NAVIGATING THE CRYPTO LIQUIDITY LANDSCAPE.
Jannah Patchay looks at the progress being made and the gaps to be filled.
When it comes to the burgeoning, fecund crypto-asset landscape, it is near-impossible to avoid discussions of liquidity. There are typically two directions – evangelical visions of a future in which the combination of distributed ledger technology (DLT), fractional ownership of tokenised assets and an enthusiastic army of global investors inject life into the previously parched deserts of illiquid assets; or a more sober and usually pessimistic view of the well-known challenges of growth markets and new products.
The true picture, it appears, may lie somewhere between these two extremes. While technology innovation in DLT and the digitalisation of assets via security tokens may not immediately open the gates to a promised land of mass accessibility, they certainly do herald the beginning of something new. The most likely outcome is that they will evolve in directions that cannot yet be comprehended.
In the European Union (including, for now the UK), adoption of tokenised securities – has been tentative. Olaf Ransome, Chief Commercial Officer of Fnality, describes the pre-requisites for widespread adoption in terms of a “Holy Trinity.” In other words, there must be a means of creating tokenised assets, exchanges and price discovery venues where trading can occur and an appropriate payment mechanism.
Currently, several firms are engaged in creating and managing tokenised assets to both issuers and investors. They may have a different spin but there are certain common threads such as recognition of the wider structural issues in small-to-mid cap markets, and an aim to put control of assets firmly in the hands of issuers, with as little intermediation as possible.
These platforms also typically include core functions for issuers including offer documentation, know your customer (KYC) processes and the issuance of securities and payment processes. Also, on the list are the ongoing management of the securities and any corporate actions. While their focus is primarily on the initial issuance process, they are also laying the foundations for secondary markets trading.
To date there has been little activity in secondary markets because tokenised securities are categorised as MiFID financial instruments and must be traded on approved venues such as an MTF or OTF. They have not been that welcoming to these crypto-assets in general but having different trading models for different levels of liquidity per asset has been key to moving the industry forward.
Changes are afoot with Archax’s plans to launch an institutional-grade exchange for trading asset-backed tokens and digital securities. The company is in the process of applying for authorisation from the UK’s Financial Conduct Authority (FCA) as an MTF.
The aim is to offer periodic auctions for less liquid assets, and a full central limit order book for those traded more frequently.
Graham Rodford, CEO of Archax, visualises a “liquidity spectrum”. At one end are highly illiquid assets such as property and private equity. Tokenisation adds benefits in terms of making the primary issuance process more operationally efficient and easy to manage, alongside the potential to access a wider investor base. Although having the ability for investors to exit a position is useful, these assets are not expected to trade on a frequent basis.
At the other end, are the more liquid blue-chip companies such as Apple and Vodafone. Rodford believes that there is an inevitability to the adoption of tokenised issuances by blue-chips, and once this occurs, they will enter the mainstream. However, he is keen to stress that the new market structure must be allowed to diverge from its traditional predecessors. “Part of the whole movement, of what it’s all about, is decentralisation, direct access and the removal of intermediaries, and we don’t want to fully replicate the old world,” he adds.
There are also other initiatives being introduced on the operational side. For example, Tokeny Solutions, a Luxembourg-based fintech company, has been building out their technology to support the full transferability of both OTC and exchange traded digital securities. The issuance process includes the creation of smart contracts that validate compliance criteria, such as the jurisdictions of investors and KYC requirements.
The technology is built on the Ethereum T-REX (Token for Regulated EXchanges) standard, allowing for the compliant transfer of tokenised securities, not only in the initial issuance, but also in secondary markets. These tokens can be held in almost any wallet on the Ethereum blockchain (enabling self-custody) and are tradable on any compatible exchange.
Tokeny’s objective, according to CEO Luc Falempin, is “to be the white-label toolbox for market infrastructure when it comes to tokenised security issuance.” There is clearly support from the traditional exchange sector in this goal: Euronext has recently invested Ä5m in return for a 23.5% stake in the company. “The liquidity is a key component that’s been missing in the industry, by partnering with the eurozone’s largest stock exchange we are striving to solve this problem,” he adds.
Tokenisation can also open up investor access on a more global scale. “Right now, if you want to have securities listed on different exchanges around the world then you need to create ADRs (American Depositary Receipts), GDRs (Global Depositary Receipts) or something equivalent,” says Myles Milston, CEO of Globacap, a UK blockchain-based platform that enables direct equity issuance. “By using tokenised securities, you could actually have a block chain-based security listed in one venue in one region and then listed on another venue in an entirely different region.”
He adds, “Those securities could be completely fungible and in the longer term could improve both access to capital, and on-going liquidity, by having more investors accessing essentially the same security, globally.”
Asset servicing hurdles
Progress is also being made on the settlement front with Fnality’s Utility Settlement Coin (USC), which when it goes live, will enable delivery versus payment (DVP) on the blockchain, which will help facilitate the process. At the moment, the operational benefits of immediate and direct security settlement are nullified if there is no instantaneous capability for settlement of the cash leg on the transaction.
The safekeeping of assets, though, is more problematic. Institutional investors will be reluctant to trade assets unless there is a convenient, reliable and safe means of custodying them, with full connectivity to all the venues and mechanisms by which the assets are traded.
Francesco Roda, Chief Risk Officer at Koine, an institutional-grade, segregated, fully regulated digital currency and asset custodian, summarises the situation: “Liquidity is primarily a feature of the market in which the asset is traded. It is driven by the interest and the demand that the asset can attract, the ease with which the asset can be converted into cash and the barriers to entering the market in which the asset is traded. So, bringing down the barriers to accessing assets is a way of creating liquidity.”
He adds, “Liquidity is made by market makers – but in traditional markets, market making is costly in terms of capital. Digital assets can lower the operational barriers to entering the market, potentially allowing new types of player – which may have a lower cost, or a surplus, of capital – to become market makers.”
©Best Execution 2019