What Boards Must Know About Asset-Backed Tokens
Over 10 years ago, in the early days of blockchain and crypto, there was a widespread expectation that one of the main use cases would be fractionalization and tokenization of physical assets, particularly real estate. So far, this expectation has not come to pass. The first crypto currency, Bitcoin, is becoming a mainstream investment. U.S. dollar backed stablecoins are currently on the front page of the financial press, as they start to become a viable method for payments and a real competitor for existing forms of cross-border payments. Conversely, tokenization of real assets has not really taken off.
This article examines the market opportunity for stablecoins that are backed by assets like gold and real estate and the lessons for boards from the development of these markets.
Though at first glance these real assets-backed tokens appear very similar to the fiat currency backed stablecoins, they are solving a very different problem. The latter are primarily a means of payment, while the gold or and real estate backed stablecoins are primarily an investment.
For all investments, buyers consider the investment yield, the potential for an increase in asset price over time, the volatility and the overall risk. The spectrum of investments is vast and very diverse, and most investments could be tokenized, but that does not mean that there is a valid case for real assets to be tokenized in the short to medium term.
The first consideration is whether the token is pegged to a tangible asset with a liquid market like gold or an illiquid asset like real estate. In the former case, there are well-established liquid financial markets that ensure that the value of the stablecoins closely tracks the underlying asset and, when it diverges, arbitrage will quickly bring it back in line. Equally, it is straightforward to increase and decrease the supply of these stablecoins to match market demand. If there is an increasing demand for gold-backed stablecoins, then the operator buys more gold either directly or via a financial product on a traditional exchange and issues the corresponding number of tokens, which it sells to finance the purchase of the gold.
Another key issue is how the issuer of the stablecoin is going to pay for operating the system. Essentially, there are two options: using the interest earned on the underlying asset or taking a margin on the trade. Fiat-backed stablecoins have focused on the former, which works well when interest rates are high, but not so well when interest rates are low or the asset does not have a yield, like gold. Nonetheless, despite the need to charge a margin, tokenized gold is going to trade very similarly to investing in a gold exchange-traded fund (ETF). There is a margin built in like a fee on an ETF, but the investor does not have to worry about custody of physical gold and benefits from a wider market of potential investors and 24/7 trading.
Illiquid assets, like real estate, are much harder to tokenize. They do not trade very frequently, so it is hard to get an accurate price or find a counter party. Much is made of the opportunity for tokenization to create a more liquid market for these traditionally illiquid assets. The theory is that by breaking a large asset down into smaller standard tokens it becomes easier to trade, opens up the market to more potential investors and makes it easier for investors to create a diversified portfolio of assets. The key problem with this approach is that it requires a sophisticated investor to correctly price the token and many of the offerings do not divulge the key financial information.
An often-quoted example of a real estate backed token in the U.S. is the Aspen Digital Token. The underlying asset is the St. Regis Aspen Resort in Aspen, Colo., initially entirely owned by the New York-based asset manager Elevated Returns with $120 million variable rate mortgage. After an unsuccessful attempt to IPO, they eventually raised $19 million from the sale of tokens, which now trade sporadically. There is very little information disclosure and it appears that essentially all the free cash flow from the hotel operation is going toward servicing the mortgage. If the asset manager breaches the mortgage covenants, then they would lose the building and the tokens would be worthless.
In a previous article, we discussed fiat-backed stablecoins and their potential to disrupt payments and foreign exchange transactions. Many more companies will be users of stablecoins for cross-border payments or treasury operations, and directors need to have oversight of the strategic opportunity and understand the risks involved and how management is addressing them. However, less liquid and more complicated assets are less likely to see significant disruption in the short to medium term. The further out on the liquidity and transparency curve you move, the harder it is to make a case for tokenization. Gold and some other commodities make sense for a certain type of investor. Real estate, minerals and fossil fuels in the ground sound like a good idea, but in practice may not be attractive outside a narrow group of sophisticated investors because of complexity and lack of accurate and trustworthy pricing information.
There is also an issue of product market fit: Does the product solve an important problem for the user?
Investors in Bitcoin are generally risk takers. They are prepared, at least in theory, to tolerate high volatility for significant upside in a scarce asset. Stablecoins are either a store of value for people in developing countries to get access to dollars or a means of payment to reduce the cost and friction in payments, particularly for cross-border transactions. Tokenized gold may also act as a store of value and an easier way to access gold for some investors.
However, it is not clear that there is a significant market for illiquid tokenized assets, especially those without a yield and where it is difficult to determine a market price.
As an investment, less liquid and transparent assets require a lot of due diligence. The story of the St. Regis in Aspen only became clear when we looked at the S1 for the IPO as opposed to the documentation for the token. When investing in a tokenized real asset, there may be less information readily available than investing in stock or buying a building. Therefore, it is higher risk and there is less regulatory support if things do go wrong.
In conclusion, crypto is having something of a hype cycle, but it is important to focus on the real use case. Tokenizing an asset does not, and should not, make an unattractive investment any better. Boards need to view proposals to invest in these tokens with a fair degree of skepticism and be clear about the market benefits of proposals to tokenize assets. Otherwise, the company could be incurring costs and regulatory and reputational risks for no benefit to the shareholders.
About the Author(s)
David Crosbie is a former Visiting Fellow at the SEC Cyber and Crypto Unit and senior lecturer at University of Pennsylvania.
Susan Holliday is a director, advisor and Qualified Risk Director.