Security Tokens, Real Estate and Liquidity: Promises or Realities?

In RealFund we are working in tokenizing real estate businesses because our goal is to achieve fractional an liquid finance for real estate developers obtaining

- more inclusion,

- more efficiency,

- more transparency

- And, above all, more liquidity.

Real estate has traditionally been a very illiquid market, due, in large part, to the lack of digital markets, opacity in the information and therefore, asymmetry in it, and difficulties in both entry and exit.

The cost of this illiquidity can be estimated between 20% and 30% with respect to other assets.

Thanks to the fractioning of the ownership of these real estate businesses, using formulas such as crowdfunding / lending, the entry of many capitals hitherto prohibited in this sector is already being allowed, characterized by very high unit investments. However, this being excellent news, it did not solve the liquidity problem.

Thanks to the digitization of these fractional properties through tokenization, we have a very valuable tool for easy transmission: a token is by definition very easy to transmit, as easy as entering the address of a wallet and hitting “send”. In first issuances the transmission of tokens from the issuer to the investor is a clean, cheap and transparent process.

What happens in second transmissions? Is it really that easy?

Security tokens and secondary markets: some limitations.

KYC / AML: Everybody identified, please.

Representative tokens of real estate businesses are clear examples of security tokens. In order to transmit them, the buyer must necessarily go through a prior KYC / AML process, for legal and operational reasons. This means that it must be, therefore, included in a whitelist to be able to access the token. The logic of the smart-contract programming (in our case, ERC-20) must include this limitation. In other words, whoever is not in the whitelist of that token, cannot buy it. This will limit us, for example, in decentralized finance pools.

The secondary markets that have not just arrived

It was said that 2020 would be the year of decentralized finance and 2021 of cryptos securitization, but we haven´t seen great progress.

Organized ATS and OTC markets are currently scarce for security tokens. None of them in the EU (only Louxembourg!). There are in Switzerland and the United Kingdom, some in the USA and in Asia.

European regulators are not helping much in promoting a technology that will inevitably replace the capital markets as we understand them now, for its better benefits (on-line cap-table of any financial product with millions of investors just by asking the smart-contract, 24/7, disintermediation, costs, global …). European MICA reagulation literally tiptoes over this matter, referring it to laws of the last century. The reality of the facts will end up imposing itself on the inaction of the legislator.

On the other hand, improvements in the narrative of the tokenization solution and in the user experience are still expected, but the accumulated value in the real economy is so gigantic that with a small percentage being trapped by tokenization will provoke, relentlessly, very important changes in the next years.

P2P solutions are perfectly viable and some are working (for example, Airswap), and we hope that more will emerge, with more capacity and features.

So why not use decentralized finance?

During 2020, decentralized finance or DeFi has grown exorbitantly, presenting a value proposition unknown to date: individuals, thanks to the programming of smart-contracts, could carry out regular financial operations, such as lending or borrowing, receiving interest or mortgage assets, without the need for intermediaries and without depositing the custody of tokens with a third party.

Platforms such as Maker, AAve, Uniswap or Balancer, among others, have managed to attract the attention of 43 billion dollars (today, and growing steadily) that are currently deposited in any of these protocols.

Therefore, the temptation to look for points of intersection between digital assets in the real world and AMMs[i] is unavoidable.

The idea is simple. We create a pool of two tokens:

- one that represents, for example, debt on a real estate asset.

- and the other, dollars (DAI)

so that whoever has the debt token can sell it before its expiration to another investor who wishes to invest in this product.

Fantastic, so get to work!

We decided to create in the Kovan testnet a pool with our security tokens that would represent real estate debt.

For tokens issued by RealFund for its clients, we have chosen the Balancer protocol due to the flexibility and configuration options it offers. For example, Uniswap only allows you to configure a pair of tokens in a pool, each of them at 50%, while Balancer allows you to configure up to 8 different tokens in a pool and with weights that can range from 4% to 96%.

The challenge within RealFund is to be able to use within these liquidity pools some tokens that represent real estate debt. These tokens, due to current regulation, must ensure that they can only be transmitted to people who have been previously identified by RealFund and who have approved a KYC process.

To achieve this, we have added an additional “whitelisting” functionality to the ERC20 standard of Ethereum tokens, so that if the user who wants to transmit or receive one of our tokens, must first have their KYC approved on the platform to that user is added within the whitelist.

Unfortunately, the use of a whitelist mechanism for the transmission of the token makes it difficult to use any of the existing DEFI protocols including that of any AAM, so the most important challenge in this development has been the creation of a liquidity pool in Balancer 100% compatible with RealFund issued tokens, so that any investor can buy or sell RealFund issued tokens as long as they have previously registered on the platform and carried out the KYC process.

Jorge Gomes, our CTO, after struggling hard with the programming of the whitelisted pool and doing a fantastic job, has deployed a Balancer pool compatible with RealFund issued tokens on the Kovan testnet at the following address: https://kovan.pools.balancer.exchange/#/pool/0x69c3e03B50E8560082814d17aeEb1980BB2f75A4/

In this pool you can see how there are two tokens, the RFD (tokens issued by RealFund clients using RealFund methodology) and DAI (stable coin with a value of $ 1). In the pool configuration you can see how the weight of the RealFund issued tokens is 90% and that of DAI is 10%. This is precisely one of the differences of Balancer over other decentralized exchanges such as Uniswap, and that it allows projects that are beginning to be able to create pools providing a lower liquidity in DAI with respect to the liquidity of RFD tokens.

Additionally, liquidity pools not only allow an exchange of RFD tokens by DAI, but also offer investors of RealFund issued tokens the possibility of adding liquidity to the pool in order to obtain a fee for each trade that users make, allowing to maximize the return on your investment in RealFund issued tokens.

This type of decentralized liquidity pools is a great solution for projects that intend not only to tokenize an asset, but also to offer their investors the opportunity to obtain liquidity in a secondary market if, for example, they want to sell their tokens in advance.

Actually, some DeFi pools for real estate security tokens are already working, like pioneers RealT in Uniswap and brave Spanish RentalT in BSC.

Let´s rethink the DeFi stuff for a while

The experience has been very satisfactory, although we have decided not to bring it to production on the main net for now, for the following reasons:

1- Gas: the price of gas currently makes it impossible to use these pools, since the fee that must be paid often makes the profitability of the operation negative.

2- Lack of liquidity in a pool. The prices of tokens in pools that do not have great liquidity suffer greatly if a swap of a certain entity occurs, so that it could happen that someone wanted to sell their tokens in the pool and would find a loss -due to the very operation of the pool, which tries to “protect” the price of tokens, for example 10%. It must be taken into account that the profitability of these tokens, which are nothing other than the digital representation of a real estate asset, is limited, so these oscillations will greatly retract the token holders when using the pool.

3- The price of the asset: related to the previous point, there can be a strong discrepancy between the value of the underlying asset — linked to a real estate business and, therefore, with little volatility in short periods of time — and the value of the asset/token attributed by the pool’s operating formulas, which causes inefficiencies in the market and great volatility in the price of the token in an AMM.

However, we continue working on it, trying to improve the composition of these pools, to attract more liquidity that takes commissions on each swap.

NEXT CHALLENGES COMING

Likewise, these tokens necessarily have to work very well as collateral in protocols such as Aave, which allows you to leave your tokens there as collateral and borrow it under certain conditions, that is, mortgage your real estate tokens: this will be our next challenge.

So, meanwhile the organized ATS and OTC markets are being, step by step, constructed here and there, we — and many others- will continue trying to bring liquidity to the real estate security tokens, as we promised.

Murcia, 3/15/2021

[i] AMMs are liquidity pools implemented with Smart Contracts that, through mathematical formulas, are capable of always giving the price of a token automatically without the need to use a price Order Book as used by all centralized exchanges.