CONCEPTS, TERMS, DEFINITIONS WHICH REPRESENT OUR THINKING ABOUT OUR MARKET
- ASSET OWNERSHIP, PERFORMANCE, & VALUATION
- PRIVATE ASSET VALUATION AND ITS DATA
- TOKENIZATION OF OWNERSHIP
- SECURITY TOKENS (3RD GENERATION DLT)
- DLT BENEFITS FOR CAPITAL MARKETS
- DLT BENEFITS FOR FINANCIAL INSTRUMENTS & REAL ESTATE
- DLT BENEFITS FOR OWNERS OF ILLIQUID ASSETS
- PUBLIC SECURITIES: DATA AND TRUST FACILITATE EFFICIENT MARKETS
- PRIVATE SECURITIES: INADEQUATE DATA AND TRUST BURDEN PARTICIPANTS
- OPPORTUNITIES DATA-RICH, SELDOM-TRADED ASSETS
ASSET OWNERSHIP, PERFORMANCE, & VALUATION
Evidence of Ownership for Private Assets Asset ownership requires evidence. While various methods exist to evidence ownership, most assets with high-value require registered or attested data to prove ownership.
Physical Possession is the oldest and simplest evidence. The old adage was “Possession is 9/10ths of the law” and expressed the practical reality that physical control was nearly-always sufficient as proof of ownership. Sometimes chain-of-possession is documented through receipts and bills of sale.
Central Registration allowed governments to validate (and tax) higher-value and financial assets via an official ledger. Developed economies adopted this in the recent 400 years and extended it across many asset types:
- Real Estate
- Financial assets (cap tables and liens)
- Intellectual property (trademarks, copyright, patents, and domain names)
Distributed Ledger Technology (DLT), is a recent innovation that spreads the job of asset registration across a network of computer participants. Rather than rely on a central authority, DLT relies on published rules and various proofs compared between peers. A final determination of ownership is made via consensus (a published vote).
PRIVATE ASSET VALUATION AND ITS DATA
Asset valuation requires evidence. This evidence can be recorded and shared as data.Physical Condition is the oldest and simplest evidence: Looking a horse in the mouth, to judge age from tooth-wear. Costs—such as manufacture, book, purchase, or replacement costs, etc.–are also commonly-used evidence of value for private assets. Earning Power (Cash flows)—entitlement to and certainty of future cash flows—predominate in most transactions for financial and real estate assets. Market Price—an agreed price by the most recent buyer and seller in an arm’s length (impartial) transaction for a specific asset or lot and assigned to all identical-fungible assets of the same type. Market Price of Comparables & Substitutes—when near-identical and similarly-useful items (or a “basket” of them) are used to price. Modeled (Agreed-Upon) Prices—a model incorporating all the above, calculated in a published procedure by a trusted intermediary or third party. Data As Evidence Of Both Ownership And Value. Public markets have long attached evidence of value—disclosed data such as periodic financial reporting and other disclosures—to evidence of ownership (equity and bond holdings), and often to unique identifiers (Ticker symbol, CUSIP, ISIN, FIGI, etc.). Distributed Ledger Technology is a new way for Private Markets to deliver the trust and the data that was previously only available in Public Markets.
» » MORE INFORMATION: 03/30/20
TOKENIZATION OF OWNERSHIP
DLT as Evidence of Ownership and Transfer. Distributed Ledgers rely on blockchains to maintain a record of ownership (a wallet or account) that is capable of holding a value and governing how wallet holders can transfer value among themselves. The first blockchain the Bitcoin cryptocurrency, specifies how (a) all Bitcoin accounts and balances are maintained on that blockchain and (b) bitcoin accounts can transfer their bitcoins to other accounts.
DLT Smart Contracts. A second generation of DLT, e.g. Ethereum cryptocurrency, introduced a method that initiates transfers automatically. Ethereum calls these automatic methods Smart Contracts and defines them in the ERC20 standard. Smart Contracts need not be particularly smart and aren’t even technically contracts: they are simply computer code governing a token and are potentially as simple as an “if-then” statement.Because second-generation blockchains are capable of being used according to a smart contract (rather than simply held or transferred) they are also called Utility Tokens. In addition to Ethereum, examples of Utility Tokens include the Ripple, EOS, and Binance tokens. Tokenization: Smart Contracts as Evidence of Ownership. Tokenization is the process of converting the financial claims conferred by a financial asset into a digital token on a blockchain (O’Meara, Shotton, & Swart, Introducing the Tokenization Of The Global Debt Markets, 2018). With second generation blockchain technology, a token could represent not only the underlying fixed-income security but also its associated data, covenants, terms and conditions. Inveniam Capital calls this combination of digital ownership and ongoing/underlying data a Digital Financial Instrument (DFI). The DFI is a “next generation certificate” enabling the certification of the underlying debt (or equity) instrument along with its frictionless, almost instantaneous trading and settlement, dramatically enhancing the transactional efficiency of these markets.
SECURITY TOKENS (3RD GENERATION DLT)
Security Tokens is a term applied to a promoted third generation of DLT purpose-built for specifying the ownership and performance of financial assets. Inveniam Capital believes that ERC20 tokens are sufficient for most DFI applications but is prepared to support any Security Token capable of delivering the reduced transaction costs, cross-border settlement, and enhanced automation (lower legal-regulatory burdens) for which Security Tokens are being promoted.
DLT BENEFITS FOR CAPITAL MARKETS
Benefits: Capital Markets Inefficiencies Addressed by DLT. In his 2015 annual letter to shareholders, JP Morgan Chase CEO, Jamie Dimon, presaged that, “Silicon Valley is Coming [bringing technologies that will compete directly with the likes of JP Morgan Chase]. There are hundreds of startups with a lot of brains and money working on various alternatives to traditional banking.” Technological solutions will convert every operational inefficiency into a new profit center.
» » MORE INFORMATION: 03/24/20
Benefits: Replacing Paper (Physical Settlement). In few domains are the available profits greater or the inefficiencies more pronounced than in the current functioning of capital markets. Protocols requiring the creation and moving of paper certificates still persist, and the clearing and settling of trades still can take not minutes or hours, but days! In the industry whose raison d’être is the time value of money, it is a certainty that these points of transactional friction will be eliminated.
Benefits: Disintermediation. It is a near certainty that the agent for this increased efficiency will be DLTs. The most salient innovation of blockchain technology to capital markets is that it allows for the disintermediation of transactions that until recently necessarily required structural intermediaries such as formal exchanges, broker-dealers, and clearing agents.The initial attraction of blockchain technologies à la Bitcoin was the anonymity it provided its users in bilateral transactions. This benefit will continue to appeal to those who operate in grey and black markets, and for that reason it is this very feature that has raised the concerns of regulatory and tax regimes worldwide.
DLT BENEFITS FOR FINANCIAL INSTRUMENTS & REAL ESTATE
DLT Benefits for Financial Instruments (and Real Estate) which lack Public Market Data and TrustThe real value of blockchain technologies in the financial arena is their ability to facilitate efficient disintermediated markets with an indefinite number of buyers and sellers who will be able to use it to frictionlessly trade, clear, and custody their financial instruments. Because the trading (as opposed to clearing) of public equities has already become very efficient with the advent of the NASDAQ and the subsequent rise of SEC-permitted alternative trading systems such as electronic communication networks (ECNs), the need for DLTs in these markets is less acute. Real Estate and private fixed-income markets, on the other hand, enjoy no such infrastructure and will be utterly transformed once issuers begin to “tokenize” their real estate holdings and debt (Tapscott, 2016).
DLT BENEFITS FOR OWNERS OF ILLIQUID ASSETS
Illiquidity Burdens Addressed by DLT. The transparency provided by DLT’s connection of data to ownership can address several of the burdens that illiquidity imposes on assets, such as:
- Lower asset values
- Higher borrowing costs
- Disadvantageous “Level 3” accounting treatment (under ASC 820 / FASB 157 for USA GAAP and IFRS 13 in International Financial Reporting Standards)
- Computed discounts on asset value that may totally disallow consideration of an owner’s equity when computing capital reserves under the Basel III
» » MORE INFORMATION: 03/25/20
PUBLIC SECURITIES: DATA AND TRUST FACILITATE EFFICIENT MARKETS
Public markets have done a progressively-better job at making public securities (equities and bonds) data-rich:
- Data: requiring public disclosure of material data, and standardized reporting of financial data (ASC & IFRS)
- Trust: disclosures are made in a regulated or legal context which can impose financial or criminal penalties for fraud, perjury, and other intentional or systematic inaccuracies.
» » MORE INFORMATION: 03/27/20
PRIVATE SECURITIES: INADEQUATE DATA AND TRUST BURDEN PARTICIPANTS
Even where the underlying asset, such as real estate, is potentially trustworthy and data-rich, without a mechanism of notarizing, validating, and modeling data, private markets burden their participants:
- Asset owners receive lower asset values
- Borrowers pay higher borrowing costs
- Investors (Lenders) demand and receive higher returns, but still suffer illiquidity (lack of a secondary market)
- Fractionalization: Breaking large assets into smaller shares
» » MORE INFORMATION: 03/27/20
OPPORTUNITIES DATA-RICH, SELDOM-TRADED ASSETS
Public-Quality Data and Trust for Private Assets. Distributed Ledger Technology has the potential to deliver data and trust to private assets that is comparable to what public assets enjoy today.Specifically, DLT can:
- Capture data, allowing it to be stored “off- chain” but maintaining distributed ledger entries as to its source and ownership.
- Notarize data (confirm authorship and date) using the same cryptographic techniques that give cryptocurrencies their name. Once captured and notarized, data can be validated. Similar to calling multiple witnesses in a court trial, the facts asserted by a single witness can be validated by collecting more evidence and comparing the implications.
- Historical performance (autocorrelation of a data stream).
- Peer-set performance (statistical validation).
- Contemporaneous data (cross-validation of data).
Real estate assets, particularly Smart Buildings, have the potential to be data-rich and for their data sources to be validated against each other.
» » MORE INFORMATION: 03/26/20
Pricing for Private Assets (Real Estate). Mark-to-model is a pricing method for specific assets or securities based on internal assumptions or financial models. Pricing models rely on inputs of:
- Sufficient, trustworthy asset-specific data
- Reliable recent transaction prices for similar assets
- Observations of applicable interest rates, default rates, and yield curves
Asset, transaction, and rate data are combined in an Agreed Upon Procedure (AUP) typically undertaken by an auditor, trustee or other fiduciary.