Sabine MelicharThe blockchain breaks down illiquid assets into their smallest shares. It makes them tradable without intermediaries and thus opens up asset classes with traditionally high access barriers to small investors. So far, so good. Tokenization is advancing and attracting investors. Investors can now invest in a wide variety of assets – from real estate to vintage cars, art and wine to diamonds. These are almost always so-called “security tokens”.
No direct participation in tangible assets
What is not immediately apparent in offers for tokenized assets is that as a security token holder, you as an investor do not own any part of the commercial building, work of art or diamond. You merely own shares in a so-called “tokenized debt security” – also called bonds or debentures (see box below). This is also stated in the small print of token providers. However, inexperienced investors, even in the USA or England, tend to read over it with the motto: Sounds complicated, I’ll find out more about it later.
Tokenized debt security is central
The German BaFin classifies tokens as securities of their own kind. The Austrian Financial Market Authority FMA and the Swiss FINMA proceed in the same way. Here, the aspect of the debenture is central in the tokenization business. For the investor, this means:
- Each token represents a share in a tokenized debt security.
- This works like a classic bond. It transfers debt claims to an asset to investors.
- Providers such as Finexity or Exporo establish their own special purpose entity for each security token offering. In return, this company promises in the terms and conditions of the bond to pay out interest and repay the amount at the end of the term.
Token owners are actually lenders
When you invest in tokens, you give the provider a loan. He uses that to buy the property, car or diamond. The interest on the loan is usually made up of a fixed rate and a variable portion of the proceeds from its use. In the case of a real estate investment, this is the rental income; in the case of a work of art, it is the income from renting it out for exhibitions. In addition, you profit from the increase in value when the work is sold. However, no one can guarantee this.
Token holders bear a high risk. Not only do they have an unfavorable, subordinated position. They also often lend their money to very young companies with novel business models.
Peter Mattil, specialist attorney for banking and capital markets law in Munich, Germany
Tokenized debt securities are subordinated
The catch: tokenized debt securities are so-called “subordinated loans.” These are not uncommon. Classic crowdfunding also uses them. For investors, they are risky. Because:
- Debenture holders agree to a “subordination.” In the event of insolvency, they do not receive money until all claims of other creditors have been settled.
- There is only a “pari passu” with other subordinated creditors. All those who are not serviced until the end therefore receive the same amount of what is then no longer left.
- The issuer can only repay subordinated claims from freely available future annual or liquidation surplus. In other words, even if there is still money available, it does not necessarily have to be paid out.
- Bondholders thus bear a risk of loss that goes beyond the general risk of insolvency.
Advantageous for providers, risky for investors
Main advantage of subordinated loans for companies offering tokenized financial products: They gain more entrepreneurial leeway. In return, investors benefit from a higher return. The construct is unproblematic as long as the crypto project develops as planned. If the token provider runs into financial difficulties and becomes insolvent, investors are left out in the cold: they only get their deposits back when all other creditors have their money. That is, if there is anything left. Peter Mattil, a specialist lawyer for banking and capital market law in Munich, also warns of another danger: “Token holders bear a high risk. Not only do they have an unfavorable, subordinated position. They also usually lend their money to very young companies with novel business models.”
Investors bear the full entrepreneurial risk
And it gets even better: as a rule, token investments are tokenized debt securities (bonds or debentures) with so-called “qualified subordination.” This means that you as an investor do not have a problem only in the event of insolvency. You already cannot assert the claims to interest and repayment of the loan if this would cause a reason for insolvency for the borrower. In other words, the outflow of money stops if the continued existence of the property company that financed your real estate or artwork is in acute danger. American or British investors share the full entrepreneurial risk with qualified subordinated loans – until total default.
Every investment has risk
Buying diamond tokens, like any investment, carries various risks. Unlike a painting, which can be destroyed, the risk of total loss with a diamond is more theoretical. However, the value of a gemstone, and thus the return on its sale, is highly dependent on supply and demand.
What is a debt security?
Debt securities - also called bonds or debentures - are securities for which investors usually receive interest. With a bond, the investor transfers a certain amount to the issuer - the issuer of the bond - for a certain period of time - the term. In doing so, he grants a long-term loan. Holders of bonds are not part-owners like shareholders, but creditors. The issuer undertakes towards them to repay the debt at the end of the term.
FAQ – Frequently Asked Questions
No. If you have invested in a tokenized asset, such as real estate or wine, you do not own a direct interest in the asset. You merely own shares in a tokenized debt security – also called bonds or debentures. You are making a loan to the company, which uses it to buy and hold the asset.
Companies that finance themselves via subordinated bonds have more entrepreneurial leeway and give themselves breathing room in the event of insolvency. This is why subordinated loans are attractive for providers of tokenized products. Investors bear a higher risk, but also receive higher interest rates in return.
Because they are subordinated debt securities. Subordination means that in the event of impending insolvency, you as an investor are last in line with your claims to interest and repayment. All other creditors receive money before you. In the case of a qualified subordination, you even waive interest if its payment would cause financial problems for the company.
