Listed shares tokenization: Why and How
- Why tokenize listed stock?
Of late I have been invest on a personal level.
I have never been a fan of investing in so called utility tokens. I fundamentally cannot comprehend why anyone in their right mind would think that their value will go up.
I have written about this previously here
Nor do I think that Bitcoin is an investable asset or anywhere close to being like gold.
I want my money to make money by creating value for its participants. It should not be based on the “pass the parcel” exchange value.
When value is created the asset value increases fundamentally.
When you construct a building, you are creating an asset that did not exist before. This is a process of creation, where the output is greater than the input.
Only when an investment leads to value creation, can you then realistically expect your investment value to go up.
Few such opportunities exist in the Blockchain space.
I am bullish on defi. I think it is going to fundamentally replace the plumbing of finance in the years to come. I have personally deployed some monies on various defi platforms and the interest I receive is real value creation. However the space is limited right now with interest rates real low.
When real world lending use cases start plugging into defi this will situation will change dramatically. For now I make more on interest rates by making loans anywhere between 8% to 24% on real estate (depending on where they sit in the capital stack) and nothing in defi comes close.
Beyond that while I am a big fan of cashflow, the problem with only debt based investing is not keeping pace with inflation.
A debt instrument stays worth the same amount through its life time. In theory it can go down in value if the quality of the underlying assets deteriorate. It can also go up in a reverse scenario.
In either case the bond by itself is not doing more or less. It is the markets perception of its quality vis-a-vis relative factors that is changing. There is no new value that is being created by the Austrian bond that would cause it to spike in price.
A venture however creates value over time. It creates solutions, infrastructure, products, services etc which make money and if the business does well, its revenues should go up over time as its offering is accepted by more people.
The value of a good venture should hence go up over time.
In the blockchain space there are very few such opportunities to invest in ventures that create and grow in value. If you are part of a select club, you can be an equity investor in the businesses behind various defi platforms. But that would require you to have insider access to get behind the most quality offerings out there.
The major (and probably only) exception to this situation is the MKR token.
MKR is the token for the DAO that stands behind the DAI currency.
For those who do not know DAI is the only truly decentralized stable coin out there and is the backbone of the defi movement. MKR token gets you a piece of the entity behind it.
So as defi booms as expected over the next few years, MKR should boom as well. Unlike most utility tokens MKR is the closest that comes to sharing in the proceeds of the venture itself.
I hold small amounts of MKR tokens and am bullish on it.
However of late I have started trying to understand how investing really works and how and why you should choose to invest in something or other. And what better way to look at investing than the legendary Warren Buffet. Warren Buffet swears by the writings of Benjamin Graham who was a mentor figure to him.
“The intelligent investor” is as good a place to start looking at to understand the basics of investing.
One of the key takeaways I have from this is, before you invest in something you need to:
- Understand it
- Have a sense of what its current value is, and
- Assuming you are satisfied about its growth prospects ideally pay a price that is lower than what its value is.
If you have bought an asset which is worth $100 and you expect it to grow to $110 with a reasonable degree of confidence in the next 12 months and if you have paid $90 for it then you are already coming ahead by $20
On the other hand if you got into a bidding war and paid $110 for an asset which is worth $100 then even if the asset does exceptionally well and it grows to $120 then you are only coming ahead by $10.
I am a big believer in Tesla for instance, and I look forward to buying more and more products from them. But their stock prices and the underlying financials won't be attractive to a value investor.
In the case of Tesla stock atleast I have access to the financials and I can make an informed judgment about what the future would be and what its stock should be worth.
MKR despite coming close to equity is very hard to value. There are no comparable financials, no meaningful projections. Heck I do not know where it is incorporated (or even if it is actually incorporated). I do not know how well the team behind it is funded, what their processes are.
And to be honest, this is not an commentary on MKRs lack of transparency. They may even have posted it publicly. But it is nowhere as easily accessible as data for stocks is.
Having easier access to underlying data makes it easier to value an asset.
It is not just important to ensure that an asset is a productive asset, but also to ensure that you do not over pay for it.
And in order to not overpay for it, you need to be able to come up with a meaningful valuation for it.
And meaningful valuation can only be arrived at if you have access to all the data that is needed to make that determination.
I have no idea about whether or not MKR is a good investment or not because I cannot arrive at a meaningful valuation for it in the absence of any basis on which I can make some projections that are worth the paper they are written on.
I am a crypto and defi believer, but every single principle of investing tells me that there are no meaningful investment opportunities here.
Note that by investing I do not mean trading, or arbitrage, or collateralized lending, or even angel investing (which is accessible to select few).
I mean buying an asset that is publicly available for sale, by paying a price that is less than its value (that is determined using publicly available data) and holding it for years to come, safe in the knowledge that it is likely to do well in the most conservative of scenarios due to the fact that they create more value over time.
So what are such assets?
Real estate is an obvious one. It can be bought and sold publicly, and data for it is publicly available. Long term holding generally leads to price appreciation (if you have bought well).
However real estate is a lumpy asset.
It needs significant amounts to get in, and it is not as easy to get out.
The other asset that comes to mind is shares.
Shares unfortunately have got a bad rap in the millennial crowd. Probably because we came of age in the GFC of 2008 we are once bitten twice shy. We have been fed a steady diet of anti-establishment propaganda, and especially in the blockchain world we carry a streak of contrarianism.
These factors combined mean that a number of young people who are quite tech savvy are often not invested in stocks at all.
After careful study I have come to the conclusion that shares are basically ownership of a venture that is productive and hopefully leads to value creation for the wider public and long term wealth creation for its owners.
Data for listed stocks is publicly available and a fair value assesment can be arrived at based on it.
Retail listed stocks are open for everyone to buy and generally carry liquidity which means you can sell your shares and cash out as necessary.
Investing in stocks is a fundamentally good idea.
Getting more people to deploy their money in the share market would mean more long term wealth creation for them and it would also mean capital is also deployed efficiently so that ventures that need them have access to them.
I have many friends in the crypto space and all routinely “invest” in various tokens and coins.
They all use metamask or their own cold wallets. Logging onto a centralized custodial solution to invest their money is a big no no for them.
Tokenizing listed shares in the form of ERC20 tokens could allow these (and me) to deploy a significant amount of capital towards productive and investable assets and engage in true wealth creation.
In addition these tokenized listed shares can serve as a defi primitive. For instance a tokenized apple stock can serve as the collateral for a Maker DAI like stable coin. You would tokenize listed stocks in countries like India and create a DAI like INR tracing stable coin using these liquid stocks as collateral. Other interesting applications can be built on top of them once these assets are made composable.
Listed quality stocks are excellent collateral as they sit on the top of a wide pool of liquidity. Data about it is publicly available making it possible to arrive at plausible valuations upon which investment and liquidation decisions can be made. Apple stock alone has a greater capitalization than the entire crypto market put together. Not tapping into this is a disservice to self and the wider defi industry.
So now that we have been able to establish the case of why listed stocks should be tokenized, lets try and figure out how to tokenize them.
First the problems.
The challenge with tokenization is composability. Tokens by their very nature are expected to be non custodial. I do not think that platform hot wallet only tokens add any value to existing centralized solutions. The real magic is when you allow them to be transferable from one wallet to another wallet freely and without restrictions.
Listed stock being securities carry a ton of restrictions on who can own them, how they are transferred etc. Bearer securities have been clamped down on by most regulators world wide.
Note that the below content is not meant to be a proposal or a blueprint, but just a discussion of ideas. It is not meant to circumvent or encourage circumvention of any AML/CTF or other securities regulation. On the contrary we at Konkrete, are of the opinion that smart regulation is a necessity in the crypto space to enhance the integrity of the systems which would in turn attract more capital to the ecosystem.
However the very nature of borders based sovereign nation state regulation and the borderless, permissionless idea of tokens put them at loggerheads. Regulation as it stands is fundamentally incompatible with the long run arc of defi. Regulators need to wake up and start figuring out how best to address the coming challenge before they end up in a position of being powerless to enforce anything.
This has already happened twice before, Bitcoin and Ethereum.
2. How to tokenize listed stock?
Let's come back to our idea stage conversation about how to tokenize listed stock.
In order to tokenize listed stock, someone needs to buy the stock and lock it up and issue tokens representing that stock. These tokens can change hands any number of times and can be on demand redeemed for the actual stock.
So there should also be a mechanism to liquidate these stocks if someone wants to redeem them for tokens.
And the system should be censorship resistant, so that there is no single point of failure that would allow it to be shut down.
In essence 3 things are needed
- Ability to verify publicly that someone owns the stock they claim to hold (to enable tokenization)
- Ability to lock these stocks and publicly verify that these stocks have been locked and can be liquidated on demand as necessary
- Censorship resistance
Public verification of ownership
This part is actually easy enough to achieve. There are a number of existing online brokerage platforms that support social trading, where you can copy what other investors are doing. You have to pay for the privilege of copying their trades. The investment portfolio of such traders is publicly visible for others to verify.
Public verification of lock
Once someone has bought the shares, in order for them to tokenize them they need to be locked. This can be achieved via the process of what is commonly referred to as “Pledging”. You can pledge your shares to borrow money from a bank which takes security over them. While your shares are pledged you are unable to sell. The entity taking the security has the right to liquidate the shares in the event you do not pay back the borrowed amounts as agreed upon.
Pledging is an existing mechanism to lock shares and along with social trading is a simple way to ensure that someone actually owns a said stock and that stock is locked up and can be liquidated on demand.
Censorship resistance
While the simplest way of creating tokens is for one custodian or broker to hold the shares in custody for the token holders, it creates a single point of failure. USDC for all its claims of being regulated etc is actually a far more unsafe way to hold tokenized funds than even Tether. Tether claims to be a custodial system with fiat held in reserves. While there is a good chance that Tether is actually a scam, unlike USDC their accounts cannot be seized by the regulators for the simple reason they do not publish where the money is held.
While this is a pretty unscrupulous mechanism, it creates more censorship resistance than USDC which has to tell the regulators exactly where the money is being held. This single point of failure makes USDC more unsafe as it is at the mercy of the regulatory bodies and we are at the mercy of USDC operators.
Tokenization is only meaningful if it incorporates censorship resistance. It should not be possible to seize your tokenized shares from you against your will.
The way to achieve that is to make it possible for anyone to tokenize their shares rather than just one entity. And it should be possible to verify that the tokenized shares represent an equal amount of pledged stock without actually making it public which specific holders are the ones who have tokenized their stock.
This can be achieved via a combination of Zero Knowledge proofs and Shamir secret sharing mechanisms.
We will publish a detailed article describing this mechanism in the next few days.
