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Tranche Warfare: Are STOs Simply Teaching Old Dogs New Tricks?

Written by Matthew Dove (Digital Editor)

Innovation is a double edged sword, it cuts both ways and if fintech is capable of pulling us up it can also drag us back down. As Brexit looms, feckless opportunism could easily trump functional innovation…

Champions of digital assets are heralding 2019 as the year of tokenisation the practice of digitally fractionalising new and existing assets which can then be traded in their smallest increments quickly and without barriers. The idea is to open up the market to previously excluded retail and institutional investors, as well as loosening illiquid assets like private equity, real estate, diamonds etc.

This new asset class consists of two categories; the security token and the tokenised security. The former is a beefed-up, generally asset-backed, reimagining of the ill-fated initial coin offering (ICO) rebranded here as a security token offering (STO).

The tokenised security, on the other hand, is a traditional security given the DLT treatment. Gone are cumbersome secondary markets and in come blockchain-based trading solutions guided by smart contracts.

In a post-Brexit economy, such products may be just the kind of stimulus needed to restore timid markets to their bullish glory. However, the pursuit fresh of liquidity could just as easily bring nasty habits back to the fore.

Collaterised debt obligations (CDOs) can be seen as a trial run of the kind of fractionalised digital assets being floated today. Take a illiquid and potentially risky asset (i.e. a subprime mortgage), chop it up, repackage it in a tranche with a less risky assets (A and B graded loans) and sell it on. Repeat ad nauseum. The only problem here is that you soon run out of “good” debt and start repackaging crap with more crap. The profits are great in the short term but the risk is huge (especially if everyone is using the same insurance company!). This way global financial ruination lies…

John Iadeluca, managing director of Banz Capital

Speaking to TFT, John Iadeluca, managing director of Banz Capital, acknowledged the disturbing similarities between the class of derivatives whose wanton trading was heavily linked to the financial collapse of 2008 and the fledgling STO. He’s quick to assert though that he feels that the comparison is largely superficial.

“The similarity between CDOs and STOs is undeniable, however, at current blockchain structure levels, STOs offer efficiency that CDOs never did. If you’re packaging cash flow, revenue stream, and passive value yield into any other product and reselling it you’re definitely running the risk of it being bought irrationally and justified only by speculation as was similar with CDOs. However, with STOs the framework has made it financially more efficient for investors to use products that integrate tech as opposed to not doing so. A lot of the evil with these “repackaged” financial products falls at the hands of lack of knowledge.

Many STOs offer convertibility at the lowest possible level, which is great. With convertibility, the security tokens issued are convertible at their truest value relative to malleable assets, say for example, real estate or art. The product has a use case in this instance, but it’s when company revenue, loans, and other obligations are repackaged to no end is when things can be dangerous. In those cases, it’s easy to mirror exactly what happened during the financial crisis, and it’s absolutely possible for STOs if traction picks up.”

“The similarity between CDOs and STOs is undeniable, however, at current blockchain structure levels, STOs offer efficiency that CDOs never did.”

In a Medium piece published in December last year, Iadeluca also fleshed out what he sees as the fundamental operational differences between the two products and the how, in the right hands, STOs could provide a safer alternative to the much-maligned CDO.

“You can code a Security Token to function exactly like a CDO, as long as the approval is there. The main difference that should be stressed between the two is that Security Tokens possess the programmability to function as a CDO, whereas CDOs do not have programmability at all. Security Tokens are more so frameworks, capable of being linked to debts, but not absolute. CDOs are entirely static representations on paper. With proper Security Token framework and a very serious amount of compliance oversight, you can even go as far as to say CDOs can theoretically be more reliable & transparent if issued on a blockchain.”

If that “very serious amount of compliance oversight” is provided by the same agencies who did such a great job in 2008, then we should all cash in our pensions before some bright spark decides to tokenise them!

As ever, the distinction between innovation and “weapon of mass destruction” depends entirely on who’s using it and why.

With uncertain times ahead, Iadeluca thinks that fintech, especially the distributed ledger technologies (DLTs) on which STOs are built, will be an indispensable tool, if used responsibly. When asked whether new financial instruments are simply offering the world more of the same, teaching old dogs new tricks, he responded;

“Post-Brexit, I do believe at its absolute simplest level, binding blockchain to cash flow related products can be efficient, but past that, it can be more or less the same thing just reworded and resold. If done correctly, binding to blockchain means absolute immutability and transparency, two qualities that if implemented during the financial crisis would have statistically mitigated losses. The challenge is adding those factors without disrupting significant profitability for any party involved. In financial technology, I think it comes down to using technology to give an edge to both the buyer and seller of something in a more sustainable way than if a technology wasn’t used.   

When it comes to new approaches, the idea of fintech offering more of the same is dangerously realistic. It’s easy to attract interest using big words and complex sentences, but at a certain point, you need to take a step back and assess what financial products are adding real value and utility, and which ones are just rehashed products issued with a slight premium.”

The worry is that DLT has the power to produce supercharged derivatives which would make CDOs seem like savings bonds. The last thing the rattled British economy needs is a load of City boys chasing easy money by hocking complex products that no one understands. We’ve been here before and it wasn’t funny the first time.


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