Digital Dives
In the last Digital Dives, we looked at the promise of using blockchain technology to bring liquidity to alternative investments. Finance executives broadly believe that tokenizing assets could transform the industry for the better because creating an ecosystem where illiquid holdings can be traded freely on a secondary market has potential to offer faster and cheaper transactions, more transparency, and greater accessibility, while generally lowering the cost of capital. Since developed markets and traditional investments already enjoy many of these benefits, it’s likely that we’ll see tokenization first succeed in underserved speculative assets and emerging jurisdictions.
The most important obstacle to a sweeping tokenization trend is regulatory clarity. Network effects are critical to unlocking the gains from providing liquidity to assets that don’t already have secondary trading. The value accrual across the system grows as the number of participants increases. To reach its potential, tokenizing investments requires cross-border cooperation among regulators, while today policymakers can’t even agree on domestic oversight of digital assets. Further, the technologies to create, manage and secure tokenization are relatively nascent. Hence there is a need for infrastructure to bridge digitized assets with legacy systems to ensure their smooth onboarding and management.
The authors of An Unreal Primer on Real-World Assets, believe that the supply side of the market will come more easily. Consider esoteric loans like emerging market consumer finance, factoring, or legal settlement advances. These assets tend to be illiquid and more speculative in nature, but they also offer attractive returns and potential diversification benefits. Originators of these credits are naturally open to new sources of cheap capital because their business model is grounded in the ability to borrow relatively inexpensively and lend at a premium. However, they’re also balance sheet constrained, so it’s often preferable to sell the assets at a gain and recycle the proceeds into fresh loans, compounding the lender’s growth faster.
On the other side of the market, we have the folks who oversee credit funds. These vehicles invest most of their holdings in the more liquid segments of the market like corporates, mortgage-backed securities, or collateralized loan agreements, allowing the manager to adjust his/her positioning according to economic conditions and satisfy capital redemptions. However, this profession gets rewarded for outperformance, so to gain an edge, managers will often have smaller allocations to speculative assets, including the unconventional loans described above. Dabbling in these niche areas of the market requires specialized knowledge and it takes time to evaluate the prospects. However, such efforts are reasonable in the pursuit of outperformance and many groups are happy to go the extra distance. Another important feature of these atypical investments is that deal flow is sporadic, and relationship based, which makes it difficult for many to get meaningful exposure.
We can see that asset managers are used to pushing boundaries to gain an advantage. Therefore, this segment seems likely to be one of the first to adopt tokenized assets (assuming they can do so legally). The fact that such holdings require an additional layer of due diligence and complicated custody is offset by differentiation, higher return potential, and prospect of liquidity.
Adding to the demand side are several crypto-native groups who want to gather yield from real-world assets (RWAs) and represent those income streams on-chain. Goldfinch, Centrifuge/Tinlake and Ondo have tokenized hundreds of millions of dollars worth of real-world assets to bring new sources of return to DeFi. These are tiny sums in the context of the greater financial system, but this might be something to watch as DeFi seeks a catalyst to kick off another bull run.
Dropping some “hot alpha”, the authors of the Unreal Primer believe that an important narrative in 2023 will be fintechs incubating their own tokenization platforms to bring liquidity to the financial assets generated by their platforms. Companies who provide embedded credit, SaaS revenue loans, or even supply chain finance are natural originators of real-world assets. However, they’re relatively capital constrained, so being able to get the loans off their books is important for growth. They could sell the borrowings to someone like Centrifuge, but then they’d lose sight of their journey thereafter and as such could be missing out on valuable insights. These fintechs tend to be digitally native and data driven, so it might make sense for them to design protocols which can be attached to their origination, underwriting and servicing arms. Here’s why they think Flexport will be first to market:
Traditional finance houses have run tokenization experiments, but so far, they’ve mostly focused on already liquid markets like foreign exchange and fixed income. However, some asset managers like KKR and Hamilton Lane have tokenized their private equity funds on public blockchains, unlocking liquidity and expanding the universe of investors by reducing the minimum investment threshold. It’s worth noting that Securitize will still act as a central party to confirm that purchasers of the fund are accredited.
Back in April 2021, the European Investment Bank issued and settled its first-ever digital bond on the Ethereum network. Interestingly, the EIB was back at it again a couple weeks ago, but this time they used Goldman Sachs’ tokenisation platform – GS DAP. It might be that the EIB switched to a private blockchain after catching some flack for using the pre-merge Ethereum, but I think it’s indicative of a trend whereby TradFi operators will conduct their experiments using permissioned or private environments. Once the financial institutions have gained comfort moving their operations on-chain, then perhaps they’ll launch products/services on the public networks to capture a larger audience. We don’t have much insight into each bank’s strategy, but this is exactly the sequence that JP Morgan’s Christine Moy outlines in this conversation (25 min mark, but the whole thing is good) and what Goldman describes as well:
The idea of private distributed ledgers has been criticized in the past, but they make a lot of sense for the heavily regulated financial industry. Banks can leverage (and contribute) open-source code already on GitHub to speed along their proof-of-concepts, which can be used to gain policymaker buy-in and eventually some protocols can be rolled out publicly.
As Luke Brereton and Nitin Gaur from State Street’s digital asset group discuss, we see a similar set-up in the ETF landscape where only Authorized Participants have permission to create/redeem fund units. This is conceivably due to the required size of the trade blocks and technology required to monitor/execute, but also due to trust and to avoid spam requests coming from random sources. That said, anyone with a discount brokerage account and capital can buy the ETF.
To most of the DeFi community, the situation I just described would trigger a gag reflex. It’s not necessarily the outcome I’d push for If I Ruled the World, but taking stock of where we’re at, it seems like a probable and reasonable path towards a more open and permissionless system. Incumbent financial institutions have the balance sheets and customer bases to justify investing in the space at scale, while many crypto-native groups remain stunned by this year’s events and hungover off too much leverage.
Tons of smart people will continue to build creative applications and infrastructure for the public chains and barring some serious overreach from the regulators, that space will thrive based on the engagement from social apps, games, and DeFi. However, I think that early iterations of global finance on the blockchain at institutional scale will be somewhat gated. If the digital asset incumbents want a seat at that table, then there will be a myriad of collaboration opportunities ahead.
This is the last edition of Digital Dives in 2022. I wish you and your families a delightful holiday season. Here’s to a 2023 turnaround! 🍻
