Security Token 2.0 Protocols Part III: Fund and Derivative Tokens

This it the third and final part of an essay that explores the different types of tokens in the next wave of tokenization platform. The first two parts of this series covered debt and hybrid/convertible token protocols respectively. Today, I would like to focus on two types of security tokens that are likely to become one of the most attractive tokenized offers for sophisticated investors: derivative and fund tokens.

Crypto-Financial Primitives

The current generation of security token protocols have mostly focused on solving the compliance challenge incorporation capabilities such as KYC/AML. Using those protocols as a foundation, the second wave of security token platforms should be more focused on enabling the implementation of financial models that mimic real world securitized products.

· Debt Tokens: Tokens that represent a debt or cash generating vehicle.

· Equity Tokens: Tokens that represent an equity position in an underlying asset.

· Hybrid/Convertible Tokens: Tokens that convert between debt and equity based on their behavior.

· Derivative Tokens: Tokens that derive its value from underlying tokens.

In the current ecosystem, we tend to think of security tokens as atomic units whose valued is derived from an underlying asset. In that sense, if we tokenize the shares of three commercial real estate properties we should expect three different types of tokens. As the space evolves, we are going to see a new generation of security tokens that derive their value from a group of underlying tokens. In our example, we can have a security token whose performance is based on the value of our three underlying real estate tokens. Using an analogy from the securities market, these types of security tokens can be classified into two main groups: fund and derivatives tokens.

Fund vs. Derivatives Securities: Time vs. Ownership

In the general sense, a financial derivative is considered any product that derives its value from an underlying asset. However, if we dig a little big deeper, we can find two main groups of derivative models. Structures such as options or futures can derive its performance from the performance of an underlying asset at some point in the future and the owner of the derivative doesn’t necessarily own a position on the underlying asset. This type of product is what we commonly known as derivatives.

A variation of pure derivatives are products such as mutual funds or exchange traded funds(ETFs) in which the price of the security is based on the current price of an aggregated pool of underlying assets. Those structures are known as funds and the shareholder investing in the fund-security does, in fact, owns a position on the underlying securities. This is why most ETFs are not considered derivatives despite the fact that they derive their value from underlying assets. There are some ETF models such as Leveraged ETFs that aggregate derivatives and those are considered derivatives themselves. The following chart illustrates the distinction between fund and derivative securities.

The principles of fund and derivative securities are very applicable to security token protocols. As a matter fact, I would argue that these types of derivative tokens token is one of the key elements in order to make crypto-securities appealing to large institutional investors.

Derivative Tokens

Bringing the concepts of derivatives to the security token space, we can think of different models that can be relevant in the next generation of security tokens:

a) The Forward-Futures Model: Following the model of forward or futures derivatives in financial markets, we can envision smart contracts that specifies the criteria to buy or sell a security token at a specified future time and at a previously agreed price. This security token derivatives can follow the futures model if traded in centralized exchanges or the forward model if traded in decentralized exchanges.

b) The Options Model: Options offer another powerful inspiration for security token derivatives. In this model the owner of the security token option will have the right but not the obligation to buy or sell the underlying security token at a specified price on a specified date.

c) The Swap Model: Like swap models in financial markets, we can envision security token derivatives that exchanges the dividends or cash flow produced by two different security tokens in order to serve as a hedge or insurance against future market conditions.

Let’s take the example of a security token that represents shares on a private company. Using that token as the foundation, we can structure a derivative security token whose value will be based on the price of the token a year from now. Buyers of the derivative token do not necessarily need to own the underlying security token. In fact, the derivative token can be used as a hedge against the performance of the underlying security token.

Fund Tokens

Fund tokens can be seen as aggregated pools of security tokens with certain arbitrage mechanisms that keep the price of the fund token close to the net asset value of the underlying token. The issuers of the fund token will have to own positions on the underlying security tokens and those positions will be transferred to the investors in the fund token. There are two main types of models that can be applied to fund tokens:

a) The ETF Model: We can envision ETF-like security tokens that represent the value of an underlying group of assets such as real estate leases, loans or private shares of different companies.

b) The Mutual-Fund Model: The mutual-fund model is better suited for enterprises such as financial institutions that are looking to issue their own security tokens. Just like ETFs, Mutual-Fund tokens will aggregate a pool of security tokens but, unlike ETFs, they won’t be actively traded and only priced on regular intervals.

Derivative Tokens vs. Tokenized Derivatives

One of the most fascinating aspects of derivatives and fund tokens is that they can emerge following two fundamentally different paths.

1. Security Token Funds or Derivatives: The most obvious scenario is to compose pools of security tokens into new fund or derivative tokens. This model offers new trading vehicles, risk management and price hedging vehicles for emerging security tokens.

2. Tokenized Financial Derivatives: An alternative the previous point is to create security tokens that represent existing market derivatives such as futures, options or ETFs. This model can offer some advantages such as fractional investment/ownership and expose a new group of crypto investors to those financial vehicles.

Fund and Derivative Token Protocols

Implementing fund or derivative security tokens is far from being an easy endeavor but it doesn’t require you to start from scratch. Platforms such as Securitize or Polymath can expand into the fund-derivatives token space by incorporating existing blockchain protocols that are focused on derivative models. Specifically, there are two protocols I believe are incredibly well-equipped for security tokens:

Derivative Tokens Using dYdX

dYdX is one of the most complete derivative protocols in the market. At its core, dYdY introduces the notion of a Margin Trading Protocol which mimics the analogous behavior in financial markets. In traditional margin trades, a trader borrows an asset and immediately trades it for another asset. The asset must be repaid to the lender, usually along with interest, at a later date. Margin trading includes both short sells and leveraged longs.

The dYdX Margin Trading protocol uses one main Ethereum Smart Contract to facilitate decentralized margin trading of ERC20 tokens. Lenders can offer loans for margin trades by signing a message containing information about the loan such as the amount, tokens involved, and interest rate. These loan offers can be transmitted and listed on off-blockchain platforms.

Recently, the dYdX team released a series of second-layer contracts that use the base Marging Trading protocol to implement more sophisticated financial constructs such as Price Oracle or Lenders.

Fund Tokens Using {Set} Protocol

{Set} Protocol is an Ethereum-based protocol for collateralized ERC20 tokens. Practically speaking, a {Set} token is an ERC20 token with two additional functions: issue and redeem which serve to convert between the {Set} token and its constituent tokens.

While the {Set} Protocol team has their eyes set on enabling higher order derivatives such as index funds, they recently launched TokenSets to illustrate the possibilities of the protocol.

There are other derivative protocols in the market but dYdX and {Set} seem incredibly well positioned to play a role in the security token space. Regardless of the path we take to enable the first generation of fund-derivative security tokens, it seem pretty obvious that both crypto-security models are called to play a relevant role in the next generation of security token platforms. More importantly, derivative-fund security tokens might be one of the bridges we need to make security tokens attractive to large institutional investors.