Tokenisation: reinvention of capital markets part 1

Alex Medana
July 29, 2019

I haven’t written about blockchain in a long while, actually it was in March last year when I published the keynote I did in HCMC for the blockchain week. I remember it well because it was the first time I talked publicly about the opportunity in real-asset tokenisation.

This idea is not new and I won’t claim to be the first one having thought about it either. I must say, when I first learned about blockchain in early 2015, I was enthused at the possibility of one day coming close to a distributed golden source but then that thought got quickly replaced by the more practical opportunity of creating “crypto-stocks” or deploying a balance sheet.

As a golden source rests on the basic tenets of trust and truth (and completedness and synchronicity and portability and so on), it takes time to build because it needs the right incentives and controls to be useful, useable and used. For example, if today’s input is the start of our journey towards a “shared truth” of a transaction between two counterparties (veracity, provenance, quality, quantity, price, ownership, taxation, legality etc.), how do we treat the mass of data created before that transaction? Do we grandfather and hash it? Do we ignore it?

I am not a legal or even a tech person but the simplest way might be to start fresh from a point in time with new transactions (or assets) in order to create that historical chain that cannot be refuted, reversed, cancelled or amended.

DABS not STO

Back in 2015, I was having a coffee with someone and talking about selling units of my time, electricity, shares. You can find those ideas here. Fast forward four years and now it’s all the rage with Securities Tokens Offering (STO). I prefer using the term Digital Asset Backed Securities (DABS) to make a clear distinction with SecuritiesTokens Offerings (STOs) and highlight what we are trying to achieve with our CrossPool platform i.e. issuance, trading and market-making of DABS. There is always a link and legal contract to an asset, a company or receivables etc. so it is easier for me to think of a token as an access to something else. At the basic level, a token is a representation of rights to any tangible (financial or otherwise) or intangible assets. Those rights may represent ownership interests, voting rights, access to the underlying asset’s capital appreciation, yield or cashflows. Whilst these tokens may take various forms, they must be treated as securities inasmuch as they follow the same principles and regulations as the traditional securities, i.e. shares, bonds, derivatives, rights etc.

Relationship between fractionalisation and liquidity
Fractionalisation is a consequence of tokenising and no, fractionalisation doesn’t mean liquidity, it is just a precursor. Typical case of illusory correlation here: by making an asset available in smaller pieces, more people will be able to invest in smaller amounts but that doesn’t mean they will. Investors need price discovery, demand depth, immediacy, trust, recourse, low transaction costs and more to create a liquid market.

Private is the new public

Ownership interests are today broadly distributed through private and public markets. Private markets are more often than not seen as opaque, illiquid with high barriers to entry. Raising capital for budding entrepreneurs through private markets are done through a series of funding rounds involving the founders’ own pockets, friends and family, angel investors, venture capitalists and private equity funds until the company may be listed on public markets, though some may choose to keep private.. Comparative information is scarce and access to investment opportunities are not broadly available. The risks inherent to investing in start-ups and private companies make the access to private shares or debt the privy of professional investors and institutions.

Most of us have dabbed into public markets; they follow global rules and regulations. Roles and responsibilities are shared between all their actors: exchanges, clearing houses, central securities depositories, central banks, brokers, asset managers, custodians, prime brokers, rating agencies etc. Once a stock is listed on an exchange, it becomes available to anyone who wishes to buy or sell it.  In general, institutions and individuals have access to these exchanges but individuals need to go through a registered institution at the exchange, either directly or through another intermediary.

In the last 10 years since the birth of bitcoin, exchanges (I use that term loosely here because most are just an app sitting on top of a liquidity pool – real or synthetic) have cut through the plethora of intermediaries I mentioned above to let an individual open an account and trade directly on them.

Now that the scene is set.

“well, they are securities but it really depends…”

More often than not I get asked about what these tokens are and I always reply: “well, they are securities but it really depends…”That’s not a smoke and mirrors tactic…it really depends on the risk appetite and investment outlook of both asset owners and investors. And they are definitely neither utility tokens nor ICO 2.0.

For example, on the asset side, you want to retain full ownership but want to share some risk and capital appreciation, call it an equity without voting rights; you want to share the revenue from a project, call it a bond.

On the capital side, someone is interested in a guaranteed return, call it a note or a structured product; they prefer a yield, call it a bond.

Blockchain offers possibility of vanilla efficiency gain

All of what I am talking about here is pretty vanilla in the securities and derivatives markets and the blockchain story is not about creating a magical secondary market out of a fairy tale but more of producing efficiency gains to start with:

  • Less paper and therefore shorter timeframes, less errors, better controls;
  • Less intermediaries (in the future), lower costs;
  • More automation based on a lighter system architecture as well as the golden source I mentioned earlier;
  • Broader distribution and access: lower to no barrier to entry, democratising access to assets with high emotional content like arts and collectibles;
  • Faster time to market for new products (once regulation permits);
  • More transparency in terms of product offering and markets, though information asymmetries can still be maintained through the use of cryptography, consortia memberships or private communities;
  • Trust into datapoints that will slowly become the truth once enough scale is achieved due the attributes of data in a DLT (irreversibility, immutability, tamper-proof)

Those benefits are of course not immediate and they might never fully materialise but that doesn’t mean we should stop innovating and pushing the boundaries. Innovation is about the unknown so the best way to tickle the unknown is to give it a shot and be open minded whilst being transparent about the fact we don’t know yet if we are right or wrong. As they say “time will tell”.

Today, there is little to no secondary market in alternative assets, let alone in tokenised assets at least on the scale that might represent any threat to the more established securities markets. At FinFabrik, we are in the trenches for the long term.

I always get questions regarding tokenisation and where we are; here are some of my answers:

Do we really need blockchain?

Yes and No. There are three levels of markets:

  1. Primary – Issuance of buy to hold fractional ownership of physical or/and digital assets to increase the reach of potential investors base.
  2. Secondary – Ability to resell fractions to other investors on platforms where price discovery and liquidity provision can be conducted in a transparent and legal way.
  3. “Tertiary” (I coined this term) – Capacity to buy, sell, swap, pledge, lend across asset classes.

We do not need blockchain for 1 & 2 as a good OCR can do the trick to digitise most of the datapoints. Step 1 and step 2 will never be about blockchain because trading “in the old world” is already measured in microseconds and distributing the exact same piece of info to a network creates latency in the current environment.

Having said that, we need it to prepare for step 3, the “Tertiary” market whereby fractions will be bought and sold, pledged, lent, rehypo’d, swapped or bartered. In that construct, ID will also be owned and controlled by the individual (or the corporation for a business ID).

To me, and having banged about it for some time now, blockchain is about ID and data management i.e. create a datapoint that once validated cannot be contested in its existence or veracity, as long as the validator or auditor is independent and trusted. That datapoint and its constituents (e.g. a transaction where the components would be the counterparties, price, location, asset, currency, etc.) becomes part of a golden source that may distributed or used locally. Golden source of data is still a fantasy in financial institutions because of variances of sources, formats, systems (different systems create variance because of their limitations e.g. one field here has a limit of 32 characters, in another system it is free text whilst another one has no option for special cases or comments…)

ID management (of the asset and the counterparties to create a trusted environment that is consistent, portable, synchronous, irreversible and tamper-proof) is key to one day reduce the amount of money spent by counterparties to check upon each other, their clients and the assets. We all fantasise about a meta KYC where one “ID of me” could be distributed across business lines, counterparties and service providers.

Why do we need to calm down, what are the restricting factors of mass adoption?

  • There is absolutely no liquidity in digital alternatives because there is very little liquidity in the real alt assets today. It will take time to bring about.
  • No-one knows yet which assets will become mainstream hence everyone I meet says real-estate, gold and private shares because most understand them, have invested in them or have an emotional attachment to them.
  • There is no agreed taxonomy between regulators. Crypto-assets, digital assets, virtual assets etc. Talking about the same concepts globally is a pre-requisite to align everyone’s interests.
  • There is not a single local responsible authority that looks after these new assets (finance ministries, central banks, markets regulators, legislators etc. are all part of the decision making)
  • The potency of property laws, taxation, resolution mechanisms have to be rethought in a distributed world.
  • No tech is leading the way. Some prefer public other private ledgers and we have to think in terms of interoperability else we are all wasting our time and maintaining today’s status quo of complexity.
  • Investors might not bother to come. Whilst getting the right level of information to them is one hell of a challenge, they might still prefer to invest in things they know and understand as vanilla as these can be.

What real projects are you working on?

We have never taken any easy path in our three years of existence (anniversary celebrations on 26/08) because we believe in solid foundations, enterprise-grade back-end and research-driven user experience.

Our platform, CrossPool built on corda for transaction management and settlement as well as Hyperledger Indy for ID management and wallet is live. It is complemented by our trading technology future-proofing us for when secondary becomes a reality. Our efforts are focussed on private markets, predominantly private equity and debt.

We have already issued two private loans and participation rights into a movie to be released in October.

Who do you work with?

We are always looking for partners particularly on the distribution/demand side, that is capital intro, underwriters, asset managers, family offices, private banks.

What do you envision in financial market?

When we look back at the appetite over the last 10-15 years for a wide range of investors to access interesting and cost effective opportunities through robo-advisors, P2P lending and crowdfunding platforms, there is no doubt in my mind that you and I will be able to invest “one dollar into anything” within 5-10 years.

Put very simply, our aim is to create a leading marketplace where assets meet capital chiefly for private markets. Let’s do it together!