In the late 1980s, asset securitization appeared in the banking sector in the United States and Europe as a channel to create liquidity. Various financial assets are merged or pooled into one group and then this group of repackaged assets is sold to investors piecemeal. Through this operation, investors receive opportunities and originators gain more free capital. Starting with the earliest applications for home mortgages called Mortgage-Backed Securities, securitization creates investable assets that greatly increased portfolio choices and that play an important role in the global financial system (Minsky, 1987).
Today, there are a great many assets that are securitized, but securitization most often occurs with loans and assets that generate receivables such as different types of consumer or commercial debt. Essentially, a holding vehicle is formed which “buys” the loans or other assets. This shares of this vehicle are, in turn, sold to participating investors. This pooling of assets provides for diversification, reducing the risk of ownership, and large, global portfolios with assets sourced from around the world provide further risk reduction. It further breaks the portfolio into small enough pieces for average investors to participate. Vibrant markets for these asset-backed securities (ABS) exist most of the most important financial markets in the world, including New York City, Singapore, Hong Kong, and London.
However, as evidenced by the 2009 Global Financial Crisis (GFC), securitization is not without its limitations. During this time, ABSs were combined and packaged into Collateralised Debt Obligations (CDOs). Holders of these CDOs were entitled to a stream of income derived from the repayment of the obligations underlying each ABS. However, in many cases, a single ABS may consist of thousands of debt obligations and up to 150 ABSs may make up a single CDO. The relation between CDO value and the value of its underlying assets is complex and nonlinear.
Furthermore, in some economies, complexities in the ownership relationships of assets underlying ABS make repatriation difficult. For example, a building underlying an ABS might have dozens of owners, each of whom would have to consent to the sale of the asset in the case of default. In addition, the asset-selection and pooling nature of ABS result in management fees and agency costs that are often as high or higher to mutual funds and other mainstream investment products. Leverage is also commonplace as ABS managers use the assets underlying the ABS to borrow money and improve returns. As evidenced during the GFC, this activity is often not transparent, leaving investors with little information as to the details of the assets they are investing in, confused by financial machinations they do not understand, and ultimately saddled with risks that are not obvious to the average investor.
Blockchain provides a tool to allay many of these concerns. First, because of the transparent, immutable, shared nature of distributed ledgers, information is fully shared and available for all to see. Assets that are written to a Blockchain have clear ownership rights and any leverage is fully revealed. Second, tokens created by the Blockchain are natural units of investment into the assets on the chain and can be made easily accessible to investors around the world at very little cost. This process, known as tokenization, pools and splits the cashflows from the assets on the chain and each token represents fractional ownership. Put simply, if there are $10 million worth of assets written to the chain and 1 million tokens issued, each one would cost $10 and would be a claim on 1/1-millionth of whatever cashflows are created by the assets. Third, because of the digitized, automated nature of blockchains, costs of operation are likewise low and hence associated fees are small. Smart contracts can be utilized to streamline and fully automate the collection and distribution of cashflows in a non-intermediated way that simultaneously reduces overall system frictions and eliminates opportunities for leakages due to unscrupulous behavior or human error.
As discussed in Chang and Wang (2019), several of the early adopting countries already have regulation and policy in place that legitimize the so-called Security Token asset class, including the US SEC and authorities in Hong Kong, Singapore, and elsewhere. However, it is also important to note that tokenization is a close cousin to securitization. In many jurisdictions it suffices simply to revise existing securitization laws and regulations to allow for tokenization. Unlike their Blockchain cousins the crypto-currencies, security tokens are not so much a totally new asset as they are the evolution of an existing, facilitating regulatory reform. This distinction and separation from crypto-currencies like BitCoin has been key in the adoption of security tokens, especially in the case of certain jurisdictions (such as China) which have completely disavowed crypto-currency only to embrace applications of security tokens.
It is also important to differentiate security tokens from coins/tokens generated in initial coin offerings ICOs). In the latter, claims to assets are generated in the form of coins based on a white paper that describes the functioning of and potential uses of said coins. Because the issuer need only describe the intentions of the coin rather than demonstrate any physical assets or business model, in most cases, ICOs generate tokens connected to ideas or intangible assets (like intellectual property). In addition, white papers vary in quality and reliability, and as ICOs are built on the original intentions of complete decentralization, they are not regulated by any securities authority. As a result, ICO markets have been wrought by fraud, attracting all manner of speculation and issuers seeking to raise money selling tokens often attached to nothing, all in a space where there are seldom legal repercussions and no clear jurisdictions for prosecution. In contrast, in a security token offering (STO), the issuer must demonstrate ownership of the assets backing the token and must demonstrate viability in a formal process on par with that of of the ABS or IPO.
2. Security Token Applications
There have been a number of security token applications already. Perhaps not surprisingly, the earliest of these are linked to real-estate, as was the case in ABS. However, in most cases, tokens have been linked directly to individual pieces of property and the cashflows arising from it, rather than to mortgage obligations. Importantly, we will see that most tokenizations focus on individual assets, making ownership rights and transparency simple and easy to understand. In contrast, traditional ABS pools may have hundreds of assets, each with different qualities, making it difficult for lay investors to be fully informed. While it remains unclear if tokenizations will also take on a portfolio approach going forward, one can, of course, simply create one’s own portfolio of tokens to achieve the desired level of diversification.
In January 2020, the largest real estate project as yet financed by a security token offering took place in Switzerland. Executed by Blockchain company BrickMark, a building in the posh Bahnhofstrasse area of Zurich was financed with a token offering of up to 120 million euros (at the time about 150 million US dollars). This deal exhibits many of the core qualities of a security token offering (STO). First, because of the efficiencies afforded by the Blockchain technology, tokenizations are often on single assets, rather than portfolios. As such, they are free from the complex, non-linear payout relationships that make traditional ABS risky. Included and transparent on this chain would be information on asset ownership, leases and payment-related details, revenue-sharing confirmation and transaction tracking, and digital wallet account verification. Furthermore, the offering can be made open to institutions and individuals alike, in investment sizes that can suit even the most modest investor. Built on the protocols compatible with the Ethereum platform, BrickMark has positioned this to be “the start of the development of a large international real estate portfolio.” The BrickMark token is also smart contract enabled and will be able to handle repatriation, distribution, and other operations in an automated way.
Above: the largest real estate tokenization to date, a 120 million euro token raise.
While real estate STOs are unique from their ABS counter parts in important ways, there are also now a number of companies performing STOs on non-traditional investments, generating liquidity in asset classes that had previously be considered untradeable. For example, companies like LiquidArtX and ArtPi Art Exchange have expanded their businesses from simply using blockchains to verify provenance and register artwork to generating security tokens linked to pieces of part, allowing investors to take fractional ownership in pieces sometimes worth $100 million or more. Through traditional means, the huge majority of investors would have little or no access to investments of this size. Furthermore, most investors have neither the personal knowledge nor access to expertise necessary to perform due diligence in this space. By connecting communities of experts through the Blockchain and incentivizing the same through tokens, these platforms provide both access to investments and the know-how needed to make investment decisions. Fraudulent behavior is all but eliminated through the rigorous artwork registration process that requires validation through a multi-party consensus system. Also important is that living artists who register and trade their artwork through the platform are provided with tokens for each of their pieces, ensuring that they have an ownership stake, even after the piece is sold. This allows the artist to continue to benefit from appreciation in their work while incentivizing them to participate in the validation process in the future.
Above: ArtPi Art Exchange (China) allows investors and collectors to trade art as if it were stock.
Indeed, there is already innovation in the area of STOs of securities, that is, issuance of tokens whose value is connected to that of another security, most often unlisted stock. For example, SharesPost is a California-company whose main business is the transfer of ownership of private shares. In the US, the number of listed firms is falling and IPOs are a method of fundraising is waning in popularity as a result of the arduous process, expense, and compliance required. Meanwhile, private funding has reached new highs with more than 70 raises of 100 million dollars or more in 2017 alone. There are now nearly 400 billion-dollar “unicorn firms” that are unlisted around the world, many of them in the developing economies. More than 100 of these are in China, where listing rules are draconian and reform has been slow. SharePost is now introducing a new system that can provide automated liquidity for these private firms, by generating security tokens written on a claim to these privately held shares. That is, the tokens derive their value from a pool of shares, most often pledged by founders, VCs, and large shareholders seeking liquidity. The shares themselves cannot be easily traded but the tokens directly linked to their value will be traded in a global settlement system they are calling GLASS (Global Liquidity and Settlement System). This system functions in full compliance with US SEC regulation and is considered an Alternative Trading System.
Above: SharesPost is leading the way in the tokenization of non-listed shares.
3. Tokenization of Infrastructure
One of particular importance in the application of tokenization is infrastructure finance. Infrastructures projects are large, capital intensive, long-lived, and often not immediately profitable. As a result, they almost always require government subsidy or full funding and are not generally attractive to financial investors. The Taiwan High-Speed Rail, for example, was commissioned in 1997 as a benchmark case in Public-Private Partnership. As with all infrastructure, it was long-lived (a 35-year BOT project) and capital intensive, necessitating a loan of about 10 billion US dollars. Beginning operation in 2007, it is clearly not a project most investment firms would be interested in, taking 10 years to build compared to the 5-7 year fund horizons of most private equity funds. Cracking under the stress of operating shortfalls and the huge debt servicing requirements, Taiwan HSR entered default proceedings in 2008, just one year after operation with a 10-times debt to equity ratio. Unfortunately, this example is not unique.
Infrastructure projects often generate far more value to the community than they generate in revenue for themselves. Highways, railways, and airports enable commerce, reducing logistics costs. Power plants and harbours enable business development and industrial clustering effects to bring together ecosystems of related players to the betterment of all. Of course, there are also enormous social benefits in terms of connect people and providing access to resources like education and medical care. One should not be surprised to see the value of homes and businesses to increase when a subway stop is added to a neighbourhood or when a highway connects a village to a major metropolis. It is often our most vulnerable who require access to this core infrastructure.
The United Nations Sustainable Development Goals have outlined core areas of growth that are required for sustainable development. One of these is financial inclusion, which appears in at least 7 of these goals. Tokenization provides a tool through which to achieve this inclusion while simultaneously engaging those who benefit the most from infrastructure development in its financing. Tokenization allows us to take a large, capital intensive project and split it into small pieces, pieces that are accessible to institutions and individuals alike. Furthermore, by providing a channel through which local constituencies from the ecosystem served by the infrastructure being built, we greatly improve the investor profile. What once would be a heavily leveraged project driven by large financial investors interested in immediate returns is transformed into a community-financed project with investors that have a long-term view and whose personal benefits augment the returns generated by the project. As such, we can achieve financing that is more stable, less risky, lower cost, and has higher stakeholder engagement.
One example are projects along China’s Belt and Road Initiative (BRI). BRI spaces from China, through Asia, Europe, and Africa, to the EU. It connects nearly 65% of the world’s population and engages about 40% of global GDP. Experts estimate it will involve 2 trillion US dollars in infrastructure investment alone, more than any one institution or government can provide. Indeed, China’s annual proportion spent on infrastructure domestically has steadily declined over the last 10 years and there is little reason to believe it could finance the many needs of the BRI. However, in one particular project along the Belt and Road, tokenization is playing a role.
The project is a hydro-electric power plant. As a source of power, this green energy is a first-choice alternative, providing power at low marginal cost while taking advantage of the mountainous features of the country. However, as power projects go, hydro is particularly capital intensive and long-lived. Financial analysis shows that the project would return just over 4% owing to the long construction period (at least 5 years) and large up-front cost (about 2 billion RMB). Given foreign investment benchmarks for projects in developing countries are well in excess of 10% depending on industry, this is a project that would almost certainly not be built if we relied on financial investors. However, this project made use of the power of Blockchain to simultaneously bring together core members of the community and provide opportunities for investments from the those who would benefit the most from the power plant—users of electricity. That is, the commercial ecosystem that benefitted from the power plant being built financed it.
Here, 1 billion RMB was raised in “ecosystem financing” in exchange for tokens worth 2 billion in power going forward, providing both access to power and a hedge against growing energy costs consistent with economic growth. At a 50% discount, businesses, developers, and individuals were all incentivized to take part in the investment, one that would clearly reconcile on their balance sheets. Assuming only 75% capacity, builders could also realize a 16.6% on capital as half of the investment is covered by the ecosystem investment. Perhaps most importantly, a green energy project that might not otherwise have survived gets built, and the ecosystem surrounding the build is included, both in the consumption of the energy and in the potential future returns of the project.
Projects like these require the participation of government regulators (like the power grid), local businesses, competent builders and contractors, and the entirety of the local ecosystem. However, the resulting inclusion and potential to self-finance provides for long-term stability and sustainable growth that may not be otherwise attainable.
Above: Infrastructure projects can be ecosystem-financed using tokenization (not actual project pictured).
4. Final Thoughts
Tokenization is a natural step in the evolution of securitization enabled by Blockchain technology that allows for greater transparency, vastly improved transactional efficiency, and better risk management than ever before. It can provide liquidity to asset classes that had before been untradeable and, as a result, can greatly improve financial participation and information efficiency in these markets.
Security token regulation can be seen as a natural extension of existing securities laws and policies and hence do not require us to “start from scratch.” The technology is regulation-friendly and allows for monitoring and risk management by regulatory authorities. In contrast, crypto-currencies that are seeded in the spirit of full decentralization are without jurisdiction and hence lack the investor protections and monitoring necessary for mass market growth and fraud prevention.
Applications abound, and while many of the early uses are consistent with existing securitization practices, it is worth noting that security tokens are generally written on assets themselves and cashflows related to those assets, rather than debt obligations. Furthermore, they are as yet being written on individual asset in fully transparent environments so as to the avoid the complexity and opaqueness that laid at the root of the Global Financial Crisis of 2008 and 2009.
Moving forward, we should expect to see ever-more value-creating and creative applications of tokenization including in assets that have heretofore been inaccessible or the privy of an exclusive set of investors. These might include natural resource investments like mining rights. Or perhaps movie rights and box office proceeds? How about an ownership stake in your favorite sports franchise? Through the power for Blockchain and tokenization, virtually any asset can be domiciled and its cashflows or future appreciation divided in a fully automated, fully transparent and monitored, fully compliant, and virtually costless way.
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