Very often we hear voices in the security token community claim that we need better projects in order to improve the momentum of the crypto-securities markets. I often find that argument a bit shortsighted as I don’t believe the quality of token offerings alone is enough to enable market making and liquidity in the security token ecosystem. In my opinion, security tokens are still missing some fundamental building blocks in order to become a relevant financial mechanism. Among those building blocks, disclosures and information symmetry mechanisms are fundamentally required to achieve any level of fairness in the security token market. I’ve a vocal proponent of disclosures and security tokens in the past. Today, I would like to explore some new ideas about this area that I think might be relevant to the current generation of security token platforms.
In the context of security tokens, the relevance of disclosure protocols seems conceptually obvious. In the absence of relevant information about a crypto-asset, how can we possibly expect to arrive to fair pricing and trading models. However, I believe that’s only a fraction of the argument. After all, we have products like Bitcoin without real disclosure models that achieve fair market prices and vehicles such as collateralized debt obligations(CDOs) with plenty of related information available whose prices spiraled completely out of control. While disclosures are certainly an enabler or fair market dynamics, they also require robust distribution and consumption models in order to be effective.
The Friction Between Disclosures, Decentralization and Network Effects
An idea that I’ve found quite intriguing recently is to think about disclosures in security tokens as a complement to decentralization and network effects. The core principle of this thesis is that the there is a linear dependency between the relevance of disclosures in a given crypto-network and its level of decentralization. This thesis contrasts with the traditional economic models for information asymmetry but seems to be well suited for crypto-networks.
The traditional way of thinking about disclosures and information asymmetry has its roots in the work of economists like George Akerlof. The recipient of the Nobel Prize in Economics, Akerlof created one of the most comprehensive theories about information asymmetry in financial markets. In a 1970 paper titled “The Market for Lemons”, Akerlof considers the example of a seller who has private information about the quality of a used car. A buyer would like to acquire a car, but is keen on paying a “fair” price for it. To make things more concrete, suppose that there are nine different cars, each car having “fair” values, 100$, 200$… 900$ respectively. As the buyer cannot observe quality, owners of low quality cars will always claim they are selling a high-quality product worth 900$. A fair price will then reflect the average quality of the market, in this case 500$. However, under such circumstances, sellers whose cars are worth more than 500$ find such price too low, hence exiting the market. The average price must then drop to 300$, inducing more exits, and so forth. Consequently, at the exception of worst-quality cars worth 100$, no seller is willing to sell a car that a buyer is willing to buy!
Akerlof theory about information asymmetry makes a strong case for the need of disclosures. However, how can we explain financial assets like Bitcoin or Ethereum that achieve a relevant level of fairness without any formal disclosure mechanism? We can make the case that the access to information in a network like Ethereum is completely asymmetrical as the core team in the Ethereum Foundation not only has a disproportional level of access to information but they can also influence the behavior of the network. How is it possible for Ethereum to achieve market fairness? The answer is related to the level of decentralization in the Ethereum network. In sufficiently decentralized ecosystems, price fairness is achieved by the behavior of the participants in the network and not so much by the flow of information. In a decentralized ecosystem, any unfair behavior will be balanced by other network actors without having to rely on a centralized authority. In that sense, disclosures are not as important in a sufficiently decentralized ecosystem as they are in centralized markets.
Security tokens are evolving based on fairly centralized models with minimum network effects. In that context, disclosures are likely to play a key role in the fairness of the market. The relationship between information disclosures and the level of decentralization from the perspective of different crypto-assets can be illustrated in the following figure:
If security tokens ever evolved as a network ecosystem, the importance of disclosures might be balanced by the corresponding network effects. At the moment, disclosures remains a foundation building block of security tokens and one that should be enabled by blockchain protocols. As mentioned before, publishing information is only part of the equation, we only need effective mechanisms to consume that information.
The idea of programmable disclosures for security tokens relies on modeling information sharing workflows as part of blockchain protocol that can be used during security token issuances and transfers. Security token disclosures should not only be used by humans but also by protocols in order to achieve fair market trading. This notion becomes a bit tricky if we factor in the level of centralization in the current security token platforms as the models for validating the information using network participants are simply not available. While I don’t claim to have a concrete idea about an end-to-end protocol for security token disclosures, there are a couple of principles that seem to be a common denominator across all models:
· Disclosure Oracles: This component represents trusted entities that publish off-chain, publicly available, material information about security tokens. Disclosure Oracles should be able to gather the information on-demand or on schedule basics and relate it to the corresponding crypto-security.
· Disclosures Payload: To be truly programmable, disclosures would need to be encoded in a format that allows its indexing and querying. Unstructured data formats such as PDFs are practically useless to enable programmable disclosures.
· Disclosures Query Model: In order to be used in security token transfers, disclosures would have to be accessible at the protocol level. For that to happen we need a mechanism to query and access the information encoded in a disclosures payload.
Those three components: oracles, payload and query model, constitute the basics of a security token disclosure protocol. The specific interactions between the participants in the disclosure process can be modeled in different ways depending on the composition of the security token ecosystem. Some of the ideas of protocols like TruSet might be applicable to security tokens.
In the current state of the security token market, disclosures remains an unsolved problem and one of the main roadblocks for the evolution of the ecosystem. Disclosures should go beyond just publishing documents and we should aim for programmable models that can be incorporated into security token protocols. In semi-centralized ecosystems as the ones enabling security tokens, disclosures should be considered as one of the fundamental building blocks of the next generation security token platforms.