Oct 15, 2020
One of the main promises of digital asset securities, or security tokens, is the ability to drive liquidity for private securities. Private capital markets are much larger and growing faster than public markets, but they are mostly illiquid. According to the World Federation of Exchanges, private capital markets raised $2.9T in 2019, more than double public capital markets at only $1.4T, and in 2020 that trend is continuing in spite of the burgeoning IPO market and the rise of SPACs. While public markets are extremely liquid, with $33T annualized volume trading, private markets are extremely illiquid with only $0.1T annualized volume trading, an astounding 330x less.
Source: Tribe Capital
Issuers of private securities have reasons to be excited about the possibility of greater liquidity. One reason is that many investors cannot afford to have their money locked in a single investment for years. More liquid securities are accessible by a larger pool of investors. It also gives issuers access to the so-called “liquidity premium” where investors are willing to pay more for liquid securities than illiquid ones, therefore achieving higher prices in the market. The ability to trade out of a position reduces risk for investors, which means they can allocate more of their capital for liquid assets than illiquid ones. Industry estimates put the “liquidity premium” at up to 30%.
So why are private securities so illiquid? Well, there are a number of reasons. Of course, some private issuers might not want liquidity or the value of their securities might be too difficult to discern given a lack of disclosed information about the underlying asset or issuer. Private companies typically have multiple classes of securities issued, complex regulatory restrictions around initial investment and secondary market trading, and clunky clearing and settlement processes. Also, for the most part, private securities are poorly digitized, which adds substantial time and complexity to the transaction process. While we don’t expect private securities to ever trade with the frequency of public securities, we do think there is room for improvement in closing the gap between the annualized trading volumes of private and public securities. The right number is probably somewhere in between existing figures.
So how do we solve this? Blockchain-enabled securities, or security tokens, partially address these problems since they are programmable. As a registered transfer agent, Securitize has coded the regulatory complexities of private securities into smart contracts, which govern the movement of the security token on the blockchain. We do this through our Digital Securities (DS) protocol. On top of that, you can represent in the same ledger cash or cash-like instruments like stable coins alongside the other asset representing the security and perform clearing and settlement automatically and nearly instantly as we have also shown here. And you can track the trades on the blockchain and reconstruct the cap table so you can track the beneficial ownership of the securities in real-time.
But technology only addresses part of the problem. A trading venue for private securities in the United States requires regulatory approval. For example, there are registrations like ATS (Alternative Trading System) in the US, MTF (MultiLateral Trading Facility) in Europe and PTS (Proprietary Trading System) in Japan. These registrations are scarce, there around 50 ATS registrations in the US, around a dozen MTFs in Europe and two PTS in Japan. On top of that, those registrations are typically invalid for digital asset securities and require additional approvals from the regulators.
When the security token industry started, there was a lot of excitement about creating security token marketplaces across the globe. The Security Token Group published a list of more than 60 projects in development. We at Securitize signed MOUs or had discussions with over 40 different companies that were working on launching a regulated marketplace for security tokens and hoped to list the securities of our customers.
Unfortunately, very few of these projects have launched, and those that have, haven’t been particularly successful in driving liquidity.
One of the US-based marketplaces announced it was shutting down in April and since then liquidity has dried up with only slightly above $30K trading volume in the three months between July and September for 5 securities trading. Due to the lack of liquidity some of the securities actually trade at a discount of their intrinsic value (e.g. BCAP trades at $3.45 although BCAP’s more recently announced NAV is $5.53). Instead of enjoying the liquidity premium mentioned above, issuers are actually being penalized for trading at a low liquidity venue!
Others are building centralized trading approaches with a traditional clearing system and no usage of tokens or blockchain at all. This approach prevents some issuers from listing their securities simultaneously on other regulated marketplaces. We believe this negates a primary advantage of security tokens on the blockchain, which is the use of a common decentralized ledger as a communication layer for multiple parties.
We faced a conundrum in early 2020. Should we partner with others attempting to solve the liquidity problem or proactively go and try to fix the problem ourselves? After extensive internal discussions with our team and board, we decided to pursue the second option. And project Aquaman was born.
Aquaman as some of you might know is the DC superhero that can breathe underwater and control fish and other underwater life. If someone understands liquidity it is definitely Aquaman, so we adopted this as our internal project name and our symbol to solve the liquidity problem for security tokens.
For Securitize to start from scratch and go through the broker-dealer and ATS registration process would have been an expensive, long and uncertain process. We looked at potential acquisition opportunities in the US given the size of the market, our existing operations, and registration with the SEC as a transfer agent. As mentioned above, there are very few registrations and even less already approved or in the process of being approved for digital asset securities. Moreover, we obviously have our own opinion on the fair value for this and preferably wanted to avoid inheriting legacy operations and technology so we could start fresh building things the way we envision it.
Our search was fruitful, and today we are announcing that we have signed a definitive agreement to acquire Distributed Technology Markets, LLC, (“DTM”), a broker-dealer/ATS. DTM, formerly known as Orchard Platform Markets, LLC, that received approval in 2020 for the primary issuance and secondary trading of privately placed securities, including digital asset securities. The acquisition is subject to regulatory approval. As part of the acquisition, Securitize would also acquire Velocity Platform, LLC, a money services business with money transmitter licenses in several states.
The acquisition of DTM will pave the way for Securitize to develop a suite of services for private capital markets that will be better from top to bottom than anything available in the market today. The acquisition will leverage Securitize’s existing technology stack to simultaneously enable seamless liquidity for issuers and investors, which, as discussed in this article, is currently one of the most underdeveloped yet critical components of the digital securities industry.
We couldn’t be more excited about this new expansion of our business and look forward to unleashing the superpowers of Aquaman in the security token industry and solving the long-standing puzzle of security token liquidity.