Noelle Acheson is a veteran of company analysis and member of CoinDesk’s product team.
The following article originally appeared in Institutional Crypto by CoinDesk, a newsletter for the institutional market, with news and views on crypto infrastructure delivered every Tuesday. Sign up here.
With so much buzz around tokenized securities, compounded by strong progress from platforms and issuers, it’s worth looking at the hurdles still ahead, and what they mean for investors.
First, a brief recap: by “tokenized securities,” we mean a crypto asset that reflects an investment in things that do not typically trade on liquid exchanges. Obvious examples are real estate and private equity, but the concept can also apply to art, diamonds, ships and other coveted items that are difficult to exchange efficiently.
The technology for this is developing fast – platforms and specific token designs are emerging to make it easier for issuers, investors and regulators to get comfortable with the concept.
On a panel at CoinDesk’s Consensus: Invest conference in November, Harbor announced the launch of its platform with the first tokenized real estate investment trust (REIT), and an entire panel about crypto wealth management declared itself bullish on security tokens.
More recently, SharesPost, a broker-dealer and alternative trading system (ATS), said last week it had executed the first secondary trade of security token in which the assets were held in custody by the same ATS. This was a notable milestone because large investors are required in the U.S. to use a qualified custodian.
Why such enthusiasm? By wrapping a traditional asset in a tradeable piece of code, tokenized securities offer a way to broaden access to investments by lowering barriers such as illiquidity, high entry points and steep costs.
They also open up the possibility of more detailed configurations, making it possible to design return opportunities tailored to specific objectives, and they potentially offer greater transparency as to ownership and movement.
While the promise is great, the reality – as usual – is more complicated.
One thing often overlooked in the excitement is that a new technology does not create liquidity. Markets create liquidity. Without supply and demand, the tokens will not trade. And demand does not necessarily spontaneously emerge.
And not just any supply and demand will do. Liquidity, in the traditional financial definition, requires sufficient volume of buy and sell orders around the current price so that a large order will not noticeably move the market. With new types of investment, that is not easy to come by.
Initially, this probably won’t matter much, since the initial tokens – assuming that they are compliant with U.S. securities registration exemptions – will only be available to accredited investors. Yet even these wealthy investors will want relatively narrow spreads, something that only happens when there is a certain level of trading activity on a platform.
Furthermore, for the market to fully realize its portfolio-management potential, derivative markets would need to emerge on top of the security tokens. This could bring further regulatory and transparency complications, as final ownership gets obfuscated through borrowing and hedging.
Settlement is another issue. Immediate settlement is often touted as an advantage, citing a more efficient use of funds. Actually, it’s the opposite – to settle immediately, buyers will need to have the necessary amount already in the relevant account.
In traditional finance, the money gets moved when it is needed, not before. Until then, it “rests” in interest-bearing instruments. Middlemen provide assurance to seller and buyer that the trade will happen, giving them time to get the funds and assets ready for exchange. Sure, it may be faster and cheaper to do it on a blockchain with instant settlement – but that may not be in the best interests of the buyer.
Another hurdle is conceptual: are these a new asset class? Or are they just a reconfiguration of an existing one?
In other words, do they require a new framework for investing – new metrics, dashboards and knowledge base for a new investor? Or is the target market the same as the old target market, only a bit broader? If the latter, how long before it becomes comfortable with crypto assets? Is it really worth the while to do so, given the relative “clunkiness” and youth of the new platforms?
Solutions will most likely emerge to all of these obstacles. It’s not easy to spin up a market, but with perseverance, communication and investment, it can happen.
The settlement issue could be solved with further innovation in payment methods and types of programmable money. And the conceptual confusion will settle with time. The benefits are intriguing, and even traditional market participants tend to be open-minded when it comes to the possibility of enhanced returns.
Given the intensifying build-up of tokenized security technology and marketing, as well as increasing regulatory clarity, we are likely to see a flurry of activity in onboarding and launches over the coming months. And as the market gets comfortable with the concept, the creativity of the issuers and sophistication of the investors will generate new opportunities for wealth creation, hopefully broadening access to both returns and capital. This will encourage further development in the crypto space, opening up even greater potential.
But we need to keep our expectations realistic. Getting the technology working is just the first step. Markets are unpredictable, and reliable demand for these new assets may take time to emerge.
Early investors usually get access to greater profits than latecomers, which is fair given the higher risk. But no one knows how long they will have to wait.
Harbor CEO Josh Stein image via CoinDesk Consensus archives