Blockchain is being used for new and inventive ways of dividing assets and allowing shares of those assets to be tracked and traded.
Whether it is commercial real estate, art, or even oil, a large variety of projects are popping up to offer new classes of financial instruments in the form of asset-backed security tokens.
The idea behind these projects is to increase the liquidity of these markets by making them available to smaller investors and making shares easier to buy and sell.
There is a very important and overlooked question when it comes to tokenizing assets: does the token represent a claim on the asset, or does the token represent actual ownership of the asset itself? Investors and token issuers must think carefully about what exactly a token represents.
The design of the tokens and the rights bestowed by them will have a large impact on how much they are worth. This article outlines a few major concepts from the economics of property rights — claim rights, ownership rights, and governance — and explains why these concepts must be considered in the design and evaluation of any tokenized asset.
In order to illustrate the relevant issues, we can look at the example of commercial real estate, or nonresidential properties that are rented out for profit.
Capital in this industry is relatively illiquid, and a variety of blockchain projects have been initiated in this space. Asset backed tokens could be used to represent loans that support leases on units or to represent the buildings themselves. Here I will discuss the implications for tokenizing a commercial real estate building, but the concepts and analysis apply to any tangible asset in any industry.
A tokenized share in commercial real estate has some obvious potential sources of value. Token holders could be given the right to the profit flows from ongoing leases and/or they could be given the proceeds from the sale of the building. However, associating a token with a claim to the profit flows from a commercial real estate property is not enough to determine the value of that token.
In order to determine value, we also have to specify who will have the control rights over the building and how those control rights will be exercised.
These concepts will be explained in more detail below. A key takeaway is that whoever has control rights over the building will be able to make decisions, such as how much to charge for rent, that have a direct and significant impact on how much the asset and profits generated by that asset will be worth. Additional examples of relevant decisions include how much will be spent on marketing the units, how much investment will be made in maintaining and upgrading the units and the building, and how often those investments will be made.
Assignment of asset control rights can be done primarily in two ways when an asset token is issued:
- Control rights can be assigned to the token holders.
- Control rights can be assigned to the token issuer (or some other entity).
Token issuers may choose to design the token so that it bestows control rights. Such a token would functionally be very similar to equity in a business. Importantly, this type of token must be accompanied by a governance system for the asset in question. Governance is the system by which a group of people, such as a set of joint asset owners, can come to unified decisions; in this case, decisions regarding the management of the asset. Without some system to make a determination on these issues, impediments to making and implementing decisions will cause the asset’s value to diminish significantly. Imagine, for example, not being able to rent out the units of a building because the building owners — all 1000+ of them — cannot agree how much lessees should be charged.
Governance could, in theory, involve some type of direct voting system, but it could also function in the same way that corporate governance has functioned for centuries: delegating decision authority to a management team or board of directors who oversee ongoing affairs, combined with a voting system to remove managers for non-performance. For (non-tokenized) commercial real estate this is typically done through a real estate investment trust (REIT).
Sometimes an asset token may not bestow control rights to the asset. For example, the token issuer may be selling a fraction of the profit claims in order to raise funds and want to retain full control over the asset for itself.
The separation of claim rights and control rights creates a situation of misaligned incentives. In such a scenario, the person or entity making decisions may not take into account the impact of their decisions on the value of the claims held by others, and instead only seek to maximize the value of their own position.
For example, a commercial real estate company that wholly owns properties maximizes profits by keeping administrative costs down. But, if that company primarily generates revenues by managing the property, because most of the profit claims have been granted to token holders, then reducing those administrative costs could be at odds with their own profitability. In particular, a company that has sold tokens representing a partial profit claim stake but has retained control rights, could make decisions — such as increasing overhead cost or choosing to forego a sale — that benefit itself to the detriment of token holders.
The best way to ensure incentives are aligned is to unite ownership and claim rights. Doing so would enable the claimants to fire and replace the managers of the asset if they are unhappy with the performance. If giving control rights to token holders is not possible, then other mechanisms for aligning incentives should be explored by the token issuer and prospective buyers should consider how misalignments might impact their returns.
Among blockchain audiences, I often get the question, ‘why do control rights need to be given to anyone; can’t we just automate these decisions through code?’
In short: The answer is no, and the reason is that contracts are incomplete.
We could attempt to specify in a contract between the token issuer and token holders — on paper, in code, or via algorithm — exactly how much will be charged for rent, how much will be spent on marketing and other costs for acquiring lessees, how much will be spent on the administration of leases, how much will be spent on building maintenance and upgrades, and how often those investments will be made.
However, as with all contracts, over time these algorithms would be proven inherently incomplete.
Somewhere, sometime, circumstances will arise that were not accounted for in the algorithm. Something as simple as a new regulation requiring facade upgrade outside of the pre-scheduled maintenance period, or market conditions making it difficult to lease units within the defined price range, or the asset being destroyed by fire. What happens then?
Humans — who in the end are responsible for writing contracts or for programming algorithms — cannot possibly specify every eventuality, let alone what should happen in each of those circumstance over time. Therefore, at some point, an unanticipated decision will have to be made.
In the economics of property rights, ownership is an extremely specific right. Ownership represents the residual control rights to an asset. This means that an owner has the right to make any and all decisions regarding the asset that are not specified or delegated in a contract.
Ownership tells us who makes decisions when the contract cannot.
Because contracts are incomplete, at least one owner — one entity with control rights — must always be specified.
Any blockchain project that is aiming to tokenize asset shares needs to consider more than how to bring liquidity to a market.
Ownership of the underlying asset must be given to someone, and because it will have an impact on the value of the asset’s tokens, the choice of who retains residual control of the asset should not be taken lightly.
Equally important as determining who will have control rights is designing how those control rights can be exercised. If those tokens do represent true ownership of the asset, then the entity issuing the shares needs to think very carefully about governance so that the token holders are able to execute their decision rights. An inability to act jointly when contractual incompleteness rears its head can destroy the value that token holders initially bought into.