Some Big Picture Thoughts About Liquidity and Security Tokens

ORIGINAL ARTICLE by Jesus Rodriguez is sourced from HackerNoon and can be found here 

Liquidity is one of the golden promises of security tokens as a new asset class. Unfortunately, until now, the security tokens have shown an almost concerning lack of liquidity. Most people tend to see liquidity as a factor related to the maturity of the market and assume that it will develop organically in the security token space. The truth is a bit more complex. Liquidity is in fact a sign of maturity in financial asset classes but only those with the right infrastructure. Many mature financial asset classes remain highly illiquid as they don’t possess the correct building blocks for nurturing organic liquidity. Similarly, other asset classes with the right liquidity framework take years fail to achieve relevant levels of liquidity in its early days. Today, I would like to explore some of the key building blocks that need to in place to enable liquidity in security tokens both from the technical and financial standpoint.

If there is a single principle I want you to take away from this article it would be this: “In financial markets, liquidity is something you build for not something that happens”. In the context of security tokens, the market could remain highly illiquid unless we establish the right infrastructure for the different participants to engage in trade dynamics.

From the perspective of traditional financial markets, liquidity manifests in two main dimensions: funding and market. Funding liquidity is typically associated with the availability of credit or funding mechanisms that allow institutions to borrow money or take on leverage. Complementary, market liquidity refers to the ability of market participants to transact or of the overall market to absorb large purchases or sales without affecting the overall prices. Both market and funding liquidity are closely related and mutually reinforcing dynamics. When funding liquidity is abundant, traders have the resources with which to finance trading positions that smooth price shocks and make markets liquid.

In order to build funding and market liquidity, security tokens need to establish the basic protocols for the funding and trading of assets. Differently from other financial asset classes, security token liquidity is an infrastructure building exercise rather than a financial engineering process. Liquidity pools for security tokens are relatively available as they are a combination of traditional security investors and crypto advocates. However, the bridges for those liquidity pools to participate in the security token market are not available. Without those bridges, liquidity in security tokens will remain an elusive goal that can impact the evolution of the entire space.

The Exchange Liquidity Myth

Arguably, one of the biggest fallacies in the security token space is associating liquidity with the availability of the new generation of security token exchanges. By exchanges, I am specifically referring to centralized marketplaces such as tZero, OpenFinance or Malta’s Security Token Exchange which will enable the listing and trading of crypto-securities. Exchanges are certainly an important component to achieve liquidity in security tokens but they are far from being an enabler of that market dynamic. Without infrastructure artifacts such as disclosures, custody or liquidity protocols and without high quality projects, security token exchanges will be just a centralized marketplace for highly illiquid, digital assets. There is also the question of whether security tokens will be actively traded in centralized marketplaces or in a peer-to-peer fashion( I will cover this in a future article) which is not exactly trivial to answer. Considering all those factors, centralized exchanges should almost be seen as one of the latest manifestations, rather than an enabler, of a liquid security token market.

The Building Blocks of Liquidity

If centralized exchanges are not the answer to liquidity then what is it? In my opinion, liquidity will be the result of building not one but a series of infrastructure building blocks and protocols. The following figure attempts to provide an evolutionary view of liquidity in security token markets considering some of the fundamental building blocks that will act as enablers of this market dynamic.

 

Disclosures

If you have no information about a crypto-asset how could you possibly engage in any level of fair trade? Disclosures are the most basic block that needs to be in place to fight information asymmetry and illiquidity in the security token space. A security token disclosures protocol should be associated with any crypto security and integrated into exchanges and marketplaces. Protocols like TruSet incorporate some interesting ideas about disclosures that can be relevant to the security token space.

Liquidity Protocols

Programmability is the biggest advantage of security tokens compared to traditional securities. As a result, many of the market dynamics in security tokens can be express as programmable protocols and liquidity is not the exception. Protocols that facilitate liquid trade dynamics must become a key building block of the security token space. Efforts like Fuidity’s Two-Token-Waterfall or Bancor are very relevant in this area.

P2P-Swap Trading Protocols

I believe that a significant percentage of security token trading won’t take place in centralized exchanges but in peer-to-peer decentralized models. For that to happen, p2p or swap protocols should incorporate aspects of crypto-securities like compliance or regulation. Protocols like AirSwap or Kyber Network are incredibly well positioned to lead this effort.

Debt Tokens

Nothing increases liquidity in an illiquid market like cash flow and, for that, debt vehicles are ideal. Compared to equity tokens, tokenized debt represents a lower barrier of entry for most investors into the security token space and one that can offer higher level of short term liquidity. I believe debt tokens are going to become one of the most prominent forms of liquid crypto-securities in the short term. Protocols like Dharma provide a foundation for debt protocols that can be applied to the security token space.

Decentralized Marketplaces

If many security tokens are going to be traded in a decentralized model, then we are going to need some marketplaces to enable that. Decentralized marketplaces are likely to become relevant for some forms of crypto securities. AirSwap’s Spaces is a good effort in this space.

Custody

Custody is one of the aspects that helps to legitimize any financial market and increase its liquidity. Security token custodian products have the potential to unlock new forms of liquidity that are just not viable in the current market. Established financial players such as Fidelity Digital AssetsNorthern TrustGoldman Sachs and Intercontinental Exchange are well positioned to lead this segment of the market.

Centralized Exchanges

As mentioned before, centralized security token exchanges are certainly an important component for achieving liquidity in the security token market. Protocols in areas such as disclosures or custody should be incorporated into centralized exchanges. Efforts like tZero, OpenFinance and the Malta’s Security Token Exchange are leading the charge in this area.

Futures

Futures is a vehicle often used to increase and hedge liquidity in a financial market. As security tokens evolve, we are likely to see futures as the first form of derivative that can increase the levels of liquidity in the space.

Other Derivatives

In financial markets, liquidity foments the creation of new products that, in turn, help to increase liquidity. Derivatives is one of the most prominent financial models that can unlock new forms of liquidity not available to traditional asset-backed products. Options, exchange traded funds(ETFs), composed products like collateralized debt obligations(CDOs) are some of the products that are likely to achieve relevance in this space.

These are some of the building blocks that are necessary to build and unlock liquidity in security tokens. As the security token market evolves, programmability might unlock new forms of liquidity that are not available in other forms of securities.