One incredibly important aspect of market dynamics for any asset is — price discovery! The hypothesis goes that the free market will use its mechanisms to find the “real” price of an asset. This works for stocks, commodities, real-estate and — of course — crypto tokens!
However — this process is not as simple as it might seem on first glance. Where there is money to be made — there are people willing to lie, cheat and steal for their own financial gain. In traditional markets — these forces are balanced out through law. If you commit fraud — you go to jail. Simple, elegant, functional (at least in theory).
In crypto however, a lot of times we’re working with anonymous investors investing behind a 0x address. Not to mention that the market is worldwide — any type of legal action is several orders of magnitude more complex and costly to perform. This is why, most crypto projects work through a system of predefined incentives to, well, incentivize people to act in a fair and constructive manner.
Economic Behavioral Incentives
In order to achieve a realistic price discovery mechanism in decentralized systems — there must be two opposing forces working on the pricing of an asset:
- Upward Force: Punishing investors for undervaluing an asset
- Downward Force: Punishing investors for overvaluing an asset
In this article we will explore how AMPnet and the APX protocol handle these two forces for the APX Trusted Synthetic
Just like in high school math, let us set a working example through which we will explain the process. It will be the simplest possible Trusted Synthetic, but all conclusions can be extrapolated to more complex Synthetics.
Assume a Trusted Synthetic Exists. Let us call it $APX(CRESE12) (AAPX Swedish Commercial Real-Estate Synthetic #12).
This trusted Synthetic was created by crowdfunding a commercial real-estate project in Sweden. The total amount of crowdfunding was $10M and it was completed 1 year ago while the project was still under construction.
The APX auditors have assigned the $APX(CRESE12) a 10% secondary market collateral requirement.
Now the project is constructed and doing very well — it should be worth more than the amount invested. But how much more exactly?
Don’t cheat on collateral deposits
One of the mechanisms through which the APX protocol rewards trustworthy tokenizers is by allowing Auditors to lower their collateral ratios. This is done when tokenizers provide additional documentation, secure themselves with legal obligations, etc…
Due to the “real-world” nature of everything — there is always a risk for default on the asset (doesn’t get constructed, gets destroyed, gets into legal trouble). The collateral is there to provide some immediate relief to token holders if this should happen. The riskier the asset, the bigger the collateral.
The collateral is calculated in percentages of project value. But how can the protocol know what the value of an asset is? The answer — it can’t! The best a protocol can do is to force the people doing primary emission (minting the tokens) to value the asset themselves!
So — whenever a new unit of a Trusted Synthetic is minted, a collateral must be deposited. It’s an integral part of the minting process and inseparable from it.
An investor does this by assuming the value of an asset and multiplying it with the collateral ratio of that asset.
For our $APX(CRESE12), let’s assume an investor holds a 1% stake in the project which, at the moment of crowdfunding, was worth $100.000. The investor assumes the project value to be bigger now — let’s say $200.000.
They go to the minting portal, find the $APX(CRESE12) and lock their crowdfunding tokens and deposit $20.000 as collateral. They go on the secondary market and sell their remaining (un-collateralized) shares for $180.000. The buyer gets their tokens, the seller guarantees with the collateralized $20.000 and retains the $20k ownership of shares. All is well and good.
But what if the investor didn’t have $20.000 to put down as collateral? Or the collateral reserve was 80% and they had to put down $160.000 to sell their shares?
A savvy investor might try to undervalue their asset by simply locking e.g. $1 as the collateral — effectively valuing their assets at $10 — even though they know they will be able to sell them on the exchange for $200.000.
This would render the collateral system completely useless! Fortunately for us, the APX Protocol has an inbuilt mechanism for preventing just such things from happening.
The amount of collateral set in the mint function sets a Liquidation Price for a set of tokens held by a certain address. This means that anyone can “liquidate” (or in simpler terms — buy) the tokens from the minter at the price set by the collateral. This makes undervaluing the asset a very dangerous proposition.
Let’s examine our example one more time: Our “savvy” investor knows the market value for their assets is $200.000 and the mandatory deposit is 10%. They decide to “cheat” and value their assets at $1.000 by putting a $100 deposit in the mint function. What happens?
The investors tokens get issued as an ERC-20 token! However — anyone who pays $100 into the ERC-20 contract of the token is allowed to transfer all of the tokens into their own account. If there is anything true about blockchain — we know arbitrage bots would jump to this opportunity. By undervaluing the asset — the investor has effectively “sold” the tokens at this lower price.
This system shifts the burden of “initial valuation” of an asset to the primary issuer (minter). The primary issuer is either the primary investor (in the case of crowdfunding platforms) or the owner of the asset (in case of direct tokenization). The amount on which this has been valued will be the amount at which the primary investor must guarantee for the asset.
By connecting the mandatory deposit of an asset to a percentage of its value, the person doing the primary emission is disincentivized to overvalue an asset, because that would force them to deposit more money than they would if they properly valued the asset — which nobody wants to do.
Because the minter is guaranteeing the security of an asset with their collateral, they are allowed to perform a “liquidation buyout” of the asset. They can buy 100% of the asset shares from the holders — without the holders having a say in this. To fairly compensate all holders and to “value” the asset on blockchain, a holder can increase the collateral reserve made by the minter to a larger value by adding more collateral into the smart contract.
Remember — only the minter can call the liquidate function once an asset has been transferred away from the minter.
By adding collateral to the asset later — the holder is guaranteeing that the minter cannot liquidate their holdings for anything less than what they value the asset. But also — it becomes difficult for them to overvalue the asset and prevent the minter from liquidating them, because that would require bigger and bigger amounts of capital.
Why would the minter need to be able to liquidate the holders? Because we’re tokenizing real-world assets and the minter might be forced by the government or by some external forces to regain full ownership of the asset. By employing this mechanism, we’re this can happen at any point (if the minter has enough money — if they don’t, well, they will have to settle in some off-chain way, probably though a court settlement with the token holders — a measure of last resort in APX).