Blockchain platforms, particularly those focused on asset tokenization, often make promises of transparency in real-time operations, leading investors to trust the technology without fully understanding its capabilities. The buzzwords “immutable, decentralized, incorruptible, trust machine, traceability” often lead to a belief that there are universal advantages inherent to blockchain in any platform. One of the major promises of blockchain technology is traceability, but its scope and limitations must be defined on each platform according to the type of operations being recorded.
Asset tokenization platforms allow the issuance of tokens that represent ownership in assets or rights, providing benefits such as immutable registration of transactions, fractional financing, and increased liquidity. Fractional financing enables smaller investments, making it accessible to a wider range of investors, while increased liquidity through secondary market operations facilitates the resale of tokens and a better exit strategy. The records of token issuance and all subsequent transactions are recorded on the selected blockchain platform, but this traceability does not extend to the use of funds raised from token sales. These funds are transferred to the designated account, and the issuer or administrator has complete discretion in its use unless costly controls procedures are put in place to prevent diversion. Asset tokenization is not a solution to fraud and insolvency in the real estate sector but funds traceability based on blockchain can cope with this challenge.
Recurrent fraud and insolvency in the real estate sector
Google search results for “real estate fraud” (718,000 links), “real estate scam” (286,000 links), “real estate Ponzi” (8,890 links), or “real estate fraude” in Spanish (95,300 links) show the prevalence and impact of these issues globally. In Chinese, links are likely to reach very significant figures following the recent debacle of Evergrande, the country’s largest developers which has unleashed a domino effect on the real estate and banking sector. Some other prominent examples include the German Property Group fraud in Germany, and the Woodbridge Group fraud in the United States. These cases, among others, demonstrate the severe consequences of real estate fraud, insolvency, and illiquidity for millions of individuals and families who have invested their life savings in property. Given the magnitude of the issue, it is imperative that more effective solution can be found so as to prevent fraud and insolvency in the real estate sector.
The root cause of fraud and mismanagement in real estate sector: The Principal-Agent Problem
The principal-agent problem is a much-studied academic topic in the field of agency theory that focuses on how to delegate decision-making power and responsibility without losing control. This problem arises when a principal, such as an investor, donor, or lender, transfers funds to an agent, such as a developer, donations beneficiaries, or borrower, to carry out specific projects or tasks. However, the agent, who has more information about their true intentions, may divert the funds for other purposes, in breach of the agreement with the principal.
To mitigate the risk of funds being misused, the principal must implement strict contract clauses and incentive systems or incur the cost of ex-post audits to validate the proper use of funds. However, in some cases, these control mechanisms may be circumvented, or the cost of control may make the operation unviable, leading the principal to withdraw the investment. This situation, known as moral or counterparty risk, can result in the loss of many economic, environmental, and social development opportunities. It is particularly prevalent in projects where the roles of the principal and agent are not clearly defined.
Asset tokenization is not a solution to fraud and insolvency in the real estate sector.
Assets tokenization alone will not be enough to solve fraud and insolvency in the real estate sector, as it does not provide a comprehensive solution for tracking the flow of funds. To address these issues, traceability of funds through blockchain technology can ensure that decision rights are unambiguously assigned to a specific position and responsibilities. This will increase accountability quality and reduce the risk of financial mismanagement.
Decision rights: how, by whom and when to make decisions on use of funds.
One of the main causes of fraud, insolvency, and mismanagement of funds is the diffuse allocation of responsibilities between different actors. The role of the investment fund and construction company should be kept separate, as merging these roles can lead to confusion and accountability issues. The investment fund should represent the interests of investors vis-à-vis the construction company; having separate roles between the two organisations helps align interests to achieve the desired strategy and facilitate frictionless collaboration between stakeholders. To this end, roles and responsibilities should be clear to ensure that accountability is ensured and that investors’ interests are protected.
“When roles and responsibilities are not clearly defined, accountability becomes ambiguous and uncertain”
In summary, difficulties faced by investors when making decisions about transferring money to investment funds and development companies include:
- Lack of trust leading to illiquidity: If trust is lacking between parties, this can result in a lack of funds being available, resulting in projects that could have a positive impact not being carried out.
- Lack of transparency and potential misappropriation of funds: If the investor entrusts the funds to the agent, the lack of transparency and potential mismanagement of funds can result in high control costs.
- Difficulty in optimizing decision-making rights: If roles and responsibilities are not clearly defined, it can be difficult to determine who is responsible for managing the funds and executing the projects.
- Limited trust and credibility: Trust and credibility can only be earned over time, through a proven track record of good performance and management.
- The importance of reputation: When real estate projects are financed through sales of units that do not yet exist, reputation is key to convincing future owners and financiers.
The aforementioned difficulties scare off investors and reduce the liquidity of investment funds and developers. To overcome these difficulties, investment funds and developers can invest in aggressive marketing campaigns, create a strong brand as well as a large and well-paid sales force, or invest in high-quality products and services that add real value reducing the root causes of friction and mistrust. For instance, funds traceability in real time can compensate for the lack of reputation or recognition of the brand. Ultimately, trust is earned through accountability and by delivering and building a solid reputation over the long term.
Dilemma: more marketing or more fund traceability using blockchain
When real estate projects are financed through the sale of unbuilt planned units, reputation is crucial to convince potential buyers and financiers. If a company lacks brand recognition, the traditional strategy is to invest in marketing campaigns to create an image and reputation that it does not exist yet.
However, building a reputation through marketing campaigns requires significant resources:
- Invest in massive and aggressive marketing campaigns that create an image and reputation that does not yet exist.
- Create a sales force with appropriate incentive systems to achieve a permanent flow of sales.
- Compete on price to attract investors in the “less security for more profitability” segment.
- Combine the first three strategies which could result on their own set of challenges and risks, particularly in the face of a macroeconomic financial crisis that could lead to a decrease in demand.
Branding involves transmitting corporate values and creating recognition through advertising, but it does not guarantee a direct correlation with increased sales in the short-term. On average, construction companies allocate between 7% and 20% of their annual sales to marketing efforts, which can be a significant financial burden.
Trust is not asked for, it is earned.
Lack of liquidity can be a sign of lack of trust and credibility of investors with the investment fund or construction company. This trust can only be built over time, after achieving an unblemished track record of good performance and management. Marketing campaigns can help to better position an image, but communication with investors must be accompanied by facts that build trust.
“Trust is not asked for, it is earned with hard work, with diligence and by creating the habit of delivering over many years”
As trust is not scalable, the vast majority of construction companies will have to go a long way or bet on a marketing strategy and price competition that is very risky and of questionable profitability.
Therefore, the dilemma between investing in marketing or in traceability of funds is not so difficult to solve. While marketing may be a traditional medium-term solution, building trust and a strong reputation through transparent fund management is a short-term solution and a more sustainable option in the long run. This solution can only be provided by automated traceability of funds without the intervention of trusted third parties.
To recap, while marketing may seem like an attractive option, building a strong reputation through transparent fund management is a faster, efficient, and more sustainable solution. This solution can be provided by automated traceability of funds without the intervention of trusted third parties.
Fraud and mismanagement can be easily tackled with funds traceability in blockchain.
The key to solving the problems of corruption and mismanagement in real estate development projects lies in transparency and traceability of funds with blockchain technology. Bimount has created a funds traceability blockchain platform called BM-Trusck, tool which provides a safer and more cost-effective alternative without excluding marketing strategies but substantially reducing its budget. BM-Trusck provides investors with automated, real-time information on the use of funds that investment funds and construction companies excute. It gives investors the security of knowing that a code is controlling and monitoring the funds, while also allowing investment funds and construction companies to increase their growth and scale new projects with the trust generated from automated accountability.
By automating the accountability process and reducing investor control costs, as well as marketing costs for the development companies, BM-Trusck can help increase liquidity for investment funds and construction companies. It can also provide an ideal complement to asset tokenization platforms or work as a standalone solution.
“Funds traceability on blockchain increases trust and liquidity”
In conclusion, traceability of funds through blockchain technology provides numerous benefits, including increased confidence, liquidity, and cost savings. In addition, it can be the ideal complement to tokenisation platforms, enhancing fractionality, liquidity and efficiency between the two platforms.
If you’re interested in learning more, please consult BM-Trusck.
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