The market for tokenized securities is lifeless. Nobody is buying these securities. A squad of zombie startups staggers on, announcing infrastructure and posting deals for sale, hiding the dismal truth behind happy faces. But nobody is buying.
We see articles like this, highlighting some deals that failed (Andra), and a few that were coaxed and cajoled and side-dealed to a smaller group of buyers than originally planned (Aspen Digital, 22X, Lottery.com, tZero). These articles claim to show that a market is emerging, but they actually prove the complete opposite — that the market is dead.
The non-tokenized private security market absorbs about $50B a DAY in new supply, proving that there is a massive base of buyers for desirable securities. The tokenized security market attracts approximately zero percent of that demand.
The secondary trading market, AKA “liquidity”, staggers toward Bethlehem to be born, but it is genetically deformed. We see announcements that a few private fund securities have started trading. These articles are also misleading. These securities may conceptually print a “trade”, but they aren’t designed by the issuers and regulators to trade in any volume. Funds like Bcap and SpiceVC can only be purchased by US investors under special circumstances. If they accept US accredited investors, they can only have 100 shareholders. They may create PFIC tax liabilities. They don’t disclose enough information to allow a buyer to determine a fair price. And, they are tiny issues — under $20M in total float. The problem is not just that the market is early and it will grow. These securities are fundamentally not designed in a way that will allow much trading at any point in the future.
Again, compare that to a daily turnover of billions of dollars in crypto markets, and hundreds of billions of dollars in public security markets.
These offers SUCK
From the point of view of buyers, these securities suck. They are bad investments. They don’t really have the promised liquidity, and they either have high costs, or they don’t do enough disclosure to allow the investor to price a risky investment, or they are incredibly boring and low yield.
Entrepreneurs use a rule of thumb that a new product needs to be 10X better on some dimension. If it’s only a little bit better, then nobody will make the effort to figure it out. It has to be a lot better. That will motivate people to figure it out, even when it has rough edges, and it will create new channels. In securities, “better” means it’s a better investment.
So what is the tokenization crowd selling?
Flimsy startups and failed ICOs
When the SEC started cracking down on unregulated ICOs, a lot of startups tried to relabel their fundraising offers as equity securities. However, nobody is buying these offers, because they are terrible investments. Most of the smaller ICOs are headed to zero. The new wave of freelance startup deals has the same problems. They are offered by startups with no revenue, an unclear business model, poor governance, and no investor representation. The truth is that an early stage startup is not worth very much money.
These deals demonstrate the horrifying power of adverse selection. They are being offered in a tokenized channel because they failed to pass the due diligence of professional venture capitalists, investors and brokers.
Horrible and expensive funds
If the market is dormant like Dracula, and the vendors are staggering like zombies, the current crop of tokenized funds are like the boogyman that jumps out suddenly and tries to steal your wallet. They have high costs, few privileges for investors, little or no liquidity, and I expect low returns.
Fund issuers have tried to offer PE and VC investments that normally require a ten year holding period, but in a tokenized security that is packaged so that investors can trade out. Unfortunately, US regulations are hostile to the trading of private funds, with severe restrictions on the number and type of shareholder, expansive times for due diligence, and tax penalties. In the US, a fund needs to be either a long-term private holding, or fully public.
Real estate is the world’s largest asset class by a huge margin. But, it’s a boring investment compared with crypto. People who are attempting to sell low yield real estate investments and debt are dramatically misunderstanding the purchasing patterns of tokenized security buyers.
There is a competitiveness problem. Why would someone buy tokenized shares in a private real estate deal, when they have more attractive options in public markets with high liquidity, or private markets with customized deals? Many public REITs are selling at a 10% discount to NAV, so you can get $111 of earning assets for every $100 you spend. Many tokenized securities take out the sales cost and give you $94. There is a cost problem. Tokenized securities cost more to sell. There is a product/market fit problem. Crypto buyers are looking for a chance to make 1000%. Real estate investments make 10%, which is 100X less. Why would an active crypto trader looking for 1000% return look at an investment that pays 10%? They will always be outbid by institutional investors with access to QE money that are willing to buy deals with a 5% yield.
Single Asset REITS
We have seen two tokenized deals in the odd category of a single asset REIT. Both of these deals were boring real estate deals that were poorly received by buyers. This losing structure has a rational motivation. The goal of the REIT designation is to be able to pass through income without paying extra tax on it, and to pass it through to non-US investors, who would otherwise be subjected to withholding of 30% of revenue under FIRPTA. The goal of the “single asset” structure is to avoid the many restrictions that US regulations apply to private multi-asset funds at the level of allowed shareholders, exchange process, and taxes. Either FIRPTA withholding or private fund status would be enough to kill the deal. However, the private REIT status also kills the deal, because it puts the issuer into a game of twister to try to satisfy various shareholder restrictions: Less than 2000 shareholders, more than 100 shareholders, nobody can own more than 10%, and non-US shareholders must have less than 50%. Just say no.
So why bother?
In the face of this horror show, why do we keep trying? Because there are good reasons to believe that tokenized securities are the wave of the future and will eventually carry good assets.
There is a good argument that the tokenized security market will enable more efficient documentation than the current private market, and also offer global distribution, automated compliance, and exchange. I like this argument. When this actually becomes true, significant volumes of deals will migrate to a tokenized format. However, since we are using automation mainly to lower costs, the margins for middlemen and technology platforms will be small. And, the value added by this move is not very big, so all of the pieces need to be in place before customers will be motivated to move.
More money will change hands if blockchain technology disrupts the public markets. The need for disruption is clear. Currently, public markets involve a lot of different complicated systems that interact with each other. Changes are very slow, because it takes a long time to change and then test all of these systems. For example, to move US exchanges from delivering securities in three days after a trade, to delivering them in two days after a trade, required five years worth of planning. This initiative is already obsolete because blockchain-based trading can deliver securities with real time settlement, and also real time reporting.
The older system evolves slowly and painfully. It has a lot of complicated parts that need to be integrated into any change, it is walled off by licenses, and it is siloed by country. There are a lot of features that securities investors and issuers want that are taking decades to insert into the older system. This includes features such as global distribution, immediate settlement and delivery, and automated compliance and reporting. The blockchain-based system can provide these features because it evolves much faster. It is simpler, and innovators can access it more easily. It’s a classic disruptive technology. It’s currently too simple and crude to replace the older system. But, the open blockchain system is evolving more quickly, and it may start to grab pieces of the market that need new capabilities.
New types of deals
Putting an existing security into a blockchain wrapper doesn’t add much value to that security. The market will really take off when we see new types of deals and business models that require the flexibility of the tokenized format. The cryptocurrency market provides an inspiration. Bitcoin is valuable because it did something completely new — it monetized and coordinated the efforts of an open source community. Maybe corporate securities can also learn to do something new.
I will be posting more hopeful proposals in future articles, including proposals for solving the problems of small cap securities (this is the core of the tokenization problem) and a new SPV + ETF market. So, please follow.