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Tokenization Use Cases
Asset and security-backed tokens are not only the most compelling and immediate real-world example of how blockchain will impact the world, they also quickly call down the regulatory wrath of the compliance gods, which in most cases is helpful, not hurtful, to investors.
Investing: Cryptocurrencies vs. ICOs vs. Asset Tokenization
Before we delve into both the broad benefits of tokenization and the compliance surrounding various structures, it will be important to address what investing in tokenized assets means vs. investing in the next ICO vs. simply buying Bitcoin (or other cryptocurrencies). There is often a misunderstanding about the difference between these very broad investment types.
Technically “investing” directly in a crytocurrency (or what we have previously outlined as a payment token) is a misnomer. It’s not investing at all anymore than buying dollars is investing. It’s speculation.
Similarly, Initial Coin/Token Offering investing, unless said tokens are true security tokens, in most cases, is not a long-term investing. Most ICOs do not have a sustainable story to answer the following questions:
- Why do you need your own token? Why wouldn’t USD perform what you need?
- Where is your active buying and selling group for your utility token? How large is it? Does it already exist or will you have to build it?
No, most ICO “investors” (and I use that term loosely) simply benefit(ed) from artificial price increases in the value of a given token based on the artificial structure of the smart contract for each coin/token offering. In it’s simplicity, the process looks like this:
- Buy tokens or coins as early as possible in the “pre-sale” to lock in a low price basis.
- Wait for artificial and smart contract pre-configured price increases in both the pre and public sale.
- Sell into the fervor as the marketing and hype take off
It’s classic pump-and-dump at its finest. This is far-cry from the asset/security tokenization opportunity.
The biggest differences related to current, regulated securities offerings (which could easily be security tokens) and the ICO-fever we saw in 2017 in non-asset-driven initial coin/token offerings include the following:
- Cash held is not FDIC insured for each individual customer.
- Securities are not SIPC insured for each individual account. Ultimately, if a hacker steals your coins via theft of a private key, what insurance product do you have against its theft or loss?
- Digital real estate does not have title insurance like physical real estate.
- Private securities are direct negotiable instruments with the issuer and held on your (street) name, not some blurred private key
- There are lack of price controls over pump-and-dump schemes. Any good investment steward would demand token velocity economics be judiciously tracked and controlled. Without such, immediate and irreparable harm is inflicted on the long term efficacy and longevity of both the token and the underlying business it serves.
Thankfully, these shenanigans have been exposed for what they are and compliance-driven processes are being added to both security and utility tokenization.
Regulation & Compliance
As the SEC exercises their (much needed) right to oversee asset and security-based tokenization, it is important to understand how compliance and regulation plays a key role in direct, tokenized asset investing and how the technology itself is particularly ready to address many of the hurdles.
- Rule 144. Rule 144 restricts the sale of stock before a set holding period as defined by the type of security being offered. Thanks to smart contracts, Rule 144 can easily be automatically and autonomously implemented and monitored for any given offering and tied directly to KYC of each investor.
- KYC & Affiliate Blacklisting. Know Your Customer (KYC) rules are required for 1) ensuring accredited investor qualifies for a given transaction and 2) that a given investor is not on FinCEN’s blacklist, precluding them from investing in any deal. Blockchain-powered KYC will assist in providing compliance solutions in this regard.
- Transfer Agency. Transfer agents track the ownership of securities and other assets using a ledger–the very thing blockchain was built to disrupt. While transfer agencies may not be completely upended, they are likely to be virtual shells of their former selves in future years as automation upends their existence.
- 12(g) Exemption Token Fractionalization Limit. The SEC’s 12(g) fractionalization limit restricts an upper-bound on the total number of shareholders that can be in a particular transaction based on a given schedule for its size. Properly written and structured smart contracts will automatically put new purchase holds based on additional fractions automatically in check without the need for manual human intervention.
The rules and regulations mentioned here will need to be altered, depending on the type of offering you (or your investment bank) run. For instance, a tokenized Regulation D 506(c) debt/equity offering will have different smart contract automation trigger points than say a merger/acquisition, Regulation A+ or Regulation CF offering.
Smart Contracts: Autonomous Compliance Automation
In its truest form, blockchain is automated, tamper-resistant and compliant.
Smart contracts ensure compliance measures are carried out in an autonomous fashion to comply with independent regulatory frameworks. It’s more than just automated know your customer (KYC) requirements, blocking bad guys and ensuring proper restriction and holding periods.
While those things are good (and we will discuss them a bit more in a moment), they are nearly as interesting as what smart contracts will do for advancing and automating investor distributions.
Smart contracts will hold the key to automation for:
- Yearly distributions
- Quarterly distributions
- Monthly distributions
- Daily distributions
- Return of capital waterfalls
- Preferred return waterfalls
- European waterfall distribution
- Restricted token issuance based on triggers
- Clawback or automated clackback provisions
As an autonomous and automating tool, smart contracts will become a “set-it-and-forget-it” means of picking your deal structure and letting the payout run in its course while simultaneously ensuring you keep the all-important compliance gods at bay.
Assets Available for Digitization
There are literally no real-world assets (both tangible and intangible) whose ownership interest processing is not going to be impacted by blockchain and tokenization.
- Equity interests in public & private businesses from blue chip stocks to early-stage startupsand everything in between
- Large or fractional ownership of business debt in both public and private markets
- Gold, silver, platinum, diamonds, wheat, corn or any other commodity product
- Residential & commercial real estate investing interests
- Royalty agreements
- Insurance products
- Intellectual property rights & patent agreements
- Rights to movies, songs or any other non-physical, but valuable, income-producing asset
Any physical or digital good that has value can be translated to tokens and recorded on the blockchain. Goods that are difficult to transport are keenly impacted by tokenization. When it comes to the free transfer of goods from manufacturer to distributor to consumer, I would expect the tokenization of such goods to further automate the processing of standard commerce-based Incoterms.
Physical goods that have value, regardless of their location and ownership, will benefit from tokenization. This is more important as you move up the chain of command from commerce to full and fractional ownership of investments in real estate and other securities.
Real Estate Tokenization
Real estate is an easily-understood, real-world example that showcases the benefits of tokenizing a given asset. What if you wanted to invest in the fractional income available from a large commercial office complex? If such a property were tokenized, one could very easily sell all (or a fractional) interest in the income of such an investment.
Fractionalized Ownership. Associating the real estate asset with a token (e.g. a single token represents 1% equity value in a given real estate property) creates liquidity for investors without the need to sell the entire property. If sold and marketed similar to a close-end fund, real estate property is sold at a point in the future and token holders are compensated for their stake in the invested enterprise.
Asset Interoperability. Fractional ownership allows owners to own smaller fractional interests across various similar or uncorrelated assets, allowing for greater diversification and protection against future systemic downside risk.
Tokenization & Mergers/Acquisitions
Both private and public debt and equity securities are not only areas in which we specialize, they are also the areas that are likely to see the greatest shift toward tokenization. Undone will be the traditional model of third party transfer agents and gold medallion guarantees on securities.
Replaced by distributed ledgers, mergers and acquisitions will be enhanced and empowered by smart contracts, but some of the automation areas for things like earnouts and other contingency-based consideration for M&A will take time for effective implementation as transactions of this type require a large degree of hands-on customization.
Broad Tokenization Benefits
As we discuss all the relative ways asset tokenization will impact investments and investment banking, it may be helpful to revisit some of the broader benefits of tokenization should be helpful, particularly as we look through the lens of debt and equity securities:
- Predictable Supply. Tokenization provides an auditable, transparent and predictable supply schedule for security. Compliance regulation aside, predictability provides more stability and more value.
- Permission-less. Permission is not required to begin using blockchain technology. Software + private keys are technically all that is required. However, compliance may preclude one from investing or divesting in a particular holding, but that is also an added benefit (not a detriment) of tokenization.
- Resistant to Censorship. When it comes to payment and utility tokens, no single third-party can preclude any individual holder from interacting on the blockchain either by buying or selling cryptocurrency.
- Divisible. Investments and goods of differing values are not a problem as tokens are easily divisible into smaller pieces to accommodate for smaller transaction sizes.
- Fractional Ownership. Not only are tokens divisible, high value assets are more easily funded by the crowd using far more fractional shares. High-value assets such as real estate, debt and equity are able to be offered to new investor classes at a lower cost of entry.
- Self-sovereign. Third parties are not required to be a part of any transaction. Someone with a knowledge of private keys can be the bearer of any physical asset as long as s/he can provide the required private key.
- Asset Interoperability. Tokenization provides a means for holding a very wide array of global assets in a single basket (e.g. real estate, public & private equity stocks, corporate bonds, t-bills, etc.).
- Portability. Tokens can easily be carried in physical form via a digital wallet or stored as a memorized private key.
- Liquid & Fungible. Units of a given token, coin or currency are liquid and easily interchangeable.
- Monetization. Tokenization is not simply limited to fundraising. Tokenizing various assets provides a means of generating and introducing new revenue and business models.
- Speed. Automated compliance provides faster transaction processing.
- Cost Savings. Speed saves money, but digitization of contracts placed on the blockchain will have significant impacts on what was once a more human-capital intensive process.
For items 2, 3 and 6 above, SEC and other federal laws will still apply, particularly when tokenization involves tokenization of assets, including securities. Luckily though, smart contracts help to automate the processes that may be restricted by both internal stakeholders and compliance regulators.
Liquidity Premium & Valuation
As tokenized assets autonomously play within the rules, all asset classes will likely increase in value across the board. One of the main reasons public equities experience a valuation boost is due to something the financial markets refer to as the Liquidity Preference Theory. Per Wikipedia:
Liquidity preference is the demand for money considered as liquid.
In short, there is higher investor demand for assets that are more liquid. The increase in demand for liquid assets tends to drive up the value of assets that cater to investors’ desire toward liquidity.
As more assets are tokenized, the value of the available tokenized assets is likely to increase relative to non-tokenized assets. This is likely to create both a increase shift in both supply AND demand of tokenized products–a positive feedback loop wherein more tokenization will drive more tokenization.
In other words, if your assets are not tokenized, but your competition’s are, you will feel the pressure to tokenize and drive-up your own value. How this valuation boost plays out is anyone’s guess, but I would expect more and more assets (from homes to inventory shipments) to be blockchain tokenized.
In spite of its naysayers, blockchain continues to march forward. As it does, we will see tokenization impact more and more asset classes. Sure, they will start with large, institutional-based assets, but as the systems and processes get less expensive to operate, the size of compliant transactions will become smaller and more democratized. Yes, utility tokens will one day have a place, but the much bigger opportunity is in assets and securities where true value is inextricably tied to the ledger.
Additionally, as technologists work to marry their expertise to fit within the compliance bucket, we will see a broad swath of security token structures that will only improve over time. In fact, it’s the compliance-friendly nature of blockchain that makes the technology the most compelling we have likely ever seen for our innovation-stagnant financial sector–something we tech investment bankers are drooling over.
Note: we are actively working on several projects involving asset and security tokenization. If you are looking to discuss your asset or security tokenization deal with an investment banker, please get in touch.