Five key things to consider when creating an asset-backed security token or fund

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Five key things to consider when creating an asset-backed security token or fund

With the rising interest in creating various types of asset-backed security tokens, the question of creating the optimal structure for these types of tokens has been a recurring topic of conversation. In this post, we will take a moment to discuss some of the typical considerations when creating a crypto-based asset offering.

Choosing a blockchain

The first consideration is choosing a blockchain and smart contract environment. At fraction/al we use Ethereum for our security tokens. We’ve chosen this environment because it provides us with the broadest pool of users and capabilities. Among the reasons, we like Ethereum is it has the broadest ecosystem of developers, tools like wallets and broad market liquidity.

Although there are many other blockchains, ultimately it comes down to understanding your potential investors/buyers and ensuring they are able to easily purchase the tokens, trade them and receive recurring monetary distributions or payments.

Choosing An Asset-Backed Structure

There are generally two approaches to creating asset-backed security tokens, one is an “asset-backed security” and the other uses a “fund” structure. Each structure has its own advantages and drawbacks.

Asset-backed tokens are typically collateralized by a pool of debt-based assets such as loans, leases, mortgages, credit card debt, royalties or receivables this is also known as “Securitization.” This type of asset-backed security provides recurring cash flow to buyers. In the token world, the distribution could happen at a predefined frequency, such as monthly or quarterly with a payment based on the fraction corresponding to the token. So if there are 100 fractions and the net payout is $100 you would receive $1 per token. Having a process in place to handle the exchange rate from traditional fiat currency to crypto when doing the automatic payment is important.

A drawback of an asset-backed security is pricing the token can be problematic since the price of the token is derived from the yield of assets underpinning the token. For example, if the monthly payment from each token is $1 month, and the initial price per token is $24 the ROI on the token would be roughly 24 months assuming no appreciation or increase in the yield over the term. If the security token is tradable on secondary market the price per token could trade at a premium or discount to the initial offering price not including risk and yield volatility (some months may pay more or less than others) also plays into the price of the token. A predictable yield will most likely limit fluctuations in the price per token, but may also limit upside.

Consider if: The underlying assets generate immediate positive cash flow.

Types of Funds

Another option is to create a fund structure. There are two primary structures of crypto-centric funds: open-end funds and closed-end funds. These structures use a similar approach to traditional mutual funds where money is pooled from many investors to purchase various types of assets and securities.

A closed-end fund is a collective investment model based on issuing a fixed number of tokens which are not redeemable from the fund, meaning you can’t sell the token back to fund. Unlike open-end funds, new tokens in a closed-end fund are not created by managers to meet demand from investors. Instead, the tokens can be purchased and sold only in the market. Closed-end funds are usually listed on a recognized token exchange and can be bought and sold on that exchange.  

The price per token is determined by the market and is usually different from the underlying value or net asset value (NAV) per token of the investments held by the fund. The price is said to be at a discount or premium to the NAV when it is below or above the NAV, respectively. A closed ended-fund is the most common format for an asset-backed token. It provides both a freely tradable token backed on real-world assets with known methods of valuing the underlying assets. The drawback is the value of the token could be less than the value of the assets held. The risk associated with closed-end funds is potentially higher than other structures because market confidence is potentially a key factor in pricing the token.

A limitation of a closed fund structure is how money is raised. The structure is similar to a company going public, a closed-end fund will have an initial public offering of its tokens at which it will sell, say, 10 million tokens for $10 each. That will raise $100 million for the fund manager to invest. At that point, the fund’s 10 million tokens will begin to trade on a secondary market.  Any investor who subsequently wishes to buy or sell tokens will do so on the secondary market since no more token will be issued.

Consider if: You are looking to have a tradable token with upfront funding.

Open-end Funds are the most common fund type in the traditional financial world. It is a collective investment approach that can issue and redeem tokens at any time. An investor will generally purchase tokens in the fund directly from the fund itself, rather than from the existing token-holders. Using this structure, An investor can redeem tokens, meaning they can sell the tokens back to fund. A drawback to an open-end fund is because they are typically purchased directly, there is typically no secondary market for trading these types of assets.

An open-end fund token trades at its net asset value (to which sales charges may be added, and adjustments may be made for e.g. the frictional costs of purchasing or selling the underlying investments.) The price at which tokens in an open-ended fund are issued or can be redeemed will vary in proportion to the net asset value of the fund and so directly reflects its performance.  With open-end funds, the value is precisely equal to the NAV. So investing $1000 into the fund means buying tokens that lay claim to $1000 worth of underlying assets (apart from sales charges and the fund’s investment costs). But buying a closed-end fund trading at a premium might mean buying $900 worth of assets for $1000.

Another benefit to an Open-Ended fund is the concept of evergreen funding or the ability to incrementally add money to the fund. Where a closed a fund the money is limited to the initial funding raised from the IPO/ICO.

Consider if: You are looking to continue raising funds on a going basis.

Asset Custodian and Legal Contracts

When creating an asset-backed offering having a method to ensure the assets are safeguarded is extremely important. The first step is proving the asset is actually owned by the token holders or issuer, this could be in the form of a digital document providing proof of ownership or a trustee.

The next step is having a legal process in place to ensure the asset isn’t sold in the real world while the token representing the asset in the virtual continues to be sold. One of the more typical approaches is to use an asset “custodian” in the form of a trust company, bank or similar financial institution responsible for holding and safeguarding the securities owned within a fund or security.

Lastly, a token holder agreement is important for defining the terms and rights any token holder has in relation to the token. This is similar to shareholder agreement for a more traditional company.

Pricing Your Token

Determining the price of your token is particularly important. Having the right mix of incentives for early backers while also including upside for the later investor is something you’ll need to spend some time considering. Let’s be clear, there is no simple solution when it comes to pricing your token. Each offering will have unique characteristics which will dictate how value will be created from you token offering.  

For example, a yield-driven token where a predictable payout is expected may mean that the price of the token will remain constant. But if the yield changes or is expected to increase as more assets are purchased, than the price of the token may also increase to reflect the increased yield. The benefit to the token holder is they receive the appreciation of the token as well as yield. On the flip side if you choose an open-ended fund you may increase the number of tokens issued as the asset value and or cash flow of the assets increases, essentially keeping the yield constant while the net asset value continues to grow.

Another consideration is tradability of the token. Open-ended funds are not typically traded, so you’ll have a lot more control of the pricing of the token. For example, you may want to hold a portion of the token and wait for the net asset value to increase before making those available. The drawback is you will also have to handle the marketing of the token so buyers know you exist, you will most likely also need to handle redemption, meaning you’ll need to buy back the tokens if your investors want to exit their positions.

For closed-ended funds, buyers have the ability to more easily trade their token and there is an assumption that the token will increase in value based on traditional market economics. There is also a greater risk the value of the token goes down based on these same economic principles. Like anything in life, the greater the risk the greater the reward, but also the greater the chance of loss.  

Traunches and Allocation

“Tranche” is a French word meaning “slice” or “portion.” In the world of investing, it is used to describe a security that can be split up into multiple stages and subsequently sold to investors.

Mortgage-backed securities (MBS), such as collateralized mortgage obligations (CMOs), can often be found in the form of a tranche. These securities can be partitioned based on, say, their maturities or their ratings to appeal to different buyers. Dividing a financial product into parts can certainly increase its marketability, especially for early buyers.

For example, an investor might need cash flow in the short term and have no desire to receive cash in the future. Conversely, another investor could have a need for cash flows in the long term but not right now. To take advantage of this selling situation, an investment bank could split some security or asset, such as a CMO, into different parts so that the first investor receives the early cash flows of the mortgages and the second investor has the right to receive the latter cash flows. With the creation of these tranches, a security or issue that was once unattractive may enjoy some newly found marketability.

Similarly, creating a tranche structure for your security token allows you to offer various incentives for early backers of your token offering. For example, an early traunch may include options that later buyers may not receive including bonus structures, discounts, and increased yield etc.  

Token Disbursement & Payments

How you pay your token holders is a tricky one. The vast majority of cash flow from traditional assets is still in fiat currency, yet the payments to token holders will be most likely made using Crypto.

The first step is to clearly define how, when and how much will be disbursed to token holders. This should be done in the form of a token holder agreement that spells out every step of the payment process. For example, in some months the fund might be running a deficit, therefore no disbursement will be made, if this is the case, there needs to be a clear legal accounting process for how that happens. Likewise, when payments are made, it should be clear how the cash flow has been accounted for. The more transparent the process the less likely you will run into trouble with your investors.

A few good options here including having routine financial audits and third-party accounting firms handling your reporting requirements. Also making your accounting publicly available will also help add clarity.  

The last step is the process in which you actually execute on your disbursement. Having a process to handle the exchange between fiat currency and crypto will be important given the majority of your cash flow will likely be in fiat. There are a  number of “oracles” that can help facilitate this.

The actual disbursement will normally be done via smart contract. This contract will allow you to define the amount of crypto to be dispersed and should provide automatic payment to any token holders including any token holders who may have separate incentives such as higher percentage payouts etc. It’s also a good idea to publish your disbursement smart contract to all token holders so they can see the mechanics of how it works.

Another thing to watch out for is if you have a large number of token holders, especially fractional token holders, such as token holders who might own .00001 of a token, are the costs associated with disbursement. Sending 0.0000001 eth to token holder might cost you 0.001 eth in ethereum transaction costs. Meaning the cost of you disbursement might be prohibitively expensive if you have a large number of fractional token holders. One consideration is to not allow your token to be divisible, meaning you can only buy whole tokens rather than fractions of them.

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