Created on: Aug 31 2017 | Last change: Aug 31 2017

Traditional Asset Tokenization

Tokenization of traditional assets in the coming years will have an impact on liquidity across multiple asset classes. The implications of this statement are relevant to all investors, including both traditional and crypto, for reasons I detail in this post.

I. Liquidity: The driving force behind traditional asset tokenization

Let’s start by defining liquidity. Liquidity is not binary, it is a continuum. Illiquid does not necessarily mean “unable to trade,” it means “costly to trade.” Liquidity is related to trading volume and can be measured using price impact from trading, or by observing the bid-ask spread.

An example: When I was a kid I found a Darryl Strawberry rookie card in a pack of Topps. By the late 1980’s, Beckett Monthly listed the value at something like $50.

Darryl Strawberry rookie card

Upon opening my Beckett Monthly, I thought: “That’s 100 Snickers bars!” I was ten years old so 100 Snickers bars had a lot of utility value to me back then. I wanted to trade.

I marched over to my local card shop, presented the card to Calvin, the owner, and requested $50. Calvin offered me $10. Sadly, that was the only card shop within walking distance, and I had binding transportation constraints since I was only 10. Calvin represented the only market participant. I accepted $10. This is the “bid” in financial jargon. Calvin then put it on the shelf with a $50 price tag (the “ask”). This is an example of a very large bid-ask spread, therefore, the Darryl Strawberry rookie card is considered a relatively illiquid asset.

The advent of sites like eBay made life a lot better for baseball card traders because it opened up competitive markets with more participants and volume, and assets could be bought and sold with smaller spreads and less price impact. All things equal, additional liquidity increases the expected value from trade.

This post is not about baseball cards, so let’s extend this framework to think about other assets like equity in private companies. A share of stock that’s traded on an exchange is of higher value than a share of stock in an identical private company because there are less frictions to trade the public stock. Less frictions often mean more market participants, more volume, smaller spreads, and less price impact. We think of the difference in value between the public company and identical private company as an “illiquidity discount,” or analogously a “liquidity premium.”

How big is the illiquidity discount? Financial economists have attempted to measure the illiquidity discount in a variety of ways. A common rule of thumb is 20–30%. This represents a huge amount of value and therein lies great promise. Tokenizing relatively illiquid assets and creating a market in which to trade these tokens can reduce the illiquidity discount substantially by reducing frictions to trade. Traditional assets will tokenize because they will lose the liquidity premium if they don’t.

II. Traditional asset token use cases

29/ Blockchains port the market model into places where it couldn't go before.

This tweet by @naval is profound and extends well beyond traditional asset tokenization. However, it certainly applies to all the assets currently characterized by low liquidity that will get tokenized in the future. Let’s briefly unpack a couple of these.

Blockchain Capital as an example of traditional asset tokenization. Typically, investors in venture capital (VC) funds, known as limited partners (LPs), are locked up for 10 years, and for good reason: VC funds invest in illiquid securities and cannot fulfill redemption requests in the interim. In so doing, the liquidity premium is a component of VC returns.

There are often fund-level restrictions that prevent LP investors from trading their positions and VCs have historically not gone out of their way to facilitate trade for their LPs. Blockchain Capital has demonstrated that this model can be disrupted. They executed a portion of the fundraising for their recent VC fund by issuing a blockchain token (BCAP). In doing so, the fund receives the capital they need to invest in illiquid securities, yet investors can exit prior to 10 years selling the token to another investor. Importantly, this liquidity does not require a redemption on the part of the fund. Furthermore, since tokens are highly divisible, it eliminates the need for minimum investments. Blockchain facilitates trade in the secondary market.

Consider commercial real estate. Publicly listed Real Estate Investment Trusts (REITs) provide some liquidity, but they are expensive to set up and typically hold a basket of properties rather than a single building. Furthermore, REITs are typically buy and hold vehicles, so most investors are shut out of development projects entirely unless they can meet minimums which are often on the order of $25k and higher. One day you might be able to buy $10 of a single commercial real estate asset like the Empire State Building, or invest $100 in the development of a LEED-certified housing project. Real estate focused token exchanges will increase liquidity for asset owners. Real estate appraisers will become more like equity analysts, because the market value of any building will be readily apparent if the token is trading. Tokenization will make IRS 1031 exchanges easy.

Consider residential real estate. Perhaps funding models will emerge where you can tokenize your house instead of taking out a traditional mortgage. Instead of making mortgage payments, you will make payments to the network of token holders. I will not pretend to know exactly what this might look like, but I think we will see some version of this in the coming years.

Fine art will get tokenized. Perhaps small donors will collectively acquire a Picasso for their local museum through a token sale even though none of them possess the resources to acquire the painting individually. The difference between this and current crowdfunding models is that the token holders can retain fractional ownership. Charitable donations will evolve towards charitable investments. Token governance mechanisms will evolve to enable granting usage rights rather than cash flows.

These and many other assets that are costly to trade will be tokenized and become more liquid. Vacation timeshares come to mind. The lines between token exchanges and traditional exchanges will blur. Most electronic exchanges will trade tokens because most assets will be tokenized.

III. Challenges for traditional asset tokenization

Regulatory: Although there are early efforts in progress (e.g. digix for gold and rex for real estate), mass adoption of traditional asset tokenization is going to take years, and possibly decades, to fully develop. Technology evolves quickly, but regulation does not. Traditional asset tokenization represents one of the greatest opportunities, and greatest challenges, that the SEC and other global regulatory agencies will face over the next decade.

Governance: If one entity owns a building they have the incentive to monitor things like maintenance and timely lease payments. If 10,000 people own the same building then it may be the case that no owner has the incentive to monitor, because the cost of monitoring exceeds the value of their investment. Solutions will need to come to market that enable governance of widely held tokenized assets. Financial economists have spent a lot of time thinking about the separation of ownership and control and will be able to help design these solutions.

Thinly traded tokens: Let’s be very clear about this one: the mere act of token generation to represent ownership claims on a traditional asset does not impact liquidity in and of itself. If a token is thinly traded it is still relatively illiquid. Improvement in liquidity comes from increases in market depth, meaning more participants and more trade. The reason tokenization improves liquidity is because it enables deeper markets. Since tokens are highly divisible and global, the potential number of market participants is substantially higher than what we see today in markets for illiquid assets.

Status Quo: Tokenization of traditional assets will cause disruption to the status quo. Some systems that are in place today may not work the same way in the blockchain world (e.g. equity securities lending). That doesn’t mean the blockchain world isn’t coming, it means the current systems will have to evolve. The challenge is that there are stakeholders that benefit from the status quo. These constituencies have incentives to resist change, and they will do what they can to slow down adoption. I view this as a speed bump rather than a barrier.

IV. Impact of traditional asset tokenization on protocol tokens

As Nick Tomaino mentioned in a recent post, traditional asset tokens are less common and perhaps less interesting than protocol tokens. I agree with this sentiment. However, traditional assets currently represent aggregate market value that is orders of magnitude greater than cryptoassets. As they tokenize I believe that there will be crossover effects that are relevant to protocol tokens.

Consider the market sizes of low liquidity assets. Global real estate value was recently estimated at $217 trillion. Roughly 25% of that total, $54 trillion, is commercial. For arguments sake, let’s say a 10% liquidity premium would be applied to these assets if they were tokenized and could be traded freely. That’s over $5 trillion, or put another way, the illiquidity discount on global commercial real estate is about 40–50x the aggregate value of all cryptoassets as of this writing. These are big markets. Will tokens eat the whole market? Of course not, but they will eat some, and as time goes on the bites will get bigger and bigger. These tokens will become embedded within the larger ecosystem of cryptoassets. Traditional asset tokenization is going to impact protocol valuation because they will become intertwined.

If traditional asset tokenization occurs on top of an existing crypto protocol (e.g. ERC20 tokens), this will influence value of the underlying blockchain network. Further, traditional asset tokenization enables protocol tokens to be used as a method of payment in both directions. For example, perhaps dividends/lease payments/coupon payments are paid out in ETH or BTC. This will drive demand for the protocol tokens and influence valuation. Finally, there will be a demand for governance protocols within traditional asset tokens, giving rise to platforms like Tezos. This will have valuation implications. Crypto investors would be wise to watch these developments, even if they don’t intend to invest directly in this asset class.

It will be fascinating to watch this develop. As the world’s assets become increasingly liquid, the concept of ownership will evolve in ways we cannot yet imagine.