protocol which provides strong incentives for people to improve it is likely to evolve faster than one that does not. So blockchains which fund innovation through token inflation would seem to have a superior evolutionary algorithm. And over the long run, rate of change is often more important than starting point.” -Fred Ehrsam
Furthermore, the incentive alignment for non-war chest bearing entities, such as return-driven investors, to fund core protocol development is weak given the opportunity cost of capital. Why would a rational investor foot the bill to fund protocol development and let all other stakeholders capture the potential reward without taking the same, or similar, risk?
This dilemma is referred to as the “free-rider problem” — stakeholders would benefit from such an action being taken, but none benefit by doing so individually. Development efforts for open-source projects and other public goods are predisposed to collective action problems like this one. Inflation funding is an encouraging remedy to collective action problems as project funding is not dependent on a single stakeholder, but rather all stakeholders incur the same cost and may reap the same reward.
An evergreen outlook in this industry is crucial if participating as an optimistic stakeholder. As such, protocols that promote sustainable, market-agnostic funding mechanisms present compelling platforms to those with long-term views looking to adopt this technology. Inflation funding is an encouraging means to fund open-source development, and Tezos stakeholders are already leading the charge with it in practice.
Some platforms offer on-chain treasuries that allow stakeholders to issue funds for various initiatives. A Tezos on-chain treasury can be established via the Tezos governance mechanism. This would be a cool experiment, however, there are some limitations to consider. On-chain treasuries can only pay for development so long as they contain funds to do so. Once depleted, it takes time to recapitalize an on-chain treasury (e.g. block rewards).
For example, if there are 50 projects, each costing USD $1M, that would all significantly benefit a platform, but an on-chain treasury only contains USD $10M, then only 10 of those projects can be funded. With inflation funding, Tezos stakeholders can more aggressively fund protocol development and other public goods than platforms with only on-chain treasuries.
Tezos is a more upgradeable platform than others via its mechanisms that lower the coordination costs to achieve stakeholder consensus and execute upgrades. Upgradeability, combined with a market-agnostic means to fund the development of new technologies, establishes Tezos as an attractive platform for long-term stakeholders.
Platform longevity mitigates risks for stakeholders such as asset issuers and developers who must issue their assets and build on a platform that is more likely to be technologically advanced with a strong network effect in 30+ years. Lastly, security is paramount, and Tezos was designed to facilitate techniques like formal verification to support secure smart contracts. This protects not only end-users but also the reputations of those building products.
Asset tokenization is an emerging area of growth for the blockchain industry. Tokenization democratizes access to market participation by allowing stakeholders to own fractions of tangible assets and enables more efficient markets than we have today by unlocking global, anytime liquidity. Furthermore, various business processes and compliance requirements can be automated with smart contracts. These programs can also be used to create novel financial products like synthetic assets.
Several popular blockchains have attracted sizeable amounts of developers building on their platforms. The ease of development on these platforms has come at the cost of smart contract security, which has resulted in several unfortunate episodes of theft, of which their repercussions linger on today.
Some of these platforms lack evolutionary mechanisms that allow their stakeholders to coordinate and execute upgrades to evolve and adopt new technologies. Most have made it work so far, albeit with high coordination and execution costs. However, conducting upgrades as these networks scale, those that are actually decentralized, will become exorbitantly expensive and near impossible to conduct without damaging the network effects that give them value.
Tezos was designed to solve these problems, among others, by defining a formal process for stakeholders to more efficiently reach a Schelling point to retain its network effect. Furthermore, via self-amendment, Tezos automates the process of executing upgrades so that manually updating the software running on nodes is not required. Lastly, the Tezos core protocol has the ability to fund the development of its own platform and other public goods, thereby reducing reliance on token price appreciation, project-specific entities controlling war chests, and return-driven financiers for funding development efforts.
These and other aspects of Tezos support it as the best-positioned platform to survive and thrive in the long run. Platforms that lack mechanisms designed for security, long-term sustainability, and evolution carry a greater risk of becoming obsolete or abandoned entirely. Asset issuers with an evergreen time horizon are incentivized to dedicate resources towards platforms that are built to last. Tezos was built to last and will push the entire blockchain ecosystem closer to mass adoption of this technology that many of us are so passionate about.