Next-Generation Securitization: NFTs, Tokenization, and the Monetization of ‘Things’
38 Pages Posted: 2 Mar 2022 Last revised: 9 Mar 2022
Date Written: February 25, 2022
For decades, businesses have used securitization to monetize assets by selling to investors interests in the assets’ future value. Traditionally, securitization has monetized so-called financial assets, which generate cash flow to pay the investors. That payment source, coupled with the ability of investors to resell their interests, can create a highly liquid and attractive investment. Even so, securities laws generally restrict these investments to sophisticated and institutional investors.
In recent years, securitization has spawned a new generation of transactions that monetize non-financial assets and other rights that do not ordinarily generate cash flow, such as art, collectible cars, access to basketball video highlights, prestigious real estate, and even fictitious real estate used in video games. Industry observers variously use the terms “tokenization” and non-fungible tokens, or “NFTs,” to refer to these non-cash-flow monetization transactions. Rating agency Moody’s and others believe that these transactions have “transformative potential,” including the prospect of creating greater financial inclusion.
However, because non-cash-flow monetizations do not generate cash, investors in these transactions lack that source of payment. Selling the underlying non-financial assets could generate another payment source, but the relative uniqueness (and sometimes fictitious nature) of those assets can make them difficult to sell—and owners of those assets may contractually restrict their sale. For payment, investors therefore must rely primarily on the ability to resell their interests to other investors, hoping a viable resale market exists. The realty, though, is that the pricing in such a resale market is extremely volatile, and even the market’s existence is unpredictable.
Non-cash-flow monetization transactions thus create enormous liquidity risk for investors, who currently include both individuals and institutions. Although illiquidity is the central cause of bankruptcy as well as a major systemic threat to the financial system, many investors ignore that risk. They are attracted, among other things, by the cachet of the underlying assets and by the hype associated with blockchain and other financial technology, or “FinTech,” which often is used to evidence the ownership and facilitate the transfer of interests in these transactions. Investors also appear, mistakenly, to conflate the ease by which FinTech can facilitate the transfer of those interests with the existence of market demand to purchase such interests. Furthermore, because those interests are often referred to as tokens or coins, many investors fail to recognize that they are even investing in securities. Worse, unsophisticated investors might not even understand the basics about what they are buying.
This Article has two goals, one descriptive, the other normative. The descriptive goal is to help regulators, investors, and other market participants understand non-cash-flow monetization transactions, including their risks and benefits. The normative goal is to analyze how those transactions should be regulated to preserve their benefits and minimize their risks.
Keywords: securitization, monetization, tokenization, NFTs
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