Increased liquidity is the golden promise of security tokens – but so far, the lack thereof is a concern for blockchain investors. Issuers can only create a buyer market by building a secure ecosystem that gains investors’ trust.

Making illiquid assets liquid and increasing financial inclusion – that’s the golden promise of security tokens. Blockchain technology enables issuers to replicate any asset in digital form, break it down into tiny units, sell it in a primary offering, and then list the tokens for secondary trading. Everyone could buy and sell securities, at low transaction costs, virtually no minimum investments, and everywhere in the world.

So far goes the theory. In practice, security token markets still lack liquidity as there is almost no secondary market yet. That makes investments somewhat risky. Whoever buys a security doesn’t know what a potential exit may look like. Not many people want to get on a train without knowing where they can get off again – or if they can ever get off again at all.

Blockchain reduces the cost of trading and enables sellers to eliminate trade restrictions

Traditional securities trading comes with high administrative burdens. Trading requires various intermediaries, and the process of tracking trade activity is inefficient and costly. The more illiquid the securities, the higher these costs – think about real estate transactions, where lawyers, brokers, and bankers all demand their slice of the pie and it can take months to close a deal.

As a result of high trading costs, issuers create certain trade restrictions that result in a lack of liquidity, for example minimum investments. To attract buyers, sellers then need to pay a liquidity premium, meaning they need to discount their listing price and can’t capture the full value of the underlying asset.

Bring in security tokens: Blockchain technology enables the simplified, automated transfer of ownership while still adhering to traditional securities laws. The technology can solve many of the problems of traditional securities trading by increasing automation and creating a trusted system that doesn’t require that many intermediaries anymore. The lower cost of trading will enable issuers to offer their securities to a broader buyer base, which in turn lowers liquidity premiums.

The infrastructure is there, but trust is still missing

Over the past two years, several marketplaces for security tokens have launched, such as OpenFinance, Coinbase, or tZero – they all promise a liquid secondary market.

However, the idea that a new generation of marketplaces will be all it takes to create liquidity is likely the biggest fallacy in the security token space. While functioning infrastructure is necessary to create a liquid secondary market, exchanges won’t be the enabler of the market dynamics. Yes, we need roads to drive cars, but the existence of roads doesn’t necessarily mean people will buy cars. 

The lack of functioning digital marketplaces was an issue two years ago. Today, the challenge is less in the absence of exchanges but instead in custody and asset servicing, including asset safety. While there are regulated infrastructure providers that enable all steps of the value chain in an integrated and secure model, many others still work with inefficient interfaces and security models that come with inherent risks – hence, the frequent exchange hacks. 

Another key challenge is the absence of regulations that ensure legal certainty, security, transparency, accountability, and stability. Some countries have introduced such legislation, but it is still missing on an international scale. 

To sum up the above considerations: The main reason for the lack of liquidity in security token markets is the lack of trust. Buyer markets for tokens do barely exist because investors prefer to stick to what they know and understand. 

Liquidity doesn’t just happen; it’s something you have to build for

Liquidity is also a question of market maturity, but only to some degree. In financial markets, liquidity is not something that just happens; it’s something you have to build for. 

As trust is the most significant element, issuers need to address the security concerns of potential investors. In essence, the challenge is to create a professional investment ecosystem, which means working with regulated exchanges, secure custody providers, and in jurisdictions that provide legal certainty. Gaining investors’ trust can only work by delivering an institutional-grade investment product that does not fall short of traditional investment vehicles.

Additionally, issuers can take other measures to increase the liquidity of their tokens, for example buyback programs. That can be costly, but it will bring instant liquidity to a token listing. Another way could be to cooperate with market-makers, firms that will buy and sell tokens on their own accounts. 

In the end, the success of security token offerings will depend on the issuer’s ability to gain the trust needed to effectively create a buyer market. It will require an industry effort as well as the issuers themselves to trigger real demand for their assets.