The traditional securities system is amazing. It has volume, speed, and error correction. This article introduces deals where DeFi coordination and automation can make securities even better.
I introduced DeFi-ready securities in a previous article. They will be useful for specific product categories.
- Collateral for stablecoins and money markets
- Private credit syndicates
- Startups, VC investments, and private fund investments with new offering mechanics
- SPACs, new and improved
- Some real estate SPVs
- Royalties and revenue shares
- Programmable securities that innovate with governance and features
Collateral for stablecoins and money markets
DeFi has proven to be a reliable and flexible way to handle tokenized collateral. This collateral backs stablecoins, interest-earning money market products, and leveraged trading positions.
These are big markets! Stablecoins are a form of eurodollars — dollars that circulate outside of the US banking system. About $10T circulates in the non-US banking system, with a similar amount circulating as money market securities.
In this picture, DeFi software is doing “structuring”. It is dividing up the liabilities and cash flows between participants. The junior/senior tranche structure sends a predictable amount to the senior tranche, while sending other profits and losses to the junior tranche. This is the foundation mechanism for stablecoins (Circle provides a 0.6% junior tranche), banks (10% equity tranche), and DeFi CDP vaults (50% overcollateralization). DeFi is good at structuring.
The current generation of stablecoins takes money off the chain as soon as you buy the coin. Next generation designs will use tokenized treasuries to show their reserves and capital structures online. I foresee a future where a lot of the collateral behind stablecoins is structured in a DeFi securities market.
Private credit is a big opportunity in 2023. Banks are losing market share. Hundreds of billions of dollars are moving to private credit funds doing “direct lending.” DeFi lending pools can grab market share.
Private credit funds are taking market share from banks and bond markets. They are also taking share from “club” deals, which are on-demand syndicates. A permanent fund is usually faster and more reliable in setting terms for the borrower. However, I believe that crypto rails will improve the agility of syndicates and make them competitive.
DeFi has some advantages in throwing together syndicated lending pools:
- Crypto rails help pull a deal together. Participants can send tokenized money for escrow, and all of the participants can see how much is committed, on what terms
- Structuring the waterfall for repayments is simple and transparent. While terms are coming together, it’s a big advantage to see the structure directly without having to call a lawyer
- Reporting on underlying assets and cash flows can be very direct
- Payment distribution is easy, transparent, and automated
- Stablecoin-style protocols can provide a new funding source for senior tranches
- DeFi sometimes offers a cost of money advantage
We have already seen the first wave of DeFi pools that make wholesale loans to private borrowers. Many of them got into trouble because they funded terrible credit risks. It’s a bad idea to make uncollateralized loans to leveraged hedge funds.
The next generation will solve this problem. Originators will put in an adequate chunk of first loss capital. Passive pool holders will fund a well-protected senior tranche. DeFi syndicates will compete directly in the market for bank lending, where deals are designed by credit professionals. They can bid against banks for deals where the banks have already designed adequate collateral protection.
Real estate is a huge asset class that has supported dozens of experiments in “tokenization.” The tokenized packages have found few buyers so far.
Tokenized real estate will become more useful if we move the debt financing. Normally, an SPV will buy some real estate, and get a loan that is collateralized by the property. Then the organizers can sell equity shares in the SPV. In a world of tokenized shares, the SPV could buy the building and issue shares that can be used as collateral. Then individual buyers could adjust their leverage by taking margin lending against those shares.
This system can solve some of the governance problems and legal friction that arises when deals get into trouble. Power can migrate between deal sponsors, investors, and lenders.
Private funds with new offering structures
Limited partners (LPs) hold about $5T in private funds that invest in PE, VC, real estate, and private credit. They make long-term investments that are important to the economy. Private fund organizers have tried many times to sell these LP shares in a tokenized package. However, nobody buys the tokenized versions.
Fund organizers and tokenization vendors have persistently tried to push LP shares into tokens, and buyers have rejected them. Is there a way to find product/market fit?
Fund organizers believe they can reach more investors with a tokenized package and online marketing. However, the economics are not good. Off-chain LP agreements are optimized for long term incentives, use of cash, and taxes. Some of these advantages are lost in a tokenized and securitized package.
Fund organizers also believe that a tokenized package will make it easier to trade LP shares. This will bring in buyers that have shorter time horizons. “Secondary” exchanges of LP shares happen infrequently because of limited information about the underlying holdings. In the US, secondary exchange is difficult because of layers of rules that have built up around securities sales, private fund sales, exchange, and taxes. There are good reasons to organize exchanges when an early-stage fund becomes a later stage fund, and appeals to different investors. This is called a “GP lead” exchange, and it is a growing category.
LP shares are a huge asset class, and even a small amount of new liquidity will be helpful. Tokenized exchange may grow into a significant channel if it is organized outside the US. If we extend the “GP lead” responsibilities to providing marketmaker liquidity, then we can use DeFi to set up an AMM. We can also use DeFi to get some exit liquidity by borrowing against tokenized shares (again, with assigned liquidators). The borrowing mechanism reduces paperwork.
Tokenized funds will benefit from a structure that is different from the current LP fund structure.
For example, some new funds are managed as a DAO — a cooperative of the investors. Crypto offering mechanics might be a good way to accelerate the accumulation of fund commitments, which is often a long and painful process. Early contributors might get a bigger share of the GP compensation.
A more significant change will explode private funds into syndicated deals and rollup funds.
DeFi-ready securities can support VC investment through syndicates and rollup pools.
A syndicate is a group of investors that pools money to buy and manage a single deal. A syndicate can be managed like a VC fund, with a partner that organizes the investment and manages communication with the investee going forward. Crypto rails and mechanics can streamline the formation of these syndicates.
DeFi-ready securities can help syndicates.
- Crypto escrow pools make it easier to organize and close a deal
- A smart contract can handle governance and distributions
- They get new resale options
It’s a bad idea to allow trading in the early stage equity that comes out of VC deals. There is not enough information or dealflow to attract buyers, which crushes valuations. However, there are some special cases. Transparent crypto protocols can trade effectively even with small market caps. Less transparent companies might schedule windows for exchange, and line up a bunch of disclosures before the window. DeFi-ready securities can be programmed with exchange allowed never, annually, or quarterly. These can also be windows for a rollup swap.
It often takes a long time to get money back from a VC investment. And, the process is statistically unreliable. In the early stage investments made by accelerators, most of the profit comes from 1% of the companies that become unicorns. They can pay back 1000X. It’s possible to have a portfolio with dozens of investments and have it pay back zero, even though the asset class as a whole is returning 10X. Having a large portfolio gives you a big boost in risk adjusted returns.
We can create a large portfolio by swapping early stage shares into a pool. As the pool gets bigger, it gains a predictable expected value, and a real market value. Holders of a single issue can swap some of their illiquid shares and restricted shares into something with current market value.
We can clear the way for this magic by packaging the underlying securities and the pool as DeFi-ready securities.
I first proposed rollups in 2021 while writing “Innovating in Venture Capital”. Now, I am part of a group called CryptoOracle Collective that is successfully using this structure. The collective is rolling up tokens from pre-release projects. They trade $80 of their COC pool, plus some consulting, for $100 of angel-priced tokens. This converts early stage tokens into market value.
SPACs quickly ballooned into a $200B asset class. There is a demand for an investment pool that either gives you your money back, or develops into an exciting liquid issue. SPACs were bad and are mostly dead now. Crypto mechanics can improve SPACs, setting them up for another run.
I have been working on a crypto variant of a SPAC that is implemented as an escrow pool, rather than an offer of liquid shares.
- Pool buyers can deposit assets that are already earning returns or interest — tokens that are invested on safe assets. This removes the complexity and responsibility that sponsors have when they place SPAC assets with banks and bonds.
- Buyers can pull out at any time. This lowers their risk. It gives sponsors a better view into the actual amount that a SPAC can convert to cash in a deal.
- Buyers have an incentive to sign up quickly, because early buyers get more warrants, or warrants on better terms. The DeFi pool tracks the order and the reward allocations.
- As the deal develops, buyers have an increasing incentive not to pull out, because they lose their place in line and their rewards. I believe that this feature can dramatically increase the predictability of cash yield.
- Offering costs are low. SPACs are expensive for sponsors to set up, so sponsors have to take out a significant part of the pool’s upside to compensate. An escrow pool does not require sponsors to spend money on legal setup. Buyers have control of their funds while the funds are in the escrow pool. They have not actually engaged in a transaction until it closes and they convert from their escrow into the proposed deal. This removes up-front legal cost.
New offering mechanics
Pools that sell DeFi-ready securities can support useful offering mechanics. They can reward early contributors, recruit them as supporters, and provide an incentive for fast action. Transparent escrow gives investors a chance to get in and out of an offering “book” or pool as terms and demand develop.
Revenue shares and royalties
Royalties and revenue shares fit well with tokenized distribution because they are easy to administer and largely self documenting. You can see the underlying revenue as you receive your share.
DeFi has created an explosion of creativity around using tokens for governance, “staking” (sharing long term risk in exchange for extra compensation), and structuring of benefits and payments.
For example, a traditional bank offers various tiers of risk to investors — equity, CoCos, bonds, and deposits. DeFi participants move smoothly between these positions. They can stake deposits as a dynamic form of CoCo. Banks can achieve their centuries-old dream of swapping deposits for equity under stress, with free market pricing of that risk.
New features of DeFi-ready securities will add new types of value.