Michael Kogan

@mkogan4

What the Heck Are Tokenised Securities?

There are a lot of claims going around in the crypto community that tokenized securities are about to revolutionize traditional finance. In light of such optimistic sentiment, it is worth drilling into exactly what the hoopla is all about.

tl;dr;

yes, there are good use cases for tokenizing securities but not the ones I am seeing shilled on social media.

What is a Security?

A security is a concept that is both legal and economic. From economic point of view, a security is essentially a claim on future cash flows of the issuing entity that can be exchanged for value and involves a degree of risk that the claim will not be repaid or fulfilled.

From legal point of view, public sale of securities is highly regulated. An Initial Public Offering is an issuance of equity securities to the general public and involves a pretty complicated and expensive regulatory process. There are also private securities offerings that do not have as high of a regulatory burden, but are limited in the classes of investors that are allowed to participate. There are various regulations governing securities issuance, explained in more detail here

What does the above have to do with tokens and blockchains? nothing. And everything. Regulations are agnostic as to which kind of technology is involved, a Postgres Database, Ethereum blockchain or something else. They apply regardless of the underlying technology. One can argue that new, better laws are needed and sometimes they are, but that is beyond the scope of this article. We want to deal with the world as we find it, not as we would like it to be.

What is a Token?

A cryptographic token is a smart contract designed to securely store and transfer information ( value ) using private key encryption, that either serves as reward to maintainers of decentralized ledger, or requires rewards to be paid in the form of native protocol fuel ( gas ).

What Does it Mean to Tokenize Securities?

In the simplest form, accounting and transfer of a security can be implemented using a token, on either a public or private ( permissioned ) blockchain. Let’s for the moment suspend disbelief, which is required in case of almost all innovation, and try to figure out the advantages of doing this.

Specifically, let’s run through some of the claims in this article:

24/7 Markets

24/7 hour trading has absolutely nothing to do with tokens and blockchains. The reasons US stock market does not trade 24/7 have nothing to do with technological inability to do so with current systems. It has to do with tradition, convention and convenience. Yes, convenience. Opening and Closing Auctions concentrate liquidity and allow for convenient and efficient price discovery, when combined with continuous trading through the day. Note that Forex markets are already 24/7 without any help from tokens. Also note that being forced to trade all asset classes on weekends would complicate many aspects of running a professional trading business, not something that trading desks around the world are looking forward to.

Fractional Ownership

Obviously, fractional ownership is already available today. Accredited Investors can use sites like RealCrowd to buy into shares of a single building in Manhattan and public markets investors can purchase REITs which offer a variety of exposures to real estate. There are over 200 publicly traded REITs and a total of about 1,000 if we include the non-traded ones. Certainly, there aren’t any publicly traded securities that would allow one to go long one building in Manhattan, while shorting another. This is not a technology problem, though. It has nothing to do with tokens. It has to do with regulatory complexity of issuing securities and obtaining them from the issuer for the purpose of shorting and the inabiilty to hedge such short positions. None of these issues would disappear just because there is a token involved. In theory, nothing is stopping a futures exchange, such as CME or ICE, from creating a separate futures contract, one for each building in Manhattan. They have created products such as FANG futures and weather futures. The point is, betting on weird idiosyncratic things does not in any way require a token.

Rapid Settlement

“Trades for bitcoin or ether settle in minutes, not days”. Well, since most of the crypto volume takes place on centralized exchanges, technically, trades for bitcoin or ether do not settle until a request to withdraw is made, which means they sometimes do not settle for months or not at all, if the exchange database gets somehow corrupted or hacked. But fair, if we are transacting on chain, we will settle right away.

The reason for multi day settlement period of securities transactions, though, is not the technical inability to make a quick transfer. It’s because the sellers of securities are given time to come up with securities to deliver and the buyers are given time to come up with the cash for those securities. You can sell securities you do not currently have and you can buy them with the money you do not have, as long as you cough it up at settlement time of T+2. That is not completely a bug, but can be a useful feature. Nothing prohibits the parties from exchanging securities and money immediately, the regulation is about setting the upper, maximum limit on how long this process is allowed to take. More importantly, since these settlement times are mandated by regulation, they would apply to tokenized securities in exactly the same manner as regular securities. Most counterparties would choose to wait to deliver, as its clearly better to send money later than sooner.

Liquidity and Market Depth

“Security tokens could mitigate market segmentation, making it easier for for buyers in one country to access assets in another country”. NOOO! selling securities across borders involves a cross-border securities issuance process, something that already exists and is quite complex due to regulations. The same regulations that would apply to security tokens, because, you know, they are securities.

What about tokenizing shares in a private equity or a venture fund? An investor in a venture fund is a limited partner. A partner, albeit with limited rights. But a partner nonetheless. The general partner has a business relationship with limited partners and has no interest or incentive in allowing them to freely trade their interests, any more than a partner in a private business has an incentive to let her partners easily trade in and out of their shares. There is also the problem of huge adverse selection. If someone is selling their private fund interest, it is probably because they have realized this is not a great fund. Since the security is private, there is a material amount of non public information that the limited partner is in possession of. Therefore, anyone buying such interests will be subject to enormous adverse selection. This is the reason why there aren’t very liquid markets for such interests, once again, tokenizing the interest does not in any way address this problem.

Interoperability

“The thesis underpinning the idea that everything will be tokenized is grounded in the aspiration that everything will be interoperable. I want to hold ownership claims to a commercial building, early stage equity, corporate bonds, a T-bill, my house, and a decentralized network on the same platform”

Dude, you can do that already. Open a Robinhood account, buy shares of SPY, VNQ, TLT, HYG and some BTC, ETH. Ain’t got nothing to do with tokenized securities, you feel me?

Do Tokenized Securities Make Sense?

Yes, as long as we think creatively about what cryptographic tokens allow us to do and, instead of trying to reinvent things that are already quite functional without tokens, try to enable new paradigms where blockchains and decentralized systems can be used.

Let’s imagine a security for example, that represents a collection of fine wines of a particular type and/or vintage. Currently, it is possible to invest in wine funds, so such securities exist. Suppose, we create a smart contract, which adheres to ERC-721 NFT Protocol. Suppose further that we encode information into the token that represents a hash of the specific bottles, or cases, or vintages owned by the fund and that hash matches information both on the crate, the bottle itself, equipment at the wineries, etc. In this way, we have created a security where the smart contract encodes information about what is actually being securitized. One could certainly accomplish the same thing with centralized databases, but in this case, nobody has to maintain the information once its encoded, and it is as secure as the underlying protocol. Something like it may or may not be useful, but the key is tokenization in this example refers not to repackaging of the same old sh.. stuff that’s currently working fine, but to creation of something new, enabled by decentralized protocols.

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