I went to an event a few weeks ago where people talked about asset backed tokens. I was curious as to what the point of asset backed tokens were if asset backed securities already existed. One speaker had a token backed by oil (Oilcoin.io) and another was looking into real estate backed tokens (Cityvest.com).
The speakers said that asset backed tokens allowed for greater liquidity of traditionally non-liquid assets like real estate, and allowed international and retail (small) investors to invest in assets previously unavailable to them. For example, instead of buying into a fund that requires a $1mil minimum or being shut out because of rules against international investments, now retail investors and international investors can also get in on the action, allowing for more funding for projects, more liquidity for investors, and more options for small investors in particular.
Funding and liquidity and options for small investors are all great things. But why tokens? You can already invest in illiquid assets like real estate and oil using asset backed securities like oil futures or real estate ETFs. To the extent that small investors are barred from certain investments it’s either because of regulation (such as those limiting certain investments to high networth individuals to protect small investors from losing money they don’t have), or because the managers of a particular investment find it operationally inefficient to keep track of many small investors. But the financial instruments and technology to allow for such investments have existed for ages. You don’t need blockchain to sell shares in your real estate fund or oil ETF. Companies like Stash allow users to invest in a wide range of opportunities with as little as $5, proving that it is both operationally and technologically possible to get small investors into diverse sectors without any use of blockchain. Timeshares that allow you own a small piece of a property have existed for a long time, with the added benefit that you can actually use the space (REIDAO, a real estate backed token, seems to be doing the same thing).
So what’s the point of asset backed tokens on the blockchain? It seems like there are two main reasons:
- Regulatory arbitrage: just a fancy way of saying “taking advantage of legal loopholes”. Right now, there is a dearth of regulation surrounding cryptocurrency, and blockchain companies are basically writing the law as they go. Oilcoin’s whitepaper mentions that Oilcoin plans to be treated differently under the law from other oil based asset backed securities, which gives tax and regulatory advantages. The decentralized nature of blockchain may allow skirting national laws limiting real estate investment to citizens. And uncertainty around what exactly a token is may allow companies to evade regulations on securitizing assets or skirt laws that limit investments to only wealthy individuals.
- Stablecoin: right now there is a lot of volatility in the cryptocurrency market which prevents widespread adoption of cryptocurrencies as real money usable in every day transactions. There’s been a lot of talk about the need to create a stable coin that isn’t massively fluctuating each day so it can be used as a practical medium of exchange and a stable source of value. Backing a token with stable assets can lead to stability in the token and allow it to be used as a stablecoin.
“Regulatory arbitrage” is the practice of finding loopholes in the law to achieve some gain. Wealthy people using offshore tax shelters or companies keeping overseas profits abroad so they don’t pay taxes on them are examples of regulatory arbitrage. Profiting off of regulatory loopholes is probably as old as regulation itself and is a significant factor in the growth of cryptocurrencies. Most ICOs are “allowed” to raise millions of dollars with almost no disclosure or investor protections only because laws in this area are unclear. Many US based cryptocurrency companies are registered overseas to provide an excuse to not follow US disclosure requirements and participation limitations, making it much easier for these companies to raise funds. At any point, however, US regulators can tighten these loopholes, e.g. by saying that ICOs are like IPOs and therefore companies that ICO need to follow IPO requirements. Regulators can go further by cracking down after the fact on companies that have already ICO’ed, saying that they should’ve known to follow IPO rules, and fining or even shutting them down. This is why the more legally cautious major ICOs like EOS are not available to US buyers, or are only available to accredited (i.e. wealthy) investors. Many ICO companies and investors, however, are working regulatory loopholes as hard as they can while the law is still unclear.
The asset backed tokens I’ve encountered are not as flagrant in arbitraging regulation as purely digital tokens. Because asset backed tokens involve real world assets and not just “imaginary” cryptoassets, they have to at the very least, comply with existing laws on how real assets must be priced, stored, transacted, etc. Real estate tokens, for example, deal with complicated laws around title ownership, leading to some, like Praetorian Group, to wait for SEC approval before moving forward with their ICO. Oilcoin takes care to make clear that that they will comply with laws governing commodity transactions, financial disclosures, and “applicable tax laws”. It simply interprets those tax laws in a novel fashion that gives it an advantage over traditional oil backed securities.
There are two ways to look at regulatory arbitrage in the context of blockchain – one is that this, like traditional forms of regulatory arbitrage like tax shelters, is a form of “rent seeking” – a way of making money not by creating real economic value but by shifting the way value is distributed. It’s taking a bigger slice of the pie rather than making the pie bigger for society. The second way of looking at this is that certain regulations themselves are outdated and prevent value creation in a rapidly innovating economy. By pushing the boundaries of regulation, cryptocurrencies force regulation to adapt and this is in fact value creating for society as a whole. For example, creating a Real Estate Investment Trust, the current way to invest in real estate backed securities, is a complicated and expensive process, whereas creating real estate tokens may be only a fraction of the cost (especially if you avoid many of the regulations). Only time will tell which explanation is the truth. If 10 years down the line we find that ICOs have, on the whole, created wealth for small investors, then we know that the boundary pushing today is value creating and that current regulation is outdated; on the other hand, if 10 years down the line most cryptocurrencies have failed and most investors lost money, then we know that regulation today should have been more restrictive, and that boundary pushing ICOs were not value creating but simply shifted value from naive investors to blockchain “entrepreneurs”.
I think that while most cryptocurrencies engaging in regulatory arbitrage do so for rent seeking reasons, the reason that regulators have not cracked down harder is partly because they recognize the potential need to update regulations for a new era and want to see how the token market evolves before deciding whether and how to pass new regulations. I think that is wise. The blockchain case is different from old fashioned tax evasion because this new technology has the potential to create innovation in business models and economic organization, which would in turn require new laws and regulatory schemes. So even if individual token companies are rent seeking, pushing for new tax treatment and new investor regulations as a whole may very well be value creating as they force regulators to look harder at this new technology and think about how to regulate it in an innovation enhancing way.
A possibly more interesting use case for asset backed tokens is as stablecoins. Many people see cryptocurrencies as a secure and trustless (as in you do not need to trust banks or governments to validate your money) replacement for fiat currencies. For that to happen, tokens need to be stable enough to purchase real world goods rather than fluctuate wildly due to speculation. Most tokens do not have any “fundamentals” behind them – unlike equities, their value is not based on real economic factors like income and operations, and unlike fiat currencies they’re not backed by national economic trends. Since most cryptocurrency projects thus far are pre-product and pre-revenue, the value of their tokens is purely speculative. Backing tokens up with real world assets grounds its value in economic fundamentals, which should make the coins more stable and more usable for real world transactions.
Many asset backed tokens plan to step into that role as stablecoin. Praetorian Group is planning to issue a debit card that uses its tokens for real transactions, with the assumption that its tokens will have stable value based on its real estate assets. Digix seeks to create a stable coin backed by gold. Tether is backed by fiat currency (US dollars), there are even some backed by other crypto tokens. Venezuela is also planning on a token backed by its oil reserves to replace(?) a national currency broken by inflation.
New stable coins seemingly pop up every day. Some have called it the “Holy Grail” of cryptocurrencies. An investor joked to me that he is open to every blockchain project, unless you were “the 12th stablecoin to talk to me that day”. I personally think that a true stable coin should not require backing by real world assets and should be pegged to the price of some basket of useful goods (e.g. food and household necessities). This is what companies like Basis are trying to do.
Criticisms of ABT
Besides the criticism of ABTs as “rent seeking” mentioned earlier, the chief criticism of asset backed securities is that they are not decentralized. Gold and oil must be stored in physical locations. Real estate exists in a few discrete places. Fiat backed tokens (e.g. those backed by USD or Euros or Yen) must store their dollar reserves in real world banks. This seems to defeat the purpose of having decentralized cryptocurrencies in the first place, which is (in significant part) security and trustlessness. What makes cryptocurrencies secure is that they simultaneously exist everywhere, so there’s no central place to attack and disrupt the currency. But if you store all the assets backing that currency in a few centralized locations, then someone can simply attack your storage vaults to disrupt the currency. Decentralization also means you don’t need trusted intermediaries (like banks) to validate balances and transactions, because the whole network stores your balances and verifies your transactions. But when tokens are centrally stored, this means that you need to trust the organization storing them, which makes it fundamentally the same as trusting banks and other centralized institutions.
To evaluate this criticism, it’s important to recognize that there is a foundational difference between asset backed tokens looking to be stablecoins, and asset backed tokens that simply use blockchain as a way to invest in the underlying asset. One represents currency while the other represents assets. You use currency as a way to transact goods, while you invest in assets hoping that the value of those assets will increase. It’s like the difference between a dollar and a share of stock.
The point of a stable coin is to be a currency that provides all the security and trustlessness benefits of the blockchain while still being a stable medium of exchange for real world goods. So actually having the positive properties of a decentralized blockchain is important, otherwise what’s the point of using the token over fiat? For this reason, I think that a true stable coin should not be backed by assets that require central storage and trust in the storage organization. This doesn’t matter as much for asset backed tokens that exist as investment vehicles (for oil, real estate, etc). These tokens are fundamentally asset backed securities, and they exist to provide increased investment options at lower cost with more liquidity, not to provide some sort of secure and trustless fiat replacement. The focus of these tokens is the underlying asset you’re investing in, and blockchain is simply a tool to better invest by reducing operational costs and arbitraging regulation. While some tokens, like the aforementioned Praetorian Group, is trying to play both the stablecoin and investment vehicle roles, these roles have fundamentally different purposes and requirements.
For those thinking about investing in asset backed tokens, make sure you understand what their underlying value-add is. Are they looking to be a stable currency exchanging between the crypto- and real world economies? Or are they an investment vehicle for real world assets? Investment-vehicle tokens don’t really need to be trustless or decentralized. You evaluate them as you would any traditional investment – whether you trust the fund/token management group, whether you believe in the underlying asset, whether the return vs fee ratio is worth it. If you’re looking for a token to use as a stable hold of value or medium of exchange, its ability to actualize the unique properties of blockchain like decentralization matter much more.
Practically speaking though, even for stable coins, you don’t need them to be perfect to gain some of a blockchain’s benefits. For example, Tether is a USD backed token used to transact fiat currency across the blockchain. The Tether token isn’t intended to buy goods but rather to be used as a temporary waypoint in fiat transactions. This allows you to gain the speed, immutability, and low cost benefits of sending money on the blockchain, even if you don’t (fully) gain the decentralized and trustless benefits of the blockchain.
As blockchain and cryptocurrencies evolve, it’s likely that various tokens and services will realize some of the benefits of blockchain without realizing others, so the utopian vision of a perfect coin for a perfect blockchain economy may not be necessary for society to enjoy the varied advantages that blockchain brings.