With headlines like “Cryptocurrency ‘bloodbath’ as Bitcoin falls 30% in a week,” no wonder the “untrained investors” run for the hills, desperately trying to figure out why “digital gold” tumbled from $20000 to just below $4300 in 11 months. Friedrich Ebert, the president of the Weimar Republic, must have felt the same way when he first looked at the “London payment plan” and started doing math in his head.
But never mind the ancient history. What are we going to do today? Crypto is taking a beating like the one in Aug-Sept 2017 after the infamous announcement. And just like back then, $16 billion got shaved off the crypto market cap in only two weeks. The reason? Aside from the sad state of affairs with tech stocks and the BCH hard fork, the SEC yet again has flashed the badge to two more ICOs—Airfox and Paragon—for “failing to register initial coin offerings as securities.” A week later came the first-ever takedown of an unregistered exchange called EtherDelta, and somewhere along the way, the Commission had managed to wreck a poor soul named Maksim Zaslavskiy, who apparently sold unsuspecting investors some shitcoins. Amazingly, a year-and-a-half-old lesson is not learned. What gives?
Nobody knows. From Jim Cramer to Jim Acosta, everyone’s got an opinion, and none presents a balanced outlook that could decipher the situation, explain it, and give humanity the right direction. It seems the market is just really tired of us, like a rebellious toddler getting so sick of grandma’s kasha—he dirties his diaper in protest. Again, aside from Richard D. Wolff, a Marxist professor who seems to have all his ducks in a row, and weird predictions by Erik Voorhees, no one has a clue.
But after spending a week at the Singapore FinTech Festival, I clearly saw that at least two viable contenders are out to alleviate the ongoing Armageddon and cushion the blow—stablecoins and security tokens. So, let’s get a better look at both.
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Anybody who’s been in cryptocurrencies for longer than one market day knows that it’s an extremely volatile space. Yet despite actively decrying fiat currency and peddling the notion that the USD and the Fed are all going to collapse, cryptocurrency fanatics are fixated on pegging their crypto to the USD to avoid some of that volatility and maintain what they call stability. These projects are typically referred to as stablecoins. We’ve seen several over the years (the first one released by BitShares back in 2014), trying to create a viable stablecoin, but it’s the last 12 months of rampant cryptomania that have pushed stablecoins into the Thunderdome to face the price run-ups and bring some stability into this, oh, so unstable world.
A lot of actors that rode the ICO wave of 2017 have gotten considerable gains in crypto, so they want to put their little chests of digital treasure into something that wouldn’t crash overnight (so far we’re looking at Ethereum down 15.84% in 24h, Litecoin down 12.5 % in 24h, Ethereum classic, Bitcoin cash, a whole host of others—all down, down, down), which, again, would be US dollar. There are multiple ways you can try and achieve this peg, and all of them revolve around collateral.
The first approach to pegging a stablecoin is called fiat-collateralized, and it’s heavily favored by the whales of the industry, who enjoy full institutional support and invariably an amicable relationship with Wall Street—the Winklevoss brothers’ Gemini, the Circle’s USDC, and a few others. Those “relationships” make it easier to sell you the rosy image of a perfect world where you’d be able to go to the company that’s managing your digits and buy one token for one USD, but also at any given time sell tokens back to them and redeem the USD from their reserves. This fully backed reserve method is arguably the safest way to hold stablecoin because all the money is sitting tangibly in a bank account, but it ultimately involves trusting the banker. For example, Tether, which is a very popular USD stablecoin, says that they maintain a one-to-one reserve of tokens to USD stored in a bank account, but their links to the Bitfinex exchange, the way they trade, and most importantly, the inability to produce any actual audits that show reserves for the currency, resulted in the Justice Department probe.
Another big problem with Tether is that it’s not redeemable at this point. You can’t take your USDT tokens to Tether and say, “Hey, I want to sell these back to you for a one-to-one of US dollars,” although, miraculously, Tether somehow does maintain a pretty steady peg to USD on exchanges.
Still, the issue with fiat-collateralized schemes, which are supposedly fully backed by a reserve, is that they’re nearly impossible to scale and among the least efficient ways to deploy capital. Think of all that fiat just languishing somewhere with no other job but to back your token. In a world of fully digitized USD, saying it’s wasteful and plain dumb is to say nothing.
The monetization of Tether (and quite a few other coins for that matter) also calls for some scrutiny. They charge a fee to people who exchange fiat for USDT. Also, I would think all that imaginary cash they claim they have backing their token would be earning substantial interest for Tether itself and for the lucky bank that holds it, but not for you, my friend.
Another schema used in the stablecoin space is called crypto collateralized, which, essentially, is the same thing as fiat collateralized, but this time, you’re using a pool of tokens that you’re already holding to peg against each other. The argument here is that it’s an entirely decentralized system devoid of banks with their rotten influence and perfectly auditable on the blockchain in the most evangelical sense because you’re doing it through an Ethereum smart contract. Hallelujah. One must wonder whether building a stablecoin and backing it with something even more volatile than nitroglycerin—a bunch of other coins—is counterintuitive to the idea of stability. Most of these schemes are over-collateralized, which means you’ll need to put in at least 1.5 or 2x the amount of cryptocurrency to get the amount of value you want. This is done to protect the value of the stable token against downward market pressure.
For instance, MakerDAO/DAI requires you to put in about $150 to get $100 in value from the stablecoin. Cool. Of course, I could go to Coinbase and buy $100 worth of USD with my Ethereum wallet, leaving $50 worth of Ethereum left over. This over-collateralization scheme works only if cryptocurrency prices are rising, which is not the case right now, so there goes your “stability.”
Back in January, the DAI saw a sudden price drop to around 80 cents. The event was due to a trading bot malfunctioning, and it makes me wonder about the actual mechanism of maintaining the peg that they claim makes the cryptocurrency stable, and how involved trading bots are in playing both sides. In finance, it’s called “painting the tape”: you buy and sell both sides of an order book to manipulate the price towards a specific target. It seems that MakerDAO DAI is exploiting this scenario to the fullest, often setting its investors on a collision course with each other and the system, on top of which, they heavily rely on fees.
But enough with the simple stuff. Let’s talk about non-collateralized stablecoins, which, in my opinion, is nature’s way of getting us back for screwing up the planet. To put it the way even your average Ph.D. can understand, non-collateralized stablecoins attempt to maintain a peg to a fiat currency by manipulating the supply of money available with no reserves held anywhere. As a rule, these projects maintain a central bank algorithm that strives to increase supply when the price goes up and decrease it when the price goes down. Basis is probably one of the most prominent projects in this realm, if not the most visible, so it’s ideal for use as a case study.
When the price of the Basis stablecoin loses its peg and falls below $1, they start selling a “bond token” at a price below $1, with a promise that it can be redeemed for Basis coins in the future. So far so good: you speculate the price of Basis will go up, so you buy some bond tokens at under $1 and wait for a nice fat envelope to come in through the figurative crack under your door. In case the price goes up above $1, the Basis algorithm increases the money supply, and in doing so, they issue a 1-for-1 Basis coin for each bond token you hold. So, when they increase the money supply to try to keep prices down, they’re just paying back the people who bought these bonds with Basis coins. To make it even more confusing, they also have something called a “base share,” which is essentially an unpegged currency that pays dividends to people who hold Basis coins when the money supply must increase. That’s a total of three coins for a single system. Did you get all that? Probably not, but have a cookie anyway.
The problem with Basis is that it’s predicated on people believing the token’s price will go up. But if the price falls below $1 and the “central bank” just can’t sell any of its bond tokens because there’s not enough confidence the price will turn around, the whole market could go into a death spiral. A few months back Basis talked about utilizing its ICO money to buy back these bond tokens to balance the price but buying your own token back at a lower price seems like a regulatory nightmare. Also, the seed money, however considerable is the amount (and in case of Basis it’s huge: $133 million from the likes of Andreessen Horowitz and Bain Capital Ventures, Pantera, DCG, Polychain, and a few others) is not endless so, unless they plan on popping a seed round every time the bond token holders knock on your door, the entire model appears to be unsustainable at the very least.
Another big problem with this type of scheme is that the “central bank” algorithm must have a way to get a feed of the USD-to-Basis token price from exchanges. They’ve discussed a decentralized article system in their white paper, but obviously, the simplest solution is to use a centralized feed directly from an exchange, which isn’t ideal.
Another stablecoin that, for some reason, is doing the rounds right now is called Saga. It runs an Ethereum liquidity pool, but it also maintains a fractional-reserve fiat reserve. It’s a mix of crypto and fiat collateralized scheme poised to hedge Ethereum’s exposure to market turmoil, but it’s unclear what ratio they’re trying to maintain. Saga’s success is a bit of a mystery to me personally, what with all the promo dreck they put out and the website copy clearly ordered off Fiverr (and some lifted from the corporate bullshit generator). Oh, well, as a poet once said, if stars are lit up in the sky, someone must need it.
At any rate, I’m far from believing that stablecoins are actually stable enough to turn around the market and become a universal remedy for the cryptocurrency space altogether (if you read all the way to this point you see that I took my sweet time proving it) especially given that we’ve already digitized USD to a degree when it’s highly efficient (I use Venmo all the time). Besides, using good ol’ Coinbase, you could always hedge your crypto bets by just buying USD and be done with it. Even with all the de-dollarization tendencies, our aircraft carriers, nuclear subs, and private armies are ready to deliver freedom to the most remote areas of the world on a moment’s notice, so that I wouldn’t worry about the USD going quietly into the night any time soon.
With that, the question is, do we need a crypto economy at all? Absolutely, and it has nothing to do with the unbanked, financial inclusion, breaking away from or reforming the legacy finance system, IoT, and all other latest achievements in naming. I’m talking about security tokens—one of the sanest, most timely, and logical applications of the blockchain technology to date. To answer my question, yes, we do need a crypto-economy, which, in the words of Jeremy Allaire, CEO of Circle, will soon evolve into the “tokenization of everything.”
Indeed, how do we focus on fostering capital facilitation for economic growth in a more efficient, fully transparent way with a defined pathway to secondary liquidity? Certainly not through IPOs, the challenges there are immense, IPOs are cumbersome, expensive, lengthy, and the tremendous shortfall in IPOs we’re observing today makes me even think that they’re not coming back at all, not anytime soon, definitely not for the small to mid-tier offerings. So, how? To me, the answer is tokenization of securities as the most obvious next step in bridging the generational gap between real economy—you, me, and our little business ventures—and financial markets ripe for a new generation of investors.
Premium liquidity
Right now, with the exempt offerings under Reg D, there’s very little liquidity. There can be some OTC trades, but if you invest in a venture fund, you’re looking at three to ten years before exit. Tokenization enables an accredited investor to transact or exit a position earlier, selling to someone who missed the initial offering but is still interested in investing at a later stage.
Some studies suggest that illiquidity discounts of 20-30% are not uncommon for certain asset classes, such as commodities and bonds, that are traded over-the-counter. The opportunity to take $11 trillion in assets and return at least part of that sum to investors is an important driver of tokenizing those asset classes. Tokens can be structured to represent the underlying ownership of the asset, and more issuers will provide physical delivery and quick settlement of the underlying asset rather than buying cash-settled ETFs.
The compliance aspect
The Securities Act of 1933, the Howey test, and subsequent regulatory measures, along with several current developments, demonstrate that the compliance framework is already well in place. What is key for security token issuers now is to align their practices with the existing legal environment and fully comply with these regulations to become vibrant participants in the security token economy. One of the ways to handle the all-important compliance issue is to create security tokens with the identity embedded in so that only whitelisted persons/accredited dealers can participate in the offering under its terms and trade/hold the tokens. The efficiency of compliance in the security token space depends on the level of automation programmed into the token. For example, the ST-20 standard has a built-in compliance layer that elevates the token to an entirely new level of efficiency.
This is the next step forward: bringing the security token into the securities marketplace by providing comfort to institutional investors through verifiable assurances. Once all the KYC/AML, suitability requirements, reporting practices, asset validation, etc., are in perfect order, the institutional money will ensure a quick and painless migration of the entire industry into a new space.
Competition
No such thing. Even though the space is developing rapidly, simultaneously and internationally, it ultimately comes down to regulatory frameworks in sovereign countries that are perfectly capable of reining in upstarts. There will be issues with sovereignty and jurisdiction, no doubt, but to put things in perspective, there are $2.4 trillion of unregistered security issuances in the United States alone. Compared to the $1.6 trillion in the US aggregated public markets, a clear trajectory appears towards the coveted ability to capture alpha early in the cycle, which, back in the day, allowed Spotify to get pre-listed on the NYSE as a public company with a colossal valuation. The point is, we have a massive market, and there’s plenty to go around for everybody. In fact, instead of competition, true partnerships are emerging between companies that, logically, would have to be at each other’s throats. They’re developing similar products, they’re in the same HR pool, and yet instead of competing, they end up building common standards and creating all-encompassing business practices that become a global trend.
The nuts and bolts
From a sheer utility standpoint, executing a trade via a security token shouldn’t be more or less complicated than what we’ve been doing for the last hundred years with the actual trade, custody, clearance, settlement, and depository. The obvious advantages here, however, are lightning speed, volume, and access to new market infrastructure through the beauty of an individually written smart contract. In the case of Stellar, the contract supports multisignature, batching requirements for multiple transactions, sequencing, time bounds, and other features. Ethereum has its own set of rules. Platforms like Smartlands now create new dynamic security instruments for profit participation, yield instruments, revenue participation instruments, or a combination of the above, revolving them around multiple asset classes like real estate or other illiquid traditional assets, and execute them through a blockchain-based ATS to have secondary liquidity.
It’s only fair to point out that we’re far from meaningful P2P trading, but we already have the tech to put all the necessary identifiers on a security token, enabling tracking and auditing throughout the entire lifecycle. We already have the tech to prevent redundancies that may arise from fraud, loss of a key, or nefarious activity by bad actors. In other words, the “broker-dealer” institute and the “transfer agent” institute—both, though still firmly in place, are getting an extreme digital makeover.
Fractionalization
Now, there’s a major benefit of a security token for you. It is a way to invest differently in a whole new asset class, enabled by fractionalization, which lowers product structuring costs and improves market efficiency. For instance, a REIT is a vehicle created by an owner of multiple properties that are bundled together and can be sold or liquidated as a contract. Naturally, a buyer is charged a fee for the work done by the owner/agent in acquiring those properties, structuring the product, marketing it, and selling it. The fee is charged on top of the underlying asset value: 1% of the REIT, 1% of the stakes of all properties in the REIT, plus the fee.
Let’s imagine that all lower Manhattan buildings are tokenized and therefore tradable on liquid, compliant markets. Now, virtually anyone can go out and automatically buy a millionth of a percent of those buildings, effectively creating their own lower Manhattan REIT without the need to structure the bond, and no fees need to be paid for the underlying set of bespoke assets you’ve just created for your own convenience and investing needs.
The future
The World Economic Forum conducted a study in which the majority of respondents said they believe that 10% of the global GDP will be on blockchain by 2025. That’s about $8 trillion. So, it’s going to sound a bit loud, but I’m confident that in one to three years, security tokens will comprise the most robust tradable asset class, becoming the largest conduit for capital aggregation, job creation, and economic growth within the existing regulatory framework. In particular, as the mechanisms of custody, clearing, settlement, and depository are built on multiple blockchains, a gateway will be created that will enable massive amounts of institutional capital to flow into the space, forever changing the current financial market paradigm.
In other words, the road from a brave new sovereign wealth fund delving into tokenization to the “tokenization of everything” is not going to be a long one. I tend to agree with Mr. Doom that the utility token market cap may remain at or even decline from its current level, but the security token market cap could easily be in the trillions in two to three years. We will see traditionally illiquid assets become liquid and continue this never-ending march towards universal liquidity accessible to any individual with a smartphone.
