Three Forms of Liquidity For Security Tokens

The Major Forms of Liquidity Afforded by Asset Tokenization

“The core benefit of tokenizing an asset is the liquidity aspect.” If you know anything about tokenization, you’ve heard this sentiment before. It is somewhat of a misnomer in that it leads people to believe that tokenization provides liquidity.

Tokenization does not provide liquidity. Just because an asset can trade, does not mean that it will.

What is liquidity?

Liquidity refers to the ease with which an asset, or security, can be converted into ready cash quickly and easily.

The correct way to talk about tokenization and liquidity is to explain the different forms of liquidity that tokenization can lead to for investors in a private asset.

Form One — Trading

The most common form of liquidity that is referenced with Security Tokens is trading on an Alternative Trading System (ATS). ATSs are special purpose broker dealers licensed by FINRA that allow for order matching of private securities.

In the tokenized space, groups like Oasis Pro Markets, tZERO, Rialto Markets, Texture Capital, Prometheum, Realto, Securitize Markets, PPEX, and INX are leading the push in the US.

There are a number of overseas ATSs as well such as Archax in the UK and InvestaX in Singapore.

ATSs aim to match buyers and sellers of private securities. These platforms have different focuses and benefits, but all aim to allow for trading of private securities between qualified investors. All of these groups have stringent compliance requirements such as KYC/AML and Accreditation.

Form Two — Collateralization

The second form of creating liquidity for security token holders is to offer loans against the tokens themselves.

Leveraging smart contracts, the tokens can automatically be given back to the lender in the event of a default. In the event of an income product asset, part or all of the yield can function as payment for the loan. Issuers can find a lending partner that is comfortable with the underlying asset(s) to lend against and depending on the LTV ratio, may require additional collateral or charge varying rates.

Currently, RealT, a tokenization platform for residential real estate, has collateralized lending opportunities, covered in this article (RMM). Other ATSs such as Oasis Pro Markets are exploring collateralized lending opportunities with Maker Dao.

Issuers can also offer loans to token holders on the tokens themselves, which in the case of a default would result in the issuer taking possession of the tokens as collateral. One strategy would be to re-contribute the re possessed tokens to the company’s own Treasury Pool to support further liquidity.

Additional decentralized lending protocols that function to offer rates programmatically to borrowers are becoming more prevalent. This could become a potential source of capital or a decentralized solution (similar to a peer-to-peer trade) that enables more functionality for token holders, such as taking their tokens to competing lenders or decentralized lending protocols for improved terms and execution.

Form Three — Redemption/Buy back via Treasury Pool

For issuers, a common way liquidity can be provided is by offering buy backs. This is not exclusive to tokens as many funds and private placements have redemptions available.

When it comes to tokens, they can be digitally transacted, which allows the issuer to offer a 24/7 buy back program online. The rate is predetermined by the issuer and the treasury can determine the maximum amount of possible redemptions. This can help prevent a taxable event as transacting >49.9% of an asset would trigger capital gains tax for the issuer.

Redemptions can help set the floor price of a token on a secondary market, and is a form of market making.

Alternatively, issuers can create timed redemption periods and buy back programs. In certain cases, market maker partners can help create a bid / ask spread that the issuer can rely on to create the price for the token.

Certain technology platforms also exist to help create a market that is completely routed through the issuer.

An issuer-managed market is completely centralized and managed by the issuer, but can utilize market making services in order to avoid leveraging its own treasury.

There are other forms of liquidity that we are seeing such as Market Making, Automated and Decentralized Market Making, bulletin boards, and more.

Please reach out to alec@securitytokenadvisors.com to learn more about how tokenization is helping to facilitate liquidity in private assets.

Added Commentary from Peter Gaffney