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How does DeFi unleash the potential of tokenized securities?

Find out how specific decentralized finance instruments can be applied to securities to make your business more attractive for investors.
5 AUGUST, 2021
Technology
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The lion's share of businesses, more than 99.9%, isn't attractive to investors no matter how profitable they are: to get real profit, investors need to sell shares, which is impossible to do if your company is private. As long as your company is not traded on a stock exchange, it's usually impossible for your investors to sell the shares or use them as collateral against a loan; the only remaining option is hoping to receive dividends or wait for the company to get acquired. Such a scenario leaves business owners longing for new financial market infrastructures.

Tokenization ― the process of transferring the securities to blockchain ― drastically unleashes the potential of what can be done with private securities, providing an opportunity to trade them or use otherwise in crypto solutions of DeFi. This makes the business much more attractive for investors.

Limitations of private securities

What are private securities' main flaws? The first and foremost issue is that only 0.027% of all the companies worldwide have undergone the listing on the stock exchanges and are publicly traded. This means that all the rest ― which is 99.973% ― aren't publicly traded companies. Instead, their securities usually exist in the form of a mere contract (which in some exclusive cases is a literal paper certificate) or the record in a closed state register, which can only be changed with the help of a notary or any other inflexible and inconvenient form.

There are a few jurisdictions in which rules for share transfer are simpler. You can incorporate a fundraising vehicle in these jurisdictions to benefit from their flexible rules. You can find out about these countries and other legal nuances in our legal guide to tokenized securities, which you can download at our Legal Management page.
The principal problem of private securities existing in the form of a contract or record in the state database is their limited functionality. The information about their price and performance isn't based on the market and readily available, so you can't share it to attract new investors, offer securities instead of cash in the acquisition process, use them as collateral against a loan or incentivize employees with stock option plans. These are some of the benefits of being a public company, which we discuss in our video "IPO: subtle nuances. Corporate finance, corporate governance and corporate strategy" about the non-obvious pros and cons of going public.
For the reasons above, it's also hard to find a buyer for the shares, and the sale process itself can prolong for weeks. Due to these difficulties, it's not feasible for you as a business owner to sell your stock to hundreds of investors ― rather one or two large ones. The requirement to invest large amounts limits the number of people you can sell the securities to and entitles investors to extra power over your business. The issue of bargaining power is a very significant one, and we have a video "How to raise capital without banks and venture funds" devoted to this topic.
This also leaves your shareholders with a limited possibility to profit from investing in your business. In the modern environment, the primary way individuals and entities benefit from investing is capital gains, i.e. increase in the value of assets they are holding. However, to realize profits from capital gains, you need to actually sell the asset, which you cannot do with private securities. Moreover, keeping the securities in an unsafe registry is a significant drawback as it makes them vulnerable to physical loss, cybersecurity issues, or even loss due to corruption in some countries.

All of these factors make businesses unfavourable to invest in. So while publicly traded companies like Amazon or Google raise vast amounts of money, some crypto projects can raise millions in literally minutes, the majority of common businesses get only a tiny cut of the world's capital.

Limitations of private securities are problematic not only for businesses but investors as well, as it fundamentally changes their economics. Now investors can't simply invest in projects that are simply good ― they have to find a needle in a haystack, one of few businesses that will make it to the IPO or acquisition. Such incentives damage the sustainability of a business, as it makes the investors push their own portfolio companies to grow as fast as possible rather than nurture moderate, sustainable growth. Learn more about how the classic venture capital strategy harms businesses in our article "Conventional clauses in venture agreements and why you should choose tokenization instead".

How does legacy technology operate and why does it work on a wrong basis?

The reason for all the limitations outlined above is that the traditional financial market infrastructures ― brokers, banks, investment banks, custodians ― are inefficient, as they are built on centralized databases. Their crucial drawback is that, due to cybersecurity reasons, access to changing the database or getting information from it is possible only through an intermediary, which slows down all the operations. Furthermore, many processes are manual, which further increases complexity and creates space for mistakes. Despite all the sophistication of centralized finance systems, just like all the money and effort invested in them, they are fundamentally flawed and built on a wrong basis.

Here's an analogy to gain a deeper understanding: General Motors has invested hundreds of billions of dollars in their engine production line throughout the last century. This system has been improved to near perfection, but despite this, it has a fundamental underlying problem: these engines work on fossil fuels. The given technology makes it weak compared to new entrants like Tesla, who had less time and money to design the system but operate on a different, more superior basis of electric engines. For General Motors, all of the prior investments into the old system are rather an obstacle to adapting to modern requirements.

With blockchain, it works the same way. This is the reason why Coinbase is worth more than any stock exchange in the world. If this topic excites you and you want to dive deeper, see the interview with Douglas Borthwick, Chief Marketing Officer at INX ― a regulated US-based exchange for tokenized securities, that we released on our YouTube channel earlier.
Consulting for Security Token Offerings (STO)
We offer advisory, legal expertise and software solution to help successfully execute a security token offering.

Protocols of decentralized finance

While in traditional finance investors and businesses have to operate within the network of middlemen like notaries and brokers, in tokenized finance there is direct access. The legal compliance and integrity of the data are ensured not by random clerks but by rigid cryptography.

Financial services that intermediaries conventionally provide can be instead provided by protocols of decentralized finance, which you and your investors can use if the securities are tokenized. Examples of such protocols are automated market maker (AMM) protocols, also known as decentralized exchanges, lending protocols, and data oracles. Let's review each of them in more detail.

What are the Automated Market Makers (AMM)?

AMM crypto protocols work similarly to broker-dealers. Brokers buy the stocks from those who want to sell them and sell the stocks to those who wish to buy, serving as a middleman between the two parties. On the blockchain, brokers are replaced by a liquidity pool. Examples of market-making algorithms are Uniswap, Balancer, PancakeSwap.

You can think about a liquidity pool as a space where your shares and some other currency that can be traded, like dollars or euros, exist together. When investors want to buy or sell your tokens, they take tokens from the pool and put in dollars, or vice versa. At the current technology level, assets in the pool provided by AMM should be deposited by the issuer, but in the future, investors or other people wishing to acquire a percentage from the commission the pool charges may be able to fill it.

Since the broker-dealers need a big spread between the buy and sell price as well as the enormous transaction volume, they don't work with small-cap companies. The liquidity pool doesn't have that criterion. Your company's market cap may be as small as a hundred thousand dollars, and its shares can still be traded via the liquidity pool, albeit with high volatility, whereas the classical market maker would expect at least a hundred million dollars market cap even to consider creating the market for your securities. Decentralized finance makes market making much more accessible.

How does defi lending work?

Decentralized lending protocols substitute banks to some extent, giving you the possibility to get a loan using your tokenized securities as collateral. Examples of defi lending protocols are Aave, Maker, Compound.

In traditional finance, there is a service called equity line of credit. If you possess stocks you cannot sell, or you don't want to sell, you can put them in pledge against a loan at a pretty low-interest rate. The securities continue to grow in value and pay dividends, while you can use the cash without selling the stocks. However, this service is only available for high net worth individuals to be profitable for a bank. Moreover, in many countries, where the banking system is not that developed yet, it is simply impossible.

Just like in the previous case, blockchain makes getting a loan against securities available for any token holder. If the share price goes up 10% during the year while the loan's interest rate is 5%, using the lending protocol is very feasible. So even if there won't be much liquidity for a given token because of low demand, investors will still be able to monetize it.

Data oracles definition

Data oracles are solutions that increase the transparency of on-chain processes and handle data exchange between different chains and off-chain databases. The key use case is reporting: the issuers must conduct constant reporting to the investors regarding the company's performance as well as report to regulators about transactions; investors have to report to tax authorities regarding dividends and capital gains. Oracles can analyze the blockchain and create reports based on it. Thanks to this, the processes used to make investments extra complicated or expensive ― namely the reporting, payment of taxes, et cetera ― are becoming automated to a significant extent, making the investment process cheaper and more straightforward.

In conclusion, blockchain and decentralized finance fundamentally disrupt the capital market, making it more available and efficient, giving businesses access to significantly more capital and creating more opportunities to monetize their assets.
5 AUGUST, 2021
Technology
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