One question we get asked by institutions, individuals, asset developers and existing infrastructure investors is “what are the advantages of a token, why bother with a new form of security”?
We thought it would be helpful to set out our perspective on why a security in digital format presents significant advantages over a traditional security with the same underlying rights. Almost everything represented by a token can be represented in traditional form. So why bother:
Building compliance requirements into the underlying instrument is something not possible in the traditional markets, where a third party is required to manually enforce regulatory compliance, whether that’s a salesperson at a financial intermediary that is restricted in offering particular products to particular clients, or products that are confined to certain jurisdictions. There is nothing at the instrument level that controls the distribution of an asset. This is an important difference — being able to enforce regulatory compliance at the asset level does two things: 1. enables a more efficient and free trading environment and 2. improves the implementation and audit of regulatory restrictions enforced on particular products.
2. No broker
If a manual compliance function isn’t required and regulatory compliance can be enforced at the instrument level you immediately create a more open market for secondary trading, particularly in private securities. Apart from a sales function, there is little to no need for any intermediary to facilitate a transfer. Assuming that the buyer and seller have both passed through a KYC/accreditation funnel and the regulatory requirements associated with a security are accurately reflected in relevant smart contracts, no other third party is needed for execution.
3. Halfway house
Why doesn’t everyone list a security on a public market? For some it has to do with disclosure, for others cost, for others there is no public market for the type or structure of security they’re issuing. Private capital preserves the privacy of the issuer and delivers external funding. The issue of course is liquidity for investors in these instruments. Does a tokenized solution solve this issue? It does for the most part — a halfway solution between an open publicly traded security and private capital, allowing issuers the ability to access capital in a private form, at an issuance cost lower than other types of private capital, while delivering an investor exposure in a form that encourages future liquidity because of the points made in 1 and 2 above.
4. Structural flexibility
Much has been made of security tokens representing ordinary equity or debt. While the benefits of 1–3 above apply to these instruments, a security in token form allows for so much more than a vanilla security, particularly when combined with other financial structuring — whether that’s tokenizing rights to a stream of receivables, a stream of royalties, a total return swap or other contract.
One advantage that larger investors have in the traditional market is the ability to access leverage, particularly on a portfolio basis. This leverage is common in the private bank market where you see individuals able to purchase US$100 of bonds with a minimal amount of cash. A tokenized form of instrument and the evolution of the DeFi market should see a more open market for the provision of and access to leverage against individual and portfolios of assets, no matter the size of the holding.
The current liquidity in security tokens has been a hot topic. It’s true that a liquid secondary market for tokens hasn’t developed, however we are very early in this market — the exchange infrastructure hasn’t fully developed, the number and quality of assets being tokenized is limited and the regulatory framework for issuers is still evolving. Until there is a need for investors to access certain assets through security tokens we will see limited liquidity in a fragmented market, however given the ease of compliance implementation, removal of friction costs and intermediaries, we see security tokens developing quickly and becoming a critical part of the capital markets with strong liquidity, a wide variety of underlying assets and vibrant secondary market.
Putting all of the above together helps to achieve a critical outcome for the investor: holding an exposure in token form versus the traditional equivalent is cheaper — cheaper to issue than a traditional security, cheaper to maintain/hold and easier to trade with fewer intermediaries. Ultimately this means a greater share of the returns from the underlying asset can be passed through to the investor.
The above gives a flavour of why we see tokenized assets and digital securities being a far more streamlined, cost effective and ultimately beneficial way of owning and financing assets, particularly those that have traditionally been held in an unlisted form.