Despite the market over-correction fervor swinging against cryptocurrencies, those who truly understand the impact blockchain technology–and particularly asset tokenization–will have on investing, continue to remain bullish on the long-term efficacy of the technology. I’m reminded of a quote attributed to well-known personal development coach Jack Canfield:
Change is inevitable in life. You can either resist it and potentially get run over by it, or you can choose to cooperate with it, adapt to it, and learn how to benefit from it. When you embrace change you will begin to see it as an opportunity for growth
When it comes to investments and investment banking, asset tokenization and in particular security tokenization is one such area of significant change. I’m convinced it will upend investment processes in ways we have not yet creatively imagined.
The problem with most of the hype around blockchain technology is misinformation and lack of knowledge. For example, Bitcoin is one type of cryptocurrency or crypto-coin that is built on the blockchain. “Investing” in bitcoin is as much of a thing as “investing” in the U.S. dollar. Its basic structure is built as a liquid medium of exchange for other tangible items that have value, not the value itself. There are three large buckets that hold most blockchain applications. They are as follows:
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.
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:
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:
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:
Thankfully, these shenanigans have been exposed for what they are and compliance-driven processes are being added to both security and utility tokenization.
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.
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.
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:
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.
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.
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 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.
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.
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:
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.
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.
By reading this you agree to and understand that none of this represents investment advice. This is for informational purposes only and should not be construed as advice to invest in any particular market, crytocurrency or token.