The single largest bet we are making at PixelAlpha is on the eventual tokenization of everything (if you aren’t familiar with tokenization, read my primer here). It is central to our business plan because the blockchain makes derivatives issuance and tracking simple because it also gives meatspace assets a common denominator. Before, your house’s land deed would be kept at the County Recorder’s office, your dollar in your pocket, and your car registration at the DMV. Through tokenization, their ownership rights can all exist in the same location. This has revolutionary implications not only in what we trade, but how we trade it.

To understand the effect tokenization has on the variety of tradeable assets in the market, we must first understand the concept of a liquidity premium. This value is the discount from true value that sellers are willing to give for an asset that doesn’t have a deep market of buyers. Often it can be significant: between 30–50% for real estate, high because real estate sales are usually all-or-nothing deals. Entities with the balance sheets to offer cash up front like WeBuyUglyHouses.com actively arbitrage these conditions, using their scale and lower time preference to buy low and sell high. The same concepts hold true for pawn shops, used car dealerships, exotic options, and any other market where holding onto an asset for too long can be detrimental to the seller.

While tokenization has the potential to reduce the buy/sell spread, it won’t magically make illiquid assets perfectly liquid. A house in an inferior neighborhood doesn’t become inherently more desirable just because it has been tokenized, for example. However, it will bring the liquidity premium much closer to its true cost.

Combining tokens’ inherent divisibility with the programmable nature of smart contracts introduces a host of opportunities both for purchasing and reaping the benefits of owning the underlying asset. Instead of transactions being binary (either you buy the house or you don’t), they become scalar (you can now buy 0.5%, 1%, 10% of the house). Notably, this means high value assets no longer need to go to a single buyer and single buyers receive reduced leverage. Scalar transactions significantly lower the barriers of entry for investors by eliminating initial capital requirements. In turn, more buyers are present in the investment pool which ultimately reduces the liquidity premium the seller needs to accept. The benefit for the seller is represented below:

Comparison of WBUH against tokenizing equity for sale to multiple parties. Rows I&J assumes complete exit of position after the house has been upgraded.

The first difference you will notice between nonfractional and fractional (centralized and decentralized) marketplaces is how the number of investors can differ drastically. By tokenizing the home’s equity, 10 (or 100 or 1000) investors can purchase as much equity in the home as they like. Their exposure can be adjusted according to their risk appetite, while the seller receives a much higher total bid (as represented in the lower Liquidity Premium of Row F). Partial property purchases creates the foundation for many more products and indices like neighborhood ETFs.

Row G reflects the current binary state of asset ownership. When WeBuyUglyHouses buys a house, they own all of it. But with the same gross amount invested through token purchase, the current homeowner can maintain some equity for later while the blockchain provides a built-in ledger to track ownership without any additional overhead. Keep in mind the amount of equity sold is entirely at the seller’s discretion. For example, if they inherited a house that could be worth $500,000 with $50,000 worth of renovations, they can sell a percentage adjusted for liquidity premium for that amount. Through smart contracts, the party investing the $50,000 can enjoy benefits as well. They can include things like a percentage of future mortgage payments, entitlement to rent out a room in the house for revenue, or entitlement to trigger an automatic sale should a buyer be found above a certain price point.

You will surely see that sellers seem to benefit disproportionately in this model. That is simply the market correcting for the highly inefficient liquidity premium that had previously existed:

Liquidity is all of a sudden not-so-premium.

Creating more accurate valuations is a hallmark of financial markets, and tokenization is uniquely positioned to extend these markets to include more asset types than ever before. Not only are more assets easier to trade, but by using blockchain(s) as a standardized infrastructure, they can all be traded on the same medium. Imagine if the NYSE also had access to all the stocks on every other stock market — we would expect to see all the world’s traders converge there. The same thing will happen in crypto, but at a much larger scale because of the sheer variety of tokens that can exist. I predict we will see the eventual valuation of everything by a market with magnitudes more participants than today.

PixelAlpha is building towards the endgame described above. Since derivatives have major benefits in existing capital markets, they will be even more important during the geometric expansion of tradeable assets that crypto will facilitate. Derivatives mitigate risk and improve price discovery. They will carry incredible significance in a world where all pricing functions start to resemble stock markets. In addition, we have the potential to disrupt the historically nontransparent OTC industry through the same access channels that tokenization creates for traditional assets. As more market participants join, it creates a deeper pool of buyers for products with uncommon specifications that would have previously been traded OTC out of necessity.

In conclusion, blockchain is taking steps towards creating a market with more ubiquitous participation, both on supply and demand sides. Entities that leverage cash reserves to muscle their way into middleman roles will have their influence largely diminished, and derivatives will begin to play an even larger role.