Cash Flow on the Blockchain - Programmable Bonds (Three Steps)
Cashflow on the Blockchain
By Jesus Rodriguez @ Invector labs
Translation: Apatheticco @ Babbitt Column
Compilation & Graphics: Wei Ran & Kiki @ Eight-Dimensional Capital
Part I: Tokenized Debt and Security Tokens (tokenized debt and ST)
People often ask me which aspects of security tokens are the most exciting, and I always answer with one sentence: "what we have not yet dabbled in". I tend to think of security tokens as enabling the creation of a new generation of securities that don't exist in the real world. From this perspective, I am more interested in creating a new form of encrypted securities rather than just a digital wrapper for traditional securities. As a pragmatist, I clearly know that it will take years to build a complete infrastructure, but there are still some practical cases that can accelerate the development of this aspect. In these cases, I think tokenized debt or cash flow offers multiple possibilities to unlock the potential of security tokens.
The existing generation of security tokens focuses on creating a carrier of some kind of basic equity (equity). Despite its technical simplicity, tokenized equity is still a very limited tool, and we lack the infrastructure to provide liquidity and secondary markets to other asset classes. The history of financial markets tells us that liquidity and landing applications are built through short-term activities and transactions, not long-term investments. In this context, we need a security token that is easy to understand, user-friendly for ordinary investors, and provides obvious short-term benefits in order to provide a boost to the ecosystem. Bonds have the potential to be the key to bringing security tokens into mainstream investors' sights.
Unique Advantages of Tokenized Debt
Most asset classes have a debt component. Real estate assets can be represented as a combination of debt and equity, as can most corporate structures. Viewed in this light, the quest to tokenize the world is largely an act of tokenizing debt. The advantages directly brought by tokenized debt are as follows:
1) Universality: Debt is a universal concept as old as trade itself. Similar debt instruments are adopted by most countries, which allows tokenized debt instruments to be circulated globally.
2) Market size: The debt market is huge. In the public markets alone, bonds and fixed-income products account for $100 trillion, with a daily turnover of $100 billion. That easily beats global equity market valuations, and that doesn't include private debt instruments like auto loans, student loans, credit card debt, and more.
3) Short-term benefits: Tokenized debt also pays dividends. Investors will be more willing to invest in security tokens because they know that even if they make any trades, they will be paid quarterly.
4) Composability: Debt is easy to compose. Aggregating a series of tokenized real estate leases into a cryptographic security representing a Collateralized Debt Obligation (CDO) is relatively straightforward. An on-chain representation of such an instrument would also help bring more transparency to its underlying structure, security holders, risk management, and other elements that are mixed into this form of derivative.
5) Divisibility: They can also be divisible into simpler representations. Divisibility can enable instant access to tokenized debt instruments to new groups of investors.
6) Over-the-counter: Most debt instruments in the world are traded over-the-counter (OTC). Bond tokens can complement this model by providing a simplified digital footprint of transactions.
7) Futures and derivatives: Futures and derivatives remain an elusive goal for most cryptoassets, but tokenized debt could be the perfect vehicle for it. Debt is a relatively simple asset that can be modeled as a futures instrument and is relatively easy to understand.
The chart below compares debt and equity instruments in the context of security tokens:
The Building Blocks of Tokenized Debt
After talking about the benefits, we can start thinking about how to implement this new form of encrypted securities. Unfortunately, this is where the whole thing gets complicated, since debt securities have no native contract (protocol). Protocols like Dharma provided inspiration for debt-based security tokens, but they had to be heavily tuned for real-world use. The difference between Dharma and the Debt Security Token Protocol is that the former focuses on automating the lending and lending of crypto assets, while the latter focuses on creating tokenized representations of existing debt instruments and automating the terms in existing debt contracts.
If Dharma is not the solution we need, what kind of contracts do we need? The Debt Security Token Contract (ST Debt Protocol) may not be just one contract, but a combination of several contracts, covering the different dynamics of tokenized debt. At a high level, tokenized debt in a security token can be structured as shown in the diagram below:
Part II: A Protocol for Tokenized Debt (tokenized debt contract)
A major obstacle to the current development of debt-based security tokens is the lack of an on-chain contract that can abstract the life cycle of debt instruments. Equity-based security tokens are similar to a semi-static representation of “stock,” but debt-based crypto-securities exhibit more dynamic behavior during their lifecycle, such as dividends due or defaults.
Therefore, debt-based security tokens will require a new contract that delineates the unique characteristics of these debts in the form of tokens. Bond contracts for cryptoassets like Dharma are instructive, but different from the contracts needed to tokenize real-world debt.
The role of ST Debt Protocol is to use the form of smart contracts to realize the programmable interaction between the participants in the debt instrument. To create such an agreement, we need to first understand the different types of debt security tokens and their corresponding participants.
Forms of Debt Security Tokens
The life cycle of a debt instrument can be summarized by the interaction between three main actors:
Debt instruments can be realized in two main forms, depending on whether the underwriting process happens on-chain or off-chain:
Tokenized off-chain debt: issue on-chain tokens representing off-chain debt (bonds or real estate leases);
Debt on the original chain: debt token, its entire life cycle from underwriting to maturity is carried out on the chain.
We expect the first generation of debt security tokens to be primarily the former — a tokenized representation of an “off-chain debt product”, but that contracts will gradually evolve to support the creation of 100% on-chain debt.
Whether we tokenize debt instruments off-chain or create on-chain infrastructure, we need a contract that contains the main components of the debt interaction.
Structuring a Debt Security Token Contract
The debt securities token contract (ST Debt Protocol) needs to integrate various elements of the life cycle of debt instruments. The main elements include:
Maturity Date: Every debt-based security token shall have a maturity date at which the issuer will pay the token holder the face value of the token on the maturity date of the relevant debt;
Par Value: Par value is the value of the underlying bond at maturity.
· Interest rate: The interest rate is the nominal amount paid by the issuer to the token holder during the lifetime of the token. The interest rate can be adjusted according to the level of inflation;
Maturity period: interest needs to be paid regularly according to a specific maturity period;
Rating: Debt Token Rating is a value that describes the quality or risk of a Debt Token. Generally, the higher the rating, the lower the interest rate;
Yield: This is the total return that debt token holders can receive at maturity.
Putting the above components into a security token, we can picture a simple structure for a debt-based crypto-security.
Debt security token contracts need to go beyond the token structure itself and simulate the interaction between the different participants in the debt instrument. At a high level, the following roles should exist for this type of protocol:
Debt Token Issuers (Issuers): Entities that create tokenized debt instruments
Debt token holders (Holders): entities that own debt tokens
·Payment Distributors: Entities that distribute interest and income to debt token holders
Raters: Entities that issue quality or risk ratings associated with specific debt security tokens
Arbiters: Entities responsible for resolving disputes between debt token issuers and holders in case of default
Let's take a look at the whole process through a case:
Assume that a hard money loan company named IssuerA (a loan obtained through real estate mortgages rather than based on the credit of the borrower) tokenizes a loan with a face value of $1,000, a quarterly interest of 10%, and a maturity of 5 years. The Rater (rater) representing the credit institution grades the loan, and the rating is AAA, indicating that the underlying asset is of high quality. IssuerA will distribute 10,000 tokens. Two people, HolderA and HolderB, both purchased 1000 tokens. At the end of the first quarter, the agreement will pay $10 to HolderA and HolderB via Payment Distributors. If IssuerA fails to make subsequent payments, the debt contract will be locked and sent to an arbitrator for resolution.
True, this example is oversimplified, but hopefully conveys some of the simple shapes behind a security token debt agreement.
The first generation of security tokens can be very simple and limited. But as the industry develops, we will see new forms of debt security tokens that will create innovative debt instruments that do not exist today.
Part III: Reimagining Debt with Security Tokens (reimagining ST-based debt)
The magic of crypto-securities is that they not only allow us to create on-chain digital representations of existing asset classes, but also allow us to create new securities instruments that would not be possible within the constraints of existing financial processes. Security tokens will unlock a concept as interesting as its name: programmable debt.
programmable debt
The potential for programmability in security tokens appears to increase in proportion to the behavioral richness of the underlying asset. Equity assets behave based on some very limited dynamics, such as buying, selling, and holding, while debt instruments can also exhibit behaviors such as dividend payments, defaults, underwriting, or yield rebalancing, providing an opportunity to unlock the potential of security tokens. Provides a wider field of view.
Below, this article lists some new types of debt-based security tokens that leverage the benefits of programmability to enable new functionality, while also providing immediate benefits to token holders.
Composable Debt Products
Debt instruments are composable in nature. Mathematically, if D1(r1,d1,i1) and D2(r2,d2,i2) are two debt security tokens with different risk levels, dividend payments, and interest rates, we can build a new debt token D3(r(r1,r2),d(d1,d2),i(i1,i2)), combines the underlying security tokens into a single tradable unit. Combined debt security tokens are forms of crypto derivatives that can generate incredibly powerful features to hedge against different market conditions, balancing different levels of risk and dividend models. Creating composite debt products such as Collateralized Debt Obligations (CDOs) is a lot of work, but blockchain protocols like Set already provide the technical foundation that allows us to combine debt tokens with a few lines of code New forms of encrypted securities.
Divisible and Combined Debt Products
In addition to being easily composable, debt-based security tokens also need to be divisible. Token holders can receive a fraction of the debt crypto-security, which will entitle them to dividend payments, interest rates, and risk exposure associated with their particular holdings.
Debt-Stock ETF Token
Exchange-traded funds (ETFs) are vehicles that can combine bonds and stocks under a single security. Borrowing some concepts from the ETF world, we can envision baskets of bond and stock tokens combined into a single unit of security tokens that balance risk and return for specific markets and investors.
Real-time dividend distribution
Dividend distributions on debt products are done over long periods such as quarterly or annual. Debt-based security tokens do not have the constraints of traditional debt instruments and can distribute dividends to creditors in a more timely manner. Imagine a debt crypto-security representing a series of real estate leases that are programmed to pay dividends to the security holders when the monthly leases expire. Regardless of the viability of the business model, such debt instruments are unthinkable in traditional financial markets.
Tokenized Incentives
Another fascinating aspect of debt security tokens is the use of cryptoeconomics (Token Economy) to incentivize healthy interactions between debt participants. Imagine a protocol that rewards debt issuers with crypto tokens every time they pay their dividends on time. Similar cryptographic models could be used to incentivize underwriters, auditors evaluating tokenized debt instruments, or arbitrators mediating disputes between different participants.
Roadmap for Debt-Based Security Tokens
In three articles, we discuss many different aspects of debt-based security tokens. We have drawn up a timetable for the development of bond tokens in the next six months and one year, and sorted out the various landmark events that may be realized and will eventually open the door to the world of debt securities tokens. Here is the schedule:
Debt-based security tokens have the potential to be the first form of crypto-security to unlock liquidity and access mainstream investors. Starting with the basics of a debt security token protocol, debt instruments provide a unique canvas to experiment with the most ambitious concepts in security tokens. Let us start this great experiment together!
