The ability for tokenization to improve market depth by rendering previously illiquid assets liquid has been widely discussed. So has the additional value these instruments can bring to the securities space. In this article, we will explain why, despite the promise of greater market depth in the long term, it will take time for security tokens to acquire liquidity and how security tokens can separate ownership from rights to create distinct forms of value that will further increase market depth.
The current market
Public securities tend to have higher liquidity levels because they trade on a secondary market with a large pool of investors. The settlement (transfer of ownership) takes roughly two business days and is done through broker-dealers that are linked to the common infrastructure of the public markets. Hence, public markets have an infrastructure that automates compliance and is interoperable enough to facilitate the transaction of different assets.
In contrast, with a smaller pool of investors and lack of interoperability, the settlement of private securities can take several weeks, making the transfer of ownership more time consuming and expensive. The process that a private investor must undertake to sell an equity stake to another private investor is highly inefficient. Worse still, only a small percentage of investors have the financial capacity to deal with this process.
Tokenization and liquidity
Many cite liquidity as one of the major advantages of tokenization. It is often suggested that by tokenizing illiquid assets, one immediately exposes them to a large pool of investors, thereby rendering them liquid. It will, however, take time to build the necessary infrastructure to facilitate the flow of transactions. Security tokens cannot, therefore, be said to bring instant liquidity to the assets that they represent. However, the potential for tokenization to greatly increase market depth in the long term is huge.
This long-term liquidity partly stems from tokenization opening up the market for previously illiquid assets and partly from the ability to capture different forms of value by separating ownership from rights, thus enabling better allocations of value between the preferences of investors and the features of the asset. While improvements in the transfer of ownership can be achieved in the short term through automation, awareness of different forms of value within assets can take longer because this is both a learning process and a technological challenge.
Ownership vs rights
According to Sweetbridge, ownership is the right over an asset created by law and the rights are those created by the contract, which can be accomplished by creating an asset out of the right. The latter enables the creation of additional value by unbundling the properties of the asset that are captured by investors with a different set of incentives.
Real estate demonstrates this separation well; landlords are entitled to capital appreciation through the sale of the asset while tenants benefit from the right to use the property, avoiding the heavy acquisition price. Another good example is derivative contracts which, according to Mishkin, were used by financial institutions to manage risk, providing companies the right to capital appreciation/depreciation of their own security without the right to the ownership (dividend payments and voting rights). Companies could use this separation to eliminate the risk of speculation and focus on generating internal value.
There are many different approaches to the separation of ownership and rights; the key point is that the difficulty does not lie in the separation and valuation of each but in the ability to trade these different rights.
Security tokens and tokenized assets improve upon the traditional framework because they enable the exchange and efficient allocation of these rights. Below are two real use cases, where the separation of different values impacts the liquidity of an asset.
Use case 1: Air miles
According to a survey by Bankrate, 31% of credit card holders do not redeem their rewards. One could imagine a significant reduction in this number if customers realized they were able to sell air miles for dollars on the market. With the tokenization of air miles, companies could account for revenue that otherwise would be lost and provide customers with the freedom to exchange an asset with no utility for them. Let’s assume an airline spends 10% of revenue in airmiles for loyal clients. Rather than inefficiently leaving 31% of those points on customers’ credit cards, airlines could simply value that total discount over a 10-year period and derive a net present value. By tokenizing the discount, airlines could either add this to their balance sheet and increase their own value or sell it to customers who could then sell it to other customers. Either way, the airline would eliminate the inefficient allocation of rewards and receive a fair amount for the sale of air miles that would otherwise count as a revenue loss.
An air mile is a right to a fractional seat that always has the same cost for the airlines while providing faulty benefits for the consumer, where they either use it or they don’t. A customer can only travel so much in a given year, which means that the amount of benefits, through spend on a credit card, is capped by the customer’s capacity to travel. A right to a future fractional seat can be turned into a revenue stream for the airline and guarantee a benefit to the consumer as they will always consume or sell. A security token created by the airline company would lead to the increase of its own valuation as a portion of unused air miles (security tokens) remains as revenue, while consumers would be able to convert something that lacks utility into cash.
Use case 2: Artwork
One industry that is greatly affected by the lack of liquidity and ability to separate ownership from the right to use is the art world. An artwork or a painting is an illiquid asset that could benefit from tokenization. This asset possesses two types of rights:
- The right to exhibit the work.
- The right to capital appreciation when sold.
Museums have billions of dollars on their walls. They want the right to exhibit work but do not necessarily want the right to capital appreciation as the museum will exhibit the art work for eternity. Hence, if we take a Van Gogh and assume that the total value is equal to $10M ($5M for the right to exhibit and $5M for right to capital appreciation), then by selling the latter to raise capital, the museum will be able to acquire other artworks and increase its own value by efficiently deploying working capital. From an efficiency point of view, museums attract customers through the quality of artwork on their walls and that should be their strategic focus.
Finding a single investor willing to pay $10M for a Van Gogh work can be a challenging endeavor. However, selling $5M of the right to capital appreciation to 100 investors would increase the asset’s market depth and liquidity. This is because a single security token worth $50K is accessible to a range of investors that would like exposure to a Van Gogh artwork, just like they may own a piece of Apple or Google, but cannot afford to own an entire piece. Investors may want to hold a small percentage of artwork to hedge their portfolio. According to highly respected art economists Jianping Mei and Michael Moses, the art industry has a long-term correlation coefficient of 0.04 with the S&P 500. Because the asset is effectively fractionalized, the liquidity premium is significantly reduced. The asset can now be traded on the market at a fair price, since 1% ($50K/$5M) of a Van Gogh will have a bigger market compared to $5M for the whole piece, as more investors are capable of paying $50k to get exposure to the works of a renowned post-Impressionist painter.
The difficulty in achieving this in traditional systems comes from the complexity of guaranteeing that all regulatory procedures are conducted according to the law. The transfer of such fractional shares require the same paperwork as a full share. Therefore, the cost of keeping and organizing 100 files that ensure investors are compliant to transfer a piece of Van Gogh is higher than the liquidity benefit for each portion of the painting. The same thing applies to investors; the slow and inefficient process of communicating with a third party, when wanting to cash out the investment, together with the amount of paperwork required to conclude the transaction, is inconvenient and pushes liquidity away.
Though it will take time for security tokens to increase market depth and for awareness of different forms of value within assets to emerge, the potential of this technology is enormous. Tokenization could transform numerous markets, granting a large pool of investors exposure to previously illiquid assets and incentivizing participation in the market. It will take time, but this can be achieved through the unbundling of different forms of value that are currently bound within assets under existing systems of asset ownership.