December 2018 - Haseeb Awan

Mastering the Market Cycles

Financial cycles are often misunderstood by majority. It’s a zero sum game where transfer of money takes place from one entity to another. It’s combination of analysis, research but luck outplays every other factor. Markets react irrationally majority of the times.

Either you’re a fund manager or an individual managing your personal portfolio, what’t the #1 question that goes through your mind.

“Is this a great time to exit or enter”

There are three types of sentiments that exist in the market at any given point of time.

Market Neutral
Bullish
Bearish

Every one in the market has a conviction behind his decision once he is able to identify the trends based on the information he has. General trend is to follow the trend and don’t ride against the wave, however if you look at history biggest gains are made when people went against what market was doing.

Quote from 2004 Annual Shareholder Letter for Berkshire Ha

Warren in the letter explained how well the stock markets have performed & index funds was the best investment that people could’ve made, but he outlined the 3 biggest traps for any investor

Trading too much & incurring fees
No or little stock analysis
Poor skills at timing the market

He also mentions that though these are the obvious ingredients for failure, they’re added to the receipt of success repeatedly

Gold mines are found when you’re patient and have your own strategy. I’ll cover the following

Why is it a good idea to go against the market
Why crashes always follow bubbles
Why risk-free is actually the most riskiest approach

Before I dive into more details, let’s start with the basic notion behind investor mentality. He is always looking for one thing

Buy assets with high value at a low value. Delta between actual value & value he paid is the profit

My job is to invest in a wide variety of assets & construct a portfolio with different strategies to yield results beating the market average. History suggest than less than 33% of the people are able to beat the market average, but the returns for 33% are so high which keeps the remaining 67% in the game. Luckily, I am among the 33% so far, but I could be on other side of the table anytime.

Luck plays an important role in any investment outcome regardless of how much research one has done. Some are better at guessing by chance or by research, but no one has a crystal ball to predict accurately. Best thing an investor can do is to construct a thesis around a hypothesis, build a strategy around it with a backup plan & then discipline himself in following it. Every failure or success should take him back to the working sheet to validate or invalidate his assumptions.

While research is good, the biggest factors involving the market cycles are large-scale economical, geopolitical or market-related events including but not limited to security, war, military take-overs, political instability, natural resources discovery, big trade agreements or a technological breakthroughs. With advent of internet, every one has access to this information & now it’s up-to their intellectual ability to absorb, assess and guesstimate the impact on the markets.

There are multiple types of traders. It could either be day-trader, long term investors or just wicks scalper. Regardless of whoever you are, it’s the exact same mission. Beat the market with your decision. You can either be investing in hope of price increase, generating cash flow or just diversifying your asset to preserve capital, but every move you determine is nothing but just a speculation. Everyone is hoping to be smarter than others, but that rarely happens.

In the past, I acquired assets which were a steal but also picked up garbage that still to date I can’t believe. Biggest jackpot is when you’re able to time well. It’s like striking the ball in the right direction from middle of the bat. It’s super hard to time it well, so best is to have an exit and entry price & not worry about over optimising your gain. Just minimize your losses.

So what’s a cycle? They’re similar to any wave that you see at the ocean which comes and go however waves can be bigger or smaller. Despite their unpredictability, if you look at a longer time frame, you can have some level of confidence of the future. Example is night comes after day, but the time sun rises and set changes from season to season. We may or may not have a White Christmas in Toronto, but ruling out snow in January/February is very hard.

It’s easier to be right in the longer time frame while very difficult to be right in a short time frame. Reward to be right in a shorter time frame is higher but Risk reward ratio just doesn’t justify the action.

Today we’re fortunate enough to have access to so much information that we can plan our day very concretely. Though we don’t know if it’ll snow on 25th December, but history shows that there isn’t any January without any snowfall.

While it becomes super hard to predict a specific trend during the day, long term cycles are fairly easy to identify. We were in the longest bull run in the history with every assets giving returns that were unprecedented in the history for the last 10 years. General public does exactly opposite to Buffet suggested. People will jump into an asset class when it has already reached the peak and will shy away from getting into an asset when it has bottomed out.

Bubble-Burst cycle keep on repeating rewarding the smart, lucky and patient people while taking it away from the people on the other side.

Focus on Long term:

“There are only patterns, patterns on top of patterns, patterns that affect other patterns. Patterns hidden by patterns. Patterns within patterns.
If you watch close, history does nothing but repeat itself.
What we call chaos is just patterns we haven’t recognized. What we call random is just patterns we can’t decipher. what we can’t understand we call nonsense. What we can’t read we call gibberish.
There is no free will.
There are no variables.”
― Chuck Palahniuk

If we look at the great depression, dot-com bubble, 2008 recession or any other similar event, there are many commonalities. Biggest one is the rate at which things are changing. Similar to body, economies or growth can’t rely on steroids for long. You can have a shot here and there but overall it should have merits. Back in 2013, I recall there were only 2-3 investment firms which remained in single digits till 2017 where every one wore the hat of Blockchain VC with reported number of more than 100 in 2017.

Mushroom group of these wanna be investors was toxic because companies were raising millions in seconds where they won’t have even be able to raise 10k from traditional industry. Result bubble burst and cryptocurrencies have lost 90% of it’s market cap. This isn’t the first time it has happened and probably won’t be the last one. These however does act as a filter for part-timers. I read on this topic here

Tourists – Time to pack up

While things generally do recover, it may take much longer in few cases. Though there is more VC invested today in startups than 2008 but the house ownership hasn’t returned to even closer to numbers of 2008.

Overall, with population growth economy has to grow and research shows the poverty levels are improving as well, so there isn’t a mystery behind achieving reasonable growth. Perseverance is the goal. As they say whatever that goes up must come down.

Biggest challange with the short term mentality is to understand investor psycology. Research shows that 90% of the decisions that we do are irrational. Very few people are disciplined and our spontaneous decisions make or break our lives. We have our own mood swings, good and bad days & in few extreme cases it’s more like a pendulum from unbounded euphoria & bottomless despair.

#1 reason for short term market mentality is those pendulum mood swings. It could be euphoria-driven greed that lead you to go all in or despair-driven fear that lead you to sell everything. Either people think this is once-in-a-lifetime opportunity or the world is going to end. Biggest mistake people make is when they convince themselves that this time will be different.

Even though your heart is saying that markets are irrational, you get in for a swing trade. It just take one person to panic and the stack of cards start to follow down creating a dominos effect. Fear of greed or fear or losing, both are dangerous.

Though it’s super easy to comment on it, when you’re in the moment, it’s very hard to resist even for the best of the best.

An early example is the case of Sir Isaac Newton and the South Sea Company, which was established in the early 18th Century and granted a monopoly on trade in the South Seas in exchange for assuming England’s war debt.

Investors warmed to the appeal of this monopoly and the company’s shares began their rise.

Britain’s most celebrated scientist was not immune to the monetary charms of the South Sea Company, and in early 1720 he profited handsomely from his stake. Having cashed in his chips, he then watched with some perturbation as stock in the company continued to rise.

In the words of Lord Overstone, no warning on earth can save people determined to grow suddenly rich.

Newton went on to repurchase a good deal more South Sea Company shares at more than three times the price of his original stake, and then proceeded to lose £20,000 (which, in 1720, amounted to almost all his life savings).

This prompted him to add, allegedly, that “I can calculate the movement of stars, but not the madness of men.”

The chart of the South Sea Company’s stock price, and effectively of Newton’s emotional journey from greed to satisfaction and then from envy and more greed, ending in despair, is shown above.

Lesson learnt is that herd mentality kicks in after euphoric greed predominates kicking out all the sanity a person have.

Resisting such emotions is very very tough and I have to fight it out every time I am in that situation.

What worked has me may not work well for others but I had more success when the risks were higher. You can get a good price and if you can factor the risk, it comes out be a better deal.

People pay a premium when markets are good but they all give a massive discount when the markets are down.

While every one has access to the market data or media, very few are able to separate sentiments from rationality. I purchased few houses from foreclosure couple of years ago & I can’t believe that I was able to purchase houses for 10% of their value. Cash flow remains almost the same as well. So I bought few and sold them at rent-to-own with taking down payment higher than what I paid for the house. I wish if I knew more about it back then but there is always another time.

Many people won’t know that house prices in 2010 touched around 1945s level. 1945 as a reminder was post-world war II era when the entire world was going through a great depression. Economy, GDP, Population and other factors are no where closer to 1945, so that buy made perfect sense. Population, GDP was at-least double if not more in 2008 over 1945 but the house price levels were the same. Even though 2008 was a tough year but I was getting too much discount to pass.

While I don’t know if such times will ever return but if you’re patients, you can have success. As they say ” Let the price comes to you”

Summary:

Take a longer time frame while making a decision. Population is increasing so that’s a very easy factor to account for. Facts like population, inflation, GDP are easily available. We’re producing far more kids than before, incomes levels have gone up & people are working longer hour even post-retirement. Efficiency is increasing day by day in every field of life.

While US economy is growing at 2-3% per year & regardless of how slow it looks like, it is really good however it can’t be sustained for long. Though we live in the most peaceful time of history, it doesn’t take lot of time to shift things over. This is the reason, we’ve to extend our time horizon and focus on things which are sustainable in the long run.

Here is what I would be doing if I am going into the new year as an investor

Construct a thesis around a hypothesis, build a strategy on how to achieve it with a backup plan & then discipline himself in following it. Every failure or success should take you back to the working sheet to validate or invalidate his assumptions.

Good Luck in 2019

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Haseeb Awan2018-12-29T16:29:34+00:00December 29th, 2018|

Cryptocurrency is only for Geeks !

Thoughts of storing your cryptocurrency wallet is a scary one for the majority. There has been countless stories on how people funds were stolen with no chance to recover. Have you even looked at the process to send bitcoin from one person to another.

Number of digits that you’ve to write is insane. It’s literally impossible to type them & then only option is to copy/paste. I even still till this date, have to verify couple of times & also sweat till the funds arrive in the right place.

From trading cryptocurrencies, storing or sending funds & understanding the basic concept, we are missing out on a very wide audience due to complexities involved. Not many people go out to make their life miserable in pursuit of a better solution. As many have spoken about similarity between internet & cryptocurrency early days, I’ll recall my experiences here as well.

I got my first computer on June 9th 1998 which was a Pentium I with MMX technology. I vaguely remember the specs which were a 28.8 kbit/s, 2GB HDD, 4MB graphics card & a nice casing. I remember I had to source & wait for individual items since I was living in Peshawar.

Most interesting was the idea to get connected to internet.

Getting an internet connection was fairly straight forward but there wasn’t many free email or website providers. I remember registering a domain in 1998 through network solutions who sent me a bill later. There weren’t too many options when it come to free email & my ISP ( internet service provider) was proud of offering one for a very low monthly fee.

Here are some interesting things that I can recall

Internet was by the hour in addition to monthly subscription fee
There was different pricing for off-peak & peak hours.
I had to pay my landline company every-time I initiated a connection
You can’t use the telephone line while you were connected to internet
There was a minimum usage once I connected to the internet so even if I logged in for 2 minute, i’ll be charged for 15 min.
There was a famous handshake sound produced whenever the connection was being established. I hated it since I didn’t want any one want to know.
I wasn’t sure if I’ll be able to get through since the ISP had a fixed capacity. It wasn’t uncommon to hear & very frustrating
It took 30-60 seconds to connect. Not to mention it took couple of minutes to turn on my computer
Internet speed was around 14.4 kbit/s. In comparison today I am using 1gbps internet. 14.4 28.8 kbit/s is 0.0000144 gbps. It took over 90 minutes to download a 10MB file. Today it’s less than a second.
While Internet explorer was the default browser, I preferred netscape navigator. Netscape is considered to be “best tech product of all time”. I’ve gone from Firefox, chrome to Brave now.
There was no wi-fi so no more using the internet in the washroom.

Interestingly there are still couple of million dial-up internet users in North America today. To be honest, it wasn’t a great experience to use internet at that time, but it grew exponentially because it offered something never before. You can send emails, get updates in real time and do a video conferencing.

I got introduced to internet when it was already penetrating into house hold however still the experience wasn’t the greatest but the alternatives were even poor. In early 90’s it was super limited to a small group of geeks who had to jump hoops to get anything to work.They were versed with the concepts of TCP/IP, FTP, SMTP, POP3 , HTTP, IMAP etc, but it’s not something that was a barrier for me to enter.

Internet was written off by many pundits around that time but it has totally redefined how we live our lives. It has removed barriers in building and sharing ideas. It’s very easy to imagine now how you can order a taxi from your phone, but it looked like a fairy tales 2 decades ago. I am confident that blockchain will be able to remove barriers to build innovative financial products for the masses. Technology has direct co-relation with the improvement of human lives & once the impact reaches globally, we’ll live in a much better world.

We’re still in early days of discovering & solving problems for the financial world. Blockchain is an important component of that discovery. It’s an evolution & I am excited to experience it. We’re getting better day by day !

How many of you experienced the dial-up internet. What’s your favourite memory ?

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Haseeb Awan2018-12-29T16:28:42+00:00December 22nd, 2018|

Stablecoins – A Complete Guide

Preface

Bitcoins was a hope of beacon in the world of crazy inflation that’s impacting every one. Since bitcoin isn’t tied to any country monetary policy it’s only worth what believe it to be worth it. Though it has consistency outperformed every legacy asset on a longer time horizon, it’s still far from mass adoption and one the major reason is price fluctuation.

Here are some of the bitcoin price crashes

2017 was the craziest year for cryptocurrencies where we saw crazy gains of 10,000X but 2018 wiped off everything. This led to party moment for few but a nightmare for many. Fingers on the argument that bitcoin as a storage of value were raised & classic example of tulip mania was back in the market. It’s hard to argue with the pessimists because bitcoins doesn’t have any underlying fundamentals behind it. More & more negative media however has attached a taboo towards this revolutionary technology through which money can be programmed.While I personally have seen crashes multiple times over last 7 years, it’s tough to see market take a toll like this. Overall I am bullish on the cryptocurrencies however sanity has to prevail. It’s hard to deny the advantages cryptocurrencies provide but price volatility is keeping them off field for many serious players. While it’s exciting to see the upside swings, not everyone has an investor mindset. Since majority of the countries regulations are hostile towards cryptocurrencies, volatility keeps the institutional investors further away. There has been one thing certain about bitcoins & that’s volatility. There are many funny memes & jokes around but the following one is my favourite

A boy asked his bitcoin-investing dad for 1 bitcoin for his birthday.

Dad: What? $15,554??? $14,354 is a lot of money! What do you need $16,782 for anyway?

There is an interesting case of token velocity which is super high when someone is using it as the currency and doesn’t want to hold. In case of cryptocurrencies, if you’re holding for long you’ll get a HODLER ( Hold On for Dear Life). HODLERS are generally regarded as highly respectable in the industry because they’re considered to be in for the long vision rather than flipping. Everyone loves to HODL, however the scary swings aren’t for the faint hearts.

Commodities backed

Similar to fiat, there are stable coins which value is pegged to commodities they’re backed by. Most popular form of commodity is gold followed by silver, but we’ll be able to see other precious metals & petroleum based coins as well.

It’s value is pegged to an asset such as gold in a fixed ratio such as 1 stablecoin is equal to .01 ounce of gold. Gold is the most popular but silver and other exotic commodities are also being issued.
Financial institutes at any time is in the possession of the commodities backing the coin.
Transaction may run off-chain or it’s own private or dedicated public chain
Total collateral should be equivalent to circulating supply at any given time.

Technical wise, it isn’t difficult either but the fluctuating price of underlying asset does require financial management and generally the storage cost is higher as compared to fiat. Commodities which are generally supported by stablecoins has to be fluid and tradeable on exchanges. They are tradeable on exchanges and redeemable by issuing financial institutes. Trust in the entity backing is super important. Having higher deposit strengthen the balance sheet which empowers the financial institute be leverage. Similar to fiat-backed stable coins, we’ll see more of commodity based coins as well.

Decentralized Stablecoins

Decentralized coins are not controlled by a single entity but more by code that stabilizes the value. There are multiple 3rd parties who have to participate in order for the value to be stable.

Cryptocurrency backed

Most common form of decentralized stable coin are backed by cryptocurrency. There isn’t major difference between cryptocurrency and fiat backed stable coins in terms of logic but due to nature of the transaction everything is done through smart contract & is on-chain. User put up their funds as collateral which is generally significantly higher than the stablecoin issued to cover up in case there is a flash crash. Despite higher loan to value, there are still liquidation events which even has more impact on the price and has lead to black swan events.

Here are some of characteristics of stablecoins

Value is pegged to fiat but it’s pegged by a cryptocurrency
No centralized body is in control of collateral but it’s locked through smart contract & is executed on-chain
There are additional supplementary instruments and concept of oracle which keeps the price stable. These oracles have act more like a bounty hunter which is looking for liquidations and make a small profits whenever it is able to execute properly

Though it’s very similar to any centralized stablecoins in terms of mechanics, risks are far higher. Biggest risk is code exploitation which can lead to collapse of entire system. Though there are constant audits, but still history is full of breaches and hacks. Here the stakes are much much higher. Smart contract doesn’t execute by itself but requires a third party execution so the system has to rely on them. If they fail to act in time, liquidations might not happen in time destroying the peg value. Easiest option is to have a very high value of collateral with respect to loan however it may make tit unattractive since investors are looking to leverage up not the other way around.

Seigniorage (algorithmic)

They’re similar to a Decentralized Autonomous Organization ( DAO) which controls issuance and pricing, which are referred to as seigniorage-style (or algorithmic) stablecoins. They’re completely digitalized and non-dependent on any collateral whatsoever. Supply, demand & target price is controlled by the code which makes it truly decentralized and no regulatory oversight. Both of these features increases its ability to scale as compared to counter part solutions since there are not any additional collateral requirement with supply increase

Here are the major features

Full decentralized,
High scalable,
Executed on-chain,
Cheaper to maintain the price immutability due to lack of collateral requirement

It operates on the basic principle of supply and demand where coins are issued if there is enough demand & destroyed if the demand drops. This issuance and destruction keeps the price stable. Generally if the price goes down. Bonds are issued and if the price goes up seigniorage shares are issued. This is most exciting form of stablecoins but haven’t been in production yet.

There are also creative proposals on how to achieve stability while keeping the decentralization property and it’s a work in progress.

Concerns:

Stable coins aren’t stable

There hasn’t been a single example of stable coin that have been successful at keeping the exact peg for extended period of time. Multiple times they’re traded few percent above or below their actual value. Theoretically they’re great but they’re prone to market fluctuations as well. In one case, value of a stable coin has dropped by 70%.

Do they bring stability ?

Bitcoin does have a connection with alternative coins when it comes to price movement so generally the overall market doesn’t move much with respect to each other. Bear and bull markets are correlated. Stable coins adds a different dimension to market pricing where people can bring in fiat and take a short/long position making the market extremely unstable. So with stable coins, the term shouldn’t confused with the fact that it’ll bring stability to the market. It just keeps the value stable for the holder of that specific coin

3. Vulnerable

It is a new concept and haven’t been tested over long period. There are chances that one of them will break causing a spiral downward market crash. It has happened in the past but they were not as popular at that time having minimal impact. Even decentralized coins are prone to hacks Stable coins generally require us to trust a central third party. In case of centralized coins, there are always risk of custodial going illiquid.

Pursuit to perfection

Cryptocurrencies basic moto is decentralization but there isn’t a fool proof system to get a perfect solution. We’re far from perfection but we have came a long way. Stable coins are on the rise with over 2 dozens companies working on the solutions. Every has a unique approach and hopefully we’ll have a perfect solution soon. Stable coins are the holy grail of crypto and is a necessity piece in the puzzle. With extreme volatility in cryptocurrencies, it would encourage people to get in and out of the market whenever they want. None of the solutions are reliable so they’ should be only treated as an ad hoc solution. Right now it’s limited to startups, but bigger financial institutes will move into the game and I won’t be surprised if countries start issuing their own digital currencies on the principle of cryptography. Rome wasn’t built in a day & future won’t be either. It’s an evolution towards better & better

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Haseeb Awan2018-12-17T04:38:56+00:00December 19th, 2018|

HODL – Worse Use Case ?

HODL is a term that got popular through a forum post where a person claimed to hold the bitcoins forever once the markets crashed. HODL stands for Hold On for dear Life on in simple word never selling them. Now either it was intentional or unintentional, HODL did become famous in the cryptocurrency industry.

Out of the total 17M bitcoins in existence, 9M haven’t moved in the last 12 months. This represents around 53% of the total bitcoins but I am confident that this number is close to 75% in actual. It’s not possible to get the data on individual users who store their bitcoins on the exchanges

While HODLing does promote the message of hope & avoid capitulation in bear markets, it isn’t right for the network bitcoin. Bitcoin network runs due to support from miners who mines bitcoins in hope of getting bitcoins in return.

If the blocks are solved exactly 10 minutes apart, all the bitcoins will be mined by 2140 which is 122 years from now. Margin of difference actually would be +/- 10 years.

I suspect if we go that far but for a moment let’s consider we did. In that case, there are no more bitcoins to be mined so miners make money by validating transactions. Now imagine every one is HODLing and there are no transactions happening at all. There isn’t any incentive for miners to exist because the economic incentive has collapsed.

Bitcoin network strength depends on the hashpower supporting network and with the departure of miner, there isn’t any network or just a weak network. HODLing is celebrated & cheered upon in the industry, however it’s a threat to the fundamentals of cryptocurrency.

If you consider bitcoin a instrument for Storage of Value then HODLers are the #1 or Most Valuable Users ( MVP) for bitcoins.

While HODL certainly make sense to avoid the panic attacks in tough markets, it doesn’t make sense over life time of any other asset that doesn’t generate dividend. Real estate being the #1 fav HOLDing asset.

So while times are time, don’t panic & when times are great, it’s always good to take off some profits off the table. Capitulate & HODL both are bad from economical point of view

What’s your strategy when the times are great or when they aren’t that great !

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Haseeb Awan2018-12-14T14:26:09+00:00December 15th, 2018|

Blockchains Tourists – Time to Pack up !

2018 has been the worse year for blockchains if you look at the price. Unfortunately, measurement of success in this industry has been measured by market cap. It has roughly lost 85% of its financial value within12 months which may be among the worst performance for any asset in the modern history. There are many other indicators showing all time worse situation for the industry. Question is it all over for blockchain or we can recover from here.

Capital preservation is the #1 reason behind success of wealthy people. If you look at the chart below, it shows how much gains are required to make up for the loss. Summary is It’s much difficult to make up for a loss.

Gains required to makeup for the loss occured

If you look at the history of bitcoins, it has been pronounced dead 100s of times. I’ll do a blog post on death announcements vs price action some later day. Bitcoin has lost 85% or more around 5 times now in last 6 years. Defying every traditional law of finance, it has however recovered strong every time. This exponential rise isn’t alien in the tech world and hockey stick pattern is fairly common.

I got into bitcoin purely because of FOMO 7 years ago. I couldn’t resist staying out while watching everyone around me flaunting about their crazy gains. For me it was unreal & there was no chance I was going to lose. Sadly, I bought my first bitcoins at All Time High (ATH). Bitcoin crashed the very next day losing 50% of the value. I’ll be honest I was really upset over what just happened and pessimism was at all-time high. Fear of losing everything almost made me sell it, but then I figured I’ve already lost 50%, what if I lose the another 50%. Bitcoin at that time was already up by some crazy 12X or so, so there was a hope it can do it again. That was almost 7years ago when bitcoin dropped from $260’s to $40’s.

Looking back, it seems very easy to make the decision toHODL, but it’s not an easy choice when you’re in that moment. It’s very simple to classify the early bitcoiners as lucky but as a matter of fact, they’ve scars all over them. Perseverance in the end paid off for majority of them, but it was super difficult back then.

Bitcoin is lucky enough to have a cult following composed of libertarians, economic freaks & tech geeks who’re in for ideology rather than monetary benefits. This bear market has little impact on them. While everyone is hurt, they’ll continue to BUIDL. With every price rise, there has been a new set of people who come in but as things start to fall apart, they’re the first to pack their bags. In case of a disaster, it’s the tourist who leave first. Habitants stay and focus on rehabilitation.

Cryptocurrency is going through its tough time when it comes to valuations however adoption is all time high. There hasn’t been a time in history when there were this number of intelligent brains working on brilliant ideas. I’ll call it crypto winters where majority of the project don’t have enough resources to survive. It would be a litmus test that’ll differentiate the boys from men. Let’s see how long this survive & most importantly who survives.

Terms Used:

HODL – Hold on for Dear Life. A term very popular referring to holding on the bitcoin regardless of whatever is the price.
BUIDL – Derived from HODL meaning Build for Dear Life. Meaning keep on building regardless of whatever is the price
FOMO – Fear of Missing Out which makes you take an irrational risk without any due diligence in fear of missing on a massive potential upside
ATH – All time high means you’re the sucker who bought at a price at which you may not be able to offload.

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Haseeb Awan2018-12-13T21:54:12+00:00December 11th, 2018|

Security Tokens: 20 Important Things you need to know (Detailed Guide)

What is a security token?

Security Token Offering can be best defined as a “Public-Private” security offering that utilizes regulatory body framework such as Securities and Exchange Commission ( SEC ) or Ontario Securities Commission ( OSC) to offer investment products via blockchain technology.

Preface

A securities offering (or funding round or investment round) is a discrete round of investment, by which a business or other enterprise raises money to fund operations, expansion, a capital project, an acquisition, or some other business purpose. A securities offering (or funding round or investment round) is a discrete round of investment, by which a business or other enterprise raises money to fund operations, expansion, a capital project, an acquisition, or some other business purpose.

STOs would be a process to move traditional assets to blockchain & evolving the way assets are issued, traded, held & transferred. It’s a work in progress with blocks built around it to support the ecosystem.

Background of Security Tokens:

Blockchain, cryptocurrencies, bitcoins, smart contracts aren’t alien terms anymore. Information is at all time high but there is a fair bit of noise on the benefits with thousands of companies finding the use cases for this revolutionary technology. While there has been interesting technical progress, there hasn’t been a killer case which would attract industry wide adoption. Exciting news on how the industry is progressing is a weekly affair but it rarely has put a dent on world economy more than pure speculation. Bitcoin did emerge as a libertarian movement with a promise of banking the unbanked, revolution against the status-quo, decentralized system with no manipulation but so far there is very little to show. Despite all of these there isn’t any reason to write-off this industry, because we’re still in infant stages. It’s a work in progress for last 10 years & it may take maybe a decade before utopia dream is fulfilled. Digitisation had a lot of impact on our daily lives in multiple sectors but financial industry is far from perfection when it comes to frictionless banking. I still have to go to bank to do a wire transfer & it takes couple of days for funds to get to other end at a exorbitant cost. Counter-argument would be that the banks are already digital & majority of the people don’t go to the bank anymore, so we’re on the right track. I take cryptocurrencies as an experiment lab or a sandbox where ideas can be tried, tested & could be launched into masses if successful. Current regulatory environment is fairly conservative when it comes to investment product or any other financial instrument. It’s either due protection of consumer or status-quo, that’s a different discussion, but it is what it is.

We’ve seen the exponential rise in cryptocurrency valuations, institutional interest through acquisitions & whopping billions dollar of raise in Initial Coin Offerings ( ICOs). ICOs could be simply explained as pre-prepaid credits in a game that was sold before the game was launched. It was fine till recently there were issues with this model.

The game was never launched
these credits were trade-able way-before game launch leading to speculations & hype.

That ended about 10,000X returns in few cases & 99% loss in value from All Time High(ATH) in extreme cases.

Fear of Missing out ( FOMO) is a common term in which a person gets into a deal without due diligence because time clock is kicking in. Majority of the time it doesn’t end well. This FOMO lead to retail investors buying useful tokens of every kind. Doge currency was created to make fun of these tokens but that lead to 1.5B in valuation while the creator clearly mentioned that it’s a joke. In an another case a person clearly mentioned that he is creating a useless token with no use however people still bought them. Around that time Ripple CEO was worth more than
CEO of Facebook. While these tokens were marketed along the lines of prepaid tokens, they clearly weren’t. This is where Security Exchange Commission (SEC) & other regulatory bodies jump in.

Despite the legal language used in building analogies around network usage, setting up non-profit foundations in friendly offshore jurisdictions, taking shelter behind fancy buzzwords such as open-source software movements, decentralisation, blockchain 99% of them are securities & I’ve doubt about the remaining 1%.

There is a famous duck test,

“If it looks like a duck, swims like a duck, and quacks like a duck, then it probably is a duck”

This term was popularised in the US during the cold war in 1950 when Richard Cunninghand Patterson Jr, US ambassador to Guatemala at that time accused Jacobo Arbenz Guzman government of being Communist. These were the exact words
“Suppose you see a bird walking around in a farm yard. This bird has no label that says ‘duck’. But the bird certainly looks like a duck. Also, he goes to the pond and you notice that he swims like a duck. Then he opens his beak and quacks like a duck. Well, by this time you have probably reached the conclusion that the bird is a duck, whether he’s wearing a label or not”
In 1946, Supreme Court heard a case that set the precedent on what’s a security

It is an investment of money
There is an expectation of profits from the investment
The investment of money is in a common enterprise
Any profit comes from the efforts of a promoter or third party

If either of the above points satisfies during a financial transaction, whole new set of requirements kick-in. Entity is bound to register with the Security Exchange Commision ( SEC) regardless of whatever they think they’re. SEC only however generally looks over cases that involves US entities but other countries follow similar guidelines in their jurisdiction. Despite billion in funding ICOs have very little to show. Lack of investor rights, governance structure & geographical restrictions people are left with these useless tokens, but SEC has intervened in multiple cases leading to fines, capital return & other punishment. I expect them to rise, however despite all this drama, there is a very good case for issuing tokens that are actually securities but still have the benefits that a token provides. There is where Security tokens come into play which will have the legitimacy of a Initial Public Offerings (IPO) but flexibility of ICO ( Initial Coin Offering ). Welcome Security Token Offering (STO).

Business Case

There is a capital scarcity when it comes to private markets for small & medium business (SMBs) . Just to talk in terms of numbers, there are 28 Million small business in the US vs 3671 publicly traded companies. Number of public companies is decreasing year over year & this trend will continue to drop due to complicated nature of managing public market listings. SMBs are the backbone of any country economy & 70% of new job creation is due to them, but still they suffer growth due to lack of capital available. There are Venture capitalists, predatory lenders, angels & limited public after JOBS act, but that’s still a very limited segment. If they are able to access debt in return for a fractional ownership in the firm, that can be traded back & forth, it will get them out of the capital drought. It could be debt, equity, convertible note or combination of these but important point is access. This could lead to trillions of dollars in economic benefits.

Real estate is considered to be the best & safest asset class however it’s expensive to own. We’ve Real Estate Investment Trust ( REITs), but they’re still fairly out of reach for the masses. Real estate globally is worth around 265 Trillion but only 1% is accessible through these complex REIT structures. Security Token offering can remove lot of overhead making it flexible, simple & convenient for average investor to participate in an potential economic upside event. Lot of investments currently require the investor to have an accredited investor status despite there isn’t any relationship between IQ & wealth, but net worth does serves as a barometer for qualification of investor acumen. There is an argument that it’s not an acumen test but more of a ability to sustain loses. If that’s the case why isn’t a test before entering a casino or any high-end luxury store. No one gets inquired of his/her financial health at the gate while entering these establishments. If these high-risk or luxury establishments aren’t bound to do a background test on the consumer ability, why should a potential upside event be restricted ? Regardless of whatever I think, it’s a law which I respect & abide. This is where I think Security Tokens will make a lot of sense since they can solve major issues around public markets abiding with the current financial structure yet flexibility of tokens.

Here are the 20 major reasons to make a business case for Security Tokens to exist

No.	Content
1.	Liquidity
2.	24/7 markets
3.	Fractional ownership
4.	Immediate settlement
5.	Elimination of 3rd party services
6.	Real-time ownership reconciliation
7.	Cost reduction
8.	Compliance automation
9.	Expansion in the offering options
10.	Custody
11.	Vested Stocks
12.	Pedigree proof
13.	Preferential treatment
14.	Infungibility
15.	Debt restructuring
16.	Global Assets
17.	Larger investor base
18.	Stability
19.	Front running avoidance
20.	Ownership Proof/ Title

1. Liquidity

90% of the assets in the world are illiquid. It’s not possible to get in/out quickly without accruing significant slippage and/or paying a significant fee.Though liquidity is referred to as speed at which you can trade an asset, however it’s much more than just the speed in practice. Another parameter is also cost. Example is that you may be able to sell your house within 24 hours but that’ll be generally classified as a distressed sale & will lead to a loss in comparison if you wait. Price difference delta between distressed sale & regular sale is the liquidity discount that you’ve to offer. Other impact of these sale is that it lowers the bar for fair market value ( FMV) of similar houses in the vicinity.

In comparison you can trade Microsoft stocks at market value during business hours without having any major impact on the market prices by paying a very small fee. Now there are fractions if you’re a whale and cause market crash. Take this further with cryptocurrency which you to trade even a fraction round the clock.

Total world assets are 700T, but less than 10% of them are liquid. If Security Tokens are able to turn them liquid, there would be trillions dollar worth of economic activity generated.

2. 24/7 markets

Majority of the traditional exchanges operate between business hours such as 8 – 4:00 am in the morning with respect to local time zones. They’re closed during the holidays so if you want to make a move while having Saturday dinner, that’s not possible. Tokens on the other hands are tradeable 24/7. Due to the nature of STOs, it would be possible to trade them round the clock even on Christmas eve.

3. Fractional Ownership

It’s impossible for 95% of the world population to diversify into more than 2 investment classes due to high unit costs but if there is a mechanism to buy a small ownership, it’ll attract a whole new set of investors effectively increasing liquidity & raising premiums. Now in case of equities, there are options to buy them from public markets & similarly you can buy publicly-traded or private market RIETs but an estimated 99% of the real estate assets isn’t available through either of these tools. There would also be ability to make profits when the markets are going down rather than just buy & hold strategy and capture the gains with appreciation. Retail investors are unable to balance their portfolio to de-risk their investments across multiple assets, but availability of vast set of liquid assets would allow them so. Ultimately, it’ll lead to more efficient markets

4. Immediate settlement

There is a time difference between when the actual trade is executed & settled. Example is buying a house today but paperwork, transfer of funds & ownership might take 4-6 weeks. Even in stock exchanges, though you’re able to trade immediately, it’s usually 2 business days (T+2) before the owner get his hands on the purchase. It used to be 3 days but reduced to 2 in 2017. With STOs there should be a possibility of execution & settlement at the same time.

5. Elimination of 3rd party services

Blockchain has the potential to increase settlement speed for securities, but it’s more complicated than a comparison to cryptocurrencies. The degree to which these processes can be automated through interoperable smart contracts will determine the gains in settlement speed. There is a moral hazard with the usage of these companies since they can manipulate with insider information & little oversight on governance matters. With an open system, there’ll be a more transparent, fair & balance playing field.

6. Real-time ownership reconciliation

Even though the trade Trading books are balanced by the end of day. It’s costly & not optimistic. After stock issuance, there is a bundle of paperwork that goes in producing friction that leads to inefficiency. Contractual features including but not limited to liquidation preferences, depositories and depository participants management and drag-along rights etc could be easily calculated making it simple for the participants to decide their risk-reward ratio. Through STO, there would be a chance to have a real-time asset reconciliation in a transparent manner.

7. Cost reduction

There are massive costs associated with operating the exchange which could be reduced by having a lean-operated STO exchange. These smart contracts will reduce the complexity, costs and paperwork with managing securities (collecting signatures, wiring of funds, mailing of distribution checks, collection of W-2s, Sending K9s, etc).

8. Compliance automation

KYC & AML policy are the two most basic compliance things any financial institute has to take care of. There are two major frictions in the current system

Legal Restrictions
Financial institutes have to filter out the people who’re ineligible to be involved in the transaction mostly due to regulation. These restrictions could be due to buyer financial profile, industry, jurisdiction of transaction/seller/buyer or past history etc. Failure to abide can lead for serious repercussions. It slows down the onboarding process.
Complex chain of stakeholders
There is a chain of stakeholders who’ve to be on the same page during the transaction. Lawyer, government, accountant, exchange is to name the few and all of them have their own of reconciliation which leads to inefficiencies in terms of cost & time. Unless & until all of them can match up their record, it doesn’t go through.

With blockchain, every transaction can be downloaded or broadcasted in a standard format in real time which should be able to make this process more efficient. Customers can get an ID that is verifiable by any party in real time at time of settlement. Currently, you’ve to create an account in every exchange that you use but in future you only provide ID if requested.

9. Expansion in the offering options

Currently there is a very rigid set of requirements to be listed on these exchanges, but in future it might change because companies would be able to innovate on compensating their investors. Staking, proof of work, token burn, forks are few of the unique innovations that has been used to reward investors by the current token offerings.

10. Custody

Financial institutes are generally a storage for your assets and issue you I Owe You(IOU). This increases the risk just if incase a FI goes into default. Beauty of cryptocurrency is that owner can hold the private keys & no 3rd party can seize them. With STOs, investor would have ability to control and take custody of the tokens. He isn’t obliged to store them with any 3rd party if he doesn’t want to. In unforeseen condition such as war, he can transport them himself.

11. Vested Stock

There might be interesting structure for the long-term holders if they lock up their tokens. This effectively reduce the sell-pressure & encourage the company to thing big & focus on long term strategy. Firms can issue more stock in shape of interest to vested folks where if you lock the token for suppose 12 months, you can 2% in extra tokens towards end of year.

12. Pedigree proof

It’s really tough to invest into the top funds or private REITs because they keep it private. Mostly it’s because they don’t want to deal with the headache of onboarding & dealing with new Limited Partners or backers. It’s a relationship play. In regular markets, it’s hard to establish trust & have inroads if you’re trying to get into these funds. Through STOs an investor would be able to prove that he already owns ABC stock for 5 years & that might break the ice. As an investor, I do have to sell companies on taking my money if there is a good interest. I usually do that by telling about my portfolio or testimonials from the founders I’ve worked with. Through STOs I can just show proof of ownership to build the pedigree. A company can also put a restriction to raise money from people who own specific tokens already to maintain the pedigree. Ferrari is a good example of maintaining the exclusivity since they don’t generally sell it to anyone & in few cases you’re required to show a track record of ownership before getting special editions.

13. Preferential treatment

There is a big disconnect between company stock holders & customers. If you work for a company they generally have perks for using their own products, but in case of stockholder no such perks exists. Now, through STOs it would be easy to establish proof of ownership & be entitled to some perks which can be restricted by how long you had them & point. I may buy stocks of airlines I travel on to get into the line first or utilize a dedicated lane at grocery store. Through STOs, businesses will be able to encourage their users to hold onto their tokens which results in stronger brand following.

14. Infungibibility

In private capital, there are different classes of shares with “common” & “preferred” as being the most popular however there is option to have exotic stock structure. In public markets, it has to be the same but through STOs, there is an option to create different STOs for the same asset well suited for the investor type. Commonly investor is either looking at appreciation play or seeking dividends. Ideally he wants both but that isn’t possible in a practical world. Company can separate both type of assets by issuing two types of STOs at different price. You may want dividend so you can purchase stock at a different price than someone who just want to hold for long term. At the moment, it’s somehow built into the price but a clear separation would make much easier for retail investors & help company with their growth plan.

15. Debt restructuring

Debt financing have sunk ships for many businesses. Delay in permits or any other hurdle that temporary caused borrower to default on payment has lead to disaster for many. It’s not an ideal outcome for neither the borrower nor a lender however options are limits. Through tokens debt can be restructured very easily automatically. Imagine you gave someone a loan but he is unable to pay the payments such as in house cases. In this case the bank takes over the entire asset, but what instead of that, bank keeps on adding the default payment towards the loan. In STOs, upon debt issuance, tokens of the assets are pledged towards the loan & in custody of the lender. Effectively borrower is buying back those tokens. If borrower is unable to buy back token at a scheduled time, lender will repossess tokens worth that missed payment providing better breathing space in tough times. It’s fairly complicated in current scenario but through smart contract all of this enforceable & Security Tokens would be really effective at this.

16. Global assets

Access to majority of the assets is limited by geographical limits. It’s impossible or very difficult to invest in Africa from Asia for a retail investor. Approximately 97% of the global assets are inaccessible for entities outside the geographical limits. Security Tokens do eliminate that by empowering companies globally to build an STOs and raise capital. There would be less requirements to issue STOs.

17. Largest investor base

In order to trade on New York Stock Exchange ( NYSE) or NASDAQ investor has to go through a set of stringent requirements which crypto exchanges on the other hand are able to onboard customers globally with excluding sanctioned countries of course. STOs will be able to open doors to these assets to investors globally. This’ll lead to more healthy competition.

18. Stability

Every company wants to list in NYSE or NASDAQ despite them US not being their biggest market. This being said, US economics has impacts on the company valuation which is totally uncorrelated to company’s operating jurisdiction. With Security Tokens, there would be a global set of investors with different sentiments leading to more stabilized markets.

19. Front running avoidance

Front-running also referred to as tailgating is the practice of a broker or trader stepping in front of large orders to gain an economic advantage. It’s a prohibited practice of entering into an equity (stock) trade, option, futures contract, derivative, or security-based swap to take advantage of a confidential information that has impact on price. Multiple times bad actors get away with it due to lack of data availability required to establish a proof. Another reason for this is unfair access to market for different participants. Blockchain treats everyone the same & the books are open, reducing the chances of front running.

20. Ownership Proof/Title

Whenever you’re acquiring an asset, you generally go for a title check or get a title insurance to make sure the asset is free of any liens or disputes. Blockchain can track back the ownership transfer from inception without the fear of record being forged.

Conclusion:

Majority of the ideas here are not solely linked to tech but also are restricted due to regulation. I consider STOs as being the sandbox for next generation of Securities. They might eventually be offered by traditional exchanges or can operate totally separately where companies graduate from these STO exchanges into the top exchanges.

If Bitcoin is programmable money, then Security Token is a programmable ownership. They do add improvement to current security industry which may be frowned upon status quo but eventually be able to prove it’s worth & get institutional support.

Security tokens would new way to build, fund & grow companies & it’ll happen quicker than many people anticipate.

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Haseeb Awan2018-12-08T17:20:06+00:00December 3rd, 2018|

Monthly Archives: December 2018