Liquidity Part One – Can STO Reshape Private Markets?

Is Liquidity King?

Liquidity is a prominent feature of security tokens widely proclaimed to be revolutionary, capable of re-shaping private markets.


The hypothesis is that if security tokens are able to change hands fluidly, the ability to offset and onboard risk is enhanced. That is, if an investor wishes to sell 100 security tokens representing ownership in a German industrial medium-sized enterprise for currency, s/he will be able to near-instantaneously at the time of choosing.


At times, industry ecosystem players (ourselves included) are inclined to explain the potential of equity STO by drawing a parallel between equity STO and a public stock market with deep liquidity, such as the NYSE. Our wish, afterall, is that such liquidity depth ultimately develops on security token secondary markets.

It’s Beneath the Surface

This liquidity, however, is not all that it seems.


According to a CNBC report, in the public stock markets, “‘fundamental discretionary traders’ account for only about 10 percent of trading volume in stocks.”


If fundamental investors barely account for 10% of trading volume, where are the additional trades generated?


It turns out, “Passive and quantitative investing accounts for about 60 percent, more than double the share a decade ago.”


That is, in order to experience the liquidity that we enjoy on the US equity markets today, we require approximately 60% of all trading activity to be computer-generated and algorithmically driven.

Why Security Token Proponents Should Care

These market characteristics and the speed with which they developed could be highly relevant for the security token marketplace.

 

Accordingly, it may be unwise to take security token secondary market liquidity for granted. 

 

In our discussions with industry partners, we have learned that structural challenges exist for market makers in the security token space which did not exist for utility tokens. 

 

According to Helios Liquidity, a liquidity provider and high-frequency market making firm that provides millions of dollars of liquidity to cryptocurrency markets each month:

“There are multiple structural challenges in providing liquidity in a manner that is profitable, fair and efficient for all market participants. The crux of the issue though, is that there exists significant inventory risk in holding Security Tokens in volatile markets, and exchanges often do not sufficiently incentivise Market Makers to participate. This is not dissimilar situation to traditional equity private placements, where 8% commissions per trade are commonplace.

Typically, regulations regarding direct compensation of Market Makers to be a conflict of interest. We need to work with regulators and trading venues to find solutions that enable us to provide liquidity in this rapidly evolving sector without on boarding unacceptable levels of risk.”

James A. Butler

Founder, Helios Liquidity

We Need Market Makers

Observing the market structure of the publicly-traded equity markets, it is clear that there is an interplay between the algorithmic traders and discretionary traders. Whereas discretionary traders may make a few trades on a daily basis, it is not atypical for high-frequency traders (HFT) to continuously make trades on the basis of hundreds of nanoseconds.


There are signs that increasing volumes have caused lasting changes in market structure,


According to a Credit Suisse report
volume from money managers and investors, both active and passive, has remained fairly consistent for at least a decade (between about 3 and 4 billion shares per day). Total US volumes today, however, are more than double what they were in the pre-crisis, largely pre-HFT years. The difference is mainly due to HFT and high speed trading strategies.


Ultimately, what this indicates is that technological innovation in trading speed and decision-making have deeply contributed to the liquidity that we take for granted in the public equity markets.

The Takeaway

Developing security token secondary market liquidity requires a concerted effort between exchanges, investors, discretionary traders and their quantitative counterparts. As an industry, it would be unwise to assume that these market ecosystems will develop themselves.


It is possible that we will have to educate these potential beneficiaries and help transition them into pillars of our ecosystem. Such an effort will likely require clear and objective education materials detailing the current extent of development in our industry as well as the opportunities and challenges we face collectively.

What Does The Data Say? Part Two

While we draw parallels between security tokens and publicly traded stocks, there are interesting observations to be made among different classes of publicly traded stocks.


In our next piece on liquidity, we will take a deeper dive into publicly-traded equities and observe differences in characteristics across different levels of market capitalization: small, medium, and large cap stocks.

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