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Solving the Liquidity Puzzle for Security Tokens – Thought Leaders

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Solving the Liquidity Puzzle for Security Tokens - Thought Leaders

There is a wide consensus in the financial industry that blockchain technology is going to disrupt the securities market. However, despite the claims, there is no double-digit annual growth of securities on blockchain, which would be expected from a disruptive technology. The reason for that are regulatory roadblocks that don’t allow delivering the biggest promise of digital securities – liquidity for previously illiquid securities. In this article we break down this problem and present a solution.

What are security tokens/digital securities?

From a legal perspective, security tokens are common securities and are subject to the same regulations. The difference is that records about securities ownership are stored on blockchain instead of paper-based or other forms of records. That’s why they are often called digital securities.

Innovative technology significantly improves operations with securities, making them digital and automated. In particular, transfer of digital securities is much easier and may happen in minutes or seconds instead of weeks, spent on signing physical contracts, doing compliance checks and updating government registers.

Why liquidity is so important for security tokens

Liquidity of an asset defines how easy it can be sold. For example, publicly listed securities are highly liquid, while real estate and startup equity are highly illiquid. Although security tokens have multiple advantages, greater liquidity is a principal one. For this reason, they often represent ownership in traditionally illiquid assets.

Mass adoption of security tokens first and foremost requires interest from investors, which will create incentives for businesses to issue digital securities instead of traditional ones. For investors, lack of liquidity is the biggest problem of securities that are not listed on exchanges as it makes investments in them riskier and makes investors wait for decades until they pay off. Therefore, unlocking liquidity of security tokens is crucial for their mass adoption.

Why is liquidity in the conventional meaning of the word is out of reach for security tokens

In the narrow sense of the world, securities are considered liquid if they are traded on a stock exchange. For this reason, lack of regulated secondary markets is considered the main limitation. However, this ignores the fact that there are already operating exchanges for security tokens: tZERO, Open Finance, MERJ, GSX – but very few tokens are listed there. Furthermore, Open Finance is on the edge of delisting all security tokens because their trading does not generate enough fees to support operations.

Therefore, the problem is not in the lack of marketplaces. It is in fact that listing on an exchange is overly complicated. It requires registering the offering at competent authorities, having minimum trading volume, minimum market cap, being under increased reporting requirements, which often include annual audit. Basically, it requires becoming a public company. These requirements will arise not only in the case of listing on a classical exchange but any kind of regulated market. This means that listing on a regulated trading venue is not feasible for most security token issuers.

Such a flawed understanding of the problem stems from crypto origins of security tokens. They were seen as a regulated continuation of utility tokens and cryptocurrencies, for which listing on exchange is much easier, so it became a synonym for liquidity. This myth should be debunked in order for the market to move to more realistic sources of liquidity.

How is liquidity for security tokens possible?

To answer this question, we need to go back to an original definition of liquidity, which is the ability to quickly sell assets at any moment. It has two main components: complexity of conducting the transaction and how easy it is to find a counterparty.

The former problem is solved by blockchain technology. Its main benefit for private securities is that it vastly simplifies conducting the securities transaction, making it possible to do everything online in a few minutes. Conventionally, transfer of securities would require signing physical agreements, reporting changes to the government register, settling a transaction via a wire transfer, and doing manual compliance checks on individuals engaged into the transaction.

Complexity of the transfer also impacts the number of potential counterparties. When the transfer is complicated and expensive, it becomes not feasible to transact small amounts. This cuts off smaller traders and investors from the market, making it even harder to find a counterparty.

The problem of finding a counterparty is traditionally solved by an order matching mechanism of exchanges, which for security tokens is not feasible. Therefore, the key to unlocking liquidity is in creating an efficient way to find counterparties for transactions that would not be considered a regulated market. 

This way is already known. It is a bulletin board for P2P transactions. As these transactions are private and do not involve an intermediary, they don’t require regulation. However, there are a number of nuances and requirements for such a venue not to be regulated, which will be covered in a separate article.

To the author’s knowledge, at the time of writing there is no venue that enables legally compliant and efficient P2P liquidity for security tokens.

What impact unlocking the liquidity of security tokens will have on capital markets?

Currently, venture investors may sell their shares only if businesses they invest into go public or are acquired. This has two implications, which both lead to money being used inefficiently and slow down the economic growth.

Firstly, it means that only businesses with the potential for IPO are worth investing. Businesses that can offer a solid yield but don’t offer “disruption” and outsized returns are deprived of funding. These are often businesses with a need for high capital investments – manufacturing, agriculture, physical infrastructure etc. The problem with a lack of capital investment is covered in a widely discussed article in Andreessen Horowitz blog “It’s time to build”.

Secondly, illiquidity makes VCs prioritize growth over profitability because when most investments don’t pay off even a 10x exit from successful ones may be not enough. It creates incentives to scale even when the business model is not tested enough, leading to extremely large companies, such as WeWork or Uber, struggling to deliver a profit.

The plague of private markets has impacts on public markets as well. It leads to the emergence of the IPO bubble, when more than 80% of newly public companies are not profitable. It is problematic because public securities are considered less risky, and thus fit into portfolios of retail funds and pension schemes, harming them by being overpriced.

Thus, solving the liquidity problem will have a drastic impact not only on the VC industry but on the entire economy.

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Borys is the Head of Business Analytics at Stobox, an An award-winning EU fintech company with a number of digital banking, electronic payments, tokenization, and other technology tools. Stobox launches its own projects as well as helps its clients with fintech project development and setup.

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