How Security Tokens Can Prevent an Impending Financial Crisis
An in-depth view into security tokens.
Many economists argue that the root causes of the 2008 global financial crisis have yet to be addressed comprehensively, or that measures taken have been exhausted, such as the extent to which quantitative easing was used, which has been put forward by the deputy director of the International Monetary Fund (IMF).
Some argue that the efforts to address the causes of the crisis have actually made the system more — rather than less — susceptible to a catastrophic collapse. On the heels of the recent yield curve inversion, finding new solutions that address the causes of the 2008 crisis are more important than ever. The yield curve inversion, an 18-month leading indicator of looming liquidity challenges, has proceeded every major recession since the 1970s, including the global financial crisis of 2008.
The time to pursue new approaches to mitigate liquidity events is now. An investigation of the systemic weaknesses that led to the crisis points to the promise of a new financial instrument that has entered the market — tokenized securities. The liquidity benefits of these instruments derived from the strengths of blockchain and distributed ledger technology suggest that a new approach is possible to aid in preventing and addressing a repeat (or worse) of the 2008 downturn.
While the driving forces that produced the toxic instruments that were at the center of crisis remain a fiercely debated issue, there is consensus on the structural weaknesses that led to the systemic spread of their collapse. Regarding the forces that produced the toxic instruments, some claim that deregulation caused the rise of flawed residential mortgage-backed security (RMBS) portfolios, while others point to overreaching government policies that drove lenders to issue subprime mortgages.
Even with these differences, all sides agree the crisis was, at its core, an issue of transparency in the performance of the RMBS portfolios and the lack of liquidity of interests in these massive issuances.
Political and regulatory solutions of various sorts have been proposed and tried, but the time has come for another approach, one that recognizes the powerful advances in distributed ledger technology to help address these issues of transparency and liquidity. There is one technology that truly enables both: security tokens.
Security tokens serve as digital representations of any other tradable financial asset, including equity shares of companies, interests in funds, contracts entitled to a specific slice of future revenue streams, ownership of intellectual property, fractional ownership of real estate and other physical assets, and derivatives themselves. Security tokens can be regulated and effectively managed, making it easy to form capital and setting the stage for a reformed financial service infrastructure. After the experiment with initial coin offerings (ICOs) and utility tokens, the security token offering (STO), private placement offerings and how they are traded on exchanges is being done in a legal way, complying with existing regulations by the authorities in each jurisdiction in which they operate — including existing United States regulations from the 1930s.
With the yield curve inversion coupled with recent downturns and corrections in the stock market, fears of a building crisis are mounting. Many armchair economists predict an economic downturn is a certainty every seven to 10 years. As we reflect on the 10-year anniversary of the 2008 crisis and try to understand the disruption to global supply chains in a new environment of trade wars, it is important to analyze the fundamental problems that led us down this path of economic turmoil and why security tokens can help stave off future financial disasters.
The beginning of the end
By September 2008, the $2 trillion RMBS market collapsed and sent a ripple through the balance sheets of most major financial institutions in the U.S. and abroad. This resulted in a global crisis of liquidity, as both debt and equity markets froze. At the eye of the storm was the bankruptcy of Lehman Brothers, which delivered subprime residential mortgages with seemingly reckless abandon. As loan default rates rose, RMBS portfolios were under increased pressure. This led to the U.S. government issuing the Troubled Asset Relief Program (TARP) — a $700 billion bailout to purchase distressed assets that yielded limited results — and the United Kingdom government’s $850 billion bank rescue package.
While the catalyst for this prevalence of bad loans is still up for debate, many agree that a potent cocktail of inefficiencies turned what should have been a salvageable market correction into a full-scale crisis. For one, credit rating agencies lacked effective models to rate risk after issuance and lacked objectivity in establishing ratings. Investors relied on these misguided ratings and continued to pump money into portfolios despite their eroding fundamentals. Lack of transparency and inefficient secondary markets made it difficult to price and expensive to sell these assets on the market. As a result, institutions were stuck with these assets and eventually collapsed under their own weight.
Another fundamental issue that led to the crisis — and has yet to be addressed by regulatory reform such as the G-20 coordinated reduction in interest rates and a $5 trillion expansion in April 2009, as well as developing concepts like the Volcker rule in the U.S. and ring-fencing in Europe — is the “too big to fail” nature of the offerings and players themselves.
The barriers of entry to securitization markets drove the centralization of issuances to astronomical heights, as a few participants came to dominate the market. The combination of closed circles and high costs of issuance ran securitized portfolios into the billions and caused a domino effect upon failure. In addition, a lack of liquidity in private securities markets made it difficult to rebalance or break up portfolios by selling smaller positions to a wider pool of potential buyers — or even by selling individual assets.
Coupling this with the significant leverage financial institutions were taking on, they reduced their ability to absorb loss, sending ripples globally. Sometimes, the unintended consequences of regulation are more damaging than the value proposition of that legislation.
Unfortunately, the issues behind this crisis remain in play and require a solution that addresses these deeply ingrained inefficiencies. If this goes unresolved, a complete financial collapse is no longer a matter of if, but when.
The next phase
To combat the issues that led to the 2008 global financial crisis, the adoption of security tokens becomes mission-critical. Many analysts predict that the majority of financial products will one day be traded on the blockchain as security tokens, with programmable smart contracts — and for good reason: Only security tokens can bring greater transparency, oversight, access and liquidity to the market.
This begs the question: Why are security tokens not more prevalent in institutional markets? In short, it’s a matter of skepticism born of misunderstanding and a lack of education. The cryptocurrency market most recognizable to the general public is one that consists of assets like bitcoin, which are exchanged principally for their speculative market value and lack tangible underlying value.
The historical volatility and current state of the cryptocurrencies market certainly does not help the situation: 2018 is considered the worst year yet for cryptocurrencies by market cap, as the market plummeted from $800 billion in January 2018 to approximately $121 billion in December.
Complicating matters is the mistaken conflation of ICOs with true security tokens. After a barrage of ICOs left investors reeling from poor performance, data leaks and stolen funds, the public has rightfully grown skeptical of nondilutive assets sold to retail buyers and traded mainly by speculators. Another misleading factor is that many in the cryptocurrency space are wrongfully promoting security token offerings as ICOs with a veneer of compliance. Areas such as custody, insurance, risk and especially governance become center stage.
The reality is that security tokens provide the benefits of liquidity and transparency while resolving the challenges of their blockchain-based predecessors by embracing compliance, protecting privacy while shunning anonymity and automating regulatory reporting. Even more profoundly, tokenized securities can provide the basis for a reformed financial service infrastructure that addresses each of the structural weaknesses that led to the global financial crisis. Here are the chief benefits of security tokens and the issues they help modify:
- Portfolio transparency: Unlike the 2008 RMBS portfolios, security token offerings provide investors with direct, real-time software driven access to portfolios and underlying financial assets. Investors can make their own assessments regarding portfolio performance, allowing the market to play out naturally as conditions change. Furthermore, these securities exist on blockchain and provide a transparent, immutable record of transactions, preventing issuers from “cooking the books.” Token holders are given the ability to manage their portfolios via direct access to transaction records that cannot be altered. Transparent record-keeping of transactions, investments, portfolio performance and origin of the assets every step of the way (you can look inside that cleverly structured security). Clarity around how more complex instruments have been pooled, broken up into tranches, rated — and by whom and when — directly for both the investor and the regulator, who are able to track the lifecycle of the asset, security or financial instrument.
- Decentralized ratings: As a result of the transparency of security tokens, many entities are emerging with competing technologies to rate the value and viability of offerings in the security token industry. This trend combats the massive trust issues created from the easy manipulation of ratings in the traditional financial sector. This “decentralized analysis” also provides the basis for innovative new models to rate offerings in real time and employ advanced techniques, such as machine learning.
- Efficient, objective pricing: As the STO market matures and institutional adoption broadens, stronger security token offerings backed by high grade investment offerings will enter the market. STO platforms will provide convenient models for access, trading and monetization. Market makers and other tools offered by these platforms will improve buying and selling opportunities, even with minimal market participants. This, in turn, provides efficient, market-based pricing for almost all tokenized assets.
- Elimination of “too big to fail” offerings: Security token platforms provide streamlined compliance models and easy access to secondary markets. These capabilities promise to substantially reduce the costs of capital formation, creates a lower barrier to entry for all securities offerings and encourages innovation — leading to more investment choices and opportunities for diversification.
- Liquidity at all market levels: Security token platforms provide seamless market access and dramatically reduce the cost of compliance and reporting. Accordingly, assets of any size can be brought to market and, in some cases, can be made available to the masses in a more scalable and inclusive way. Both institutional and retail investors will soon have the ability to efficiently monetize their investment interests, rebalance their portfolios and access opportunities that were previously only available to narrow circles. Furthermore, streamlining cross-border liquidity through global interconnected secondary exchanges that leverage instant settlement and atomic swaps allow for enhanced operational utility and access to broader liquidity pools. Previously, there was a total lack of liquidity and the unequitable secondary market that has emerged with retail investors being completely locked out of owning stock in Facebook, Uber, Palantir and other trophy assets prior to their IPOs, but only after achieving $70 billion+ valuations. One could argue the same about commercial real estate, which STOs will open up as an asset class to the public of single property REITs without diversified REITs. At a $120 billion valuation, Uber would be valued at more than double the average of companies in the Nasdaq 100 Index on a price-to-2018 sales basis. It gives the ride-hailing company a multiple of about 12 times, compared with an average of 4.8 times for the index. This is an illustration of the total failure of the current bulge bracket Wall Street IPO system. STOs could be the best answer to address this while complying with legislation written in the 1930s.
- Control: Retail and institutional investors have greater control over the management of their assets through transparency, direct access and further empowerment to control the parameters of their investment portfolio. This, coupled with streamlined compliance frameworks and interconnected secondary markets, allows for more effective market making that promotes cross-border liquidity at a range of levels.
- Access: Many more readily accessible investment opportunities at primary issuance and in secondary markets on both the issuance, investment and trading sides, reduce costs of both primary issuances, the barrier to entry for boutique investment banks, cross-border offerings and their trading through globally connected secondary market exchanges and to realize untapped liquidity pools from the private securities markets, which provides for more novel opportunities to both diversify and hedge risk related to portfolios and avoid correlated pooled investments. The cost of completing an IPO in the U.S. is simply prohibitive and ongoing compliance does not make economic sense for a world of Mittelstand companies ignored by today’s financial systems.
- Compliance: Real-time regulatory reporting on cash flow, allows discrepancies and risks to be identified well ahead of time so that measures are taken by central bankers, policy makers and regulators to counteract any stresses to the financial system through monetary policy. Albeit this is more an application of DLT, broadly speaking, the use of security tokens better enables the process. Moreover, from a compliance standpoint, the underlying independently audited code of the security tokens can reflect the regulatory structures and regimes, and, in that way, are smart. They are coded to autonomously comply with the relevant regulations and laws, can be recalled, tracked and traced, all the while with compliance built directly into the security token itself.
- New assets: The emergence of new financial instrument vehicles such as contingent capital in token form, which are essentially IOUs that imitate bonds and generate a return until maturity — when the principal is repaid and can convert into loss-absorbing equity — will reduce the lag time in needing to quickly and effectively pivot to absorb market shocks. Such derivative and creative securities should only be executed in a programmed software and immutable manner.
Adoption of security tokens is more vital now than ever. In recent weeks, part of the U.S. Treasury’s yield curve inverted, strongly indicating that a recession is on the way. The last time this occurred was June 2007 and served as a precursor to the crisis of 2008.
Luckily, the Nasdaq predicts that 2019 will be the year of the STO, as regulators in global markets are setting the stage for adoption and working toward creating stable regulatory environments. Hopefully, these measures serve as a positive harbinger of things to come and provide a vital tool as the U.S. and other jurisdictions try to navigate toward safer financial waters in 2019 and beyond.
In short, this is an important turning point where we have to decide if we want to seize the opportunity to rewrite the rules of the financial system with new DLT-based and DLT-compatible infrastructure for the creation of security tokens to make it more resilient, sustainable and safe in order to make sure history does not repeat itself.
The article is co-written by Dan Doney, Andrew Romans and Hazem Danny Al Nakib.
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