In Capital Markets, DeFi Is About Tokenized Assets and Securities, But It Does Not Seem To Be Working
June 6, 2021
TOKENISATION — WHY THE CURRENT MODEL DOES NOT WORK?
“REITs trade at 10% discount to the value of real estate. So, if fractionalization is all that I will achieve through ‘DeFi real estate investment’, I will lose $100M on a billion-dollar building”, quipped a real estate expert among some blockchain believers. “But currently, even as rents are collected on a monthly or quarterly basis, investors are paid out bi-annually as it is too much of a headache to do that more frequently. Now, can you help with that?” Lesson One — fractionalization per se is not value accreditive.
But one thing I still knew is that investors know more about a fund from Fidelity or Vanguard, than they know about the St. Regis Aspen token because the Net Asset Values of these funds are published daily, calculated by the likes of BNY Melon or State Street (yes, intermediaries!). Lesson Two — DeFi does not automatically imply more transparency.
As those who launched the securities token secondary markets as ATSs (alternative trading systems) will tell us, there isn’t that much liquidity either (Lesson Three — DeFi does not create liquidity by default).
At Intain, our consistent view has been that transparency is a pre-condition for liquidity. In fact, that is the core promise of blockchain.
THE SOLUTION — THE CHALLENGE
Given the structure of most financial instruments, blockchains can help with disintermediation by making the underlying asset transparent and trustworthy — whether it is a hotel or pool of loans or oil wells. Alternative is what BondEvalue has done by bringing Citi and Northern Trust onboard as custodians. Here the trust is being ensured by the custodians. So, you can achieve transparency and trust through financial intermediaries or by bringing the asset economics on blockchain. There is little chance of success for tokens being issued in their current forms which do neither.
Putting the economics of the underlying assets on chain is easier said than done. It will involve parties other than the issuer who have no incentive to get on to a public blockchain. This may include counterparties, auditors, accountants, administrators, trustees etc.
Conceptually, it would make sense to have this run on a private-permissioned blockchain that publishes data on to the public blockchains where the tokens are issued and traded. This is same as BNY Melon or State Street publishing Net Asset Value (NAV) for mutual funds, only that here that credibility of the ‘NAV’ has been established using a blockchain. Smart contracts are calculating the NAVs and integrity of required documents and other artefacts is maintained on the private blockchain. In absence of inter-operability between such a private chain and an exchange which is on a public blockchain, Intain team presented a workaround (admittedly, a crude one) at the Hyperledger Global Forum in Tokyo in 2019.
Around that time, we also did a proof of concept about putting some shale oil wells under an SPV whose shares were to be tokenized. Token issuance was on one of the leading issuance platforms but the whole oil well performance data and its economics was being tracked and calculated on Intain AVB (Asset Value Blockchain) which was permissioned blockchain built on Hyperledger Fabric. Intain AVB had accountant, auditor, oil companies/owners, a third-party oil extraction data validator and the SPV manager as stakeholders. This was a slightly more refined version of Tokyo concept note, with Intain AVB receiving transfer agency data while sharing the NAV data with the issuance platform.
All these are workarounds and are not based on composability. But the consistent goal has been to bring information about the underlying asset on-chain.
Now, that we have more $2B in Structured Finance assets being administered and serviced on Intain ABS and increasing by couple of hundred million each month, we have a clearer view into this. Since we have modeled some fairly complex structured products using smart contracts, we are also more confident about putting structure of any security on the blockchain — this is important if we want to ensure that an investor in a token has view into the underlying asset without any fear of the data being tampered with in between.
Intain will work towards launch of its investment platform in Q1 of 2022. We will do it for asset classes where Intain is already the servicing and administration platform with Intain AVB. This will ensure that Intain’s tokens are structured on-chain and issued on-chain with asset servicing and administration on-chain. It would mean that both the provenance of token and the NAV are established with immutable, auditable ledgers. With transparency and trust established, fractionalization will complete the three pre-requisites for liquidity.
Our first step towards this will be linking our invoice factoring blockchain with a third-party token issuance platform. We are working towards a Q4, 2021 deadline and we should be able make an announcement in next six to eight weeks.
While financial institutions see the merit in Intain’s approach, some DeFi experts have raised two concerns:
1. There is no DeFi without composability : In absence of open and seamless connection with other applications, Intain approach doesn’t provide for composability. We somewhat agree. We do not think pushing Intain AVB on to a public blockchain is a viable option today. Hence, we are using alternative mechanisms to share asset data with issuing and trading platforms. There are multiple parties involved in structuring and servicing tokenized assets and securities. Even if one of them refuses to be on a public blockchain, it will fail.
2. No one uses smart contracts for such complex calculations: We completely agree, and when we interview people who have worked on various blockchain applications, this gets reinforced. But the payment waterfall of a credit derivative is complex because that structure may have been needed to meet the objectives of the issuer and the investor. As financial services professionals, we would push the envelope for smart contracts to deliver what we need, rather than hope FIs adjust to the limitations of the technology.
NEXT TWELVE MONTHS
It is very possible that simple structures of tokenized assets and securities, with composable DApps, all running on public blockchains is the future. It is possible that we, conditioned by our backgrounds in financial services operations and technology, are not able to reimagine things with a zero base (a criticism that recent ING paper on DeFi also has faced).
But what we are sure of is this — in less than six months, an SME would be able to click a button while raising an invoice to get it factored (or insured). The factoring company, the accounting firm and the SME all on the Intain AVB. An investor will be able to invest in tokens backed by these pools of receivables with a level of assurance that no current DeFi platform offers. Linking the SME, who needs working capital, to the investor, who is seeking returns in this manner, is our understanding of DeFi!
And yes, in H1 2022, investors will be able to invest in loan pools with the ease of P2P lending but with the risk mitigation benefits of a structured asset backed security (and yes, those ‘complex’ smart contracts will enable this)!