The most successful application of blockchain, so far, has been Bitcoin. It seems that there is nothing that blockchain can do better – recording transactions and tracking who owns what without the involvement of a middleman. This is what makes blockchain truly impactful, and what could have far-reaching consequences for capitalist societies (crypto talk?). We don’t trust other people because they (like us) have egoistic motives and make errors. There is, therefore, a need for costly layers of intermediation and the necessity for authorities ‘for the authorities’ sake’.v OK, so blockchain is good for recording ownership. Where else could this work? Well…how about stocks? Security tokens are the next generation of securities like stocks or bonds (or any other ownership rights).
They have inbuilt rules and actions, which means that they perform many functions automatically. Imagine a stock with automated dividends. Sounds good, right?
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In the today’s financial markets, to buy or sell a stock, people need a system to keep track of who owns what. This is accomplished through a network of brokers, exchanges, central security depositories, clearing houses, and custodians. This all is made even more complicated by the fact that we now want to have stocks represented in electronic form.
When someone buys or sells a stock, that order is executed through a large network of interrelated (although somewhat chaotically) middlemen and third parties. Each step of the stock transaction, from trade (sending order to the exchange), through clearing (moving stock from one custodian to another) and settlement (cash transfer) to stock servicing (safekeeping, dividends, voting) involves multiple parties, each of which has to communicate with another in a complex network. Each party maintains its own version of truth in its own ledger.
Security tokens vs stocks
So what’s the problem? After all, there is nothing wrong with complexity as long as it works, right?
Well, that’s the thing..it sort of doesn’t. The mechanism described above somehow evolved from the old system of paper ownership, which was later enriched by the element of electronic trading. Not only is it inefficient, but also prone to errors, which can lead to (nearly) unsolvable problems.
The botched takeover of Dole Food Co. is a great example how things can go wrong. Matt Levine explains (really well) how it is possible that the company had at one point some 12M extra shares. When a company is undergoing larger transaction (like a merger), DTC stops tracking trades in the company’s stock because it would be too hard. DTC ‘places a chill on the stock’. The stocks are still being traded, of course, but DTC doesn’t want to know about it. It is the responsibility of the brokers, custodians and other DTC participants to maintain some order.
Things got even worse thanks to short-selling. Short-selling means that an investor borrows share from his / her broker to sell it in the belief that the price will fall. The financial markets of today account for this by recording two positive shares (the original owner whose broker lends their share and the buyer who buys the borrowed share) and one negative share (the short-seller). This means that the short-seller has to pay dividends (and other payments like extra merger consideration) to the holder of the ‘extra’ stock.
This is a complex system relying on many intermediaries, which can easily lead to errors due to human error (see above). This has become really problematic when some years after the merger had taken place, court ordered that the acquirer should pay extra consideration to original shareholders who held the stock at the time of the merger. And as it turned up, there were suddenly too many shares. It was up to the brokers to figure out who owns what ‘really’ and how to split the extra consideration. In many cases this was impossible.
Unsurprisingly, many short-sellers did not want to pay up to the holders of the ‘extra’ stock because they felt like they had nothing to do with the mess. Some were simply no longer there to pay.
Enter blockchain and think about what it would do. A distributed immutable and perfectly transparent ledger would track who owns what in the real time. It would make the whole process a lot easier. Apart from the fact that it would eliminate the inefficiency - the necessity to go back and do the forensic work to identify the rightful owners - blockchain is humanless and that can be a good thing. Sure, the brokers would still have to call up the short-sellers from years back, but they would have little grounds to object because blockchain doesn’t make mistakes.
Security tokens bring the promise that many of the functions laboriously performed by multiple middlemen can be automated away. They are a more intelligent version of ownership rights.
Why should you care?
Dalio and tokens
Ray Dalio argues that there is a 25% probability of a recession in 2019 or 2020. According to Dalio, the politics of easy money injected into global economies after 2008 has led to a situation when debt is too cheap. Eventually, we will reach a breaking point when creditors will no longer lend money at such low rates.
Once we get there, the only assets worth investing in will be those that are detached from the value of money because money will depreciate. Dalio suggests that only assets like gold can (and will) hold value. Certainly, in light of gold’s performance this year amid trade wars and the worries about recession, his arguments seem to make a lot of sense.
Ray Dalio is becoming a rather prolific writer these days, and he especially enjoys his lament about the growth of inequality after the great crisis. It is clear that his advice is aimed at population at large – the retail investors.
It is easy to buy gold on financial markets either in the form of products (future, options, ETFs) or outright by buying stock of gold companies. But, gold is not the only asset that is insulated from the swings in the value of money.
Tokens and illiquid assets
Premium and ‘hard’ assets like a large real estate block in the centre of Paris or a Picasso have a physical form and natural value. They are not available on any exchange markets, and as such are also not prone to price volatility. They are, however, completely unavailable to the normal people.
The truly premium private assets are typically very exclusive. They tend to be owned and invested into only by large institutions and a few super-rich. Investing in these types of assets is confined to the lucky few because the minimum investment is very high due to inefficiencies. It is a fact the the investment process in these types of assets is not standardized, and that it involves a lot of very costly paperwork and the work of middlemen and institutions.
In other words, these assets are not represented in some form of an easily investable product. But this can be changed.
You see where I am going with this. Any assets, including these illiquid premium investments can be represented by security tokens. In fact, security tokens can do to private investments what P2P lending platforms did to private debt markets after 2008. They can ‘bring them to anyone’s desktop’.
People loved the idea of being able to lend directly to a small shop or just to another person to finance his/her business idea, and in same way security tokens can make expensive and inaccessible assets investable from desktop. The automation described above can make investor onboarding, subscription, transfers, or even the payment of distributions seamless and most importantly automatic (read cheap). A lot of the expensive work of middlemen and institutions can be ‘automated away’.
Despite this, it will be many years before security tokens can replace the volume and liquidity of traditional securities, but even in their present form, security tokens (when done properly and legally) can be an innovative, paperless and seamless way of connecting investors to premium, alternative projects, which have historically been only accessible to a few ultra wealthy.
Undertaking an STO can be very costly. Often times, companies that are planning to do an STO end up hiring an armada of lawyers and sink into a lengthy correspondence with regulator to learn (create) the process. Fortunately, first ‘proto’ advisory shops are emerging to advise entrepreneurs and companies on how to do STOs properly.
George Salapa is the co-founder of bardicredit (BC), a Swiss turnkey tokenization service. BC is helping fund managers and entrepreneurs to use tokenization for easier capital formation. Before BC, George was in consulting (PwC), banking (Sberbank), and tech (smart data Braintribe). In the past, he co-founded a smart city App (Shout Platform Ltd) and wrote for Forbes US as a contributor.