Tokenized Securities

Digital Investment Banking

I’d like to thank every person who kindly gave their input on this article prior to publication.

As I mentioned in the “Token Economy” article, "Tokenized Securities" are my favorite asset class, it would be interesting to understand what kind of product can be offered to investors.

However, before that, we will dive into some History of securities to understand how they have evolved. Then, we will study the competitive advantages those Digital Securities.

I like to call them “investment tokens”. (it’s more comprehensive for non-financial backgrounds)

 But first, what is a Security? In short, it is a tradable financial instrument that holds a monetary value. I say, “in short” because depending on the jurisdiction, it can include or not different instruments, usually it is equity, bonds, debt, real estate.

 And then, what is Tokenization? It is the process of converting analog or electronic “paper-based” files (rights to an asset for example) into a “tokenized” form, which is ultimately a cryptographic key with the contract embedded in it. In other words, it encrypts information to allow more security, efficiency and trust to the system because all the regulatory is codified within the token.

 The three eras of life cycle of Securities:

Analog age: from the birth of the Amsterdam stock exchange to 1990. Mass Market Model.When people traded paper shares for Cash. It was a bit noisy in the market room.

Electronic age : With the rise of Information Technology. Mass Market Model. Today, we still trade paper shares for Cash, but thanks to I.T, everything is more efficient and the papers are in the custody banks.                    

Digital age : Enable Customer Centric Model. Started by the Digital Revolution and platforming, add to that DLT and Tokenization for all the benefits they deliver. 

Tomorrow, I expect to trade cash for a Security Token / Investment Token (Digital shares instead of Paper shares). This option will be opened to a global investor base with faster and more efficient settlement at a lower cost. (Thanks to programming)

(Just ask yourself, why do we, mainly, use e-mails instead of mails ? if you’re not convinced. The answer is because it’s “Faster, Cheaper and more Secure”).

Hence this Security Token / Investment Token is a programmable (“interest” or “ownership”) digital share that is issued and traded on a Blockchain or another Distributed Ledger. Therefore, this specific token benefits from the advantages given by DLT (Trust, Security, Efficiency, Transparency) and the beauty is that it can be easily divisible, whereas the paper share. And these particularities solve a whole bunch of pain-points in Capital Markets, including liquidity, undervaluation of assets and barriers to entry in term of investors base (the legendary “entry ticket”). They are an improved traditional financial product that removes middle men from the transactions. They are backed by tangible assets that are made fungible, thanks to the underlying protocol used. They can represent equity, real estate ownership or interests, a right to future revenues of companies… and entitles you to possible voting rights, dividends, profit shares, interest in future entities, depending on how they are codified. 

“You never change things by fighting the existing reality but rather by building a new model that makes the existing model obsolete.” Buckminster Fuller (Professor at Harvard)

Advantages of such Digital shares:

Lower cost of transactions, Higher efficiency and faster trade execution: thanks to Consensus algorithms, there is less intermediaries, as well as automated services functions, such as legal. Usually, the more people involved in a deal, the longer it takes. Decentralized trading exchange accelerates the timeline to, humm, almost Immediate trade settlement, on the secondary market for security token (again, decentralized exchange. This is attractive to both issuers and investors) No more cash lock-up for 5 to 12 years when you invest in a Private Equity fund or a VC.

 Greater Security against (potential) Manipulation : the tricky part. Let’s just say that, less intermediaries decrease the likelihood of mistakes/corruption/manipulation.

 Destroy all barriers to entry in a Global 24/7 free Market exposure: How hard is it, today, for foreign investors to invest in your local companies or real estate ?

They have to see a local lawyer, sign a whole bunch of papers, then wait, then repeat, then wait again, probably repeat all that, one or two more time. The process is expensive, time consuming and gives you a hell of a migraine.

The way I see it, any Asset Owner should be able to market their deal to anyone with an internet connection, within Regulatory Limits and proper Due Dilligence of the underlying project. We are neither in the Software business, nor in the Service business, we are in the Empowerment business. This is “4.0” Crowdfunding! (for the “4.0 Industrial Revolution”, I’m not inventing 2 models of crowdfunding here)

 Improved Liquidity: Since the token is divisible, you can easily put, whatever percentage of what you own, to trade in a Decentralized Exchange (Secondary Market). This opportunity solves the Undervaluation and liquidity pain-point. And it's definitely better than having an intermediary take 20% of the profit because he found a buyer.

I’ll explain my self, in real estate. For example, if you cannot sell your, let’s say, castle at a given price, you will have to decrease the initial price to meet an offer, and then goes all the lawyer part again. Maybe it’s better to embed rights and not ownership in a token... (depending if your castle is creating value or not). And regarding the "20% profit", if you invest in a fund, you are eligible to "Management fees" (~2%) and " + "Performance fees" which follow the "Pareto" "80/20".

If you want to see it the other way around, it happens that owners split an apartment to Optimize the returns. You can apply a similar model of rights thanks to the divisibility “property” of the Security tokens. Creating the opportunity of new business models of co-ownership associated with co-living, co-working, co-parking. The quintessence of the sharing economy is still to come. (Why would I own 100% of a holiday house in one place only to spend 10% of the year there ? What if I own 10% of it, would it be a more suitable process ? or what if I own 10% of ten houses in ten different places ? humm) Well, for digital nomads like us, millennials, this is just the world we want to live in)

 Low cost of set up : Tokenization-as-a-Service (TaaS). (Well, in reality it’s just another SaaS, but I like the name)

 Easy to track : Thanks to the Distributed Ledger Technology.

 Can be applied to various Asset Class: Equity, LP shares, Bonds, debt, oil, gold, fine Art...). Artists could tokenize their activity easily, to have cash in exchange of potential future returns (royalties tokenization), beware big musical Majors, you are soon to be disrupted (works with painters too). Here is another example, one of my favorite, Galleries and Museums could tokenize their activities in exchanges of some “luxurious perks” for the token holders, or whatever, while enjoying the financial benefits of the token. If there is a market and you like what you are doing, go for it, Tokenize Your Activity !. (Personally, I’m already dreaming of all the new sustainable financial instruments and diversified portfolios we can build, far from the complexity of CDOs, SWAPs...).

And the cherry on the cake is that, this change of paradigm is actually reinforcing the current legislation. We do not need to change a thing! We are in-building a compliant contract in the token. Meaning, before you had your advisor telling you what you can and can’t do. Now, if you can't do a transaction with someone, it means that the system won’t allow you to. And so, you won’t have the risk of doing something not compliant, subject to fines or worst...

Even though an attractive taxation could foster the shift… I don’t think we can fight this evolution. I expect, with the ruthless conviction, that within the next 30 years, Security Tokens will take over all traditional securities currently being issued and traded.

I’ve tried different market sizing methodologies to estimate the Total Addressable Market (TAM), even if I never fall within a significant confidence interval, the TAM is always counted in Hundreds of Trillion of Dollars / Euros. This could lead to the biggest creation of wealth ever! 

Security Token will flood the market with cheap capital, leading to attractive investment environment, spreading the virus like in the 80’s when Mike Milken introduce Junk bonds, (<BBB) also called high-yield debt, for Leveraged Buy-out (LBO). He created cheap capital and made a lot of people billionaires. (Yes, I love history!)

 Moreover, from an economic stand point, every current asset is mispriced because the price depends highly from the investor base. And since digital shares can be bought and traded by anyone in a global market place, they can be considered as “mispriced”.

Disadvantages of such digital shares:

Issuers will have to:

-     Ensuring Token Consistency (key legal & technologic challenge)

-     Underwrite their own deal

-     Prepare their own marketing materials

-     Solicit investor interest

-     Ensuring high level of security and compliance

-     It’s a Transfer of Rights and not (necessarily) a Transfer of Ownership !

“As the world’s asset become increasingly liquid, the concept of ownership will evolve in ways we cannot yet imagine” Stephen Mckeon

But everything should be fine with proper advice. I’m thinking of third party consultants and auditors. Nothing impossible, So many are already pretending to be experts. 

 Different strategies are possible to benefit from the security tokens:

- Analog / Electronic owners could shift their security to digital, so they would shift from illiquid-single-owned to liquid-multi-owners. This would ultimately increase the underlying asset price due to liquidity premiums, geographic arbitrage and an increase investor base. This is called Capital Appreciation.

 - You could also build portfolios of digital securities of previously illiquid assets. Build small amounts of fractional ownership in a variety of assets to create new financial products & opportunities. Creating the same way “super” Diversification. (such a fan)

 - Or, simply issuing digital share from the beginning. Entrepreneurs could bypass “classical” Venture Capital funds (with their 80/20 rule, again...) and raise money faster, cheaper and easier in a secure way.

I like the Real Estate use-case, so let’s deep dive into it.

 Imagine, you purchase individually some real estate with fiat money. Convert your Analog property paper (called “Paper-Rock”) to Digital Security / Investment Token. You would be able to list it on an Alternative Trading System used as a Security Token Exchange, (Remember our hypothetical European Token Exchange) and meet global investors base 24 / 7 / 365. Just to remind you, Decentralized Exchange are a new technology that allows users on a distributed ledger to transact with each other (peer-to-peer), in a regulatory compliant way, without reliance on a centralized authority (point of failure). This Exchanges take the power and responsibility out of the hands of brokers and place it back in the hands of individual buyers and sellers.

In short, you get the most of your assets, you transact when you want, with who you want (those the regulators allowed you to deal with, of course), wherever you want, in a compliant way. You are in control !

There is also a social component here. We are Empowering, anyone, to gain access to assets which were previously reserved for the (ultra-)wealthy and well-connected people. Thanks to fractional ownership, modest families (for example) will be able to invest, whatever the amount they can, in the best geographies and asset types, potentially leveraging the best yields. However, I’m not a big fan of limitless capitalism, so I really advise proper audit & strategies to limit the capital appreciation that will be created due to high demand in some specific geographies, otherwise for some specific securities, this could sky rocket them ridiculously….

The people that will lead this Evolution will need a very High Level of Conviction, as well as a large pool of Capital and Network and a strong appetite to move quickly and rigorously. This is an efficient system that will reward by an order of magnitude the first movers or as I like to say, those who will embrace this change of paradigm.

But, is it the right moment for the Security Token / Investment Token?

To answer this question, once again, we need to map the evolution of Distributed Ledger Technology. I used past data, and for the prediction I simply extrapolated the evolution of Internet (1.0) to apply it to what’s happening today (Internet(s) 2.0).

2008 – 2013: Selling the Vision for the initial Bitcoin Whitepaper

2013 – 2016: Building new Networks (Ether) / 240M$ raised in ICOs

2016 – 2018: 1st generation Token deployment (Payment Token, Utility Token) / Crash

2018 – 2020: 2nd generation Token (Security Token) / DApps deployment

2020 – 2021: Innovation tsunami / Crash

2021 – 2025: Market Stabilization (Top Capitalization redistributed)

Therefore, I consider this exact moment as the opportunity to catch this new wave of innovation.

You want another pattern? Fine, let’s investigate investment and capital raised in the industry.

- 2016: $240M in ICOs

- 2017: $5,6B in ICOs (Global Market base) + $1B from VCs

- 2018: $1B in STOs

- 2019: > $10B in STOs (Global Market base) (Underestimated Prediction)

“Token-to-market-fit is the new Product-to-market-fit” 

The potential is definitely huge for both Investors and Entrepreneurs. And the best part is that it will not be retail investors who will make up for the greatest demand for STOs. It will be Institutional Finance, lending to a greater momentum than the first generation Tokens.

Investors & Institutional entities:

-      Highly accessible and compliant crowdfunding model via more traditional channels

-      A way to onboard new asset class with “digitalized” value (Art, DNA, Diamonds…)

-      More fractionalization, smaller initial investment amounts for greater retail investor accessibility

-      Lower fees due to blockchain’s low-cost model and disintermediation.

...

Entrepreneurs & Blockchain enthusiasts:

-      A way to trade tokens that you are familiar with (Improved User Experience and User Interface), except via their bank account and credit cards directly.

-      Hedging opportunities for crypto volatility with tokenized haven assets.

-      Wider array of investment opportunities.

-      A way to raise money by your terms.

...

In the next article, we will dive in what I call Tokenization-as-a-Service (TaaS), where we will dive into some interesting Use-cases, to understand how we can build a service that will enable all of this. Every tangible asset will be able to become a Security! (What a wonderful world)

The views and opinions expressed in this article are those of me and do not necessarily reflect the official policy or position of any agency.

Happy to discuss further.

Kindest Regards.

PS: If you're looking for the domain names, I'm the one who got them since March... ;)