The biggest promise of security tokens is easier access to investors and the possibility for investors to trade securities and assets that historically were illiquid. Nevertheless, despite the rise of security token exchanges, the vast majority of tokenized securities are still not traded anywhere, failing to execute the promise of liquidity.
In this article, we review the reasons why centralized exchanges are not suitable for many token issuers and how decentralized trading via automated market-making protocols can unleash the full potential of security tokens.
Importance of liquidity
For investors, one of the key properties of the financial instrument is liquidity, which means that buying or selling the financial instrument is relatively easy. Highly liquid assets like Tesla stock or Bitcoin attract the investors’ attention thanks to the reduced risk of investing in them due to the possibility to make a quick exit, i.e., sell the asset at any moment. Meanwhile, impact bonds, which are issued to finance the green economy, build infrastructure and fight poverty in developing countries, often freeze your money for 15-20 years, which drastically limits the potential audience of their buyers.
Unfortunately, the majority of existing companies aren’t liquid. According to the World Bank, there are around 150 million companies globally, of which, according to OECD, only 41,000 are traded on stock exchanges, which constitutes 0.027%. This makes the overwhelming majority of companies unattractive for investors, depriving them of getting sufficient capital. This is the primary market inefficiency, due to which business and economics can’t develop at their natural pace.
Transferring the company stocks to a blockchain is supposed to solve this problem, as within this system, all the operations, including trading, are held significantly easier. Still, the liquidity for security tokens wasn’t built as fast as expected because limitations on trading in most securities are not simply technical; they are also legal. This is the reason why security tokens haven’t unleashed their full potential yet.
Decentralized trading can be the instrument that will help the token-issuing companies to finally access liquidity. Thanks to this, they will be able to realize the full potential of their security tokens, which, in turn, will increase their financial attractiveness.
The difference between private and public companies
Public companies are the ones that are traded on stock exchanges (Amazon, Apple, etc.). Basically, private companies are all the rest — those that are not traded publicly.
The problem with private companies is that the possibility of investing in them is legally limited. It means that only some particular types of investors can do that since the law limits the number of such individuals or entities, types of investors, and the amount of capital that can be raised. Partially, this problem can be solved by international investments: even a private company is able to engage a large number of investors if it fundraises across the world and complies with the different countries’ private placement legislations.
The second and more significant drawback of private companies is that trading of their stock is usually quite limited. In any country, in order to go through a listing on any stock exchange, the company must become public. Therefore, shares in private corporations are traded only by a small circle of brokers and financial institutions.
Private trading through brokers or financial institutions meets a lot of problems and in general is not sufficient. There are two reasons for that:
- Discovery of a counterparty. Finding somebody from whom you can buy or who you can sell the securities to is quite challenging since it requires manual search beneath all the viable populations of your country.
- The usual mediators facilitating transactions of shares of private companies are broker-dealers that act as market makers. The problem here arose after electronic trading had come around: profit margins of such intermediaries decreased significantly, so it became unprofitable to work with smaller companies. For this reason, liquidity for small-cap issuers deteriorated, not only for private companies but also for listed ones. Even initiating an IPO got more challenging, as the small public companies with a market cap of less than a hundred million dollars — which is actually a huge market cap — lost their attractiveness for market makers.
Given all the challenges and limitations of private corporations, the logical question is, why wouldn’t private companies who want to increase investment attractiveness and create liquidity just switch to being public?
The issue is the price. Going public requires severe expensive disclosure, which includes preparing piles of documents and undergoing audits. The reporting requirements come next: this includes continuous reporting and audit so companies need to keep the accounting and legal staff. The price of listing itself is high as well. Generally, stock exchanges demand that a company conducts the listing via the listing agents or investment bankers who charge a certain percentage of the fundraising proceeds in addition to a very generous retainer. All things considered, the threshold of conducting an IPO is very high.
Because of all mentioned above, the businesses, including security token issuers, face a liquidity dilemma: they are limited both from the position of tradability of their stocks and the possibility of becoming a publicly traded company.
How does Decentralized Trading Solve this Problem?
It’s common to think about decentralized trading in the context of decentralized exchanges, such as Uniswap. However, most people don’t realize that they are not actual exchanges in the classical meaning of this word like NYSE or Coinbase. Instead, they are rather protocols of decentralized automated market making. What is replaced in this case are not exchanges but broker-dealers that serve as market makers, connecting the buyers and sellers. Working with small companies isn’t favorable for broker-dealers, since they have to finance the legal and accounting staff; but this point goes blank for the AMM protocols, which are simply a piece of code run on the blockchain, ergo, even a company with as little as a $100,000 market cap can be serviced. This leaves us with the AMM protocols as a more convenient substitution for broker-dealers, which has the potential to be used by the majority of private companies.
Decentralized trading solves the liquidity dilemma because it doesn’t make the company become public; the described transactions are still private P2P trades and are conducted between an investor and liquidity pool. There aren’t any centralized operators or exchanges where the listing is performed, or conventional trading rules are enforced.
Decentralized trading doesn’t remove the obligation of the company to provide potential investors with all the necessary information regarding their business so that they are able to make a proper decision. In some countries, the mere fact that there’s a significant number of people holding the company’s shares is sufficient to trigger the requirement for such a business to become public. But even then, you won’t have to go through the complicated process of stock exchange listing.
Decentralized trading through automated market-making protocols can vastly increase the investment attractiveness of private companies, hence reducing inequality in access to capital and increasing efficiency of the economy by directing cash to sectors where it can yield greater returns.