by Mara Schmiedt, Global Strategy and Business Development Lead, ConsenSys Codefi

This is a two part article.  Part 1 can be found here.

Summary

• The emergence of delegate work entities present a critical development to drive broader end-user adoption and participation, simultaneously posing new challenges to decentralization and token distribution in the evolving chapter of on-chain governance
• Token distribution strategies, as a result of the above, have seen a proportional increase in use-focused distribution mechanisms including proof of use and interactive airdrops

Trend 3: The New Kids on the Block

THE EVOLVING ROLE OF VCS AND DELEGATE WORK ENTITIES

With the rise of Proof-of-Stake, on-chain governance and other protocol-native work functions, networks require active user groups that have both the expertise and/or technical resources required to provide network-specific services and infrastructure. At the same time, these productive crypto-assets present new value accrual opportunities for entities with crypto-native business models that play an active role in network participation and adoption.

On one hand, traditional venture models are increasingly evolving into crypto-native hybrids. Capital providers with long-term holding strategies such as Multicoin Capital and ConsenSys Labs recognize the opportunity to create additional alpha by supporting networks in their portfolio through the provision of infrastructure and performance of crypto-native operations. These entities are uniquely positioned to support teams that are building decentralized protocols to bootstrap and jumpstart network effects.

Well designed agreements and incentives can ensure that all token holders involved in early stage project funding in the protocol’s development lifecycle can be valuable supporters that earn rewards from their own and ongoing participation and contribution to the network.

On the other hand, there has been a proliferation of another stakeholder group – so called ‘delegate work entities’ (see article by Ben Sparango). Delegate work entities are network stakeholders elected by a token holder to perform network-native work functions, such as staking and voting, on their behalf.

The premise of earning rewards on productive crypto-assets in exchange for contributions to the network is an attractive one, yet not all token holders necessarily have the time, desire, or technical ability to perform the required tasks themselves. This is where delegate work entities come in. Today, delegate work entities including non-custodial (Staked, Stakefish) and custodial (e.g. Binance, Coinbase, Anchorage) providers are largely focused on providing staking services to both institutional and retail clients. I believe custodians, exchanges, funds and independent delegate work entities will play a critical role in driving broader institutional and retail adoption of productive crypto-assets.

Source: PoS Bakerz, 2020

Recent developments such as Katalyst, Kyber’s 2020 protocol upgrade, reveal the increasing relevance delegate work entities will play in the governance realm either as direct actors in the voting process or by offering proxy voting functions on a token holder’s behalf.

I expect to see further growth and diversification in delegate work entities and other service providers as the Proof-of-Stake landscape continues to expand and believe these entities will continue to play a critical role in driving broader adoption and maturation of the industry. A research study conducted by ConsenSys in March revealed that across almost 300 active token holders 41.4% would like to participate in on-chain governance directly while 28.2% would like to delegate their vote to a representative.

Source: ConsenSys Codefi

It is important to note, however, that delegate work entities, particularly custodians, exchanges and funds with large and accruing token allocations, could result in centralization risks particularly as Proof-of-Stake systems increasingly co-evolve into on-chain governance.

Trend 4: Evolving Token Distribution Strategies

THE FUTURE OF USE-FOCUSED TOKEN DISTRIBUTIONS

As network participation data indicates, having a broad distribution is not enough and it is critical that distribution aligns incentives amongst all network stakeholders. Healthy networks have a representative and actively engaged network of stakeholders.

How have the aforementioned trends manifested themselves as design considerations in more recent token distribution models?

There has been a proportional increase in public token distribution mechanisms focused on targeting actively contributing users.

Source: Smith & Crown, 2019

These have come in the form of both interactive airdrops, such as Livepeer or Edgeware, as well as different implementations of proof-of-use enabled token distributions such as NuCypher, Solana and SKALE that are focused on distributing tokens to actual users.

I believe that designing distribution models that factor in self-selected productive efforts beyond capital contributions in a sale or (pseudo)-random selection in a passive airdrop is essential to:

• Maximize regulatory compliance by ensuring that a token is being used for its intended purpose on the network, rather than a speculative holding.
• Filter for participants most likely to participate in the network to disincentive short-term speculation, price volatility and dumping.
• Effectively bootstrap the network at launch, whilst enabling early adopters to familiarize themselves with the network and earn token-based rewards for their efforts.

Conclusion

With the technical maturation of token-powered networks, particularly in the context of rising Proof-of-Stake adoption, the industry is leaving its adolescent, wild west years behind as it enters the chapter of ‘actual’ use and utility.

The chapter of use also creates a new window of opportunity for stakeholders with crypto-native business models, including VCs and delegate work entities, that play a critical role in the adoption and maturation of productive crypto-assets and the decentralized networks they are a part of.

While there is still a lack of formal regulatory guidance on the blueprint for compliant token launches, I believe the emerging discourse, setting of industry best-practices and increasing focus on use-focused token distributions are steps in the right direction.

Despite the financial uncertainty posed by 2020, the tumultuous year has represented something of a prosperous one for the stablecoin market. Since the beginning of the year, the cryptocurrencies that have their values pegged to existing assets like gold or the US Dollar have seen a heavy flow of funding as more traders look to buy into stable assets as a way of keeping their money from depreciating.

While stablecoins have become a useful store of finance that promises stronger protection against the disruption threatened by COVID-19 and subsequent recessions, there’s reasonable evidence to suggest that the currencies are actively evolving beyond their role as a trading asset and are increasingly being looked upon as a means of transferring value.

Over the coming years, we’re likely to see a range of central banks and large corporations start to tap into the stablecoin landscape, with global behemoths like Facebook already signalling their intent with the shelved Libra Project. With large scale investment into stablecoins looking like an inevitability, what will this mean for the crypto world’s smaller, un-tethered assets, like Ripple?

The Rise and Rise of Stablecoins

Tether entered the fray as the world’s first stablecoin. Launched in 2014, it took a matter of years before the US dollar-backed cryptocurrency started to receive widespread adoption.

As Bitcoin made its famous rally towards the end of 2017, more and more cryptocurrency exchanges started to make the switch from fiat currency-to-Bitcoin trading pairs to Tether-to-Bitcoin – thus enabling crypto-only exchanges to build on market share gains.

The late 2017 boom opened the door for more stablecoins to enter the market, with countless projects surfacing in a bid to emulate Tether’s purpose and success.

The subsequent year saw the arrival of several major players in the world of stablecoins, from USD Coin, to Paxos and TrueUSD.

As the arrival of COVID-19 caused widespread financial uncertainty, the market capitalization of stablecoins swelled up collectively to over $7bn in value in a matter of three months – with almost $6bn comprised of Tether investments.

Since the spring time, the rise of DeFi protocols have caused stablecoin markets to swell up by as much as $100 million each day – leaving the industry’s market cap more-than doubling in size since the start of the year.

Furthermore, more emerging trends surrounding the acceptance of stablecoin projects among banks have led to a greater level of acceptance among investors. The Liechtenstein-based Bank Frick recently announced that it would be supporting USD Coin – allowing customers to send, receive and store the stablecoin using their bank accounts.

The meteoric rise of the stablecoin market, coupled with ever-increasing levels of interest in blockchain technology from both banking institutions and big businesses alike means that stablecoins are set to emerge as the cryptocurrency market’s primary form of banking coin. But what will this development mean for coins like Ripple and investors who look to switch their holdings in Bitcoin to Litecoin, for instance, in order to leverage fast transactions?

Eating Into The Crypto Market

Ripple’s formative years brought widespread excitement for the blockchain technology that the XRP coin was built on.

Payments using the coin were set to be swift and free of hefty processing fees that some early crypto assets commanded. The focus of the coin was set on interbank payments, but its early success caused Ripple to expand into a leading crypto payments network around the world.

At the height of its popularity, Ripple was easily accessible on leading crypto exchanges that allowed easy access to digital finance that could be easily traded.

However, Ripple also unwittingly formed the blueprint on how to build a successful stablecoin.

The implementation of stablecoins that are pegged to various assets designed to hold their value amid economic downturns while operating on an easy transactional framework with limited processing fees has placed numerous stablecoins in direct competition with Ripple.

With the arrival of other corporate-backed stablecoins like the JPM Coin and the Utility Settlement Coin Project, it’s clear that the old guard of XRP faces a significant battle to avoid being drowned out by the market’s new upstarts.

The financial might of corporate stablecoins means that Ripple’s swift payment systems may soon be bettered via new transactional developments.

However, there may be some hope for Ripple due to the coin’s longevity in a rapidly expanding market. Ripple has helped to onboard over 300 customers during its lifespan, and possesses a greater level of crypto experience compared to its competitors.

It’s clear that stablecoins are here for the foreseeable future, and even hold the potential to overhaul national fiat currencies in mainstream usage. With market caps inflating exponentially, the old guard of un-tethered cryptocurrencies may be at risk of losing out as more adopters look to find practicality and consistent prices within crypto assets.

For Ripple, the notion of competing to recapture its place as the industry’s preferred coin for transactions seems too whimsical given the financial might of these new players introducing stablecoins into the market place.

Instead, what was once looked upon as one of the world’s most promising cryptocurrencies will have to tap into its experience to adapt away from its swift transactional roots. The cryptocurrency market is based on natural selection, where only the most innovative survive. In this unforgiving climate, many of the pragmatic cryptocurrencies of yesterday will be required to explore new blockchain developments elsewhere to maintain their relevance to adopters.

Baxter Hines, CFA, is managing partner with Honeycomb Digital Investments. He co-founded the firm in 2020 to provide income producing solutions for clients. His firm manages portfolios consisting of traditional assets, security tokens and digital assets.

His new book “The Digital Finance Book: Security Tokens and Unlocking the Real Potential of Blockchain“, is currently available to be pre-ordered at all major on-line retailers globally and will be in stores on November 17th, 2020.

What initially attracted you to blockchain and digital assets?

I spent an extensive amount of time looking into cryptocurrencies initially because I was so curious as to what the buzz was all about and after learning as much as I could about Bitcoin and cryptos I sought to gain a deeper understanding of the underlying technology, its capabilities and real world applications.  It was at this point that I came to realize that blockchain is so much more than simply Bitcoin. It became obvious to me that this innovation would impact the transfer and management of assets such as stocks, real estate, bonds, private securities, intellectual property and much more.  Placing real-world assets on the blockchain can lower costs of capital and that feature alone will cause eventual widespread adoption. When that idea sank in, I knew I wanted to learn as much about blockchain and digital assets as I could.

You’re a managing partner with Honeycomb Digital Investments, an investment firm that manages portfolios consisting of traditional assets, security tokens and digital assets. What are the things that you look for when reviewing investment opportunities?

I spent twelve years as a portfolio manager at NFJ Investments (a subsidiary of Allianz Global Investors) focused mainly on stocks with an emphasis on dividends. I bring that mindset to the digital asset space in that I seek out investment opportunities that I believe will capture the benefits of the upcoming growth of blockchain technology and its underlying ecosystem. Specifically, Honeycomb looks to invest in companies that are building the platforms and infrastructure to support the megatrend of blockchain and those cryptocurrencies and projects which will also be a part of the underlying ecosystem.

How would you personally describe what security tokens are?

Simply put, security tokens are a digital representation of real ownership in an asset – in most instances, one token is equivalent to one share in an asset. Security tokens are a digitized title to a financial instrument combined with the agility and speed of blockchain. Security token holders are entitled to certain rights and privileges of an underlying asset just as they would be if they owned the asset outright.

By building on top of the blockchain, security tokens offer capabilities, features and innovations that would never have been possible in a world of paper certificates. We are truly at the dawn of a new digital age in finance! Some of the brightest financial, technological and legal minds of today are working feverishly to develop the potential of this reliable, consistent, safe and consumer-friendly method of doing business. The future potential of these technologies is massive and the growth will occur over many, many years.

One factor that distinguishes security tokens from cryptocurrencies is that they are more regulated instruments. Tokens can only be released after meeting stringent legal and compliance hurdles providing investors with certain protections. Because of the programmable nature of the blockchain, security tokens can include features to automate servicing, embed compliance and enforce contractual obligations.

Not only do security tokens contain regulatory safeguards; but also, they provide investors with two major additional features: cost saving efficiencies and the potential to create enhanced liquidity. Process automation brought about by the blockchain will allow for security tokens to provide greater functionality, lower costs, faster speeds and increased transparency to financial markets. These aspects should ultimately lead security tokens to have lower costs of capital than their traditional paper alternatives.

Security tokens have been a bit slower to take off than most of us expected, in your opinion what are the reasons behind this?

Three major factors are holding security tokens back from wide-spread adoption: regulatory uncertainty, lack of education and first mover hesitation. The benefits of digitization are significant and eventually projects will have to go on the blockchain just to stay competitive. But before a takeoff in demand can occur, these three issues must be resolved.

Regulatory certainty has begun to arrive and technology is matching what is needed for this digital future.  Jurisdictions like Singapore and Switzerland are taking a clear approach to how they want to govern security tokens and their leaders have noted digitization to be the path to a better and safer financial future. It is my opinion that larger economies such as the United States, the European Union and Japan will likely eventually follow and simply refine the earlier established frameworks. Once the financial community sees the incredible benefits digitization has to offer, other countries will be fast to adopt digital-friendly laws so to reap the subsequent rewards.

Second, for security tokens to grow and flourish, the market and all of its constituents need to be further educated. Security token usage will be a growing trend in the market; but to realize the full potential, certain terms, concepts and a better understanding of the functions and benefits of blockchain must be realized by all of the players in the financial services industry including retail

investors, those employed in the financial industry, market regulators, and entrepreneurs trying to issue securities to raise capital. Hopefully my book can help out on this front!

Finally, we need more traditional financial services players and issuers to bring high-quality projects on the blockchain. Asset classes with higher frictions around trading are prime candidates for early adoption. This includes fixed income, real estate and private equity investments. We have already seen several pioneering projects in these spaces gravitate towards the blockchain. Many other projects are sitting on the sidelines today, waiting in anticipation to see how the first movers to blockchain fare. As these initial projects that have already digitized prove themselves to be safe and legally compliant, a new group of followers will jump in. Like the old saying goes “Nobody wants to be first to a party, but nobody wants to be last!”.

Are there any current security tokens (digital securities) which you are bullish on?

Without getting into specifics, I must say that I can say that I am bullish on the benefits of security tokens for the financial services industry as a whole – in particular the benefits this technology will have on the underlying investors and such investors ability to better gain access to liquidity when it comes to certain asset classes.

You recently wrote a book on security tokens and digital securities called “Digital Finance” which is set to be published in November 2020. What inspired you to write this book?

After extensively researching blockchain and its “better, faster, and cheaper” nature, I realized our financial system is on the verge of a massive transformation. Blockchain technology is the solution to spearhead the next generation of financial market infrastructure and blockchain may be the most important innovation since the internet.

While most people are aware of Bitcoin and other cryptocurrencies, few realize the far greater potential of blockchain. Blockchain has already proven itself to be an incredible means of exchanging value and information – but there is so much more to offer! My book examines how this powerful technology can overhaul our current financial infrastructure in a way that will increase efficiency, transparency, and security.

I wanted to publish a non-technical, easy to understand primer on blockchain and security tokens that would be relatable and practical for those in the financial industry. John Wiley & Sons seemed like the perfect publishing partner to assist in realizing my aim of producing a clear and concise framework on how to think about investments in the digital space. My goal with the book is to help readers uncover how blockchain and distributed ledger technology are disrupting the financial industry in an easy to understand and non-technical manner.

In your book you will be discussing case studies, historical perspectives and latest trends. What are some of the case studies that are discussed?

One of the book’s objectives is to make sure the reader can truly connect with the subject matter and as a result, the work contains many case studies, historical perspectives and latest trends to bring key concepts across. “Digital Finance” focuses on three major areas of digital assets: cryptocurrencies, stablecoins (like Central Bank Digital Currencies or other digital representations of money like the US Dollar or Euro) and security tokens. It is important that the reader get accustomed to real-world illustrations from all three of those fields. The book covers cases like Facebook’s Libra project building a global blockchain-based platform for cryptocurrencies and Britain’s Royal Mint creating a digitized way to own gold in its vaults. As security tokens are the main topic of the book, most of the examples focus on how blockchain can affect stocks, bonds, private equity and other alternative asset classes. As a result, examples such as the World Bank’s Bond-i, the Aspen St. Regis’ hotel token, and NBA player Spencer Dinwiddie’s professional athlete investment token (PAInT) are covered in detail. There is also considerable attention placed on projects that large established corporations such as IBM, HSBC, Goldman Sachs and the Singapore Exchange are undertaking to build a new blockchain-based infrastructure that will run our financial markets in the coming years.

The book also contains numerous examples from history that provide a framework on how to think about the upcoming rise of digital solutions. Through my research, I have noticed a striking similarity between the Internet Age of the 1990’s and the adoption of blockchain. By looking at the growth of the Internet from a historical perspective, one can gain a glimpse into what will unfold as blockchain becomes a bigger disruptive force.

What do you believe needs to happen to accelerate the pace of adoption of digital securities?

The move to a blockchain-based financial system will unfold one step at a time albeit in a quick manner with the most basic levels of finance developed first. As a result, payment systems will be at the forefront of digitization in the coming years and digital currencies will be a powerful force that will later aid in the growth of digital securities.  The main reasons for gravitating to digital securities from their paper-based alternatives are largely two-fold: lower costs and enhanced liquidity. Without a digital payment mechanism in place first, security tokens will not be able to fully capture those benefits.

Cryptocurrency and stablecoins representing a national currency like the U.S. dollar have been the typical gateway people use to first experience digital financial products. Today, we are seeing many countries float the idea of a blockchain based national currency; the list includes the world’s largest economies such as China, Brazil, France, Canada and the United States just to name a few. If government entities around the world begin to formulate legislation that will allow for currencies to become digital in a legally compliant manner, this would be huge for digital assets in general. The move would certainly encourage people to further explore utilizing digital financial products and would provide an amazing amount of comfort in doing such.

Not only will national digital currencies facilitate adoption but also, they will clear hurdles for further regulatory reform. After creating a digital currency, government entities will have already had discussions around blockchain, its safety and the infrastructure that is needed to flourish. Leaders will then be more likely to debate further initiatives such as digitizing securities like stocks or bonds.

Liquidity around a digital security or security token is much easier once a digital currency is in place. Whenever a security token is bought or sold, it needs to have a digital currency on the other side of the trade to fully reduce frictions and allow for instant settlement. If the cash systems of today are used in that process, the trading aspects of security tokens will still be much slower than they can be. As a result, government entities will need to first focus on payments and central bank issued digital currencies in order for the pace of adoption of digital securities to really take hold.

Is there anything else that you would like to share regarding your book ‘Digital Finance’?

I think it is important for people to have a perspective as to just how big this wave of tokenization will be.  Digital assets and security tokens are going to be a major factor in the future of capital markets and will represent the first new asset structure in roughly 30 years! The last new product with even remotely the same scale and effect was the ETF. This upcoming blockchain breakthrough will have a profound impact on the way we trade securities, how shares are maintained throughout their life cycle and even influence the ways we invest our money. This innovative process opens up the possibility of unlocking trillions of dollars in assets to new investment!

There are more and more signs that digitization will help to transform the traditional investment business model of today into a modern, fair, transparent and distributed marketplace. This new paradigm will connect investors and the projects they invest in directly with blockchain based platforms. Just recently, the first regulated security tokens have gone to market. We are at a point in time where more regulatory certainty has arrived and technology is being developed to match what is needed for this digital future. Everyone in the financial industry will need to have a broad comprehension of how the technology works, what it can affect and what consequences this could have for business.

The pace of development in this industry is remarkable. Almost every day I see another groundbreaking story that gets me excited. As a result, I’ve started a Twitter account for the book which highlights articles covering the hottest topics of the day. The purpose of this page is to aggregate the most important stories at a given time and put them into a one stop location for people to see the incredible milestones that digitization is hitting! Be sure to follow us on Twitter for the most important news!

Thank you for the fantastic interview, I enjoyed learning about your views on digital securities and the future of the industry.

Readers who are interested in learning more should know that the book is currently available for pre-sale at all major on-line retailers globally and will be in stores on November 17th, 2020.

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Follow the Book on Twitter: @digifinancebook