Asset Backed Securities, ABS for short, were responsible for the financial crisis. As early as the beginning of 2000, American banks began bundling real estate-backed bonds with high probability of default with other bonds and bundling them into intransparent packages. The result is well known. Well, in 2019, the first ABS will start on a token basis. Will there be a bursting of a mortgage bubble this time as well?
Just like the few of us today still buy a CD, but download the music in a purely digital form as an MP3 file or listen directly to Spotify, also changes the medium of securities. Physical documents become digital tokens, ergo security tokens. Accordingly, each security that is currently held in the form of a deed at central securities depositories will in future be kept in custody via a blockchain. The more efficient medium to securitise and exchange property replaces a less efficient medium.
Security tokens alone do not make the difference
Everything that can be portrayed with previous securities can also be securitized via security tokens. Accordingly, the medium gives no indication of the quality of the underlying asset, for example, the company or the property. In principle, security tokens can thus cause bubbles and undesirable developments like the subprime mortgage bubble in 2008.
The first Asset Backed Security Tokens (ABST) – we will have to get used to this abbreviation in the future – are currently being released. One such example is the security token offering of Crowdlitoken AG, whose token is modeled after an ABS based on tokenized real estate and its credit claims. Many of these small projects are planned in the coming months.
Still in its infancy: tokenized real estate
Nevertheless, we are at the very beginning of a wave of tokenized real estate. The volume is to be regarded as irrelevant to the market in the short to medium term. The risk of ABST forming dangerous bubbles within the next few years that pose a systemic risk is likely to be close to zero. Although some projects will fail. However, these will leave the real estate and securities market completely cold. Not only is there a lack of a comprehensive offer of tokenized real estate, but there is a lack of complex securitization structures of ABST. After all, a market must first emerge before bubbles can form.
However, the end of 2017 ICO bubble taught us how fast that can be. However, as real estate is a real asset, the risk of rapid blistering is significantly lower than that of blockchain service platforms’ utility tokens.
When the kennel is tokenized
In the transformation process of securities securitization it has to be differentiated whether tokenize new projects or to convert already existing securities into tokens. Finally, the volume of existing real estate investments in tokens will be much larger than that generated by new token projects. It could be critical if the reduced transaction costs and, in the future, lower barriers to entry make the bundling of risky bonds even easier.
If more and more unprofessional and semi-professional actors push into the market of tokenization in the next few years, opening up previously unranked assets can create a new junk market. By making it extremely easy to emit tokenized assets in the future, the general market level can be lowered and the risk profile turned negative.
At the same time, however, decentralization tendencies in the real estate market are promoted. It then finds a shift from centralized actors such. For example, large real estate funds or housing associations such as Vonovia or Deutsche Wohnen, are becoming smaller and smaller players. This has advantages, but also disadvantages.
The publication of a book: Market vs. Companies
Publishing a book can help us better understand the conflict between decentralization and centrality and apply it to tokenization. So suppose you have written a book that you want to publish. So there are two possibilities: One chooses the way over a publishing house or one decides for the “Selfpublishing”, thus the independent publishing of the book.
The advantage of going through the publisher is that all the work necessary to publish a book is ideally handled by a professional actor. This ensures that supposedly bad books do not come on the market. At the same time, publication via a publisher can ensure a particularly high reputation of the book.
Self-publishing does not have this selection mechanism. Everyone, no matter how good or bad, can make his book available to the market. The decision as to what is good or bad is not left to a central authority (publisher) in the first instance, but to the market. As a result, many books can be published that have not made it through the centralized organizational structures of a company (publisher). If an author has enough tools (network, marketing, etc.), he can not only enrich the market through self-publishing, increasing the substantial offer, but also making a bigger slice of the pie himself.
Both variants (market or company) are therefore in direct competition with each other. At the meta level, however, it’s all about a conflict: central vs. decentralized. Blockchain and tokenization can thus lead to the ability of individual actors to participate independently in the decentralized market without having to go through central instances.
What securities prospectuses and leaflets of medicines have in common
In order to reduce complexity and avoid chaos, companies have emerged in recent decades that, in many cases, are superior due to their central coordination of decentralized structures. Exactly this form of centralization has also developed in the financial market, in which large investment houses process the information centrally and hierarchically.
The problem with this centralized organization of information is that wrong decisions can do more damage and, secondly, that a particularly large asymmetry of information can arise. In practice this means that few leaders in an investment bank make decisions that can have serious consequences for many stakeholders.
In order to minimize this risk and to inform the market about the risks, there have been prospectus requirements for many decades. Anyone who issues a security and also an ABS must issue a securities prospectus with a differentiated risk profile.
Also to the toxic papers that led to the collapse of the Lehman Brothers, there were publicly available prospectuses.
The crux: A prospectus is a bit like the package leaflet for medications – just longer and more complex. Side effects or, to put it better, default risks in high-risk bonds are outlined unintelligibly in page-long essays. Nevertheless, the problem remains that the quality / credit rating or impact / return of the drug or the bond remains uncertain. What happens after the securities issue depends solely on the distribution of information and processing. Securities prospectuses are especially good for the government conscience – “It has pointed out”. However, they can not reduce systemic risks or financial bubbles. Since security tokens fall just as much under the prospectus obligation as traditional securities, nothing will change on this point.
Decentralized information distribution instead of brochure
The question of whether blockchain technology can reduce the risk of financial bubbles is still not answered. The key to success here could lie in the decentralized distribution of information. So it is not the token that brings a change in the framework conditions, but the blockchain as a decentralized infrastructure. Blockchain technology is designed as an infrastructure for the market, not for business. Unlike companies, markets are decentralized. The information flows peer to peer from participant to participant and not, as in companies through a hierarchically organized bottleneck.
The collective term Decentralized Finance, or DeFi for short, covers not only bitcoin transactions and tokenization, but also blockchain governance concepts such as the Decentralized Autonomous Organization (DAO). DeFi is changing the information dynamics in a market or ecosystem. Monitoring and control functions are distributed in a decentralized way to all participants and not carried out by a single department in a company.
In a well-functioning market, there is no need for a central instance. By eliminating centralized instances, markets can operate more dynamically and flexibly. Now this is an absolutely theoretical assumption that often could not prevail in practice. In the competitive relationship between the market (decentralized) and the company (central), it is no coincidence that companies often prevail against the market through a more practicable coordination and provision of services and goods. This is exactly what could be changed by better tools (blockchain protocols).
Therefore, financial bubbles are contained by Blockchain
The better the information and transaction technology, the more practicable the decentralized handling of global transactions. While it used to require centrally organized companies, ie banks and central securities depositories, for the exchange of values or ownership, blockchain technology can already ensure a re-decentralization of the financial market today. If the technology is implemented in a practical and user-friendly way, it can lead to the already mentioned higher dynamics and flexibility, especially in the flow of information. As a result, risk monitoring and real-time analysis can be carried out by a particularly large number of market participants and lead to better results than in central collection points of companies.
The blockchain reduces here as decentralized infrastructure the so-called single point of failure. Misallocations and developments can – at least in theory – be detected and mitigated faster, before more serious financial bubbles arise. The new market transparency can – if the chaos that brings decentralization, is better resolved – counteract pervertions on the financial market earlier.
Change through decentralized finance
The tedious financial market and actor structures will not change overnight with blockchain technology. Rather, it is about creating tools and infrastructures – tokenization and blockchain – in order to be able to realign the financial market in the long term. A private DLT solution from the house J. P. Morgan hardly counts. Also, it only changes the degree of decentralization in the company, but not in the market.
The realignment through blockchain protocols promotes decentralized transactions between participants. The more one empowers the market or all market participants to carry out transactions themselves, the less necessary are centrally organized companies, which in turn discourage information dynamics. This re-decentralization can lead to a recovery of the financial market ecosystem, which in turn makes financial bubbles less likely. So the difference is not the token or the regulation, but a really decentralized transaction structure, which allows a better distribution and coordination of information.