I regularly get asked what areas I find more exciting about security tokens and I always answer with a single line: “the ones we are not working on right now” 😊. Beyond the sarcasm, that statement clearly reflects my philosophy when comes to security tokens. I tend to think about security tokens as an enabler to create a new generation of securities that are impossible in the off-chain world. From that perspective, I tend to be more excited about imagining new forms of crypto-securities than creating digital wrappers of existing ones. Whereas the pragmatist in me recognizes that we are still years away from having an infrastructure that allow us to re-imagine digital securities, there are immediate use cases that can catalyze the movement. From those use cases, I believe tokenized debt or cash flow offers a unique plethora of possibilities to unlock the potential of security tokens.
The current generation of security tokens have centered around creating tokenized representations of equity in underlying vehicles. While technologically simple, tokenized equity remains a very constrained vehicle in a market that lacks the liquidity and secondary market infrastructure of other asset classes. The history of financial markets teaches us that liquidity and adoption is built by short term activity and trading not by long term investments. In that context, we need security tokens that are easy to understand, simple to adopt by the average investor and that offer clear short-term benefits that can build momentum into the ecosystem. As an asset class, debt securities have many benefits to extend the world of security tokens to mainstream investors.
Unique Benefits of Tokenized Debt
The use case for debt-based security tokens becomes clear if we think that the vast majority of asset classes have a debt component. Real estate assets can be represented as a combination of debt and equity and so are the structures of most companies. From that perspective, the quest towards tokenizing the world is in large part an exercise of tokenizing debt 😊. In the context of security tokens, tokenized debt brings some tangible benefits that are hard to ignore.
1) Universality: Debt is a universal concept as ancient as trade itself. Most countries operate comparable representations of debt which offers a global footprint for tokenized debt vehicles.
2) Market Size: The size of the debt market is immense. Just in public markets, bonds and debt security account for $100 trillion with a daily trade volume of $100 billion. Those number easily surpass the valuations of the global stock markets. If we add private debt vehicles like auto loans, student loans, credit card debt and many others you might get an idea of the potential.
3) Short Term Benefits: Tokenized debt pays a dividend on a regular basics. From that perspective, its easier for an investor to venture into security tokens knowing that he/she will receive a quarterly payment even if he doesn’t engage in any trading.
4) Composability: Debt is easily composable. Its relatively simple to put together a series of tokenized real estate leases into a crypto security representing a collateralized debt obligation(CDO). The on-chain representation of these vehicles also helps to bring more transparency into its underlying structure, token holders, forecasted performance, risk and other elements that are notoriously obfuscated in this form of derivatives.
5) Fractionalization: Just as debt vehicles can be composed into more sophisticated debt tokens, they can also be fractionalized into simpler representations. Fractionalization can make tokenize debt vehicle immediately available to new pools of investors.
6) OTC Trading: Most of debt vehicles in the world are traded over the counter(OTC). Debt-based security tokens can complement this model by providing a streamlined, digital footprint of the transactions.
7) Futures: Futures and derivatives remain an elusive goal for most crypto assets but tokenized debt might be a perfect vehicle for it. Debt is a relatively trivial asset to model as a futures vehicle and one that is relatively well understood. In that sense, tokenized debt futures might be another vehicle that helps unlock liquidity in the security token ecosystem.
To put things in perspective, the following matrix compares debt and equity vehicles in the context of security tokens.
The Building Blocks of Tokenized Debt
Now that we are sold on the benefits of debt-based security tokens, we can start thinking about how implement this new form of crypto-securities. Unfortunately, this is where things get complicated because there are no native protocols for debt securities. Protocols like Dharma provide an inspiration for debt-based security tokens but they would have to be seriously adapted for a security token use case. The difference between Dharma and a debt security token protocol is that the former is focused on automating the borrowing and lending of crypto-assets while the latter will focus on creating tokenized representations of existing debt vehicles and automating the terms in an existing debt contract.
Well, if Dharma is not the solution then what is it? A debt security token protocol might not be just one protocol but the combination of several protocols that abstract different dynamics of tokenized debt. At a high level, an architecture for tokenized debt in security tokens can be picture as the following diagram:
What are the roles of each one of those components? That will be subject of the second part of this article.