A summary of the webinar of 20th October 2021 entitled What it will take to tokenise the securities markets.
For both issuers and investors, the benefits of tokenising securities seem unarguable. Yet tokenisation has so far refused resolutely to take off. Security token issues are dominated by security token infrastructure providers and one-offs, many of which fail to reach their funding targets, as institutional money in particular refuses to get involved. The question is why. Regulatory uncertainty is a factor. Though the uncertainty is exaggerated – some jurisdictions have passed token-specific laws, and in all major jurisdictions it is clear that tokens are regulated as securities – international coordination of the regulatory treatment of security tokens would make it easier for institutional capital to get involved, especially across borders. Lack of a supportive infrastructure is no longer a valid objection. What is really missing is decisive leadership from banks prepared to invest to insulate their clients from the costs and risks and take a long-term view of the return on the investment. A marquee Security Token Offering (STO) might well spark the security token markets into life. This is not a role traditional stock exchanges are able to play, though they must be mindful of the threat to their franchise from crypto-currency exchanges, and especially those with licences to list and host the trading of securities. It remains to be see if the banks have the courage to make security tokenisation happen.
What are the benefits of tokenizing securities?
In theory, tokenisation benefits both issuers and investors. Issuers obtain capital for issuers at a lower costs, because an initial token offering (ITO) is cheaper than an initial public offering (IPO); greater liquidity leads to higher valuations for equity and debt issues; the range of investors is broadened, tapping new sources of savings; the costs of servicing securities, in terms of automation through smart contracts of the distribution of dividends, interest, rights and proxy voting materials to a register of investors that is always up-to-date rather than dependent on periodic record dates, is lower; and issuers also have a direct relationship with investors.
Investors (in both equity and debt) also gain a direct relationship with issuers, unintermediated by custodian banks, paying agents and proxy voting agencies. They also gain through tokenisation from increased liquidity, which makes it easier to buy and sell tokens; access to currently inaccessible assets, such as corporate bonds and private equity; access to a wider range of asset classes, since any asset or income stream can be tokenized, including fine art, collectibles and royalties; lower ticket sizes and minimum investment amounts, thanks to the ability of tokens to be fractionalized (the minimum size of a Bitcoin investment, for example, is 0.00000001 Bitcoins); and, above all, lower transaction costs as a range of intermediaries are eliminated.
How big are the securities token markets?
There is no reliable source of information about Security Token Offerings (STOs), in terms of their number or the sums raised. Lists of STOs range from 15 (stomarket.com) through 28 (securities.io) to 120 (blockstate.com). Estimates of the sums raised range from US$10.3 billion since 2017 (Cointelegraph) to US$30 billion (Tokeny). Many STOs fail to reach their fund-raising targets and some remain open sine die.
Although projections of the rate of growth of the security token market by 2025 are as high as US$8 trillion (KPMG/WEF) to U$9.5 trillion (Finoa), even these figures are small by comparison with the current size of the global equity markets (US$105.8 trillion) or the global bond markets (US$123.5 trillion) , as measured by SIFMA in its 2021 Capital Markets Fact Book; or the global mutual fund markets (US$US$68.6 trillion) as measured by the Investment Company Institute; or the global real estate markets (US$326.5 trillion), as measured by MSCI.
Why is it taking so long to realise the benefits of tokenising securities?
Many of the apparent obstacles adduced to explain the limited growth of the security token markets merely restate the problem: lack of enthusiasm from institutional investors and issuers and the absence of a supportive infrastructure to purchase, trade, safekeep and service security tokens.
Even the lack of regulatory certainty, while certainly a factor, ought to be less convincing than it is. Several jurisdictions have put specific token laws in place, and in every major jurisdiction it is now abundantly clear that security tokens are regulated under the prevailing security laws (notably in the United Kingdom and Switzerland and even the United States, even though the Howey Test has provided lawyers with a valuable plaything).
Whatever the shortcomings of the regulatory environment, it is mistaken to object that an institutional grade infrastructure is missing. A number of eminently respectable stock exchanges have built token issuance platforms. There are also dozens of institutional grade digital asset custodians in existence, some with banking licences and massive traditional custody businesses.
A more valid objection is the lack of a marquee STO to encourage other issuers and investors. Many STOs are driven by STO platforms seeking to raise funds. Others are one-off issues which do not generate momentum. Their structures vary widely too, with some offering equity-like ownership and net profits, while others offer merely a slice of post-costs revenues.
Substantial changes in markets can take a long time to reach completion. It took 40 years, from the 1970s to the Noughties, to dematerialise securities, for example – and tokenizing securities is a comparable change in how financial assets are represented.
Yet, ultimately, what is missing is leadership. The investment banks and their corporate clients need to take decisive steps towards the realisation of the benefits of tokenisation. That entails accepting a degree of disruption to the status quo and of operational inconvenience to launch a new way of raising, trading and investing capital.
What can spark the security token markets into life?
Clearly, capital markets being global, some global co-ordination between regulators would be helpful in encouraging issuers and investors to be active across national borders. As importantly, a regulatory push would encourage market participants to act and to invest, not least because regulation has governed virtually all forms of investment in the securities industry since the great financial crisis of 2007-08.
English law provides an obvious foundation for an alignment of the legal components of tokenization efforts across Europe and Asia, though probably not the United States.
Another helpful catalyst will be successful tokenisation of new asset classes, such as private equity and real estate, and privately managed and privately placed equities and debt. Post-Pandemic, tokenisation also offers small and medium-sized enterprises access to debt-based working capital is another opportunity.
A further spark might come from convergence between tokenised securities markets, the crypto-currency markets and the Decentralised Finance (DeFi) markets. If security tokens could be pledged within DeFi liquidity pools and vice-versa, for example, it would encourage issuance and investment in both markets.
However, the likelihood of the traditional and DeFi markets converging soon is attenuated by the difficulty of executing trades in DeFi markets and keeping the assets safe. Until DeFi provides more user-friendly access points, and assurance that lost assets or losses occasioned by lost assets are recoverable, it will struggle to attract institutional interest.
Since DeFi protocols are operated by software firms without the substance afforded by capital and insurance, these demands from institutions for reassurance will be difficult to meet without banks agreeing to entere the DeFi marketplace.
Once change begins, however, digitised markets can grow quickly. The market capitalisation of crypto-currencies, for example, has increased from US$4 billion in 2015 to more than US$2 trillion in 2021, a compound annual growth rate of 182 per cent. The rapid growth of the Non-Fungible Token (NFT) market in the last year is equally encouraging in this respect.
Are securities market intermediaries obstructing change?
A number of intermediaries – stock exchanges, investment banks, broker-dealers, paying agents, central securities depositories (CSDs), central counterparty clearing houses (CCPs), registrars and transfer agents and custodian banks – are making a very good living out of the current system.
This does reduce the incentive of intermediaries to embrace change enthusiastically. They are assisted to some extent by institutional investors that wish to retain high levels of intermediation to, for example, make them whole if assets are lost. It is easier for an asset manager to secure internal approval for tokenisation initiatives if existing service providers are retained, because they provide a degree of reassurance.
On this view, the new dispensation needs to prove that it can fulfil the functions of the intermediaries as well as the incumbents before the intermediaries can be allowed to disappear, because institutional investors value the assurance of having a provider to sue if the technology falters or fails. It suggests the security token markets must evolve towards a disintermediated model, rather than begin from that point.
There are other reasons to believe change will be gradual. The benefits of atomic settlement (token-versus-token) remain theoretical, in three senses: fiat currency is not available on the network (until Central Bank Digital Currencies (CBDCs) are issued in major markets); crypto-currency settlement is expensive and slow; and trades will not in practice settle continuously all the time. Likewise, the capabilities of smart contacts (for asset servicing) can be exaggerated. All of which implies that CSDs will still be required, at least initially, even in tokenized markets.
Custodians will also survive, even though safekeeping of tokens (in the form of private keys or digital identities tied to tokens) will be distributed across tokenised networks. Custodians are already providing custody services to buy-side clients investing in crypto-currencies so adding security tokens – where the custody risk is actually lower because lost tokens, unlike lost private keys, can be replaced – does not represent a large philosophical jump, even if some custodians are still educating themselves about the industry.
In fact, the provision of security token custody services by the major custodian banks is essential to attract buy-side institutions at scale. And the custodians risk being overtaken by digital asset custody specialists if they do not develop services. So they have an incentive to act, probably by buying rather than building the necessary technology or by acquiring a digital asset custody specialist .
As the changed role of a custodian indicates, even if an intermediary survives, the nature of the risks that they cover will evolve. A CCP, for example, might in future cover not counterparty risk but the risk of technological errors or of financial crime facilitated by a coding vulnerability.
A catalyst for faster evolution will be the costs intermediaries currently incur in the operation of legacy systems. If tokenization can cut their costs and widen their margins, they will adopt it.
Which is better placed to catalyse security token markets: crypto-currency exchanges or stock exchanges?
Ironically, the leading crypto-currency exchanges are centralized entities operating in ostensibly decentralized markets. Which suggests the traditional stock exchange model has advantages in terms of concentrating liquidity and price formation.
Indeed, Coinbase itself chose in April 2021 to IPO not on its own exchange but on Nasdaq. However, not many traditional exchanges (SDX and SGX are exceptions) have built or acquired the capabilities to support tokenised issuance and trading.
Crypto-currency exchanges are not burdened with legacy technology but they do have reputational issues – however unfairly – that date back to some of the earliest defalcations in the crypto-currency markets, and in many cases they have yet to agree to being regulated.
The automated market-makers in the DeFi industry may be fully decentralized, and also unburdened by legacy technology but unlike the crypto-currency exchanges they are not yet attracting interest from institutional investors.
Do tokenised security markets need market-makers and/or lead brokers to generate liquidity?
The question for security token platforms is: `If we build it, will they come?’ The likely answer is that both issuers and investors will come, but slowly. Which implies that liquidity will not develop naturally but requires artificial stimulation.
Issuers may be called upon to stimulate liquidity in their own issues. Another possibility is that, if security tokens become eligible as collateral, repo and security token lending opportunities will add liquidity.
As HQLAx has demonstrated, tokenisation can broaden the range of assets that can be used as collateral without increasing the operational burden.
What would do most to help the security token markets grow?
Security token markets need a catalyst. Success of any kind – a tokenised asset that achieved scale, for example, would encourage issuers and investors to tokenised other asset classes – would be one.
A security token market infrastructure that reassured investors, and delivered genuine economies not only to investors but to issuers and investors as well, could be another catalyst. The shortening of securities settlement timetables to trade date plus one day (T+1) could incentivise custodian banks to embrace tokenisation technologies, and so kick-start the security token markets.
Yet both these catalysts are, in sense, statements of the obvious: success leads to success.
It will also be important to make any infrastructural innovations backwards-compatible, to minimise the costs of the transition to tokenised markets for all market participants. It provides a bridge between the old world and the new.
But there are three groups that could do the most to spark security token markets into life.
One is the banks, which need to insulate their buy-side clients from the costs of the transition by taking a long term view and investing on their behalf, to deliver the operational efficiencies and cost savings that tokenization promises to create.
The second group is the regulators, which can co-ordinate the regulatory treatment of security tokens at the global level, through bodies such as the Financial Action Task Force (FATF).
The third group is the major institutions in the digital asset industry today. Coinbase by choosing a conventional IPO, missed an opportunity to catalyse the security token markets. If another leading crypto-currency institution chose an STO for its liquidity event instead, it could launch the security token markets on a path of self-sustaining growth.
Highlights of 20th October Webinar
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