This is the second part of an essay that explores the different types of security tokens that are likely to become relevant building blocks in the next wave of tokenization platform. As the security token space evolves, we should transition from a model in which all security tokens are based on the same financial protocol, essentially representing shares in a private vehicle, to architectures with different crypto-financial primitives that can be composed into sophisticated tokenized financial offerings.
The current generation of security token protocols have mostly focused on solving the compliance challenge incorporation capabilities such as KYC/AML. Using those protocols as a foundation, the second wave of security token platforms should be more focused on enabling the implementation of financial models that mimic real world securitized products. In the first part of this essay, we presented a thesis of four fundamental crypto-financial primitives that can become an important block of the next wave of security token protocols:
· Debt Tokens: Tokens that represent a debt or cash generating vehicle.
· Equity Tokens: Tokens that represent an equity position in an underlying asset.
· Hybrid/Convertible Tokens: Tokens that convert between debt and equity based on their behavior.
· Derivative Tokens: Tokens that derive its value from underlying tokens.
Previously, we discussed the architecture of Crypto-Debt Tokens, today I would like to focus on Hybrid tokens and how they can be implemented in security token platforms.
In the terminology of financial markets, a hybrid security is a financial security that is composed of two or more financial instruments. For instance, hybrid securities can combine equity-like with debt-like features in a single tradeable financial product. Hybrid securities typically promise to pay a rate of return (fixed or floating) until a certain date, in the same way debt securities do. However, they also have equity-like features that can mean they provide a higher rate of return than regular debt securities. By combining debt and equity in a single product, hybrid securities can balance the risk and return of the underlying financial primitives and hedge against different market conditions. If we visualize hybrid securities in the context of the risk and return levels of financial securities, we would obtain something like the following diagram:
Another way to think about hybrid securities is as a combination of a debt security plus an option to convert into equity.
Types of Hybrid Securities
There are many types of hybrid securities ranging from very simple to some that very esoteric financial models that combine equity and debt features. Some examples of well-known hybrid security products in the market include convertible bonds and convertible preference shares.
A convertible bond is a type of debt security that can be converted into a predetermined amount of the underlying company’s equity at certain times during the bond’s life. For instance, suppose that a company issues a convertible bond with a face value of $100 and a maturity date of two years from the issuing date. The bond will pay a quarterly dividend of 5% and the value of the shares of the company at the time of the issuance was $2. Each note gives the holder the right to convert on maturity 1 note into 40 ordinary shares giving a conversion price of $2.50 (that is $100/40). Two years after the issuance, the shares of the company are valued at $4. At that time, the convertible bondholder can decide to receive a note for a face value($100) or convert the bond into equity at a value of 4x$40=$160. Let’s hope our guys is smart enough to make the obvious call.
Convertible Preference Shares
Convertible preference shares are shares of a company’s stock with dividends that are paid out to shareholders before common stock dividends are issued. Convertible preference shares typically pay a dividend to shareholders and include an option that allows shareholders to convert their preferred shares into a set number of common shares, generally any time after a pre-established date.
Let’s assume an investor purchases 100 shares of a company’s convertible preferred stock. According to the registration statement, each share of preferred stock is convertible after 2 years, (the conversion date) to three shares of the company’s common stock. (The number of common shares given for each preferred share is called the conversion ratio. In this example, the ratio is 3.0.). If after 2 years, the common stock of the company is trading at $20, then the shareholder can convert their preferred shares valued at $50 for 3 common shares valued at 3x$20=$60.
Hybrid Security Tokens
In the context of security tokens, hybrid models can include programmable transitions between debt and equity tokens. For instance, a company can issue a hybrid security token that behaves like a debt toke for certain period of time and then is reissued as an equity token. Similarly, an organization can issue different types of equity tokens based on their liquidation preferences.
Interestingly enough, hybrid security tokens can express conversions between on-chain and off-chain securities. For instance, a company can issue a security token that, after certain period of time, converts into shares in a company. This is the model followed by initial convertible coin offerings(ICCO) which are being experimented with in jurisdictions like Malta.
A Hybrid Security Token Protocol
The implementation of a hybrid security token protocol is fundamentally simple using a basic addition to the process of issuing debt or equity tokens. Let’s take a company that wants to issue a convertible debt security token with a maturity of 1 year. A platform like Securitize or Polymath can use a protocol like Dharma with a couple of basic extensions. At the time of the issuance, the platform will use a Dharma Underwriter to issue a debt smart contract with some additional clauses such as face value or maturity date and it will also issue the corresponding equity tokens based on shares of the company. During the first year, the debt security token holders will receive a dividend based on the terms specified in the smart contract. After the year expires, the debt security token holders have the option of converting their tokens into equity tokens. Platforms like Securitize or Polymath can enable that conversion as part of their protocols.
Hybrid security tokens might seem complex at first glance but they certainly open the door to all sorts of interesting tokenization scenarios. As security token platforms and protocols evolve, we are likely to see hybrid models as one of the key financial primitives that will enable security tokens match the sophistication of securitized financial products.