You have probably heard the term “stocks and bonds” before. Initially, it can be a bit hard to get a good grasp of what these investment vehicles actually are. To make things more confusing, both stocks and bonds are sometimes referred to as “securities”. Let’s take a look at what these investment vehicles are and why someone would want to purchase either of them. After that, we will explore some of the ways stocks and bonds are being utilized in the blockchain space.
Bonds represent a debt owed to the parties that hold it. So if you need cash for a business or a house, you might go through a bond issuer. You could get a normal bank loan, however, bonds typically have lower interest rates. The issuer (the party taking out the loan) is required to pay back the loan with interest to the bondholder (the lender). Usually, interest can be paid back at predetermined intervals, like annual or semiannual.
If an issuer fails to make payments on the interest or principle it is called a default. When this happens, the lenders can be entitled to any remaining assets or capital the issuer had. So in the case of a mortgage, it would be repossessing the property and then selling it on the open market giving the proceeds to the bondholders. This helps to minimize the losses of the bond lenders.
Usually, if the bond defaults the price of it falls. There is a special type of investor called a distressed debt investor who buys these types of bonds. They do this because they believe the value of the remaining assets will actually be greater than the price of the bond and therefore they can profit.
The market is smart enough to know when a bond might not be reliable and so negative price action can happen before the default actually occurs. When a default occurs it affects the credit ratings of the entity that issued it.
There are three major credit rating agencies that all have slightly different credit rating systems. AAA is one of the best ratings a bond could have while usually, D or C is the worst. C ratings indicate that there have been one or more failed payments towards that bond. As an investor who wants to make a profit from holding bonds, this would be a very bad situation.
Unfortunately, this rating system hasn’t always worked perfectly. Banks colluding with credit rating agencies to mislead their customers about the quality of their bonds was part of what lead to the financial crisis in 2008.
Satoshi Nakamoto would even mention the bailout in the genesis block with a message referencing a newspaper headline “The Times 03/Jan/2009 Chancellor on brink of second bailout for banks.”
For most normal investors, in order to participate in the bond market, they have to go through a bond fund. This is because the actual bonds are usually sold directly to large institutions as opposed to the open market, unlike in the stock market.
A stock represents the proportional ownership of a corporation among its shareholders. Another name for a stock is a share. For example, if a company issued a total of 100 shares and you bought 1 share you would own 1% of the company. In actuality, startups issue about 10,000,000 shares initially. That number can increase in the future as the company grows. To find the proportion of ownership you have in a company, you would divide the number of shares you own by the total amount of shares issued.
Why own a stock?
Why might be wondering what the actual purpose of owning a stock or share is? You are probably aware that the free market price of stocks fluctuates and can create and destroy fortunes overnight. But there are many other reasons why you might use stocks as an investment vehicle. After all, there has to be a reason why the stock price is moving to begin with.
Owning a share and therefore part of a company usually entitles you to several different things.
Liquidation of Assets
In the event that a company folds and goes bankrupt, it will likely have some assets that can be sold and liquidated. Being a shareholder entitles you to the money made from this.
Being a shareholder sometimes gives you voting rights on important issues in the company. The ability to vote on future changes to a company like the corporate objectives is a practical way for investors to determine the future direction of the company.
A dividend is a payment from a company to its shareholders. Normally, this is from the profits over the last quarter. Stock dividends take a few different forms. The first and simplest one is the cash dividend. A cash dividend is divided proportionally among the shareholders and the number of shares they hold.
The other type of dividend is a stock dividend. Instead of cash, shareholders receive more shares from the company.
The dividend yield refers to the size of the dividend relative to the stock price. The median yield in the stock market is around 4%. So if you invested $100 in a diverse portfolio of high yield stocks, you could expect to make about $4 by the end of the year. This is just a bit more than the average US inflation rate of about 2%, so in terms of the purchasing power, it is still profitable.
Although dividends from stocks can be a great source of passive income, not all stocks pay dividends. Some stocks never will. Other stocks only promise to pay dividends in the future. Tesla stocks, for example, have yet to ever pay a dividend despite being one of the larger American companies.
Blockchain is one of the biggest financial innovations of our time. Its first implementation and use case is currency (Bitcoin). But that’s not what it’s limited to. Virtually any financial instrument can go through tokenization on a blockchain.
There are several projects that are already profitable with their tokenized stocks, which we’ll discuss below. What’s more, these tokens have been able to introduce a more diverse value structure by creating multiple use cases for the token beyond dividends. It has also lead to more innovative dividend models.
Token burns are a way to increase the value of the remaining tokens in circulation. Instead of paying cash from the companies profits, it uses the profit to buy back tokens on the open market. After buying them on the open market, the company will “burn” the token by sending them to a burn address which permanently removes these coins from circulation.
This works on supply and demand theory. If you reduce the supply of an asset while demand is the same, the value of the asset should increase. These token burns are almost as popular as actual dividends payouts. But there are logistical advantages to doing this as well as potential legal advantages as well.
The cryptocurrency exchange Binance, issues its own token BNB for use on its platform. Using BNB for fees gives holders a discount on trading fees. On top of that Binance will use part of its profits to buy back. Binance will burn up to 50% of the supply of BNB. Binance is also building a decentralized exchange which will utilize these tokens for base pairs and transaction fees.
Kucoin is another cryptocurrency exchange with its own token, KucoinShares. Holders of these tokens receive a daily dividend of 50% of Kucoin’s trading fees. These dividends are paid directly in the assets that are traded on the exchange. So when holding KucoinShares, you would probably notice your wallet for every asset on the exchange would have tiny amounts added when dividends pay out. To remedy this somewhat confusing system, Kucoin intends on releasing a dust collector feature, which when used would convert these tiny amounts to KucoinShares.
Nexo is essentially a bank based on blockchain technology. They give out loans in fiat and stablecoins using cryptocurrency as collateral. Their Nexo token was used for an ICO to raise funds. Holding the token gives you a dividend from the profits of their service. The token has extra utility as it can pay back the loans.
Blockchain bonds certainly aren’t as popular as blockchain stocks. But there are some innovations happening here that are important to note.
The World Bank has recently gone public with its plans to launch the first blockchain based bond. The project is Bondi or Blockchain Operated New Debt Instrument. Although this bond just uses blockchain technology on the backend and, just as traditional bonds, can only be invested in through an intermediary.
Maker is a complicated smart contracts platform and DAO. which allows users to take out a loan in DAI (USD stablecoin) using Ether as collateral. What’s interesting is that MakerDAO generates DAI without any centralized institutions holding USD. Through a combination of clever game theory and smart contracts, it’s possible to take out a loan for Ether purely with a smart contract.
MakerDAO has another token that’s part of this system called, MKR. Although it’s not exactly a bond, it is a new kind of asset that serves a similar purpose. Over time, interest on the Ether loan accrues in the form of a stability fee. To pay this loan back and get your collateral back you have to use the MKR token. Paying back the loan burns MKR tokens, permanently removing them from circulation. So much like a bond, buying MKR tokens is a bet on loans that people will pay back in the future thus increasing demand and price of the MKR token.