Smart Contracts and Asset Tokenization

Book of Smart Contracts 1959

In his 1959 classic Theory of Value, Gerard Debreu takes a deep dive into general (Walrasian) equilibrium theory. (Yes, I know, but please try to stay awake for at least a few more paragraphs.)

He studies a very stark hypothetical scenario where people are imagined to gather at the beginning of time and formulate trading plans for a given vector of market prices (called out by some mysterious auctioneer). Commodities can take the form of different goods, like apples and oranges. But they can also be made time-contingent and state-contingent. An apple delivered tomorrow is different commodity than an apple delivered today. An orange delivered tomorrow in the event of rain is different commodity than an orange delivered tomorrow in the event of sunshine. And so on.

For any given vector of relative prices (there is no money), individuals offer to sell claims against the commodities they own to acquire claims against the commodities they wish to acquire. A market-clearing price vector is one that makes everyone's desired trades consistent with each other. How this equilibrium price-vector is achieved is not studied--he is mainly concerned with the less interesting, but still important, question of whether any such price vector might even be expected to exist in the first place.

The theory imagines all relevant trading activity to take place once-and-for-all at the beginning of time. Once trading positions are agreed to, all subsequent good and service flows across individuals over time and under different contingencies are dictated by the terms of promises made at the initial auction. Suppose I had earlier acquired the right for the delivery of oranges next month in the event of rain. Suppose it rains next month. Then the delivery of oranges is made by the orange producer who issued the promissory note now in my possession. In short, contracts look very "smart" in the sense that they can be tailored in any way we want and, moreover, they are assumed to be "self-executing." It's almost as if contractual terms have been spelled out mathematically and enforced by self-executing computer code. Indeed, this is essentially what Debreu assumes.

The Debreu model (also associated with Ken Arrow and Lionel MacKenzie) is often viewed as a sort of benchmark of what one might expect if auction markets are "complete" and worked perfectly (no financial market frictions like asymmetric information, limited commitment, limited communications, etc.) There is no role for money as a medium of exchange in such a frictionless world. As such, it should come as no surprise to learn that monetary theory is devoted to studying economies where these frictions play a prominent role. Financial institutions (governance structures in general, including "the government") can to a large extent be understood as collective arrangements that are designed (or have evolved) to mitigate these frictions for the economic benefit of a given set of constituents (either general or special interests, depending on the distribution of political power).

A recurring theme of the "blockchain" movement is how this new record-keeping technology may one day permit us to decentralize all economic activity. No more (government) money. No more banks. No more intermediaries of any sort. This seems to be, at least in part, what "asset tokenization" is about; see, for example, here: How Tokenization Is Putting Real-World Assets on Blockchains. According to this article,

Tokenization is the process of converting rights to an asset into a digital token on a blockchain. 

This sounds fancy, but as the article soon makes clear, it's basically a variation of an old theme,

There are many proposed methods for taking real-world assets and "putting them on a blockchain." The goal is to achieve the security, speed and ease of transfer of Bitcoin, combined with real-world assets. This is a new form of an old concept: "securitization" (turning a set of assets into a security), and in some cases the tokenization is of securitized assets.

Here's how the innovation is supposed to help small investors (source):

Imagine that you have some property — say an apartment. You need cash quickly. The apartment is valued at $150,000 but you just need $10,000. Can you do this quickly without much friction? To my best knowledge, this is next to impossible.

I often use a similar example in my monetary theory classes. How to liquidate a fraction of one's illiquid wealth? One way is to use a bank (say, to open up a credit line secured by your property). But what he means, I think, is that it's basically impossible to issue a personal IOU representing a claim against the property (and ultimately, against the income that is generated by that property). Well, it's possible, but any such security is not likely to be marketable at any reasonable price. The author has stumbled across the concept of an "illiquid" asset. We use institutions called banks to monetize illiquid assets (banks transform illiquid assets into liquid deposit liabilities). But why do we need banks? Why are most assets illiquid? Economic theory answers: because of the frictions associated with asymmetric information and limited commitment (or lack of trust). O.K., but is there any way to get around these frictions without the use of banks? The same article continues:

Enter tokenization. Tokenization is a method that converts rights to an asset into a digital token. Suppose there is a $200,000 apartment. Tokenization can transform this apartment into 200,000 tokens (the number is totally arbitrary, we could have issued 2 million tokens). Thus, each token represents a 0.0005% share of the underlying asset. Finally, we issue the token on some sort of a platform supporting smart contracts, for example on Ethereum, so that the tokens can be freely bought and sold on different exchanges. When you buy one token, you actually buy 0.0005% of the ownership in the asset. Buy 100,000 tokens and you own 50% of the assets. Buy all 200,000 tokens and you are 100% owner of the asset. Obviously, you are not becoming a legal owner of the property. However, because Blockchain is a public ledger that is immutable, it ensures that once you buy tokens, nobody can “erase” your ownership even if it is not registered in a government-run registry. It should be clear now why Blockchain enables this type of services.

Well, no, to be honest it is not at all clear how "blockchain" solves any of the fundamental problems associated with transforming an illiquid asset into a payment instrument.

We have to keep in mind that "blockchain" is nothing more than a consensus-based database management system (where the data is organized and secured in a particular way). Moreover, any useful innovation found in a blockchain-based database management system (recording data as a Merkle tree, for example) could likely be applied in a non-consensus-based database management system. It's one thing to transfer tokens (or information) across accounts in a database. It's quite another thing to exert your own effort to evict the non-compliant tenant of your 0.0005% share of the apartment you own, especially if other owners are not on board.

It may be that technology will one day eliminate financial market "frictions" and permit widespread asset tokenization (including our human capital), all of which will be traded using smart contracts on an Internet-based auction. If or when that day comes, the people of that world can refer to Debreu (1959) as an economic model applicable to that future world.