Josh Stein, CEO of Harbor, and Danny An, cofounder and CEO of TrustToken, talk about security tokens and tokens backed by real-world assets, often called an unsexy area of crypto. They explain the strategies their teams are using to tackle the tokenization of what currently constitute $250 trillion in assets, what kinds of new behaviors and business opportunities “faster, cheaper, more liquid” assets could open up, and how they’ll comply with regulations across all jurisdictions for markets that are global and trade 24/7/365.
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StartEngine: https://www.startengine.com/unchained
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Episode links:
Harbor: https://harbor.com
Trust Token: https://www.trusttoken.com
True USD: https://www.trusttoken.com/trueusd/
An overview of security tokens: https://medium.com/@apompliano/the-official-guide-to-tokenized-securities-44e8342bb24f
More on Harbor and security tokens: http://fortune.com/2018/05/18/security-token-harbor-ce
More on True USD: https://venturebeat.com/2018/07/18/trusttoken-readies-sale-of-more-trueusd-asset-based-tokens/
The PICO: https://medium.com/harborhq/introducing-the-private-ico-pico-3e8b782924c1
Episode with Meltem Demirors and Jill Carlson: http://unchainedpodcast.co/episode-74
Transcript:
Laura Shin:
Hi, everyone. Welcome to Unchained, your no-hype resource for all things crypto. I’m your host, Laura Shin. If you’ve been enjoying Unchained, pop into iTunes to give us a top rating or review. That helps other listeners find the show. Here’s a pause for the ads.
Today, our topic is security tokens and tokens backed by real-world assets, and here to discuss are Josh Stein, CEO of Harbor, and Danny An, Co-Founder and CEO of TrustToken. Welcome, Josh and Danny.
Josh Stein:
Thank you.
Danny An:
Hey, great to be here.
Laura Shin:
I want to have each of you describe your products, but before we do that, let’s just start simply with your areas of focus. Josh, Harbor focuses on security tokens. What is the definition of security token?
Josh Stein:
A security token is a token that represents a security interest. So, you can think…and at Harbor, in particular, we’re focused on traditional private securities, so think a share in a private company, a share in a private REIT, an LP interest in a fund, things that we know are securities, but now you’ve simply put an electronic wrapper around it.
Laura Shin:
And Danny, TrustToken focuses on tokenizing real-world assets. How do you define that and what are some examples?
Danny An:
Yeah, definitely. So, real-world assets, we create asset-backed tokens, which means there is an underlying real-world asset backing a token out there. A large majority will probably be security tokens. We started off by tokenizing currencies, and so the first tokenized currency that we created was TrueUSD, and that’s just tokenized dollars, and the basic idea there is that there’s a hundred dollars sitting in escrow somewhere, escrow account, and there’s a hundred TrueUSD out in circulation.
Laura Shin:
So, so far, the vast majority of the ICO hype has been around utility tokens. Why did you guys decide to go with what some people or even a lot of people in this space view as a less sexy area of crypto?
Josh Stein:
So, at Harbor, we, our founding story was having an aha moment. So, David Sacks was raising his first venture cap fund last year and wanted to tokenize it and realized there was no compliant way to do so, and then that’s where the idea of Harbor came from. It’s a huge market. I mean there are so many necessary protocols and DAPPs and other things we need out on the blockchain, but there’s also a tremendous amount of real-world assets that would benefit from tokenization to make them more liquid and readily accessible, and so I don’t think it’s an either-or. I think both sorts of endeavors are really useful, and we don’t mind not being sexy.
Laura Shin:
Danny?
Danny An:
Yeah, and for us, we kind of saw Ethereum as this world computer that would run humanity’s most important computation, and when we asked ourselves what’s actually going to run on a world computer, it’s pretty clear that the primary use case of digital assets like Bitcoin and Ethereum was just trading them back and forth, logging financial transactions, and when we looked at today’s markets, like the New York Stock Exchange, basically everything that’s traded is real-world assets and their derivatives, and so, for us, when we looked at the space, we thought that there was a potential for a new global financial system to emerge and that, you know, cryptocurrency, at that time, was a couple dozens of billions, and real-world assets are 250 trillion, and so we saw that the long-term potential would be, you know, the bridge between real-world assets and this new global financial system.
Laura Shin:
Interesting, so let’s now focus in on each project. Josh, why don’t you start? What are the problems you’re trying to solve and how does Harbor solve them?
Josh Stein:
We’re attacking both the initial formation of private capital and then the secondary liquidity, so I’ll start at the end and then go to the beginning. So, right now, private securities today are highly illiquid. They’re almost completely illiquid, and there’s three main reasons why, buyer and seller can’t find each other, you have to repaper every transaction the most expensive and irritating way possible, and most importantly, there’s almost always a prohibition on the transfer of that private security. If you own an LP interest in a fund or a share in a private REIT, even if you found a buyer and even if it made economic sense to pay 20 grand to repaper the transaction, you can’t do it.
You have to go through that fund manager, through that GP or that REIT fund manager, and the reason why is there’s all these complicated compliance rules and contractual rules that you have to enforce for. We call it the who, what, where of compliance, who the buyer and seller are, what the trade is, where it occurs, and so as a result, because you can only control those things by making it go through the fund manager, these things are highly illiquid, and the end result is that it takes months, sometimes years to get out of a position. It takes a lot of elbow grease, phoning, faxing, emailing around to a limited number of people. It takes 10-to-20 grand to repaper the transaction, and then you take a big hit on valuation at the end of the day. It’s called the illiquidity discount.
So, academic literature tells you it can range to 20, 30 percent or more. We’ve heard a lot of stories from folks out there with LP interests or shares in private REIT, for example, where the discount’s 40, 50, or even 60 percent off of the NAV, but when you need liquidity, you need it, and so if you can unlock liquidity, you can deliver tremendous value. So, tokenization attacks all three problems, and Harbor attacks one in particular. So, buyer and seller can now find each other because of all these exchanges that are springing up in the US and around the world, and I think there are particularly interesting aspects to the decentralized exchanges, folks like 0x that we should talk about a little bit later.
If you set up your corporate documents correctly, you do not need to repaper every transaction. Every time you trade that token, that is enough to do everything you need to do from a legal basis, and then most importantly, Harbor was established to control that who, what, where of compliance, so who the buyer and the seller are, things like KYC/AML and accredited investor status that people talk about all the time. There’s a lot of other restrictions that people don’t talk about as much, things like special restrictions on control officers, special restrictions on affiliates.
What the trade is are things usually related to the cap table, so minimum number of investors or maximum number of investors, limitations on any one investor, group of investors’ holdings, holding periods, and then where the trade occurs. So, that’s the venue. Is it going peer-to-peer, or is it going, trading on a compliantly licensed exchange? So, essentially the way Harbor works is every time that security token goes to trade, it calls to Harbor, and I’m oversimplifying here. Harbor is the all-knowing trade compliance oracle.
We check the who, what, where of compliance, and if it’s compliant, the trade goes through and no one knows Harbor was ever involved, and if it’s not compliant, we throw an error, like an email message bouncing back that explains why the trade didn’t go through. So, for example, the trade would result in too many or too few shareholders. As a result, that fund manager can lift the prohibition of transfer on the private security, allow it to trade to the limits of the market conditions and the regulatory rulesets, and you can now unlock tremendous value by making something that was formerly completely illiquid now much more liquid than it used to be.
Laura Shin:
That’s interesting, but just one quick question before we turn to Danny. So, what if Harbor goes away? Then what happens?
Josh Stein:
Then you…there’s two different alternatives. You come up with another provider, and so you reissue another set of security tokens, and if the whole blockchain effort goes away, which I think we’d all agree is extraordinarily unlikely, then you revert back to paper, and so let me explain. Harbor is designed to feel…so if Harbor goes away or if you terminate Harbor as a provider, the security tokens will no longer trade, but you now have a perfect cap table. You know exactly who owns the shares, and then you go to another provider and you simply reissue a new set of security tokens. You know who all the owners are, both by real-world identity and by wallet address. You simply reissue them new securities with a new provider, or you could keep using Harbor and do it on a different blockchain, and if the blockchain technology in general fails, you would revert to paper, but because you always have that perfect cap table, you know exactly who owned what, when, you have this ability to change providers, change blockchain technologies, or revert to paper.
Laura Shin:
Yeah, I think this is an interesting contrast to TrustToken, as we’ll soon find out. So, Danny, why don’t you tell us, for TrustToken, what problems you’re trying to solve and how TrustToken solves them?
Danny An:
Yeah, definitely, and so we’re also involved in real-world asset tokenization, but we’re much more interested in kind of the global nature of the financial system that’s emerging, and so you can think of some tokenization companies, what they do is there’s a centralized entity that tokenizes assets and then sells them off in the crypto markets, and then there are more decentralized players, for example, Polymath comes to mind, where they create a token, which is used as a means of payment to bring all the providers necessary to tokenize an asset. So, that could be on the legal side as well as on the actual issuing side.
Laura Shin:
I’m sorry. I missed the name of that project. What did you call it?
Danny An:
Polymath.
Laura Shin:
Oh, Polymath, right. Okay.
Danny An:
Yeah, and we’re kind of sitting right in the middle, where we are a centralized tokenization service, where the first thing that we tokenize is US dollars, which is TrueUSD, and then what we do is we say what’s the single component which is most important to decentralize and expand across the world, and the component that we picked is kind of the idea of decentralized underwriting, where if you’re a Chinese businessperson and you’re buying, you know, assets from…let’s say a real estate token from Brazil or US equity token, it’s difficult for you to understand the language and legalities of the underlying legal connection between the asset and the asset token, and so we created a token, it’s called TrustToken, and what it’s used to do is stake on these asset tokens, which acts as an on-chain collateral and a signal and guarantee of trust, and so if there were a case where, you know, there was no actual house connected to a house token, it would reimburse the asset token purchasers, and this happens in traditional finance whenever, let’s say, Goldman underwrites an IPO or Moody’s does a bond rating. Whenever there’s a representation of an asset created, there’s always some entity that’s doing the due diligence and taking on some form of the liability so that when the asset purchaser or the asset token buyer buys, they don’t necessarily have to do the research. They can just piggy back off of the research done previously.
Laura Shin:
And when someone puts an asset on…using TrustToken on the blockchain, does that verification happen before that or after it goes up?
Danny An:
Good question, and so it’s usually right before there’s a purchasing…there’s a, let’s say a bid to sell the asset tokens, and so there’s kind of a request of stake model or a request for stake, and what that request for stake triggers is essentially research into the underlying mechanics of how the asset token was created and how it’s connected to the underlying asset.
Laura Shin:
Yeah, I think this is what I find interesting because this is like…you know, you did say at the beginning that there is an aspect of this that’s centralized, but this part is decentralized, and in that regard I think you will always, at any given moment, have tokens, or there is the possibility at any given moment that there will be tokens that have been put on the blockchain using TrustToken that are fraudulent, and they would only be found out after the fact, right, whereas like with Harbor you would know for certain beforehand that, you know, something is legitimate. Isn’t that…am I correct in thinking that?
Danny An:
Yeah, so with asset tokenization, it…in the space it requires some of the most trust because you’re relying on someone to have done a sound legal connection, and so if you have a trusted entity, like Harbor, you know, most people will generally trust that unless Harbor isn’t as well-known across, let’s say, in the Asian regions. So, there’s always this problem of how do you create a standard by which the world can accept that that’s a signal and guarantee of trust? And so one way to think about that is if you’re on Alibaba or Amazon, you’re looking at the five-star ratings and reviews, but when those were coming online, you know, it wasn’t accepted as the standard means of who to buy from and what to buy.
Now it kind of is, but the problem with buying asset tokens is that you’re never actually getting, let’s say, a shoebox where you can inspect the quality immediately after you purchase it or sometimes soon after. You’re buying a representation of the asset, and that asset changes in value over time, and the underlying asset also changes over time, as well, and so there needs to be a process by which people can have a…let’s say a new and improved ratings and review model where you can start to see where the stake accrues to the most trustworthy asset token issuers as well as the stakers themselves, who would be given the most stake if they did the best due diligence and took on most of the liability.
Laura Shin:
Okay, so, yeah, this whole thing is interesting. We can get more into it later, but I just want to find out from you guys, so, if your projects are successful at tokenizing these types of assets, what new types of trading or investing behaviors or products and services do you think they’ll enable?
Josh Stein:
So, I think you’re going to see a really interesting unbundling and then rebundling of property interest. I think if you step back, what tokenization does and the software platforms that onboard the investors and the issuers do is it allows you to form private capital faster, cheaper, and easier, and then it allows secondary liquidity that is faster, cheaper, and easier by orders of magnitude, and so as a result, if you think of these things as LEGO blocks, you can unbundle property rights down into smaller units and different units and then rebundle them together in interesting ways. So, if you take real estate, for example, which is where we’re seeing a lot of concentrated interest, you can…imagine a world in which you have tokenized interested in a bunch of the Class A office buildings around the New York region. You could then create a fund that owns 10 percent of the interest in the Class A in Downtown. It essentially would be a Class A ETF. You could do the same for Midtown, for the Upper East Side. You could then create a fund on top of that that would be a Manhattan Class A ETF, in essence, the way it functions.
You’d have the same thing for Jersey, for the boroughs, and then using great technologies like dYdX, you could very cheaply go long Downtown, short Uptown. You could go long Manhattan, short the boroughs, long New York, short San Francisco. In other words, you could make a much more concentrated investment bet than you can otherwise and really express your thesis and lay off or take on risk as appropriate. I think what becomes really interesting, as well, is if you think about, say, sports teams, and I think those are interesting because you can now rebundle in rights not normally associated with a private security. So take, for example, let’s take a sports team, say the 49ers, and let’s use a round number. Let’s say they’re worth a billion dollars. You could tokenize a portion of that asset.
You could create a class of stock that owns, say, 10 percent of the 49ers. Today, if you did that, you’d go sell that to a single individual, who would then want a lot of onerous control provisions. If you tokenized it, if you broke it up into a lot of smaller pieces, say 2 thousand pieces, which is the maximum number of shareholders for a single class of equity, that’s now a 50-thouand dollar unit of investment, so there’s a lot of people around the Bay Area who would love to own a piece of the 49ers, and that would be a real piece of stock with potentially dividends as well as capital appreciation when it’s sold, but now you could bundle in other interesting rights. So, you could say everyone who’s an equity shareholder in the 49ers now has first dibs on box seats or on season passes.
You could say every home game you get to meet the players after the game, just for the shareholders. You could have an annual meeting where you talk to the coaches and the GM about the strategy, and the 49ers would get a much better price, a much higher value for that small minority interest in the company, the shareholders would get things that they value so much more, things that are property interests not normally associated with securities, and what’s really interesting is all those little extras I talked about have enormous value to the fans who become shareholders but have almost no cost to the 49ers, and so as a result, what you’re doing is you’re unbundling and then rebundling property interest in ways that allow each side to get the maximum value that they’re looking for, because they can get precisely what they want.
Laura Shin:
And the reason that’s not possibly now is simply because of the cost of administration of that type of thing? Is that what it is?
Josh Stein:
Yes. It simply becomes impractical. I think if we step back and we think about the effect of tokenization, I think of it as the transition from snail mail to email, right? It used to be with written communications we typed it out, we clicked print, we threw it in an envelope, we paid 50 cents, we waited 3 days, and that seemed just fine, and then suddenly I can remember, distinctly, when we started clicking send and it was orders of magnitude faster, cheaper, and easier to send that communication.
The content of the written communication was the same, but by putting it in an electronic format, you could do wonderful things with it, and I think similar to private securities. Once you put it in electronic format, in a way that’s interoperable and interchangeable across all these different systems, like exchanges that are springing up, you can now do things with it on a practical level that you couldn’t before. I mean it used to be…no one in the history of the world ever mailed a letter to somebody saying where are we going to lunch today, but we send that email all the time, because it simply wasn’t practical to do so before email came along.
Laura Shin:
And Danny, did you want to add anything about new behaviors or services?
Danny An:
Yeah, definitely. I think Josh put it very well. We can, I guess, geek out on the ramifications of tokens and tokenization of assets, and the thing that I’m most excited about but I don’t get a lot of chances to talk about, because I think it’s kind of more of a far-out futuristic scene, is around when you start to connect these assets onto a transparent, interoperable, codable system, the amount of things that you can build on top of, let’s say HouseCoin and USD Coin or Eurocoin is, is amazing, and so one concrete example of this is, you know, there’s a lot of work going into tokenizing US dollars to create TrueUSD, but then soon afterward, a project called {Set} Protocol bundled up MakerDAO and a couple of other stable coins like TrueUSD and created a set of stable coins, and on top of that you can create more stable coins, and you can start to have what Josh was describing, where you are able to create bundles or sets of all these different tokens, and then there can be code written on top of them about how these tokens should be traded and valued, and so that kind of future world, where the financial system is transparent and people can build on top of it anything and the barriers to entry to doing that is very low, I think has unforeseen consequences that will be…make our species much more productive and transparent as a result.
Laura Shin:
And Danny, you mentioned a figure earlier, about the size of the current securities market or investment vehicles based off real-world assets, and I don’t remember that number, but what is that and then how much bigger do you think it could grow?
Danny An:
The number is 250 trillion dollars. How much bigger it could grow, it generally is trending with, I guess, human productivity and how much we value assets, and so it grows just as quickly as I would guess productivity grows for humanity.
Laura Shin:
Okay, and so let’s go to the exchange question that Josh brought up earlier. Where will these types of tokens trade? Are there any exchanges that are set up now that can trade security tokens or other real-world…well, I guess there are ones that can do real-world asset-backed tokens, but yeah, let’s start there.
Josh Stein:
There are a number that are in place today, and there’s a lot more that are in the pipeline that should be getting their proper regulatory approvals shortly. We’re big fans of folks on the 0x Protocol in particular, and I think what’s really interesting about that, Laura, is the ability to have a worldwide order book. If you ask today why isn’t everything in one exchange, and the answer is, is because there’s so many different stacks that you have to do. There’s a tech stack to running an exchange, which is a nontrivial lift. There’s a relationship stack. You have to have relationships with market makers and investors and others, and then there is a regulatory stack, where you need to get the right licensure, you have to have the right compliance people, you’ve got to generate the right reports, you have to control for all the right regulatory things, and we’ve seen that, the failure to do that in some of the recent headlines around wash trading in Bitcoin in particular.
And so as a result, you have a bunch of different exchanges by jurisdiction, and what 0x, I think, is really interesting that it allows you to do is now in a security token world, you can have exchanges around the world that are compliantly licensed in their jurisdiction that specialize in their country’s relationships, in their…all the folks that they need, that relationship stack, that business stack, that tech stack, that regulatory stack, and yet there can be one worldwide order book, one worldwide pool of liquidity, which today you can’t do. All those different exchanges are fragmented pools of liquidity, and I think that’s really exciting and something that’s…only the blockchain can do and something that’s very new.
Laura Shin:
And so just name some of the exchanges where people can trade security tokens now?
Josh Stein:
So, there are folks that are compliantly set up and licensed are OpenFinance and Templum spring to mind. There’s tZero as well. I’m not quite sure on the status of their project, Ocean X or The Ocean, as they’re now called, should be coming along shortly, and there are a number of other folks that are in the pipeline, both in the US and abroad.
Laura Shin:
Okay, let’s talk about regulation. I think there’s kind of a whole soup of regulations that apply in this realm, especially around securities law. Can you name some of these, like Reg D, Reg S, and define them and any particular rules in foreign jurisdictions that might be important for people to know about, just so as we keep, you know, moving through this discussion, people have a framework.
Josh Stein:
So, sure, so Reg D, Reg S, Reg A, those things you hear about, apply to private securities that are trying to avoid becoming public securities. They’re exemptions. So, the rule generally is you start with the rule that if you’re going to offer securities, you have to publicly register. You’ve got to file an S-1 with the SEC. They have to review it. You have to comply with a whole host of ongoing regulatory restrictions, both on raising the capital and then ongoing as an enterprise. There are exemptions to that that allow you to raise capital privately, and they become very big. People raise more capital now privately than they do publicly, not just in the US but in almost all places around the world, because if you fall in one of these exemptions, you avoid a lot of expense and delay inherent with complying with all these regulatory requirements.
So, one of those is Reg D. It’s probably the most commonly used, and that allows you to be exempt from filing for registration with the SEC. You have to hit certain requirements, and one of the biggest ones is, is, to oversimplify, is essentially you’re only dealing with accredited investors, individuals with more than 200 thousand in income or couples with more than 300 thousand in income or assets over a million dollars, and so it becomes restrictive, and you’ll hear a lot of that about this issue when we’re in other crypto forms simply because people feel like it excludes a lot of people from investment opportunities. I think what’s notable about those Reg D securities is that after a year, you can have non-accrediteds buy them, particularly for non-equity securities. Another class is what they call Reg S, so those are securities offered overseas, sold to overseas investors.
Essentially what it says is the US will not apply most of its rules as long as they’re sold overseas and you take reasonable precautions to keep them from filtering back into the US, and then finally there’s Regulation CF or Reg Crowdfunding, which allows you…I can’t remember what the exact limit is, if it’s 2 million or 5 million, but it allows you to raise money from non-accrediteds more widely, and there’s Reg A or Reg A+, where you have a filing with the SEC and you can take in non-accrediteds, but there are certain restrictions around them, and there are different classifications of requirements depending on how much money you raise. People refer to Reg A, a lot of times, as IPO light, and depending on how much money you’re raising and what you’re doing, it’s much more on the light scale or much more feels like an IPO.
Laura Shin:
And Danny, are there any types of regulation that you feel like people should know about when it comes to the other types of assets that TrustToken deals with?
Danny An:
No, Josh did a good coverage of it.
Laura Shin:
Okay.
Danny An:
In the United States.
Laura Shin:
Okay, yeah, and are there any foreign regulations that we should talk about now before we move forward?
Danny An:
No, I don’t think so. There was, I guess, China had a restriction on ICOs, but that was just kind of a blanket ban, and I just got back from Beijing, and it seems like they’ve lightened and relaxed that and said proceed with caution.
Laura Shin:
Interesting. Oh, I missed that news. Okay, so let’s just dive a little bit deeper into security tokens. How do you make sure that any investors that are holding these securities are compliant with the regulations in that jurisdiction?
Josh Stein:
So, at Harbor, the way we deal with it is we’re a platform plus a protocol, so we’re a software-as-a-service platform for onboarding the investor. In that way, we always have a real-world identity that we can correlate with a blockchain wallet address, and then that way we’re able to check the who, what, where of compliance constantly. There are certain things you can’t encode. So, you cannot encode whether or not there’s underlying fraud going on in the business or the business is cooking its books, obviously, and there’s certain other aspects to the rules around how those trade that you can’t encode. So, if you trade after 90 days in the US, you can do it according to what’s called a Section 4(a)(7) exemption, where accredited investors can trade amongst themselves, but they can’t post a public ask.
They can’t generally solicit someone to buy from them. It has to be done among preexisting relationships or quietly, what we would call peer-to-peer, and so, in essence, what Harbor can control for and does control for is that if it’s posted on an exchange, it’s on an exchange that’s compliantly licensed, but we can’t control whether or not someone’s generally soliciting under 4(a)(7). That’s something that occurs off the blockchain. So, I think there needs to be a real distinction between what’s occurring on blockchain that you can’t control for and what occurs out in the real world that doesn’t have a connection that you cannot control for.
Laura Shin:
And just out of curiosity, so, what standards are you using for identity, to ensure compliance? Are you using blockchain-based identities or something else?
Josh Stein:
We go through a standard KYC/AML process. So, for example, when an investor goes to set up a Harbor account to be vetted to invest, it’s a very streamlined process, but it’s very similar to opening up an account at another financial institution, name, address, social, date of birth, a few other pieces of info, and then they upload a copy of the driver’s license, both sides, and then we go through an automated KYC/AML process to do some initial vetting, and we also check sanctions lists and other lists that you look at to avoid people that you don’t want investing, but fundamentally it’s not something that can be done wholly on the blockchain for both technical reasons and for regulatory reasons.
Laura Shin:
So then how do you make sure that the secondary trading is complaint in terms of who’s buying?
Josh Stein:
If the buyer is unknown, the trade won’t go through.
Laura Shin:
Oh.
Josh Stein:
So, short term, what it means is, it means the buyer would have to go through the Harbor platform to get vetted. Longer term, we hope to establish relationships with exchanges around the world, where we can rely on each other’s KYC, so that way…and you would pass that information probably via API off-chain or perhaps in the future through certain designations on-chain that would allow the trade to go through without any friction, but ultimately…some people view that you could put this entirely on the blockchain and rely on that, but the problem is you can outsource the work of KYC/AML. You cannot outsource the responsibility.
So, ultimately, if you want to rely on someone else’s KYC/AML work, one, under the regulations, if you’re going to rely on it, they need to be a licensed financial institution, and two, you want to make sure they’re doing it correctly, and so you would want to kick the tires in their compliance program. You’d want to know that they were reputable. You simply…some unknown party having written that this is an okay investor on the blockchain is not something that at least I would want to wager my livelihood on.
Laura Shin:
We’re going to get into more specific questions for each project, but first I’d like to take a quick break to tell you about our fabulous sponsors. Here’s a pause for the ads.
Laura Shin:
I’m speaking about security tokens and other real-world asset-backed tokens with Josh Stein of Harbor and Danny An of TrustToken. So, Danny, I actually wanted to find out, so, you know, obviously with Harbor, because it is more centralized and they are controlling this platform, if regulations change they can probably do the upgrade, and Josh, correct me if I got that wrong, but I was curious with TrustToken, how that works if it’s, you know, if there is kind of a slightly more decentralized model.
Danny An:
Yeah, and so the way you can think about TrustToken’s staking is that it’s shifting the counterparty risk that’s off-chain, on-chain, and so when there’s the actual smart contracts for when stake is released, it’ll be very clear about when is the case…in which case it is released, and so that could cover, you know, any regulatory mishap, and so the way to think about it is that the stake essentially is a guarantee that there will be a reimbursement of the purchase of the amount of the asset tokens in the case that there isn’t a regulatory adaptation that occurs, and so it’s pretty difficult to actually follow along with all of the regulatory changes going around globally and making sure that whenever a new regulatory change happens that there is a change in exactly how the code is operating, but you can create essentially a generalized insurance mechanism or some way of ensuring that someone is watching out for that and saying, like, okay, I have my stake and so I will notify…let’s say the token issuer to change this because now, now they are outside of the bounds of a particular jurisdiction’s regulation.
Laura Shin:
And just because we didn’t go into detail on this before, I just want to have you spell out for listeners how it is that stakers get compensated for the work they do.
Danny An:
Yeah, so staking incentives are…there’s kind of a twofold model, and so one staking incentive model is based off of tokenized currencies, and it’s all based off of velocity, and so asset tokens that tend to move around a lot will have a transaction fee or even collateral interest based off of the dollars or currency sitting in the bank account, and the second model is based off of asset tokens that are based off of commodities or assets that you tend to just hold for the appreciation value, so they don’t have a lot of velocity, and so this model, we’ve kind of derived just by looking at how bond ratings occur with bond issuers.
And so in the 2008 financial crisis, the aftermath, S&P 500 got fined I’d say close to a billion dollars because they had an incentive to give good bond ratings to the bond issuers for continued business, and that became a problem in the 2008 financial crisis because, you know, they were giving better bond ratings than was warranted for those bonds, and the way that the incentive model works for staking is that there’ll just be a set, fixed token dilution, where it will be printing…let’s say there’s a hundred gold coins, some number of gold coins per month to give to the actual stakers as re-compensation, and so that better aligns the incentive where now the staker, in itself, has an automated way of receiving incentives but also is aligned and you know giving…actually staking only things they have long-term belief in.
Laura Shin:
And Josh, Harbor has proposed what it calls the private ICO or PICO. What is that?
Josh Stein:
That was a thought piece we put out there, a blog post, where we talked about ways to navigate the securities laws in the US if you were doing an ICO that would be deemed as a security. It is, in essence, an explanation of how you can get increasing liquidity over time even under the current restrictive security guidelines, and we proposed it as a way for ICOs to navigate those issues. I think it becomes difficult, though, because for a protocol token, which is what I refer to when I’m talking about ICOs, for a protocol token, fundamentally, you don’t want to be treated as a security, because if you are, you can’t play that role as a payment service within the particular DAPP and you can’t become a long-term store of value, which seems to be, for a lot of protocol tokens, the important way that they get increasing value. So, it is one way to comply with the securities laws while you’re waiting for regulatory clarity, but ultimately, I think, for most protocol tokens, they won’t work if they are deemed to be securities.
Laura Shin:
Oh, interesting. Okay. Yeah. That makes sense. Danny, I wanted to ask you…I know that you guys work with a licensed trust company that will hold assets, at least, I guess in the case of TrueUSD, on behalf of token-holders. So, let’s say that there ends up being like, I don’t know, a hundred million dollars’ worth of…for TrueUSD in that account, and in that instance, I’m assuming KYC/AML has been done on all the purchasers. Will that also be done on everyone that they trade with, and if not, how does that affect any regulations that the trust company has to abide by, and if so, how do you enforce KYC/AML being done on all secondary purchases of TrueUSD?
Danny An:
Yeah, definitely, and so we do KYC/AML upon all purchases, whenever there’s fiat involved, so wiring money in and out, and then we rely also…we have a policy that we send to all the exchanges kind of clarifying what are the KYC/AML policies that we expect of them, and this is similar to the idea of that Josh mentioned where you could piggyback off of other KYC practices, and so there is a kind of a question of whether or not you have to KYC/AML every single TrueUSD-holder, and so the kind of argument that I’ve heard from attorneys about this is that you don’t KYC/AML every single person that holds cash, and there is a bit more transparency in exactly where the funds are for TrueUSD in the pseudonymous wallets.
Laura Shin:
Oh, so that there isn’t legal clarity about whether or not there needs to be KYC/AML on all those trades or transactions?
Danny An:
Yeah, and generally, a lot of the space has very little legal clarity on exactly what is the amount of…or there’s very little legal, full legal clarity here in this space, and so one thing that we test drive, which is similar to how Harbor probably does it with KYC/AML, and then we have a public-key address that we do identity verification on, and then we link the identity with the public key, and we have a whitelist, and so 0x and the relayers there are testing a way where you could have a decentralized exchange that pings the KYC/AML whitelist to be able to confirm that this person has a verified identity based off of our KYC/AML practices, and so it would be a similar methodology for checking each trade, whether or not both the buyer and seller have the proper identity of people to facilitate the trade.
Laura Shin:
I actually want to go back to our conversation about DEXs. Josh, I definitely understand, you know, what points you were making there about why DEXs seem quite promising to use and particularly in the case where you’re using relayers that can perform KYC/AML procedures. You know that would make a lot of sense, but then if you’re using the protocol in the peer-to-peer fashion, then doesn’t that risk securities being traded out of compliance?
Josh Stein:
No, it doesn’t. So, when it’s traded peer-to-peer, when it goes from one wallet address, the person who owns it, to the buyer, the buyer must’ve been vetted, if it’s a Harbor-issued token. If the buyer is unknown, it’ll throw an error and the trade will never happen, because the whole point is if you can’t, in real time, correlate real-world identity with blockchain identity, with the wallet address, you can’t control that who, what, where of compliance.
Laura Shin:
Oh, right, right, right. Okay. That’s because of the centralized aspect.
Josh Stein:
Yeah, so we have…in Harbor, it’s interesting. So, we’re not fully decentralized. I think some systems like TrustToken or Polymath are interesting in the sense of it’s fully decentralized actors who trust each other because they’ve posted bonds. It’s an interesting model. Some folks are fully centralized, where they’re the issuing platform, the exchange, and everything can only happen within their walled garden. The approach Harbor has taken is what we feel is a sweet spot in between, where we are decentralized as to everything but compliance. Harbor centralizes the compliance functions, which we think for both regulatory reasons and the state at which the markets currently are make the most sense. Where we’re decentralized is everything else. These are ERC20 standard tokens that work with any wallet, any exchange, any system that works with ERC20 standard tokens.
Laura Shin:
So, let’s keep talking about the centralization because, I don’t know, you may not have heard, but on a recent skeptics’ podcast I did with Meltem Demirors and Jill Carlson, Meltem said something hilarious. Everybody like needs to listen to this episode if you haven’t heard it because she, you know, was just saying like she really felt like there was no value add to securitizing financial…to tokenizing securities, and she said just use an Excel spreadsheet.
I had another person tell me they thought securitizing…tokenizing securities gave marginal improvements of maybe like at most 1.5x, and in general I feel like, you know, some of these people are saying, well, you know, the purpose of blockchain technology is for trustless transactions, and so in the case of, you know, tokenized security, where let’s say it’s a share of a company or something, you still have to trust that that company will honor its obligations to you. So, how can you enforce that? You know they feel like this doesn’t solve some of the other problems that we have in centralized systems.
Josh Stein:
So, they’re correct in a sense of you’re not in a crypto nirvana where everything is trustless. I think you can think of what the blockchain does for tokenized securities and trust in three areas. You can think of it in terms of the investment, the record or evidence of ownership, and then secondary liquidity. In terms of the investment itself, it doesn’t change anything. When you invest, you’re investing your money into the hands of somebody else, and that’s why there’s securities laws to begin with, because there are trust issues, what’s called the principal-agent problem. So, you need to do your due diligence on the investment, and that doesn’t change, doesn’t change at all. If you have a terrible investment and you tokenize it, it’s now a much more liquid terrible investment. I’ve used more scatological comparisons before, so.
Laura Shin:
Oh, no, the title of that episode with Meltem and Jill was something called like…something about the shitcoin waterfall, so I literally had to give an explicit warning because they had warned me in advance that there was going to be explicit language.
Josh Stein:
So, look, yeah, if you have a crappy investment and you tokenize it, you now have a more liquid crappy investment, and any parent of young children knows that that’s a bad idea. So, but your record of ownership is suddenly much better. Why, because you have one record, that distributed ledger that shows who owns what. So, particularly for overseas investors, relative to where the investment is, but even for anyone, you don’t have the double counting problem. You know if you own a share, you own that one share and no one else owns it. You don’t have the Dole Food’s problem, where Dole was, if I can remember the facts correctly, was public going private. Dole thought they had 34 million shares outstanding, the investing public thought they had 46 million shares, and the Delaware Chancery Court threw up their hands in the air and said you guys go figure it out.
Laura Shin:
Yeah, this is… Caitlin Long always references that when she talks about the promise of blockchain, but anyway, keep going.
Josh Stein:
It’s a great one. So, you know you own what you own, and particularly for companies as well, if we go back to that sports team analogy, the 49ers, for them to bundle other property rights into securities that aren’t normally associated with them, they need to know who all their shareholders are, and in the public markets, the companies don’t. All Apple knows or IBM knows is that DTC owns all their shares, and then DTC only knows they have these huge broker accounts, and those brokers only know they have the sub-broker accounts, and that’s why the records get out of whack and nobody can reach out directly. So, the investment is still centralized. You still need to have trust and do your due diligence. Your record of ownership now is clear.
You know you own what you own and you don’t have double counting, but now secondary liquidity is where you get the magic of the blockchain, and that is where you can trade 24/7, 365, around the globe, with near-instantaneous settlement and no counterparty risk, and tokenization or the blockchain, and only the blockchain, can deliver that, and that is a revolution in value, and to go back where you say, well, it’s only 1.5x, 1.5x seems wonderful if what you’re referencing is the value of the asset. When you think of the tens of trillions of dollars of assets to tokenize, if you could increase the value of them by 50 percent, that’s a tremendous amount of value to unlock. Like I said, we don’t mind not being sexy.
Laura Shin:
Well, I want to ask you about having this record of ownership that you, well, that isn’t inaccurate, right, but what if…let’s say that I own a share of a private company and I say that I lose my private keys, and you know the company thinks I’m just claiming that I lost it. So, do I lose that share forever, and so does the company just keep that money, or do they replace the share for me, and if so then how can I actually prove that I did really lose the access and I’m not just trying to get a second share?
Josh Stein:
So, at Harbor, what we would do is we would cancel the lost share, the shares that are in that lost wallet, and then reissue new shares. So, let me explain that a little bit. As a private company, you have to have the ability to control your cap table. If, for example, if a court orders that ownership be delivered from one person to another, you have to be able to amend the books and records of your corporation, that stock ledger, to show that Josh no longer owns this share, Laura does, if, for example, there’s a divorce or there’s a court decree and you have to move ownership.
You have to have the ability to do that. So, in the way we’ve organized our smart contracts and the way it interacts with the off-chain platform, we have the ability to cancel shares and then reissue them, and you need to have the ability to do that. That becomes controversial in the crypto world sometimes in the sense that people say, well, then how do I own what I own? The answer is you own it, in a sense, in the same way you do today. It’s not the token itself. It’s the record of ownership that the token is that shows you own what you own, and that record of ownership needs to be transferred as appropriate.
Laura Shin:
Interesting. So, here’s a question for both of you. Do the token standards that you’re creating, do they work together? Are they interoperable?
Josh Stein:
So, at Harbor it’s an ERC20 standard token. It works with any other system or DAPP that works with ERC20 standard tokens. There’s just simply a vetting process. So, if there’s an intermediate wallet, we would have to whitelist that wallet because we would have to ensure that it’s trading on a compliantly licensed exchange, but otherwise, like I said, only the compliance is centralized. Everything else is decentralized and fits into the larger Ethereum ecosystem.
Laura Shin:
So, if I, let’s say, you know, this kind of global exchange that you described earlier comes to fruition, if I want to exchange a security token that is built on the Harbor standard with a different security token built on the TrustToken standard, can I do that?
Josh Stein:
That is not something I’d thought through before. I know we’re on a podcast, but I’m staring up at the ceiling, thinking.
Laura Shin:
Danny?
Danny An:
I, you know, that’s something we’d have to work through, but to be honest, I’m really excited about a particular class of TrustTokens, TrueUSD, or I’ll call it just crypto fiat. We have, with our platform, come up with a way for investors to pay with Bitcoin or Ether when they buy security tokens, but the issue…that doesn’t seem too revolutionary. What was revolutionary and took a lot of engineering and a lot of thought in designing processes was nobody wanted to take cryptocurrency risk. How do you do it in a way where people invest, you can hold the cryptocurrency in escrow, and then later convert and no one bears any cryptocurrency risk? It’s actually a very difficult problem, and it made me convinced that stable coins with on-ramps and off-ramps to fiat out in the real world are extraordinarily necessary for the crypto economy to really take off, and so we look forward to TrueUSD being available to more retail-like individuals to use, because we would love to be able to accept it and facilitate it if people are buying securities as they’re issued.
Laura Shin:
Yeah, Danny, why don’t you talk about that because I know you have an interesting strategy around why you guys decided to start there, in the universe of all the different real-world assets that you could’ve tokenized?
Danny An:
Yeah, so the way that we thought about which assets to tokenize, in which sequence, is how complex the asset. The way we would think about that is how much information would you need to know from me if you’re buying that asset? So, currency, you’re buying US dollars from me, you don’t need to know basically any information. If you’re buying commodities, you need a little more, gold and oil, and when you get into securities, like real estate or corporation shares, that’s when you need the most disclosures, and so a lot of that is actually about information asymmetry, how much information you would need to know and how much information could someone take advantage of to price the asset in their favor, and so the advantage of tokenized currencies is that, one, they had more legal clarity, meaning that there’s a strong legal argument that it’s not a security token because there’s no expectation of profit. People generally buy TrueUSD at a dollar and expect to sell at a dollar, and the second thing was that there was proven demand and there was space for let’s say a more trustworthy alternative as a stable coin, and three, it was just the simplest asset class to tokenize, but that makes it also one of the most pragmatic and useful ones that the crypto economy could use, for sure.
Laura Shin:
So, a question for both of you, how do you plan to compete against traditional finance and all the firms that are currently profiting from securities and other real-world assets?
Josh Stein:
So, we don’t think that Harbor competes with those. I think the best analogy is Salesforce.com. No one ever said, oh, let’s not use Salesforce because it’s going to compete with our salespeople. They went and bought the technology because it was a platform that enabled them to be more effective and efficient. So, similarly, we view Harbor as a platform for companies raising capital, for brokers, investment banks, and others to be able to raise private capital more efficiently and raise more of it and to enable this secondary liquidity in private securities that never really existed before, and so we don’t view ourselves as competitive to them. We view us as enabling them with the new technology.
Laura Shin:
So, they’ll be your customers?
Josh Stein:
The people raising capital are our customers, so ultimately the companies, but we want to be partners with the investment banks, the broker-dealers, and others, so you’re still going to need networks of broker-dealers to sell some of these investments. You still need investment banks to structure it and place it. You still need the services of other folks in there, but if we can all become more efficient and play those roles better by using Harbor then everybody’s better off. It’s lower cost and more capital, more quickly, to the companies that need capital to go do real things in the real world, and it’s a better market for everyone involved because it’s a bigger, more liquid market.
Laura Shin:
Danny, what about you? How does TrustToken plan to compete?
Danny An:
Well, since we have a decentralized model, it very much is the case that we see it as, as long as people…if people are willing to adopt, let’s say, TrustToken staking across the world, not just in the United States, ours is much more collaborative, and so we will tokenize assets and we’ll use that as a demonstration of the standards, but we hope to work with many asset token issuers as well as traditional financial firms that enter the space and collaborate.
Laura Shin:
And a lot of people in crypto are talking about how in order for the space to take off we need infrastructure to be built. What kinds of infrastructure need to be built in order for this particular area with security tokens or other tokenized versions of real-world assets to become easily tradeable?
Josh Stein:
So, I think we’re well on our way there, and I think it’s going to be a process as it gets better and better, more and more, but I think I’d illustrate that with some things that seem more trivial or administrative are actually big lets The great part about tokenization is that you can break things down into smaller units of investment. You can create more shares. You can syndicate more widely, but that actually increases the administrative burden. So, an investment where you’re raising a hundred million that you would normally take on 20 investors or 30, and now suddenly you’re taking on 2 thousand means that’s 2 thousand more or 18 hundred more people to track.
If you’re a REIT or a fund that’s doing distributions, that’s 10x the number of checks you got to write, 1099s or K-1 you have to distribute. In other words, there’s going to need to be a whole bunch of services around cap-table management and fund administration, and that will enable this to go forward even more. For investors, they’re going to need a lot more friendly UX and UI in how they interact with the tokenized securities, and this has been said on some of your podcasts and others before, which is we’ll know we’re successful and we’ll know we have mainstream adoption at the point at which no one hears the word crypto or token. It just feels like dealing with a normal SAS interface, and you’re just focused on the investment, not the underlying technology.
Laura Shin:
Yeah, Danny, do you want to add anything?
Danny An:
Yeah, I think custody is a large component here, both from personal and institutional custody, where a lot of people still aren’t comfortable at all with private-key management, and for widestream adoption, being able to hold crypto and actually own it is an important component where there’s wider adoption.
Josh Stein:
So, I think, actually, that’s true in certain cases. I think it’s less true or a misnomer in others. That’s important to understand, which is, in the case of private securities, we get led astray by using the term token. Token is a mental model that’s not actually accurate. There is nothing physical to a token. A token is simply a notation in a ledger, like the old stock ledger that companies kept that just says Josh owns 50 shares, and then when we trade, it says Josh -20 and Laura +20. So, there is actually no share to custody. There is no stock certificate out there. So, you don’t have the same custodial requirements you would. You need similar services because you don’t want to lose your keys and then go through the hassle of having that old share cancelled and then reissued.
So, there are practical administrative reasons, but tokenized real-world assets are very different than cryptocurrency or crypto assets in the sense of if you’re hacked and lose a cryptocurrency, you are out that money. The asset is gone. If you lose your share in a company, the company hasn’t gone anywhere. The asset is still there. The record of your ownership is still there. All you’ve lost was an easy way to transfer that ownership, and now you need to be reissued a way to transfer that ownership. The magnitude of loss is not the same, and why you want good security hygiene to avoid administrative issues down the road is not the same threat of loss or custodial issues that you get when it’s actual assets.
Laura Shin:
Yeah, I think…I’m just realizing, for Danny, I have a question, because I sort of asked this of Josh, what happens if I lose a TrueUSD that I’ve bought secondarily? Since there are actual dollars in a bank, you know, obviously if I’m the one holding the private keys for those tokens, then what happens? Do I just lose that money or can the bank somehow issue me new TrueUSD, or what happens?
Danny An:
Yeah, so we have centralized control of TrueUSD. We have the ability to mint and burn TrueUSD as well as freeze funds, cancel funds, issue funds into any…a public key, and so similar to how Josh described the centralized control over the asset token smart contract, we have that ability. We haven’t had anyone reach out to us, saying, you know, we’ve completely lost millions of dollars of TrueUSD, but that’s something we would be able to do if we were…if that was proven.
Laura Shin:
Oh, okay, okay. So, in that regard, I think maybe the custody issues are not as great even for TrueUSD.
Danny An:
Yes, the custody issues are not as great, but you still need to do private-key management, and people don’t like to do private-key management.
Laura Shin:
I would second that motion. So, who are some of the issuers that plan to use either the R-Token standard or the TrustToken standard, and what will the first…well, I mean, obviously aside from TrueUSD, what will be the first projects we’ll see coming out of both of your teams?
Josh Stein:
So, for Harbor, there’s been a real flood of interest in real estate in particular, and I think it’s interesting to discuss why. So, I think an interesting question is what makes sense to tokenize and what doesn’t? So, I think what makes sense to tokenize are those interests and assets that are relatively capital-intensive, that are sensitive to the cost of capital and relatively indifferent to the identity of the investor. So, our mantra is lock up the capital, not the investors. So, things like real estate uses a lot of capital, very sensitive to the cost of capital, long-term assets where it’s difficult for them to give redemption rights or to take cash back out but relatively indifferent to who the investors are as long as they’re legal investors.
That’s a great area to tokenize because you can now unbundle things into smaller units of investment, gather more capital from around the world, and lower your cost of capital. I think great contradistinction is, say, tech startups. Folks could tokenize the equity in their Silicon Valley startup, but it really doesn’t make a lot of sense because most of them don’t want investors trading freely in and out of their cap table. They’re not going to allow for liquidity. So, in that case, tokenizing, it gives you a little bit better cap table management. There’s some incremental administrative value, but if you’re not allowing widespread trading, you haven’t delivered any true transformation in value. Tokenization, it hasn’t done much for you.
Laura Shin:
And Danny, obviously you’ve got TrueUSD. How is that going, by the way? What are some metrics or stats around how much is out there?
Danny An:
Yeah, so right now we’re at a market cap of about 60 million and then four months into creating TrueUSD had 80 million, and so TrueUSD price flux…or the market cap fluctuates as people’s perceptions of what crypto will do change, and so if it’s going down, people definitely like TrueUSD as a crypto safe haven to ride out the down-wave, and then if it’s going up, they want to participate in a positive appreciation, and so they go into, let’s say, Bitcoin, but overall it’s doing well. It’s the second-largest stable coin, and it’s the only other fiat-backed stable coin besides Tether on the market right now.
Laura Shin:
And what are some of the other first projects you’ll do, aside from TrueUSD?
Danny An:
Yeah, so we’re looking at other tokenized currencies. We’re really looking at security token exchanges, going live and getting more adoption. If we’re really looking at the most complex assets, like real estate and tokenizing other complex assets, that will definitely be security tokens, and commodities, as well, so maybe a gold or a silver token.
Laura Shin:
And which currencies are you looking at?
Danny An:
Most of the major currencies, so Euro, Hong Kong dollar, and others.
Laura Shin:
Okay. All right. Well, thank you, both, for coming on Unchained. Where can people learn more about your work?
Josh Stein:
Best place is Harbor.com. It’s all there.
Danny An:
TrustToken.com for us.
Laura Shin:
Perfect. Well, thank you, both, for coming on the show.
Danny An:
Thank you.
Josh Stein:
Thank you.
Laura Shin:
Thanks, so much, for joining us today. To learn more about security tokens and real-world asset-backed tokens and Harbor and TrustToken, check out the show notes inside your podcast episode. New episodes of Unchained come out every Tuesday. If you haven’t already, rate, review, and subscribe on Apple Podcasts. If you liked this episode, share it with your friends on Facebook, Twitter, or LinkedIn, and if you’re not yet subscribed to my other podcast, Unconfirmed, I highly recommend you check it out and subscribe now. Unchained is produced by me, Laura Shin, with help from Raelene Gullapalli, Fractal Recordings, Jennie Josephson, Rahul Singireddy and Daniel Nuss. Thanks for listening.
