Demand-Driven Assets: Introduction

Atomic Cash Flows and Next-Generation Digital Markets

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May 27, 2021

I’m Clark Thompson, a long time web3 advocate for decentralized finance, and currently Business Development and Strategy Lead for Swivel, “The protocol for interest-rate derivatives.”

My arrival in decentralized finance started with a twenty-plus year journey through traditional finance and a career spent designing, building, and running large scale transaction processing platforms for various institutions. Along with some of the first CBDC projects and tokenized cash-obligations concepts, I led some of the earliest efforts made by a major bank to develop on top of Ethereum.

Lately I’ve been solidifying my vision of how the evolution and eventual widespread adoption of such systems may play out. Since starting at Swivel, I’ve been accumulating some of my thoughts on the direction decentralized finance and finance as a whole is going.

I’ve decided to start sharing some of these thoughts in a new Swivel newsletter, “Foresight and Finance’s Future”.

The concept is simple: All investment boils down to matching the needs of an investor for a rate of return, over a period of time at a level of risk. This process can be dramatically accelerated by using emerging technologies, particularly smart contract-based digital securities, to spawn new securities based on investor appetite.

In a planned series of articles, I will explore the dimensions of this new paradigm:

The promise of an investor demand driven direct market for digital securities
Swivel’s path to support the evolution of this new market
The ecosystem requirements for a demand driven marketplace
Interest rate optimization markets historically and in the future
Opportunities for collaboration, partnership and mutualization of cost to accelerate the new market dynamic

In this first article, I tackle how securities may be decomposed into component cash flows to create bespoke structured products at low cost, and a summary of the building blocks necessary to deliver such a solution.

Diving In

In conventional capital markets, capital seekers typically use standardized asset issuance as a means of gathering capital to fund their enterprises.

These standardized instruments include the sale of ownership rights (e.g. equities) or sale of debt securities (e.g. bonds and other types of loans) and a variety of future-dated or contingent obligations (such as futures, options, swaps and other derivatives).

In all cases, these assets are a legal obligation on the part of the issuer to convey certain rights to the holder in exchange for certain obligations on the part of the issuer. In some cases there may be an exchange of rights or obligations.

Standardization

The need for standardization is driven by varying demands; from market participants to make intelligent comparisons across assets, from banks and other third parties responsible for issuance and clearing and settlement for efficient processing, and from custodians and other asset servicers to maintain registries of ownership to correctly process the future cash flows and events to the benefit of the owner. Many of the standards are driven by the need to reduce the time required to issue a new security, and to avoid the costly back office processing for clearing and servicing of bespoke instruments.

From the perspective of the investor, these assets need to be evaluated as part of a portfolio of securities, with the goal of achieving a certain level of return at a level of risk for a period of time. Standardization significantly reduces the effort needed to make meaningful comparisons between similar investments, and the due diligence required to understand the associated risks well.

Reducing Risk & Ticket Size

By combining multiple instruments from different issuers into a single portfolio the investor can, via diversification, lower their risk at a given level of return. However, by doing so, this forces the investor to take on multiple transactions each with a commission/fee. Furthermore the relative performance of each asset may vary widely over time, and the investor may need to frequently rebalance their portfolio to continue to achieve their desired ratio of risk/reward. The cost of such rebalancing can then impair the performance of the portfolio relative to the model it tracks.

For the individual investor and small institutional investor, the ability to exactly match a portfolio of highly standardized publicly traded stocks, bonds, funds and other assets to their specific needs may not be cost effective or efficient. The size of standard lots or minimum investment size may prevent the individual from entering certain investment vehicles as well. The due diligence and minimum ticket size required for certain alternative investments outside of standardized markets may preclude large classes of investors from participation.

From the perspective of the issuer, their investment banking partners may steer them in the direction of these highly standardized obligations for efficiency and cost reasons. The smaller the issuer, the less likelihood there is that the assets issued will be an exact fit to the highly specific needs of the issuer nor to those of the individual investor. However, the cost of issuing truly bespoke securities has historically been too high to allow more perfect matching.

Asymmetric Risk Adjustment

Ultimately the value of a financial asset is based on expectations of the value of the sum of all future cash flows resulting from the bundle of legal rights and obligations the asset represents. For example, the value of a loan with a balloon repayment and periodic interest payments is based on the discounted future value of the balloon repayment of principal, combined with the discounted value of all interest payments. For an amortized loan, the value would be the discounted future value of principal return over time and interest payments.

Different assumptions about personal cost of capital and reinvestment rates, or interest rate volatility, lead individual market participants to come to different conclusions on the discount rate for valuing these future cash flows. For a traditional fixed rate note, the non-discounted cash flows can be calculated for the entire life of the loan. Were the loan to be based on a floating rate, the value of each future cash flow cannot be determined until the rate is fixed at the point in time each coupon is paid. That said, projected future rates for these non-deterministic cash flows can be estimated using interest rate term structures for equivalent assets.

Composing Tokenized Cash-Flows

In traditional capital markets, traders have for many years decomposed traditional fixed income assets such as treasuries into their component cash flows and created principal only and interest only derivatives. These so-called strips allow specific maturity or yield goals to be met by combining cash flows from a variety of underlying assets.

Using smart contract logic and issuing tokenized securities through standardized representations such as ERC-20 and ERC-1400, the activity the traditional strip traders undertake at a wholesale level can be done at very low cost and at almost any scale or fractionalization of unit.

Let’s look at how this could work in practice. Alice wants to borrow $1000 repayable in one year at 3 percent in monthly payments. Traditional financial markets would have Alice’s loan agreement traded as a single unit, with a discounted value that gradually changes over time (assuming there is no default risk) until worth the full $1000 at maturity.

Fractional Cash-Flow Streams

As each interest payment coupon is paid out, its discounted value decreases by the present value of the coupon. If an investor wanted to purchase a 3 percent income stream for three months, he/she would have to either enter into a set of new transactions to sell the coupons and principal for periods he was not looking to own, or hope that the price remained stable such that he could buy in and buy out of Alice’s loan only for that period he was looking to invest in.

If instead of issuing a whole loan, Alice issued a set of tokens, each representing a specific cash flow generated by a smart contract, with each token having a face value in the case of principal, and a rate, maturity and basis in the case of interest, the investor could simply purchase those tokens that exactly met their needs for maturity, return and level of risk.

In this example, Alice would issue a principal token with a face value of $1000, carrying the obligation from Alice to repay the principal at maturity. Alice would also issue 12 interest payment tokens, each with a value equal to 1/12th of the total interest due.

Alice can then sell each of these tokens into the market. Because Alice’s need is for the full amount and full period at her desired maturity, the smart contract issuing the individual pieces could be designed to only execute as and when all of the tokens composing the loan had found buyers. Alternatively, Alice’s tokens could be purchased by a portfolio algorithm, using them in conjunction with other tokens to fit a precise investor demand. For example, in conjunction with a series of higher risk but higher return tokens to fit an aggregate risk/return level in between.

Building The Future Of Cash-Flows

The building blocks of such a system are straightforward:

A tool for investors to define the risk, return and period they are seeking
A tool for capital seekers to define their corresponding need for investment
Independent measures of risk
An issuance tool set that takes the capital seekers requirements (e.g. sale of ownership rights, issuance of debt, risk management, funding optimization etc) and creates a series of tokens representing the legal agreement with investors and/or specific cash flows governed by that agreement
An order book and/or matching engines to select the “shape” or synthetic portfolio of tokens that matches the investors need

This system while simple in components is rich in features, and with Swivel Finance serving as the first necessary component of this necessary tooling, the initial steps of this transition are already underway.

— Clark Thompson, Business Development and Strategy Lead

Swivel Finance