How Tokenization can Unlock a Multi-Billion Dollar Liquidity Premium Market
In Lendflo’s previous article, we spoke about the benefits of information transparency that tokenization will bring to some areas of the finance sector. In today’s post we look at another key component of financial markets — liquidity — and blockchain’s ability to transform and unlock huge value by improving market participants understanding of liquidity and market depth.
What is Liquidity?
In the case of a market, a financial security and in our examples a token representing rights in a financial asset, liquidity is the extent to which there are sufficient buyers and sellers to ensure prices do not move out of line with economic value of the asset due to a heavy imbalance between the number of buyers and sellers trading the particular asset class, security and tokens.
Today, total global wealth stored in equity, bonds and other financial products represents a huge amount of value (approximately $280 trillion). However much of this wealth is relatively illiquid. For the most part liquidity is a continuum, i.e. it is not binary although historical episodes have demonstrated periods where liquidity can be very low and sometimes zero for certain securities.
Therefore, when we talk about illiquidity, it does not necessarily mean ‘unable to trade’, but rather it means something is ‘costly to trade’. Liquidity can therefore be thought of as a function of market depth. For example, if the market for a stock is ‘deep’ there will be a sufficient volume of pending orders on both the bid and ask side, preventing a large order from significantly moving the price.
Let us imagine a hypothetical situation whereby we have two companies with identical characteristics. All things being equal between the two companies the only difference is that one is a publicly listed company traded on an exchange, and the other is a private company.
In this example, the shares of the public company will attract a higher value due to the fact that the shares are traded on a public exchange. This difference between the value of the public and private company is known as a ‘liquidity premium’ and is the value investors place on the fact that the shares are listed on a recognized exchange which reduces many of the costs (or friction) of trading. The exchange listing greatly increases the availability of reliable publicly available information. This is one reason for increased liquidity on the marketplace, and as a result, makes the share more valuable than the share of the private company which will be more challenging to sell quickly. Because of the confidence investors have in recognized exchanges the trading costs are reduced through more market participants, more volume, smaller spreads, and less price impact.
Typically, illiquidity discounts can range between 20–30% for illiquid assets. If we take a look at the real estate industry, valued at $217 trillion, 25% of which ($54 trillion) is commercial property, this asset class has traditionally been highly illiquid. This has meant that institutions trying to sell these assets will have to pay a liquidity premium in the process. Using the commercial property industry as an example, a liquidity premium estimate of 20% would suggest that there is $10.8 trillion locked up due to the inefficiencies of market forces. This is almost 20 times bigger than the market cap of all cryptocurrencies put together.
How can Tokenization Increase Liquidity?
When we talk about tokenization we mean the process of converting the rights to real world assets into a digital token on a blockchain. Tokenization can be thought of as asset securitization. Allowing many investors to spread their risk over many assets in a way that secures their legal rights as one of many investors participating in the same asset or asset pool through issuance of a financial security documenting the investors rights over the underlying asset.
Given that liquidity is a function of market depth, tokenization offers an efficient and low-cost method of securitization. This can have a positive impact on liquidity since the securitized nature of the asset facilitates the exchange of partial interests between many buyers and sellers — increasing the market depth.
Asset securitization dates back as far as the Roman Empire when Roman citizens were able to secure their long-term debts with land. This financing technique generally involves income-generating assets — which on their own may be considered risky — being pooled to diversify some of the risk within a specially created legal structure or special purpose vehicle (SPV). The SPV then uses the assets as the collateral to issue securities for sale in financial markets. As a result, the originators of these securities are able to sell all or part of the rights of the underlying assets to someone else and while doing so, reduce their own exposure to the financial risk of those assets.
These securities, once sold onto investors, represent fractional ownership claims of the particular pool of assets. Pooling assets has typically been done with mortgages, creating products called Collateralized Debt Obligations (CDOs). CDOs involve splitting these mortgage-backed securities (MBS) into pooled tranches, which are graded by different risks and return and then distributing them to investors depending on their risk appetite. In the case of Lendflo, trade finance assets such as SME invoices will be securitized in much the same way by using the benefits of Tokenization.
The difference with tokenization on the blockchain is that asset securitization through the use of tokenization means that these tokens (which represent the right to the income generated from the assets) now offer a number of benefits or improvements to traditional securitization. Tokenization will allow greater divisibility of the asset pool due to lower transaction costs. The ease of trade of these tokens enable smaller transaction sizes to be viable.
For example, with the prevailing business processes, a trade representing $5 of a securitized pool of SME invoices would not be feasible given the costs involved. With tokenization however, we can broaden investor classes in the trade finance market by lowering the barrier to entry for smaller investors for whom the initial investment requirements of traditional structured securitized products may be prohibitive. This increases the market depth which ultimately has a positive effect on liquidity due to the fact that a greater number of investors are participating in the marketplace at any given price, making it easier to buy and sell the security quickly.
Tokenization driven securitization will enable investors to benefit from access to increased diversity of asset securitizations from a range of economic assets, sectors and geographies. The increased transparency of the tokenization approach to securitization, due to the immutability of the blockchain, brings access to funding for businesses that do not have sufficient requirements to warrant current securitization work to a wider range of investors including those that would not understand complex securitization frameworks and security placement regulations. This will improve liquidity and market depth and will help to improve the efficiency of investor access, market pricing and reduce the principal-agent problems that amplify perverse incentives in traditional markets.
Many of the current blockchain projects ‘mimic’ value in traditional stock and bond markets where liquidity already exists but fail to unlock ‘new value’. However, there lies a huge potential value pool with illiquid assets that has, up until now, often been overlooked. For example, SPiCE VC are looking to solve the problem we mentioned previously about the difficulty of buying and selling shares of a private company. SPiCE VC are creating a liquid VC fund that will offer immediate liquidity to investors on private equity that has traditionally been an illiquid asset class. In the case of Lendflo’s invoice financing platform, invoices, although a major asset to SMEs, are illiquid, despite in many cases the obligors being large and highly credit worthy organisations.
If we were to hypothetically assume that a financial institution owned a large portfolio of invoices created with traditional securitization techniques and wanted to urgently liquidate or sell such an asset pool quickly, they would likely pay a high liquidity premium on the asset’s fair value due to the difficulty of trading the asset. Tokenization of such assets will create a market in which to trade these tokens, significantly reducing frictions to trade and as a result, reducing the liquidity premium vis-à-vis the process of going to a bank or private placement agent.
For asset tokenization to filter into the mainstream, regulation will have to be adhered to, meaning the process of adoption may be slow and expensive — yet this would pave the way to a scalable alternative source of asset backed securities. Tokenizing without ‘securitizing’ properly is the equivalent to saying you want to use the gold standard but would prefer to dispense with the gold — it is important that the early innovators such as Lendflo use tokenization to securitize and protect investor rights in the assets. Investors must be wary of innovators taking short-cuts with respect to legal recourse and regulation — blockchains and the creation of asset backed securities is a compelling combination, but there are no short cuts to getting the correct outcome.
Conclusion
It is almost inevitable that the tokenization of assets will cause a significant price change for some assets due to increased accessibility to both new investors and new investees. Global involvement in tokenization will enable all kinds of real assets to be digitized on the blockchain, allowing for efficient transparency and methods of price evaluation. With tokenization it is likely we will see enormous change for illiquid assets such as real estate and private equity, where tokenization will be the enabler. Lendflo expects substantial improvement in market depth as investors from all around the world will be able to invest in these asset classes in full compliance of local laws and with full rights and benefits. As for Lendflo, our primary aim is to enable the access for both investors and the SMEs that need better access to capital. What better way to achieve this than create a liquid marketplace in which SME’s can receive upfront cash for their trade receivables, removing the issue of uncertain delays in their cash collection cycle.
