Analysis of Financial Times Article - Asset-Backed Securities? We've been here before

Original rights belong to Don Weinland in Hong Kong and Krithika Varagur in Jakarta on behalf of the Financial Times

A Russian state-owned fund has a novel strategy for attracting investment to the tundra and swamps of Siberia: selling its forests, gas, gold, even its fresh water and fish, one digital token at a time.

The plan will be trialled this month with a digital token sale backed by Siberian diamonds. Investors can buy a share in a diamond for as little as $10.

Advertised as a secure means for people to buy into commodities in affordable and easily tradeable units, the deals have been described by experts both as the future of investment and a major risk to investors.

In the coming months, experimental transactions such as these are set to test the limits of cryptocurrency innovation, as well as regulatory tolerance for them.

“We think we have several trillion dollars’ worth of valuables in Russia’s far east” that could someday be tokenised, said Alexei Chekunkov, chief executive of the Far East Development Fund, an investment arm of Russian state development bank Vnesheconombank.

Tokenised assets are traded via digital tokens on online exchanges. Instead of receiving physical assets, investors receive a digital receipt that represents their holdings. The price and ownership of the asset are recorded on a ledger that cannot be tampered with, making the transactions secure.

The technology, often called blockchain, is the same that underlies the $150bn cryptocurrency market for bitcoin and the latest surge in initial coin offerings. Mr Chekunkov said the same principles would eventually allow Siberia to sell everything from natural gas to fish.

“Asset-backed tokens, for diamonds or Venezuela’s petroleum, are exploring the conceptual space of what’s possible with blockchain,” said Lex Sokolin, global director of fintech strategy for London-based Autonomous Research. “They are a rudimentary first step.”

The diamond sale joins a handful of similar test projects around the world, including a gold-backed token in Malaysia called HelloGold, and one launched by the Venezuelan government in February that tokenised some of its petroleum reserves into $5bn of so-called “petro” coins, later banned by the US.

The early iterations of asset-backed tokens have been criticised in some quarters as risky bets, mainly because they require third parties, such as auditors, to make the crucial link between the digital asset and the real one.

A number of outside parties must “verify that the digital token is, in fact, backed by the same value of assets or currency as is purported”, law firm Jones Day said in a white paper, something that allows room for fraud.

The diamond token, called D1, has tried to address those concerns.

The company issuing the token, Singapore-based diamond group Diamundi, said the value of its diamond stock would be audited monthly by a Big Four accounting firm and held in the vaults of Israeli custodial group Malca-Amit, steps that would ensure the safety of the asset and accurate valuation of the coin.

The Russian fund will source the diamonds from Siberia but is not involved in the issuance of the token.

“The key for these tokens will be to find a good custodian,” said Rocky Mui, a consultant at the Clifford Chance law firm in Hong Kong, adding that several traditional custodial companies were looking at the cryptocurrency industry.

“It’s still in an early stage but tokenisation could be the future,” Mr Mui said, adding that a perfected model would open a vast range of asset classes to ordinary investors around the world. He acknowledged, however, that “there are big regulatory questions”.

Richard Oh, chief executive of HelloGold, which issued gold-backed tokens last year, said the Kuala Lumpur-based company was not affected by local Malaysian regulation other than those concerned with the import and export of gold.

But digital tokens are traded globally and HelloGold could attract attention from other regulators. The Swiss Financial Market Supervisory Authority, for example, has classified asset-backed tokens as securities that will be regulated.

“If regulators go down this path, they will end up regulating Patek Philippe and jewellery stores,” Mr Oh said.

HelloGold, which says it is compliant with Islamic law, already claims 18,000 investors in Malaysia. Investors can buy in for just RM1 ($0.25).

Recognition of such products by traditional institutional investors is still far off. “I think the backing of tokens by other asset classes brings to surface several issues,” said Marc Geary, managing director at Hong Kong-based family office Major Domus. “First, if we want to invest in diamonds or gold, we’ll go and get diamonds or gold, without an intermediary.”

The operational risk associated both with the token issuer and the structure of the investment present other challenges that many professional investors will still be reluctant to take on at this early stage, Mr Geary said.

Copyright The Financial Times Limited 2018. All rights reserved.

Original Analysis and Potential Issues to Consider

Apart from the more basic upsides such as commercial investment opportunities, and the potential to own whole or fractions of natural assets that back securities, this article will seek to highlight the risks of facilitating financial crime and money laundering and why these should be of concern.

First of all, many non-professional investor participants in cryptocurrencies will probably consider this type of news as part of the homogeneous positive wave that could fuel the recent bullish trends. However, this style of "product" has been seen before . . . The precipitating cause of the financial crash of 2008 was mainly due to debt fueled products such as an MBS (Mortgage-Backed Security). The basis of this product specifically is that a pooled number of mixed risk mortgages (usually high risk of default) would be securitised as a combined financial product to be marketed and sold. These types of asset-backed securities would lead to enough significant bank exposures, that when mass market defaults occurred, liquidity retraction meant that the financial system grinded to a standstill.

It wouldn't be amiss to see that Russian-Siberian Asset Backed Securities would contain even more risks. At the global level, the exposures would be reduced due to the Russian credit-worthiness and political risks of breaching US and EU sanctions., but on the micro level of an investor, the risk lies in facilitating money laundering - meaning many reputable transnational financial institutions would be fearful of handling such securities. However, the notion of this sort of product developing is a natural reaction to countries that seek to circumvent global financial sanctions. Methodically calculating nations such as Russia have already seen the trial tests of Venezuela's Petro cryptocurrency ability to raise significant anonymous liquid funds from early investment rounds, before the slow apparatus of state sanctions become implemented to meet the efforts of sanctions circumvention. It has thus inspired Iran, also subject to US sanctions, to issue a centralised cryptocurrency from its central bank, "backed by oil barrels" and stabilized by state and OPEC production. A new form of money laundering can be facilitated and stabilized by OPEC style countries, in which the market can be so individually monetised that the likelihood of external interest increases the market cap and allows money to be laundered - through fund mixing.

The risks are two-fold for the casual investor, the first is if their affairs are investigated by regulators and law-makers through details forcefully being handed over the governments - they could not only be subject to civil penalties (fines) after the fact, but the more significant criminal penalties associated with fraud, bribery and money laundering. The other is that asset-backed securities, backed by high-risk commodities such as diamonds (which can be described with any other name) is an extremely risky investment, more-so than the basic-heightened risks associated with the volatility of your average cryptocurrency.