The State of Security Tokens 2022 — Liquidity Overview & Analysis
Liquidity Overview & Analysis
Presently, exchanges and Alternative Trading Systems are competing for investor attention and onboarding to fluff up their user base. As the organic user base grows on each of these venues, liquidity should naturally move in tandem as there should be greater volume on the demand side of security tokens.
The barrier slowing the issuance of new security tokens and a more active ecosystem is the lack of natural liquidity. It could be seen as risky to allow market orders on an order book that has very minimal liquidity and average volume, as any given trade could result in heavy price slippage. To combat this for now, some venues are allowing Limit-Only Orders — this helps predict and match orders in a more manageable fashion rather than allowing a mass amount of tokens to hit the “thin” market.
As covered in the “Immediate Settlement & Global Trading” section, venues aren’t even typically enabling 24/7 trading for the fear of an even greater lack of liquidity during off hours. For now, venues must operate within the traditional trading hours while servicing Limit-Only orders until proper liquidity solutions hit the market.
The goal of this section is to depict the opportunity that exists for traditional market makers, decentralized solutions, and proprietary solutions — all of which will contribute towards the successful adoption of security tokens. Additionally, Security Token Advisors has helped develop in-house liquidity solutions tailored towards each issuer to sustain and manage tokens that hit the secondary market, especially in the ever important early stage of trading (i.e. first 12 months).
Traditional Market Making
Existing markets like equities and treasuries are extremely liquid. An investor can place a buy or sell order and have it filled within milliseconds, with the precision of a fraction of a penny of the desired price. In order words, slippage on standard orders is minimal, and this supplies confidence on both sides of a trade.
This confidence is currently missing in the security token industry — which may be why certain secondary venues are still on Limit-Only mode. In order to feasibly accept market orders, there needs to be a dedicated party ready to facilitate deeper orders and maintain confidence in the order book.
Traditional Market Makers are a strong reason for the superior liquidity surrounding equities on the Nasdaq and NYSE, and those same players are needed to accelerate the security token ecosystem. If not, then crypto-centric investment firms could step into the role of market maker, as there is likely a lucrative opportunity here.
Think about Bitcoin and cryptocurrencies in 2016 and 2017. Order books were thin, low-volume days caused price surges stemming from single trades, and investors were not provided with much confidence in landing market orders at the targeted price. This reality was difficult on retail investors, but monumental for those well-equipped. See Bitcoin’s daily trading volume rising from near non-existence in 2017 to $80 billion in 2021. As volume grows, order books “thicken” up and provide greater liquidity support to other traders.
When it comes to applicable market opportunities, study Sam Bankman-Fried, CEO of FTX. He amassed a strong portion of his initial wealth via arbitrage across Bitcoin exchanges. Per an interview of his, “While Bitcoin was pricing at around $10,000 in the US, it traded for $15,000 on Korean exchanges.” This 50% premium provided a supreme opportunity to capture low-risk gains, and while not directly comparable to market making, the same visual can be applied to security tokens.
Not only can security token prices be mispriced from trading venue to trading venue (i.e. tZERO and INX), but single buys and sells typically have enough horsepower to shift the pricing on certain assets. Given narrow order books underlying these assets, a trading firm could form an actionable strategy around:
- Asset arbitrage across ATS and trading venues
- Market Making on one trading venue
- A blend of market making on multiple exchanges and associated arbitrage, for multiplicative returns potential
The typical market making strategy consists of offering to firmly stand to buy A number of shares at price B, and sell X number of shares at price Y. This essentially creates a predictable order book at which market bids and asks will be secured. Not only does it inspire the ever-needed confidence that investors are looking for in the security token secondaries, but it also enables the market maker to profit on everything between the predetermined Bid-Ask spread (Buy-Sell points).
The field is wide open for both crypto market makers and traditional market makers to step into and provide a symbiotic service to the industry.
Decentralized Solutions
While waiting on deep-pocket hedge funds, prop traders, and investment managers to provide steady liquidity to the security token industry, DeFi services are looking to find some traction. Much like Uniswap and its Automated Market Maker (AMM) role, security-token specific services are beginning to roll-out.
IX Swap
IX Swap offers a security token-specific market making service, similar to that of Uniswap. The thesis behind IX Swap is that IX Swap token holders (IXS tokens) may create liquidity pools amongst a variety of token pairs. Using an example ABC token, an IXS-ABC token pair can be created to facilitate trades. As IXS holders stake their tokens and add liquidity into the trading pool, the buying and selling of ABC tokens will be more supported and cause a lesser fluctuation in market price with each trade, yielding a reduction in slippage.
The trades are completed automatically through an order matching system. This trade is known as an “Atomic Swap” facilitated through a decentralized exchange (DEX) — which essentially tallies the amount of IXS tokens and ABC tokens in the pool and uses the “before and after” ratio to calculate the trading price. IXS token holders are incentivized to stake tokens through a 50% profit sharing structure on trading fees, which should scale upwards as either 1) number of token pairs against IXS increases, and 2) volume (demand) of a single asset pair against IXS increases. This incentive mechanism is designed to stack a long-term order book and fill gaps in any eligible security token.
RedMatter
RedMatter is a European-based organization that’s taken a more decentralized approach to tokenization relative to US-based peers. With the goal of offering wrapped tokens on numerous categories of assets, Red Matter is positioned to manage all legal documentation, corporate structuring, and investment instrument information on-chain (“Proof-of-Asset”), with the goal of also providing liquidity through decentralized exchanges (DEX).
Levinswap
As a Uniswap fork accounting for the 100+ RealT properties currently on the market, Levinswap is a security token-enabled decentralized exchange and AMM facilitated by its $LEVIN utility token.
Proprietary Solution: Liquidity “Tax” on Trades
Security Token Market’s own Jonah Schulman has an actionable solution for the liquidity dilemma within security tokens. Drawing on properties from Uniswap, Jonah proposes a small “tax” on every security token trade whereby the “tax” is automatically distributed to the token’s liquidity pool. This liquidity pool will be used to facilitate effective trades while continually replenishing itself through ongoing trades.
This “tax” may not be received well by investors upon first glance, but when looking at the solution from a wider lens, it may be clear that the benefits from more precise trades will outweigh the tax and create a net benefit for the ecosystem. Something as low as 0.1% on each trade would be negligible relative to Uniswap’s average 0.3% trade fee, and would support future trades even on a centralized marketplace. This method of course can be applied to decentralized exchanges (by design), although the execution benefits remain in either instance. For the full breakdown, see Jonah’s What’s Drippin’ edition covering liquidity in the digital markets.
Next week’s edition will cover Security Tokens as Collateral.
