Collateralized Debt Positions for Security Tokens
One of the transformational moments in the security token space will be when we transition from single-asset to multi-asset crypto-securities. Currently, the vast majority of security tokens are a tokenized representation of a single underlying asset. As the space evolves, we will see new forms of security tokens that represent complex underlying pools of assets. I outlined some initial ideas about this concept in my articles about collateralized multi-asset security tokens(Part I and Part II). Today, I would like to deep dive into one of the forms of multi-asset security tokens that, I believe, is likely to surface in the near future: collateralized debt positions(CDPs).
The concept of CDPs is the crypto-variation of infamous financial market derivatives such as collateralized debt obligations(CDOs). The concept has been spearheaded by projects like MakerDAO but some of the principles has materialized on other crypto-protocols. Fundamentally, a CDP represents a debt position that is backed by an underlying pool of assets. In the context of security tokens, a CDP represents a debt contract collateralized by a group of crypto-securities. CDPs represent a specialization of my collateralized multi-asset security token thesis in which the token itself is a debt position.
Before we go too much deeper into the concept of CDPs, let’s try to place the idea in the grand context of the security token market. There are three dimensions that I find incredibly helpful to classify security tokens. In their simplest form, security tokens can represent a tokenized representation of an existing security or a brand-new form or security. A second dimension is based on whether security tokens are backed by a single asset or a pool of assets. Finally, security tokens can correlate exactly with the underlying assets or represent a derivative. CDPs are a new form of security which is a derivative on the value of an underlying group of assets. Visualizing these different dimensions, we can clearly identify the place of CDPs in the overarching security token landscape.
Understanding Security Token CDPs
The concept of a security token CDP is a variation of the MakerDAO implementation applied to crypto-securities. We can define a CDP using a simple three-factor criteria:
i. A security token CDP is a debt token.
ii. The value of a security token CDP is collateralized by an underlying pool of digital securities.
iii. Security Token CDP holders can exchange their tokens for the underlying collateral
In the CDP model, a user registers an existing group of security tokens and receives another security token which value is collateralized by the underlying securities. The CDP can then be used for transactional activities as a form of stablecoin. Eventually, the underlying assets can be withdrawn by paying down the outstanding debt in the CDP smart contract.
Like many derivatives, building a security token CDP can be fairly complex. However, the fundamental structure of any security token CDP can be summarized using three fundamental factors:
The Liquidity Factor
Liquidity is an important factor to maintain the price stability of a security token CDP. Like other debt vehicles, the liquidity of the underlying asset is an important element to hedge the risk of the loan. A security token CDP backed by relatively liquid assets such as tokenized corporate bonds or real estate leases is far easier to manage than a CDP collateralized by illiquid assets like art pieces or real estate equity.
The Value Factor
The assets behind a security token CDP can derive their value from cash flows or market appreciation. A cash flow CDP derive is a traditional debt derivative whose value is essentially a credit against the cashflow of the underlying assets. A market-value CDO derives its value from the appreciation in value of the collateralized assets. At least for the first generation of security token CDPs, cashflow assets seem to be a more viable vehicle than tokenized equity.
The Risk Factor
Risk is another element that should be considered in security token CDPs. Some security tokens represent high quality assets that are likely to match or outperform market expectations while others are tied to a lower quality collateral. In a security token CDP model, risk should influence different aspects of the behavior of the crypto-security such as valuation or cash-flow distributions.
The LVR Score for Security Token CDPs
The challenge with structuring security token CDPs is that a single crypto-security tokens can be collateralized by assets of different quality levels. As explained in the previous section, the behavior of a security token CDP can be influenced by three main factors related to its underlying assets: liquidity, value and risk. In that context, how can we use those dynamics to structure a security token CDP that behaves fairly for different types of assets and token holders?
One interesting ideas I’ve been playing with is to design a CDP score based on the corresponding liquidity, value and risk levels of the underlying assets. Let’s call this idea the LVR score. The specific formula is beyond the score of this article and would likely be dependent of the type of CDP but the important thing to notice is that the score will provide a quantifiable indicator to help analyze the quality of a specific security token. In this model, highly liquid security tokens with robust cash flows and low-risk will have a higher LVR score than other security tokens with higher risks or poor value appreciation dynamics.
The LVR score will then be used to segment a security token CDP into tranches, each one representing a different quality level of the underlying security tokens. The tranches also serve as a priority list for redeeming the underlying security tokens. Suppose that a security token CDP is structured into N different tranches T1, T2….TN ordered from the highest LVR score to the lowers (LVR1>LVR2>….>LVRN). In that model, holders of the security token CDP collateralized by security tokens in T1 will be able to redeems their crypto-securities if at least 1 issuer remains solvent. Similarly, holders of the CDP collateralized by T2-level security tokens would be able to redeem their crypto-securities of at least 2 issuers remain solvent and so on and so forth until tranche N that can only be redeemed if all issuers remain solvent.
The previous model borrows ideas from the CDO structure and has been previously explored by the Ethereum community. The main idea is to balance risk for security token CDP holders in a way that is correlated with the quality of the underlying security tokens. Obviously, this type of algorithm requires a lot of optimizations in order to be applicable in real world scenarios. For instance, the tranche model might needs a mechanism to compensate the CDP investors that are willing to bet on the riskier assets. An interest-rate based mechanism should be able to help in this area.
I find some of the principles behind CDPs to be incredibly relevant for the next wave of security tokens. For starters, the concept has been validated by protocols like MakerDAO at a decent level of scale. Additionally, it is pretty obvious than security token will soon need to evolve from the current “one asset one token” model into more sophisticated financial structures. CDPs seem to provide the right balance between simplicity and financial incentives to become an important vehicle in the security token space.