In today's article, we write about the fundamental problem of exchanging non-bankable assets and present a new method for trading them in the absence of any regulated (public) market.
A few weeks ago, we introduced on this blog the question of investing in non-bankable assets. On that occasion, we outlined the advantages and disadvantages inherent to this type of investment. In a subsequent article, we addressed the fundamental problem of valuing non-bankable assets via machine learning techniques, focusing on real estate as the most common instance of this alternative asset class. In this new article, we'll focus on the value proposition for investors of tokenized non-bankable assets on the blockchain for investing in high-priced artworks and real estate properties. The generalization to other classes of non-bankable assets naturally follows.
Art as a non-bankable asset
The situation of the art market is a good entry point into the issue of investing in and exchanging of non-bankable assets. Art collections are notoriously illiquid and the sale of a work of art on the market is generally 100% (although there are cases of shared ownership collections). Associating a piece of art with securities or tokens (e.g. issuing tokens at 0.01% of the artwork value) makes it possible to reduce the investment ticket at will. Importantly, small ticket size is a sine qua non condition for the emergence of a liquid market for collectors and investors that does not require the sale of the entire asset. The different solutions available to the market participants are then:
- A model like a closed-end fund can be adopted, in which the work of art would be sold at some point in the future and token owners would be compensated for their participation.
- Alternatively, the tokens could be traded freely in a market where any holder of 51% of the tokens could call the rest at an agreed premium over the market value.
During the entire period that the work of art is tokenized, it can be kept by a museum or a collection and displayed to the public. The most important point here is that the usage and exploitation rights and obligations of the asset can be represented and negotiated separately from its ownership by a so-called smart contract token or, broadly speaking, an experience token representing custody, usage or exploitation of the asset. Consider the following use cases for fixing ideas. All of them display an asset experience, which can be monetized and negotiated independently of the beneficial ownership.
- Proceeds from the sale of exhibition tickets can (for instance via smart contracts) be combined with ownership tokens to generate cash flows. Museums can also monetize partially or totally the tokens that they wish to take out of circulation for any artwork they do not consider as part of their permanent collection.
- Museums could also allow the use of tokens to facilitate the exhibition of works from their permanent collection at another location on a shared basis while retaining a majority ownership.
The same concept can be applied to other non-bankable assets; real-estate, luxury cars, yachts – even whiskies and wines. Let's take a possibly more familiar example, such as real estate, where a luxury property may be owned by hundreds of people who can use tokens to redistribute rental income or the allocation of time for personal use of the property.
The Avaloq tokenization solution
At Avaloq, we have been convinced for years that the blockchain technology is here to stay and that it will profoundly transform the financial services sector. However, in order to become widespread, the technology needs to convince market participants at different levels:
[business] added value on relevant use cases
[technology] being built on a solid foundation and infrastructure
[regulatory] acceptance, in the absence of support, by the regulator.
We will later show that tokenizing non-bankable assets carries a wealth of promises for the blockchain, where token contracts provide an immediate proof-of-acquisition and a convenient medium to monetize and trade one’s asset experience – in this way generating an additional source of revenue for the investor.
Before digging into the business opportunity, let’s note that the market and its participants must provide the right infrastructure for it. The infrastructure must be convenient to use for the investor; it must provide:
- appropriate tools for safekeeping and digital wallet management
- reduced transaction costs
- easy access to liquidity
- a lean process to create tokens at will with very little effort
The first pillar of Avaloq's Blockchain foundation was erected in 2017. At that time, the aim was to guarantee a safe and secure crypto-key management system. As it seemed that only technically-inclined investors could manage their private key securely, this challenge has prevented the broad adoption of crypto-products. This is why Avaloq took a large stake in the crypto vault provided by Metaco, and why they have since then integrated Metaco' Silo solution into the Avaloq Core Platform.
The second hurdle faced by crypto aficionados nowadays is the full integration of crypto assets into their wealth and portfolio management systems: it is indeed very difficult if not impossible for investors to manage their crypto positions from a device separated from their regular portfolio management system. However, this is generally the case due to the non-standard and still unknown nature of crypto-assets, as well as the rather conservative stance of compliance officers towards these new products.
Yet, investors would enjoy a superior experience if they could leverage the wealth management tools they are familiar with to handle crypto assets alongside traditional ones from within their existing portfolios. We offer such an enhanced experience through our crypto module, which not only seamlessly integrates Metaco for the custody of crypto assets, but also builds upon the object model in our core platform to represent crypto assets like any other asset in the portfolio.
The next hurdle is regulatory: as the blockchain technology is mostly implemented on public networks, it is pseudo-anonymous, which is contrary to the rules in force in many countries, particularly concerning money laundering regulations. For this reason, we are a founding member of the OpenVASP association, which aims at establishing a protocol to enforce travel rules regulations (FATF 16) for blockchain-based transactions.
Having the right foundation in place, let’s now turn to the business opportunity offered by blockchain and the tokenization of non-bankable assets.
First of all, let's introduce some useful concepts and the jargon that goes with them to talk some more about blockchain, token and smart contracts.
A token is a generic crypto-asset which is a digital twin of an existing asset (financial or physical). Most of the time, it represents a share of a Special Purpose Vehicle (SPV) which holds the artwork, the real estate property, the rare collectible, the classic car, etc. Issuing digital tokens on such an SPV is then a cost-effective process in comparison to private placements, which are normally paper-based contracts. This is an important differentiating feature of smart-contract tokens.
A Token Contract is a kind of Smart Contract that describes (using the smart contract script) the rules for producing a token, for exchanging it between addresses, as well as other token-specific rules like its divisibility for instance. One finds a few token norms in the crypto-economy, the most common of which is presently the ERC-20 standard, which defines general features of the tokens and unifies them. Thanks to the ERC-20 norm, any actor on the crypto-market can trade and include any new token that satisfies the norm on their platforms.
Importantly, being by nature digital, crypto-tokens of non-bankable assets naturally integrate into an investment portfolio to provide the investor an overview of all their investments, performance and risk - assuming that the non-bankable assets are being regularly re-evaluated (see how in this article). And when liquidity is at hand, liquid tokens allow a better continuous valuation of non-bankable asset and the establishment of a market value that is independent of the original asset expertise. In this respect, liquid tokens allow one to improve the model described in the previous post.
Furthermore, token contracts are not limited to providing an immediate proof-of-ownership in a deal. These are a specific type of Smart Contracts that describe the rules to generate new tokens, how to transfer them between counterparty addresses and the token’s fungible/non-fungible character, etc. In other words, token contracts can describe the life cycle management logic of the product they represent. A token representing an SPV could, by way of example, deliver regular coupons to the investors - a logic fully defined at the product's inception.
Another exciting feature of the technology is to generalize the notion and use of coupons. Tokens delivered as coupons can, of course, represent an amount in any fiat currency (e.g. 1'000 USD), but they can also represent a right to use, exploit, and resell the use of what has been invested in. This characteristic is particularly appealing to non-bankable assets investing as shown by the art and real estate instances.
This example shows the power of the technology, where smart contracts enable the program's future flows, not only in cash but also potential instruments' flows or token experience flows. One concrete example is provided by the equity market, wherein a dividend paid in shares is an example of a programmed flow of a financial instrument.
Such a model, where cash, financial instruments and ‘right of use’ are ubiquitous, becomes extremely powerful if one considers the delivery versus payment (DVP) process. In the equity world, where shares and cash are not represented in the same way and sit on two different networks, the delivery of shares against payment takes a few days and can sometimes fail. On a blockchain network, as cash and securities have the same token representation, delivering an equity against a payment is just a swap between the owners. This makes the DVP atomic and intraday, eliminating the credit risk.
Thanks to the increased efficiency delivered from a fully digitized token process, investment denominations can be very small. This reduces market friction and opens the door to increased liquidity. When this technology is applied to non-bankable assets, the face value of these SPVs can also be arranged at low amounts, providing access to luxury or illiquid assets to a much wider audience - and contributing to the democratization of wealth management. Indeed, in times of crises, as recent events have shown, the necessity for market liquidity and opportunities for diversification only go to highlight the case for the tokenization of non-bankable assets.
This article was developed by Avaloq's David Morton de Lachapelle (Data Science & Digital Wealth) and Philippe Meyer (Head of Blockchain Solutions)