Cashflow on the Blockchain Part III: Reimagining Debt with Security Tokens

This is the third and final part of an essay focused on security tokens for debt instruments. The first part covered some of the fundamental benefits of debt-based security tokens while the second part outlined the key principles of a protocol for tokenized debt. In this part, I would like to focus on how debt crypto-securities can help us reimagining traditional debt vehicles or even create new forms of debt products that are nearly impossible to build in the current financial infrastructure.

The magic of crypto-securities goes beyond the creation of on-chain, digital wrappers for existing asset classes and allow us to create new security instruments that are not possible within the constraints of existing financial processes. The combination of cashflow and underlying assets, makes debt instruments one of the most fascinating areas to experiment with the possibilities of security tokens. Security Tokens will unlock a concept that is as intriguing as its name: programmable debt.

Programmable Debt

Programmability has long been preached as one of the key benefits of security tokens even though we have not seen many of those benefits today. The potential of programmability in security tokens tend to increase proportional to the behavioral richness of the underlying asset. While the behavior of equity assets is based on some very constrained dynamics such as buy, sell and hold; debt instruments exhibit behaviors such as dividend payments, defaults, underwriting or yield rebalancing that offer a wider canvas to unlock the potential of security tokens.

In the context of debt-based security tokens, programmability can help create new forms debt instruments whose behavior is partially dictated by the digital world. While the possibilities of programmable debt are only limited by our imagination, we still need to find those forms of debt-based security tokens that can provide value in the short term. Below, I’ve listed some examples of new forms of debt-based security tokens that leverage the benefits of programmability to enable new capabilities while also providing immediate benefits to the token holders.

Composable Debt Products

Debt instruments are intrinsically composable. Mathematically speaking, if D1(r1,d1,i1) and D2(r2,d2,i2) are two debt security tokens with different levels of risk, dividend payments and interest rates, we can build a new debt token D3(r(r1,r2), d(d1,d2), i(i1,i2)) that combines the underlying security tokens into a single, tradeable unit. Composed, debt security tokens are forms of crypto-derivatives that can result incredible powerful to hedge against different market conditions, balance different levels of risks and dividend models. While creating a composed debt product such as collateralized debt obligations(CDO) nothing short of a nightmare, Blockchain protocols such as Set provide the foundation for composing debt tokens into new forms of crypto securities in a few lines of code.

Fractionalized Debt Products

In addition to being easily composable, debt-based security tokens are also natively fractionalizable. Token holders can acquire fractions of a debt crypto-security that will give them exposure to a dividend payment, interest rate and risk that are correlated to their specific holding. Similarly, fractions of a specific debt security token can be combined into other security tokens using the composition techniques explained in the previous segment.

Debt-Equity ETF Tokens

Exchanged Traded Funds(ETFs) are the most popular vehicle in financial markets to combine bonds and stocks under a single security. Borrowing some concepts from the ETF world, we can imagine security tokens that combine baskets of debt and equity tokens into a single unit that balances the risks and returns for specific markets and investor profiles.

Real Time Dividend Distribution

Dividend distribution in debt product is done in long cycles such as quarterly or yearly. Debt-based security tokens don’t have the restriction of traditional debt instruments that prevents them for distributing dividends to debt holders in a more timely fashion. Imagine a debt crypto-security that represents a pool of real estate leases which is programmed to distribute dividends to token holders every time a tenant pays his monthly lease. Regardless of the viability of the business model, security tokens offer a foundation for implementing this type of debt instrument which is incredibly hard to conceive in traditional financial markets.

Tokenized Incentives

One of the areas that I find fascinating about debt-based security tokens is the use of crypto-economics to incentivize good behaviors among the debt participants. Imagine a protocol that rewards the debt issuer with a crypto token every time he or she makes a dividend payment on-time. Similar crypto-models can be use to incentivize the behavior of underwriters or auditors evaluating the performance of a tokenized debt instrument or arbiters mediating disputes between different players.

A Roadmap for Debt-Based Security Tokens

In the three parts of these article, we have discussed a lot of different perspectives of debt-based security tokens. I tried to not play visionary and focus on areas that can be materialized in next six to twelve months and that can finally open the doors to the world of debt security tokens. If we try to put these ideas in a timeline, we get something like the following.

Debt-based security tokens have the potential of becoming the first form of crypto-security to unlock liquidity and to enable access to mainstream investors. Starting with the basics of a debt security token protocol, debt instruments offer a unique canvas to experiment with the most ambitious concepts in security tokens. We just need to get started.