Tokens Will Consume Finance

It has now been 10 years since the Bitcoin whitepaper has been released.

A purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution — Satoshi Nakamoto, Bitcoin Whitepaper.

While Initial Coin Offerings may have tarnished the “utility” label to many as a means to skirt regulation, utility tokens do truly exist. The original utility token, Bitcoin, was created with the purpose of incentivizing security and providing access to the Bitcoin Network. The network itself could not function without the role that the token plays in the system’s architecture. Its value is determined by an open market demand of the token.

With tokens, we now have the ability to send value anywhere in the world with the simplest smartphone and an internet connection, all done without the legacy financial system acting as a middleman facilitating transactions. This is value in the form of bits of code being transferred. What these bits of code represent are up to the users and the system they exist upon. What we will begin to see are traditional securities removing middleman exchanges by entering the blockchain ecosystem. The ownership to an underlying asset will be linked, by law, to a digital token on a network. Stocks, bonds, and investment contracts are being legally tethered to lines of code and provide financial rights to the owner, e.g. voting rights, profit share rights, redemption rights, equity, and dividends.

Think of traditional assets similar to that of mailed physical letters and tokenized assets to that of emails. Bitcoin first brought us programmable money and with that we are now discovering the power of programmable securities.

The global financial system has improved immensely because of the digital age. Relative to pre-internet days, there is no reliance on anything physical in the process but they still can only streamline the process to a certain degree. At the end of it all, there still needs to be a third party involved to facilitate the exchange, which creates a level of friction that will never disappear. By tokenizing private securities, assets can be traded on secondary markets without the burden of traditional private securities. The benefits of a purely digital financial system can allow for a future in which the security token market can exceed the US public equities space within the next decade. There are over $544 Trillion worth of assets worldwide that inevitably will become tokenized on blockchains because of 4 main reasons.

Fractional Ownership. A Bitcoin can be broken down into one millionth of a coin. The same can be done with a security token. Almost all traditional assets have a minimum investment requirement which creates a level of friction for the investor. Optimal allocation of assets have historically been out of reach.

There will come a day where individuals may be able to pay for a coffee with an incredibly small percentage of an Amazon stock as seamless as using their debit card. Maybe even receive a discount on the coffee as well because their portfolio holds a small fractional percentage of Starbucks stock.

A 36.5 million dollar condominium in New York City has just been sliced into digital shares, and thanks to blockchain technology, you could own a piece of it.

Exposure. Wall Street struggles to scale to meet the new global economy created by the internet in an ever growing connected world. Complex ledgers between the worlds different financial centers create a barrier. Before Bitcoin, only increased centralization of powers could break them. A new ledger system secured by open and public blockchains have paved a new way forward for the trading of securities.

Regulation, restrictions and compliance can be coded into each token. When imagining global securities, an investor could have a portfolio made up of publicly traded companies from all over the world. Hundreds of thousands of companies all in a single investors portfolio are now possible with the efficiency of tokenization. Each one of these global companies could account for only pennies of your total investment portfolio.

In the United States alone there are over 20 million small business. If we consider the future in which the majority of these securities are tokenized, it could mean trillions of dollars being secured upon blockchains and in the portfolio of individuals across the world.

Removing Middlemen. Smart contracts or code that executes a specific command on the blockchain allows for completely programmable securities. This benefit ties in to our first two points, making fractional ownership financially viable as an investor. Even a small reduction of fees and execution time can create new dynamics in the marketplace for portfolio allocation and trading. While trades may execute quickly on traditional exchanges today, the settlement of assets can take much longer. The documentation required to verify the transfer of ownership at the correct price and time can stretch this process into days. Why can Bitcoin settle in minutes, if not milliseconds with the Lightning Network? It is a peer-to-peer solution.

With a security tethered digitally in a smart contract, the means of exchanging that security between buyers and sellers has the ability to transfer peer-to-peer. Banks and brokerage firms can be removed from the process with regulatory compliance baked directly in the code. Decentralized exchanges (DEXs) are becoming increasingly scalable and efficient, lowering the barrier to entry and allowing for more participants in the financial system.

Liquidity. Liquidity simply is the ability to turn an asset into cash. Take a common investing vehicle in real estate such as a REIT as an example. They are deemed relatively illiquid. There is typically a mismatch of buyers and sellers in the marketplace. Real estate is capital intensive and also very sensitive to it’s cost. Private REITS, like private securities today, offer little or no liquidity. The reason for a lack of liquidity is that the buyer and seller can’t find each other easily. Each transaction has fundamental transfer restrictions on shares or interests. You can’t just go sell easily, even if you do find a buyer. There are very complex requirements, both regulatory and contractual that the issuer has to manage.

Along the same lines, take a piece of artwork. It could be worth ten million dollars but the seller needs to offload it immediately. In reality, the artwork marketplace has only a handful of buyers at that value. There is a good chance that the seller will also have to take a reduced valuation due to this lack of liquidity. This is known as an illiquidity discount. On average it is 20–30% across the security marketplace.

This can be taken the other way as well in the form of a liquidity premium. The more liquid an asset is, the bigger increase of value to investors. Just because you tokenize an asset doesn’t automatically make it more liquid. Liquidity will only increase if market depth does also. When a security is tokenized, it becomes easier to trade on a secondary market due to the lack of middlemen. It does not lose cost-effectiveness while gaining market depth. Using a trust-minimized exchange paired with fractional ownership allows for the reduction of friction between buyers and sellers. That benefit will force institutions and companies to consider tokenization as a means to stay competitive in an ever growing global marketplace.

Securing Security Tokens

Created value in theory should naturally flow down through the stack to the foundation. A protocol using Proof of Work (PoW) or Proof of Stake (PoW) is only as secure as the chain is valuable. The means of security in these systems uses value based game theories. Financial incentives to stake either energy or tokens provides a balance that fuels the consensus mechanisms. Relationships between assets and the base layer are yet to be played out at scale to determine the ratio of value of the chain itself and the assets secured upon it. Long-term, only the most secure, decentralized and censorship resistant blockchains will acquire the value of the world’s financial system on their backs. While many investors may be chasing the latest tokenized offering, the protocol layer is the the sector to watch.

We are seeing Ethereum lead the public blockchains in an attempt to gain their market share of tokenized securities. If this trend were to continue, the demand for Ether (ETH) would grow as it is the fuel to help power the exchange of these assets on the chain. The value proposition of Ethereum can then be equated to that of the infrastructure facilitating the new global financial system. There are multiple other projects competing for the market share of tokens such as Ravencoin, Waves and Stellar to name a few.

There is also a slightly more indirect investment view that a world of tokenized securities, no matter the specific blockchain, all need a single settlement currency. Fiat in its current form is incompatible with this new financial system. Bitcoin, however, fits the criteria of such a currency. As an example, dividends will need a digitally native currency to paid out to holders in. These concepts deserve their own post and will be built upon in a follow up.

What is standing in the way?

A lack of infrastructure. We are seeing the security token stack develop in the form of compliance and exchange layers needed to bring liquidity to the market.

As liquid as the future of security tokens are, there is a massive amount of infrastructure components that still need to be built to realize it. As the market currently sits, they remain severely illiquid. Fully regulated layers of the system are still being formed. We are seeing the security token stack develop in the form of compliance and exchange layers needed to upgrade the current system.

The stack is further along than it may seem. Cryptocurrency exchanges are transitioning as fast as they can to offer security tokens. Earlier this year we saw the largest exchange, Coinbase, gaining approval for listing security tokens. Even more exciting are the statements from Nasdaq on their openness to incorporate blockchain assets. They have already partnered with some of the larger cryptocurrency focused exchanges and may themselves transition into one.

The issues persisting have already started to smooth themselves out. While the process may seem slow, for an upgrade of the financial system this is moving at a breakneck speed. Different from the upgrade to the digital age, value is being created in new places. Looking at this simply as a performance increase, the largest opportunities as an investor will be missed.

More reading. I highly recommend doing so. I credit these resources for a lot my education on the subject.

The Official Guide to Tokenized Securities (Pompliano)

Liquidity is about market depth, not magic (McKeon)

The Future of U.S. Securities Will Be Tokenized (Marks)

Rhythm Trader (@Rhythmtrader) | Twitter

I’ll do my best to update with feedback I get. If you enjoyed this post, please “clap” so more people are exposed to the future of security tokens!

Not financial advice.