Tokenizing investment products using algorithmic smart contracts

Investment products such as shares, bonds, etc are entitlements to cash flows they produce to their holders. So, if you buy a bond that pays monthly interest, holding the bond entitles you to receiving that interest amount every month.

But as an investor, are you always aware of what you can expect to be paid off on your investments at any given point in time ? A fixed interest might be easier to calculate, but what about floating rate products. And it gets more challenging as the products become complex. Imagine a structured product with underlying bonds and options.

And it is not just about calculating pay offs from investments, investors also lose track of when important events occur in the lifecycle of products they have invested in. When is the next interest due ? What is the record date for a bonus that is announced on a stock ? When does a product become redeemable ? Has anything happened that breaches the terms of offer for a product ? And the list goes on.

So, does your regular securities brokerage account give you all the information ?

Or does the mere digitization (dematerialization) of investment products make them smart enough to provide you all the information investors need from them ?

The answer is ‘No’. Digital brokerages and Digitized securities are not enough.

This is where ‘smart contracts’ come in. A smart contract is software code that represents the terms that the investment product is offered at to investors. Examples of terms include coupon rates, redemption schedules, strike prices, calendar conventions for reset dates and distributions, etc. An ‘algorithmic smart contract’ is an advancement in the sense that it contains logic for calculating a time schedule for pay offs and the cash flows due to the holder of an investment product at any time on that pay off schedule.

Smart contracts live on a blockchain. The reason they are deployed on blockchains is to ensure that the contracts are immutable and that they can not be changed once terms are agreed to by the issuer and the investor of the investment product.

Now, where does Tokenization come into the picture ?

Fractionalizing a product and making it affordable for smaller investors and enabling distribution by making them accessible on digital platforms aside, what do security tokens do ?

A smart contract for an investment product represents the whole of the product or the whole of the cash flows produced or consumed by the product. An investment product is obviously brought by many investors. Each investor therefore is entitled to a share of (the cash flows of) the product. Each share of the product is a token which represents a proportionate share of cash flows the token holder is entitled to. A smart contract that represents an investment product therefore needs to be tokenized.

Do Tokenization software platforms out there today enable cash flow calculations and pay offs ?

The answer is again ‘No’. Security tokens complying with the ERC standards today are dumb and only allow transfers and querying balances of tokens held, but not of withdrawable cash flows.

While this article is short and I won’t go into the engineering details of the product contract implementation or its tokenization, we can take the example of an Active Managed Certificate (AMC) which is implemented using a smart contract and is further tokenized. An AMC is an investment product that can have a number of underlying assets such as shares or bonds and may or may not pay an interest coupon. The asset manager for an AMC can actively rebalance the underlying assets to maximize performance on returns from the AMC.

The AMC itself can be created and managed using a software service integrated to external trading venues, and the terms can be imported to initialize the AMC product contract on a public blockchain. The AMC contract implements an Algorithmic Contract protocol. The AMC product contract can then be tokenized for distribution.

This is how it can look like — first, the issuer selects the AMC to tokenize. This imports the terms of the product, initializes the AMC contract on the blockchain with a security token created for the AMC which is used to create a liquidity pool for investors to subscribe to the AMC and trade it.

The Issuer application 

Second, the transfer agent can update the AMC as it progresses through it’s lifecycle. The transfer agent can also fund the AMC with stablecoins when pay offs from the AMC occur.

The Transfer agent application showing actions it can take on the AMC.

  The AMC contract showing the Transfer agent scheduled pay off dates and amounts to pay off on the AMC.

Third, investors can check funds when funds are withdrawable from the AMC and withdraw them from the security token contract linked to the AMC. Corporate actions can also be viewed and acted upon by investors using the security tokens they hold.

 The Investor application