On Tokens and Liquidity

Abstract: Tokenization is an often cited solution for improving asset liquidity. This blog explores the concept of liquidity in detail without tying the reader into financial services jargon as much as possible. Then the article lays out specific reasons for why asset tokenisation could improve liquidity and consumer access to certain assets that are currently largely illiquid. For the savvy reader, it also briefly emphasises the value of thinking upfront about asset servicing in tokenised asset markets.

Understanding Liquidity

Liquidity is complicated. Really complicated. Creating liquidity is even more complicated. This is why you shouldn’t get too carried away by the idea of instant liquidity.

To understand why tokens can improve market liquidity for certain illiquid assets, let’s look at the concept of liquidity without any reference to technology.

What is a liquid asset?

An asset is liquid if I can sell a lot of it without impacting its market price. For example, if I sell one million dollars of bitcoin on Coinbase in one sell order, its price might fall by 10%. If I sell one million dollars of DogeCoin, the price will probably fall by 30%. In banker lingo, we say that Bitcoin is much more liquid than DogeCoin. Further, I can always sell a million dollars of GE stock (if someone sends me a million dollars first to buy GE stock), without impacting its price much at all. Essentially, GE stock is very liquid.

If on the other hand I place a sell order on my house in Orpington at a million pounds, it will be days if not weeks before any buyer even shows up to offer me some very British sarcasm. My house is quite illiquid unless I drop the price by 40% in which scenario, my house will go in 5 days and I will be personally illiquid (insolvent to be precise).

1. The more of an asset I can sell on a particular market without impacting its price, the more liquid it is.
2. If I can’t sell an asset at all because there are no buyers it’s illiquid.
3. If I have to spend 1 dollar to sell 10 dollars of an asset A it’s less liquid than an asset B of which I can sell 10 dollars worth by spending only 10 cents.

Asset liquidity depends on the market

An asset doesn’t have the same amount of liquidity in every market .For example. my house is much more liquid in the Orpington market than in the Dallas market.

Some Markets are More Liquid than Others

Some markets are much more liquid than other markets for one or more assets. For example, Coinbase is much more liquid than Decentralised Exchanges — which means on the whole most assets traded on Coinbase have higher liquidity than on 0x.

This can also vary by asset. Similar to the choice of Orpington vs Dallas market for my house, Coinbase may have more liquidity than binance for Bitcoin but Binance may be have more liquidity than Coinbase for DogeCoin. It depends on a variety of factors, particularly who’s buying and selling on Coinbase or Binance and what assets they are interested in trading.

Liquidity is About Risk

Liquidity is about risk. To understand liquidity, one needs to understand four types of risks that interact with each other in complex ways. If you haven’t spent your life hanging around with bankers, lawyers, auditors and mathematicians, don’t worry — it’s complicated but logical.

There’s even a risk called liquidity risk. It means, not being able to sell when you really need to sell. A good example will be ICO coins I bought in 2017 and 2018 with my meagre supply of bitcoin and ether. A popular crypto community term for this unfortunate condition is “being a bagholder” or “REKT”.

Think about it this way — the more reliably you can trade an asset without the risk of losing too much money, the more you will be willing to buy or sell an asset. If you can’t be sure that you won’t unexpectedly lose a lot of money in trading, you will avoid trading and the asset will therefore be more illiquid.

Four Types of Risks That Affect Liquidity

1. Market Risk: The risk of unexpected changes in price.
2. Credit Risk: The risk that your counterparty (the buyer if you are a seller and conversely) will not be able to (or choose to) send you the money they owe you.
3. Settlement Risk: The risk that your counterparty will get the asset you sold but you won’t get the money they sent you — at least not in time.
4. Operational Risk: The risk that people or technology will fail to do what they are supposed to do — e.g. your phone will be sim-jacked and your money will be stolen by hackers. If a market shuts down often or unpredictably, it will be a less liquid market than a market that’s up and running reliably 24*7*365 like the ethereum mainnet for example.

Clearly — all of these risks make a market, or an asset more illiquid i.e. make it harder for people to buy and sell with confidence.

So what drives risks that drive liquidity?

The four risks we laid out are impacted by the following factors

Information

1. Quality of information is key. If the information that impacts trading decisions is wrong (accuracy), too late(timeliness) or not there at all (availability), then people won’t be trading freely. In fact people will bail and go to a market where this is not the case.
2. Quantity : can cut both ways. If there’s too much noise (as on bitcoin twitter) or if there’s no information (e.g. in most government departments), bad decisions will be made and people will avoid pressing the button.
3. The information that matters is the information that impacts price. This is materiality. People go to jail for sharing material information they are not supposed to share (insider trading). Material information is generally circulated fairly in public markets where grandma is trading.
4. Asymmetry: All markets have asymmetric information i.e. people who own the asset know much more about the asset than buyers and sellers. However, too much asymmetry can hamper trading — in that the buyers don’t know what they will really own and the sellers don’t know why they’re selling.

A liquid asset may become suddenly illiquid if the underlying economics changes or new adverse information becomes available. Lehman stock would be a good example, mortgage backed securities in the financial crisis are another.

Market Economics:

Depending on the asset, the chosen approach to market economics and market operations can help or hurt liquidity.

For example, my friend

Alex Batlin

, the CEO of Trustology says … You can’t sell a turd in any physical or digital form. Well, he’s probably wrong. maybe there are no buyers for individual turds — but if millions of turds are aggregated and shipped, fertiliser manufacturers might buy and sell, and even create a market in turd derivatives, which is sort of how we got the global financial crisis. In fact there are two powerful global financial industry bodies called the Financial Stability Board and the Basel Committee on Banking Supervision whose day job is to stop another Fugazzi market from forming, storming and blowing up again.

What moves the Price of Assets?

There are many many factors that impact asset prices in markets. A simplified mathematical version of the real world is what we call a pricing model. Benjamin Graham, the ‘Satoshi of stock markets’ laid out the orthodoxy of discounted cash flows in the brilliant idea that you can price a stock by calculating a weighted sum of future dividends, free cash flows and other such future things. This idea is in fact so powerful that it has become religion in capital markets in the same way that “bitcoin is real money and dollars are fake money” is orthodoxy on crypto twitter. This idea works in the long run — especially for fixed income instruments (because future cash flows are more guessable than for stocks) but in the short run, randomness rules markets.

Since then, physicists and mathematicians have expanded on this idea and applied a lot of grad school mathematics to pricing just about everything. From what I have seen however, all theories of asset pricing apply only in equilibrium, which sadly happens only in college textbooks. In real markets day to day, price goes up when there are more buyers than sellers and price goes down when there are more sellers than buyers.

Price Discovery and Liquidity Discovery

Nevertheless, it’s important for buyers and sellers to find each other agree on price. If that doesn’t happen, a functioning market doesn’t happen. So if you want to build a liquid market, make it easy for buyers and sellers to find each other (liquidity discovery) and what they are willing to buy or sell an asset for (price discovery).

The mechanisms designed to allow buyers and sellers to find each other, interact and agree on price often make a huge difference to market liquidity for the exact same asset.

Asset Economics: Know Thy Asset

The asset matters and the token isn’t always the asset. For example, physically settled oil would generally be less liquid than cash settled oil. Not always but generally. Only so many people can take delivery of barrels of oil but everyone can hold a tiny fraction of digital ownership RIGHTS in a barrel of oil.

Make no mistake, a barrel of oil is a VERY DIFFERENT asset from equity held in a digital form. The barrel may be destroyed in fire and the digital rights holder may have no cover to protect themselves. The barrel might get confiscated by the government. In that case the digital ownership right might be worth something or it might be worth zero. Depends on the legal framework, not tech. Market participants may be perfectly happy trading digital rights in a fictional barrel of oil that no longer exists or never existed. That’s how derivatives markets, gaming tokens and ICO token markets for many tokens work.

Repeat — the token can be the asset but is not necessarily the asset. If you’re trading, know thy asset.

Buyers and Sellers

The economics that really matters in markets is demand and supply i.e. buyers and sellers. No one has a pricing model for Bitcoin (

Chris Burniske

s model didn’t work) but that has not stopped Bitcoin from being worth 20K at the peak and 1 million each in various twitter dreams.

This is why user experience and cost of trading is key — if it’s painful to trade (e.g. Crypto wallet experience), people will trade less. If I don’t need to call my stockbroker anymore and pay $9 per trade (e.g. e-trade) then 1000s of developers will start trading instead of doing the work they get paid to do (like me for a month in the dot com boom — shhhh).

As long as there are buyers and sellers willing to buy and sell, the asset doesn’t even have to exist. Gaming tokens, kids trading fictitious alien friends, … where should I even begin? However, who the buyers and sellers are matters. People who trust each other make more liquid markets. Honor code, honor amongst…., bro code — markets exist even where none should (e.g. the Westminster market in favors ) because… honor — otherwise known as trust, which is just the flip side of risk.

Different investors have different liquidity risk preferences. I invest in property because then the money is stuck and I can’t spend it on electronics or world travel. It’s me insuring against myself. Similarly, certain distressed asset funds and VCs explicitly seek out long term investments that force them to commit to helping the asset grow.

Buyers and sellers matter more than anything else — in fact, they are the only market that exists. Lewis Ranieri (Mortgage Backed Securities) and Blythe Masters (Credit Default Swaps) knew this — and did they create markets that didn’t exist before? Spectacularly so.

Law and Regulation

If you are a young programmer working on wall street and want to make a senior trader metaphorically throw you out of the window (I swear this never happened to me), just say that you’ve found a market where people are always nice and honest, technology never fails and things never go wrong.

In markets, things go wrong repeatedly for all sorts of reasons. People argue about price, people argue about collateral, people argue about the terms and above all — people argue about what happened and who did what and when. Disputes are the constant in market life. The only reason real markets work is because of a well functioning legal system and clear regulation designed to reduce the burden on the legal system. The general idea is to avoid having to go to court because going to court is so painful and unpredictable (think OJs trial) that you’d rather not trade at all.

A liquid market may become suddenly illiquid if traders can no longer trust the counterparties or the market operators or the regulator that their rights will be upheld and everyone else will perform on their obligations. That’s another way we got to the financial crisis.

Law and regulation affect market liquidity by creating safety, soundness, and transparency. Without these, there’s no trading and therefore no liquidity This is why I say, engineers build markets, bankers use markets but only lawyers can make markets work.

Technology

There’s a reason technology is the last in my list of factors determining liquidity — its only, yet critical role is to support improvement in the other factors.

Liquidity is a relative and not an absolute notion. We must remember that We had markets before we had liquid and illiquid markets before we had any computers at all, let alone databases, blockchain and AI. However, Technology can improve liquidity dramatically by impacting information, asset economics, buyers and sellers, and law.

This is not a complete list. The reader is very welcome to provide their insights, hypotheses and experience in the comments.

1. Asset Economics: Unbundling of rights and obligations embedded in asset ownership : More Buyers and Sellers

Tokens will enable rights and obligations corresponding to an asset to be unbundled and digitized separately and efficiently. This can allow creation of liquid assets from an illiquid underlying.

Let’s take an example of my house. Let’s say I want to continue to live in it (habitation right), but I don’t necessarily want to pay for all of it (mortgage liability) or own it (ownership rights/equity). All 3 are distinct assets that can be priced and traded individually. Tokens promise to enable efficient unbundling these rights cheaply into tradable assets using standard asset formats, secure shared transaction history and automated execution.

Availability of such liquid ‘unbundled’ assets or rights can improve the liquidity of the underlying illiquid asset. If I know I can sell tokenised rent on a property, it helps finance and reduce the risk of buying the underlying property.

2. Asset Economics: Fractionalisation : More Buyers and Sellers

Similar to unbundling, inexpensive fractionalisation can enable new buyers and sellers, who were previously unable to own rights in a particular asset. For example, a grandma who makes guaranteed $100 losses in Atlantic city every week is permitted to do so but she’s not allowed to invest the same $100 in an angel syndicate as an LP which might turn into $100,000. That makes these “accredited investor” restrictions well intentioned but rather unfair. Part of the reason grandma can’t invest in venture and private equity is because of suitability.

This is because current suitability regulation sets risk limits on issuers and market operators rather than on investors, which in turn is because of the sheer cost of issuing and administering private asset markets in small chunks. So by protecting grandma using current technology, the state makes sure Grandma stays poor — compared to “accredited investors”. Tokenization promises to lower the cost of fractionalisation and market infrastructure operations (remember reconciliation) sharply, allowing grandma to risk $100 as a venture capitalist rather than at at the lonely slot machine.

It’s not just Grandma. In the UK, young people are locked out of property markets because of the rise in property prices and their low creditworthiness. Old people on the other hand don’t want to leave the house they have lived in for decades and where their memories still live — but would like more cash to spend on vacations in Tenerife. Fractional ownership of home equity rights solves the problem for both without expensive HELOCs or other such illiquid and complex to access/brokered bank issued products.

By doing this not only have we created liquid tokens and cash from an illiquid asset, we have also improved the liquidity of the underlying asset by lowering the barrier and hesitation and risk involved in buying the house.

3. Transaction/Market Economics : Better Information

Today I can’t do what I described in ‘unbundling’ without going to a bunch of expensive lawyers or at the risk of a painful court battle later with who owns what. Lawyers then have to spend a lot of time checking paperwork on who owns the land, who owns the house, if there’s a lien on it, how many loans I might have taken against the house, who’s actually living there, which zone it is in, if there was damage and so on… provenance of rights and obligations can simplify all of this using a well designed blockchain platform.

Tools like openlaw.io can standardise and digitise legal paperwork and legal workflows and tie the contracts to tokens that implement events and event processing in the form of tokens. No need to worry about the 1000s of different pdf document management systems conveyancing lawyers are sitting on. This reduces the cost of transaction as a percentage of the asset price and reduces the barrier to pressing the buy/sell button.

4. Market Operations: Risk Reduction

1. Tokens on #blockchain can reduce settlement risk depending on how the cash leg is funded and how the legal rights of token holders are honored by the market and the legal system.
2. Tokens on a #blockchain can also reduce settlement risk by simplifying delivery versus payment subject to how closely the offchain world is reflected onchain. In the extreme case, Crypto to Crypto settlement is gross and prefunded and there is no settlement risk.
3. Tokenised assets tied to digital legal paper can streamline negotiation and dispute resolution. Tokens tied to digitally available and verifiable information about rights and obligations reducing paper processing costs of lawyers and auditors involved in verification of asset ownership and owner identity.

The Catch : Asset Servicing

Here’s a rule I learnt from a trader at a major EU bank: The real world is always the catch in the real world.

In this case, when real world assets are digitised, there needs to be a well laid bridge between events in the real world and the actions in the digital world, or it all kind of goes black mirror out there. Critically, all real world assets need servicing. The more complex the asset definition, the more servicing it takes. In this case, if we unbundle and fractionalise the property, not only does the property asset need servicing, all the token assets (equity rights, habitation rights, rental income rights) need servicing as well.

Essentially to make the assets and the markets do what they do, someone has to do the information gathering and processing in the real, non digital world and link such information back to the token (using Oracles for example). This includes things like corporate actions processing, property inspections, processing dividends, serving notices, collecting and passing rental income around, accounting and reporting for ongoing maintenance costs and allocating such costs… and so on. If you are building a non-native tokenised market and intend to achieve the benefits I have laid out, plan to address asset servicing upfront before you do much else.

To summarise, Know thy asset, know thy buyers and sellers, know thy lawyers and regulators, know thy servicing and know thy kill switches. Then Tokenise freely and all shall be wonderful.