Qiao Wang, part of the founding team at Messari recently wrote this on Twitter:
We don’t think Qiao is wrong, in fact we at Apollo generally agree with the view presented here, with the exception of governance. There is significant, and growing value in owning a stake in the governance of a crypto network. 0x, Decred, and Maker are three examples in our portfolio of tokens that derive at least some of their value from governance.
This post will look at at the second category Qiao Wang listed above, namely tokens that give right to cash flow.
By security tokens, we do not mean future utility tokens are issued by a central entity prior to network launch. Note that since the SEC announced that all ICOs they have looked at are securities — many ICOs are structured as securities. The vast majority of these however look to be converted to utility tokens at a later date when the network is live.
Tokens that give right to cash flow
Cash flow to a security token can come in two forms, either as a native digital asset or an off-chain ‘traditional’ asset. I will call these categories Tokenised Securities and Blockchain Native Security Tokens respectively. Let’s start with the former.
Some of the potential benefits include:
Illiquid assets — like VC interest, hedge fund interest, real estate etc can become liquid
Lower issuance cost, i.e. fundraise at much lower cost
Global markets could become accessible with less friction
Trade fractions of an asset
Overall lower cost, ease of transfer and settlement
Potentially enables an open financial system as security tokens become compatible with smart contracts
Instant convertibility between crypto assets and currencies (in the future we might be able to pay our expenses with our portfolio of tokenised securities).
Below a simple illustration comparing a crypto asset like Bitcoin and a security token like Robinhood which equity is trading on the Swarm platform:
There are a number of challenges for Tokenised Securities. Since they are associated with an underlying asset, this means that possession of the crypto token doesn’t equal possession of the underlying asset. If you hold bitcoin and you lose your private key — the bitcoin is lost forever. If you hold equity through a token, the equity doesn’t disappear — a trusted intermediary is needed. That’s a very different value proposition to crypto assets. So far, this category has had limited traction and much work is needed to solve custody, oracles, and the legal enforceability of smart contracts across jurisdictions.
Blockchain Native Security Tokens
This category may or may not be securities from a legal standpoint as typically these won’t have a company behind them. One example is Maker, a token in the MakerDAO stablecoin system. There is a foundation in Switzerland supporting in the development of the software behind MakerDAO. The Maker token is used for decentralised governance but also receives cash flow in form of a sort of buyback from a fee emanating from the issuance of the stablecoin Dai. This is just one example of a purely software based system that looks and feel like a security by having an on-chain cashflow stream in the form of a dividend or a buyback. Other examples include a set of stablecoins where ‘revenue’ from transaction fees are used as collateral in a two-token system. Yet another example is Binance Coin which represents a middle ground where you have a for-profit company providing cash flow in the form of a quarterly buyback and burn. Importantly, the token itself however doesn’t represent equity in Binance.
Blockchain Native Security Tokens open a whole new playbook where only the imagination of the software developers will limit the construction, functionality and the resulting value creation. Maybe our new generation of ‘companies’ will be software code running on networks like Ethereum and Dfinity with no entity or person behind them. This is a fascinating thought that has the potential to reshape the fundamental structures of our economy and society.
We believe the second category is vastly more interesting than the first category. That’s because the first category is just a traditional asset (like equity) that is traded on the rails of a blockchain but still requires off chain record keeping. On the other hand, Blockchain Native Security Tokens have the potential to transform the very concept of companies.
Finally, for those who would like to explore this area more, here is a list of the major player in the regulated tokenised security space:
Henrik Andersson is the Chief Investment Officer of Apollo Capital — Australia’s Premier Crypto Fund. The Apollo Capital Fund is a professionally managed portfolio of crypto assets, offering investors exposure to the fast growing crypto market. For more information, please see apollocap.io.