Next-Generation Securitization: NFTs, Tokenization, and the Monetization of “Things”

In Next-Generation Securitization: NFTs, Tokenization, and the Monetization of ‘Things’, forthcoming in the Boston University Law Review, I examine the recent phenomenon of non-fungible tokens (NFTs) and tokenization. These are being used to monetize—that is, to raise cash by selling to investors interests in—a diverse range of non-cash-generating assets, including art, collectible cars, access to basketball video highlights, prestigious real estate, and even fictitious real estate used in video games. Although the market for these monetization transactions already is in the tens of billions of dollars and rapidly growing, there is virtually no regulation. My paper has two goals: to help regulators, investors, and other market participants understand these transactions, including their risks and benefits, and to analyze how these transactions should be regulated to preserve their benefits and minimize their risks.

Monetizing assets has a long and established pedigree, encompassing securitization, project finance, production payments, and similar transactions that raise cash by selling interests in cash-generating assets or projects. The difference with NFT and tokenization transactions (collectively, “non-cash-flow monetizations”) is that the underlying assets do not themselves generate cash. Nor may those assets be sold to generate cash. Hence, investors in interests in non-cash-flow monetizations have only one way of being repaid: by reselling their interests to other investors. That limited source of repayment creates liquidity risk (among other risks). Illiquidity is the main cause of bankruptcy as well as a major systemic threat to the financial system.

On the other hand, non-cash-flow monetizations may have real benefits. Rating agency Moody’s believes, for example, that such monetizations have “transformative potential,” including creating greater financial inclusion by giving smaller borrowers, such as start-up companies and small and medium-sized enterprises (SMEs), much greater access to low-cost financing. Promoting the growth of SMEs is critical because they play a major role in most economies, particularly in developing countries, and also are important contributors to job creation and global economic development.

The goal, therefore, is to try to preserve these benefits while minimizing the risks. To put the risks into perspective, consider that liquidity risk, for example, is very different from the ordinary risk of investing in non-financial assets such as art, collectible cars, or real estate (even fictitious real estate). Liquidity risk arises when investors buy interests in non-financial assets thinking that the interests themselves are liquid. The problem is that those interests are not always liquid. The market for reselling those interests is unpredictable, and the pricing is extremely volatile.

Consider also that the extension of monetization transactions from cash-flow monetizations (like securitization) to non-cash-flow monetizations raises a distinction somewhat akin to that between debt securities and equity securities. Investments in debt securities, like investments in cash-flow monetizations, depend primarily on payments and secondarily on the ability to resell the securities. In contrast, investments in a firm’s equity securities, like investments in non-cash-flow monetizations, depend primarily on the ability to resell the securities and secondarily on dividend payments. Investments in equity securities with neither the ability to resell the securities nor the receipt of dividend payments would have little value. Likewise, investments in non-cash-flow monetizations with uncertain ability to resell the interests therein would have uncertain value.

Why, then, do investors buy interests in non-cash-flow monetizations thinking (mistakenly) that the interests are liquid? They might be attracted by the cachet of the underlying assets and also might view those assets as a hedge against inflation. Or they might be daunted by the financial technology, or “FinTech,” which often is used to evidence the ownership and facilitate the transfer of their interests—especially those that are evidenced by blockchain-based digital ownership. Furthermore, some investors might mistakenly conflate the ease by which blockchain (or other FinTech cryptography) can facilitate the transfer of their interests with the existence of market demand to purchase those interests. Additionally, because the interests are often referred to as tokens (or even coins), many investors fail to recognize they may be investing in securities. Worse, there is evidence that some unsophisticated investors don’t even understand the basics about what they are buying.

The paper analyzes whether non-cash-flow monetizations should be regulated any differently than cash-flow monetizations. To that end, it examines how the former changes the monetization business to create new risks. One such change is to use blockchain (or other FinTech cryptography) to evidence the transfer of interests. This change primarily affects process, not the actual substance of the interests being transferred. Another change is more substantive: non-cash-flow monetization broadens investments that previously were limited to interests in financial assets to include interests in non-financial assets.

Next, the paper examines how the law should develop to regulate the risks associated with these two changes, including liquidity risk. It identifies the market failures associated with these changes, and then analyzes how to design regulation to correct those market failures. Thereafter, the paper engages in a cost-benefit balancing of the possible regulatory options.

Based on that cost-benefit balancing, the paper recommends that regulation should require better disclosure to try to make investors more aware of the liquidity risk. Because unsophisticated retail investors would be most susceptible to information asymmetry and to suffering harm from losses, the paper proposes that regulators further study how to design disclosure and other securities law protections to protect those investors, including by possibly limiting their investments in non-cash-flow monetizations.

The paper also recommends that sponsors of non-cash-flow monetizations be required to retain a minimum (unhedged) investment in the interests sold to investors, in order to help align the sponsor’s and investors’ interests. Finally, to help protect the interests of investors in the event of a sponsor’s bankruptcy, the paper recommends legislation—similar to that enacted under commercial law to address risks arising from the advent of the indirect holding system for securities—providing that investor interests in non-cash-flow monetizations represent direct property rights in the underlying non-financial assets.

The complete paper is available for download here.