Moral Imperative for Blockchain
Or: How I Learned to Love Tokenized RWAs
Imagine that one day hospitals and the doctors that work there decided to no longer care for people’s health. Instead, they’d provide patients with a list of the top 10-20 medicines and antibiotics as well as guidelines or heuristics for their use. Seems quite unfathomable, doesn’t it?
Well, if you squint, that’s pretty much what has occurred over the past few decades as corporations have shifted from defined benefit (DB) pension plans to defined contribution (DC) plans. Beyond upending a social contract between employer and employee, corporations effectively transferred all the risk related to managing a retirement plan and paying benefits from their balance sheets to their employees. Surely this must be one of the greatest transferences of risk in history! One of our colleagues describes this as a “near-criminal risk transfer”.
It seems ludicrous for individual amateurs to be required to achieve results similar to professionals and institutions, yet that is exactly what has happened with the shift from DB plans to DC.
In the case of investing, as compared to medicine, the playing field is not even level. Asset owners, professional investors, and wealthy individuals have access to a range of investment opportunities – private equity, infrastructure, private debt, real estate, hedge funds, and more that typically require very large sums of capital for investment. Additionally, they possess an information advantage not available to most individuals. So, even the most astute individual investor will have a hard time achieving the risk-adjusted returns of a well-run defined benefit plan.
As long as the full range of investment opportunities available to institutions and wealthy individuals is essentially off-limits to most people, we face a terrible inequality of our own creation.
As a digital assets manager, we are often posed the question: “What are specific, tangible, and valuable use cases for blockchain technology?” We love this question!
While the currency use case dominates most people’s understanding of blockchain utility, we won’t argue with skeptics who point out that bitcoin (for example) doesn’t possess the characteristics required of a functioning currency. The currency use case, while potentially revolutionary if it comes to fruition, is not our primary interest.
What does capture our interest? The tokenization and subsequent fractionalization of private assets!
We’ve previously written about tokenizing real-world assets (RWA). Extending the idea to tokenizing and fractionalizing perhaps all categories of private assets is the key to democratizing investing and leveling the playing field to the extent possible, given the historical off-loading of investment risk from corporations to employees. Some of the reasons this approach will help democratize investing in private assets include:
Reduction in capital requirements as a result of fractionalization
Lower costs for buying and selling
Transparency in the history of asset ownership and maintenance
The idea of large-scale tokenization and fractionalization of private assets is made possible by blockchain technology.
At the time of this writing, the tokenization of private assets on blockchains is happening, but on a relatively small scale, and not in a scalable manner. For example, only $178 million of real estate and $460 million of private debt have been tokenized as of September 2023, according to Galaxy Research.
We see an inevitable future where:
Standardized mechanisms exist for individuals and organizations (including governments) to tokenize and, importantly, fractionalize private assets, such as private equity, real estate, businesses, infrastructure, etc., on blockchains. These mechanisms could either be centralized or decentralized, or a mix of both.
Platforms exist for people to trade these tokenized assets. These platforms could either be centralized or decentralized, or a mix of both.
It won’t be easy to get to this state – if it were easy, we’d already be there. Developing the processes and verifications for each token will take some thought and experimentation, and there are likely to be a blend of smart contracts and middlemen at the outset for the tokenization. After all, if you’re buying a piece of a French vineyard, you would want to be sure it’s not actually desert land.
Projecting into the future, we see that there may be millions upon millions of tokenized assets available for fractionalized investment. Think of how many pieces of land, commercial properties, residential properties, private commodities/collectibles, private company equity and debt, intellectual property, and more could be tokenized. Many of these tokenized real-world assets may have limited liquidity due to small float and/or limited interest in the exact, specific underlying asset. Unlike, say, equities, where each share of a company (of the same share class) is fungible, nearly all the tokens available for trading will be distinctive and differentiated. If we limit ourselves to trading only literally identical tokens, liquidity would be vanishingly small. In this case, “close enough” might be a perfect solution. For example, four commercial skyscrapers sit at the intersection of East 54th Street and Park Avenue in New York City. If these real estate properties were to be tokenized, they would be arguably close enough substitutes for each other in a diversified portfolio even though they are not literally fungible. This line of thinking opens up a near-infinite array of options for investors to design the composition of their portfolios. This number of choices may be overwhelming for many investors.
One appealing solution is to utilize an algorithm to characterize similarity across a standard set of characteristics and possibly across user-defined characteristics in order to describe compatibility or acceptable (near-)fungibility. Given that there may be billions of tokens available to trade across all types of private assets, participants will need to lean into these compatibility algorithms, and some type of AI is likely to be part of the picture.
Fully functioning, efficient (ha!) markets for tokenized securities will also require the ability to borrow and short. The token compatibility topic and shorting topic are related, and we can gain some insights by looking at the NFT part of the digital assets ecosystem. Currently, platforms such as dyve, Wasabi, and Fungify allow participants to lend, borrow, and short NFTs, with equivalence between NFTs from the same collection allowed.
Stepping back from implementation details, which for sure will radically evolve as generalized trading of tokenized private assets grows, we stand by our assertion that developing broad access to a wide range of tokenized/fractionalized private assets is a moral imperative. It is perhaps the best way to begin addressing the injustice of the risk transference that resulted in the shift from DB to DC plans. And it’s made possible by blockchain technology. We won’t kid ourselves into thinking that developing this ecosystem and capability will be easy – beyond technology and behavioral changes, there will almost certainly need to be changes to regulatory and tax codes across jurisdictions. In some sense this mirrors the issues facing the digital assets investment landscape at this moment. With the right collaboration between developers, exchanges, and regulators/policy makers we believe that democratizing investing is absolutely tractable.