How fundamental misunderstandings about the function, behavior, and purpose of digital securities have stymied the path to liquidity — but there is hope…
We’re nearly 18 months into the digital security (security token) market and it’s fair to say that meaningful liquidity hasn’t yet materialized. If you polled industry participants about the culprit, many would blame a lack of marquee assets while others would cite the July 2019 joint statement from the Securities and Exchange Commission (SEC) and FINRA on broker-dealer custody of digital securities. These are valid gripes, but there are also other factors that have disadvantaged the market and hindered liquidity.
Principally, the digital security trading frameworks we see today have been built on faulty assumptions, including the idea that digital securities would trade with the volume and frequency of public equity or cryptocurrencies. The problem with this thinking is that digital securities today almost exclusively represent private securities, an asset class that has traditionally traded at a much more deliberate pace – and for good reason.
Here are four realities of the current digital securities market that have contributed to limiting liquidity:
Digital securities are inherently different from cryptocurrencies.
This statement is a truism to those familiar with traditional capital markets, but some participants in the digital securities industry have long expected digital securities to mimic the behavior of cryptocurrencies. They must disabuse themselves of this notion. While public digital securities may eventually reach the liquidity levels of cryptocurrencies or traditional public equities, private digital securities will not. It’s worth noting that all digital securities issued to date have been privately placed.
Unlike cryptocurrencies and public equities, private securities are subject to transfer restrictions. Most digital securities in the market are transfer locked for US investors for at least a year after issuance. These securities may also be subject to additional contractual restrictions, such as rights of first refusal or co-sale rights. The benefits of tokenization, especially with regard to liquidity, are apparent when you compare private digital securities to traditional private securities. The transfer of a traditional private security may require intervention from lawyers, payment of fees to a transfer agent, and weeks to complete. Smart contract technology allows issuers and investors to automate much of that process. Transactions can be initiated, reviewed, finalized, and recorded in a matter of minutes, without the payment of fees and in complete observance of applicable transfer restrictions. While the inherent limitations of a private digital security prevent it from bouncing around with the fury of cryptocurrency, it undoubtedly provides liquidity enhancements over its off-chain analogue.
Limited information scares investors.
While a dearth of information hasn’t impacted trading in the cryptocurrency markets, efficient price discovery and meaningful liquidity in the capital markets requires periodic disclosures about the issuer or the performance of the underlying asset (e.g. disclosures about a property’s rent collections are imperative for a yield generating digital security connected to the property).
The digital security industry, particularly at the issuer and marketplace levels, has not delivered this information in sum and substance sufficient to peak the interest of prospective purchasers. Issuers and marketplaces expected the liquidity of the public equity market without the corresponding burden of disclosure. Meaningful liquidity will never manifest without the flow of timely and accurate information. At a minimum, institutional investors won’t participate in a market if they cannot properly value assets when acquiring them.
Marketplaces can rectify this issue through the listing agreements they sign with issuers, by requiring periodic disclosures to prospective investors transacting through the marketplace. Though transactions on these marketplaces do not typically rely on its safe harbor, why not look to the information requirements of Rule 144A as a guide? Rule 144A requires prospective purchasers of private securities to be provided with a brief description of the issuer’s business, products, and services; the issuer’s most recent balance sheet, profit and loss statement, retained earnings statement and similar financial statements for the two preceding fiscal years. Using Rule 144A’s requirements as a baseline for marketplace traded private digital securities would engender trust and continuity of information such that investors, institutional or otherwise, would be able to properly value the assets when acquiring them.
Marketplaces aren’t optimally designed for digital securities.
Most digital security marketplaces were designed with high-frequency trading in mind. Their colorful order books and flashing numbers are reminiscent of crypto platforms but aren’t built for the reality of private digital securities. As a result, order books on these marketplaces often stagnate and give rise to a perception that liquidity is non-existent. However, until the market is replete with public digital securities or notable private digital securities that aren’t subject to transfer restrictions, marketplaces should consider restructuring their trading format.
A “super” bulletin board might suit the current market. Only sell-side participants would be able to post their interest, which would reduce clutter. Prospective purchasers could communicate directly with the seller and, if the price is agreed, seamlessly execute the transaction through the use of smart contracts and stablecoins. While these transactions would not be as rapid as trading Bitcoin on Coinbase, they would be far more efficient than buying private securities in the existing OTC market. Once the market matures, order-books may make sense. In the meantime, a new approach to trading, coupled with more publicly available information about issuers and assets, could generate the liquidity that issuers and investors seek.
Make blockchain invisible.
Using blockchain to trade can be an exceedingly cumbersome process. The average capital markets investor, and even sophisticated brokers, will struggle to transact if they’re required to use wallets and safeguard private keys. It’s hard to imagine that “hot” and “cold” wallet will ever become terms the average investor knows or cares about.
While decentralized marketplaces were de rigueur in 2018 and the SEC’s recent guidance has seemingly pushed alternative trading system (ATS) applicants to adopt a non-custodial approach, requiring buyers and sellers to link wallets to the marketplace and “self custody” will preclude many prospective investors from joining the market. Industry participants must quickly solve how to provide the benefits of blockchain to issuers and investors without making them endure the pain of using it.
The good news is that many of the historical impediments to liquidity can be remedied. There are reasons for optimism.
There are appealing assets in the digital security pipeline and large institutions planning to issue and underwrite them. Once regulatory clarity is provided on broker-dealer custody, there is a path to a meaningful secondary market if expectations around trading frequency are adjusted and marketplaces reformat to fit the types of assets they trade.
Brian Farber is General Counsel at Securitize. Prior to joining Securitize, Brian was a senior associate in the capital markets group at Sullivan & Cromwell LLP in New York. Brian holds degrees from Fordham University School of Law and New York University.