Given the recent elevated levels of volatility we have seen with popular cryptocurrencies such as Bitcoin and Ethereum, the concept of asset-backed tokens has emerged as a new talking point for people seeking some tangible downside protection in the world of crypto investing.
Most cryptocurrency valuations are entirely dependent on the perceived quality and scalability of their use cases. When investors think that a particular token can be globally adopted as a medium of exchange and store of value, the coin’s price can appreciate wildly. Alternatively, increasing “guidance” (and in some cases, enforcement actions) by regulators in countries such as the United States and China can put tremendous downward pressure on cryptocurrency prices. So there is an odd dichotomy here – on the one hand, large amounts of “open source money” (retail investors) are chasing highly speculative ICO’s while, on the other hand, regulators are simultaneously attempting to tame the market, which creates yet more volatility for this burgeoning asset class.
It is likely that over 90% of cryptocurrencies will go down in flames and trade to zero during the next decade. This process will look very similar to the internet boom of the 1990’s. Why? Because ICO’s are startups just like any other business and it’s widely understood that statistically, 9 out of 10 won’t make it. For non-asset backed tokens, use cases must be globally scalable, which is why a select group of fintech blockchain ICO’s are, in my view, the most likely to succeed. Large traditional financial institutions are getting very nervous as they realize how disruptive the technology is. Best in class companies focused on building the “infrastructure of blockchain” are likely to succeed as well.
So what’s all the chatter about asset-backed tokens? They may help to reduce volatility associated with cryptocurrency investing by establishing an incontrovertible basis of intrinsic value. The use case of a particular asset-backed-token may or may not reach desired scale, but at least investors might be left with a security token that has a claim on assets. Also consider that an asset-backed token issued in a regulated market such as the United States will provide investors with clearly defined rights, which means that in the case of liquidation, a token holder can have a real legal claim on assets. If a U.S. corporation issues asset-backed tokens, then the assets on its balance sheet will be visible to the public and the liquidation rights of token holders can be clearly defined.
That leads us to the next question – how do I know if my asset-backed token is legitimate? In an unregulated market, any issuer can offer an asset-backed token to investors without necessarily defining the legal rights granted. That’s where registered issues come in. The trend for U.S.-domiciled companies conducting ICO’s in the U.S. capital market is to register ICO’s as “security tokens,” which means that tokens are registered usually as a special class of participating preferred equity shares.
What types of assets are appropriate for tokenization? Real estate and renewable energy are two good examples. Both are stable assets which generate relatively predictable cash flows, so the ability of an external auditor to verify portfolio net asset value (NAV) is relatively straightforward which allows investors to value the tokens. In the case of renewable energy, things such as solar projects can be tokenized which allows anyone to invest fully or fractionally in a project anywhere in the world and earn a return. Blockchain technology makes this possible by reducing transaction and due diligence costs, which would be prohibitive using traditional labor-intensive methods. Distributed ledger technology also immutably records asset performance data which facilitates more efficient valuation.
A potential disadvantage of asset-backed tokens is that upside may be limited. Generally speaking, if a fixed amount of tokens are issued at the token generation event (TGE), then the upside to token value is limited by the growth of net operating income of the asset portfolio. Ideally, tokens whose value is based on both underlying assets and a globally scalable blockchain platform which can generate additional income, may offer much greater upside to investors. Such a model provides the downside protection of an asset-backed token with globally-scalable, income generating blockchain technology upside. Clearly, there are many workable iterations of this model, but the idea that tokens have some quantifiable intrinsic value, based on real-world assets could help to reduce crypto volatility in the short-term while also revolutionize the way people invest in high-IRR assets which have traditionally been available only to accredited investors.