At a time when banks are frantically trading $15 trillion in government debt at negative interest rates, it may seem that global liquidity isn’t actually “locked.” But for now, let’s disregard the banks’ inimitable talent for magically creating money out of thin air. Let’s focus on something real – the $360 trillion global asset pool, of which the lion’s share still lies in slumber waiting to be let loose on an open market or, as they say on The Street, made liquid.
What exactly is Liquidity?
It’s almost impossible to talk about concepts like “liquidity”, “illiquidity” and “liquidity premiums” without grossly oversimplifying things, but we have to start somewhere. In market terms, liquidity is a feature of an asset related to the asset’s price, current value, ease of purchase, and the ability to exit an investment for both buyers and sellers trading in the particular asset class. The cheaper and faster an asset can be purchased, and then sold on an open market without any value loss, the greater liquidity it has. Conversely, illiquidity is “the cost of buyer’s remorse: it is the cost of reversing an asset trade almost instantaneously after you make it,” as one frequently cited NYU paper succinctly puts it.
Liquidity v. Illiquidity
Publicly traded shares will be valued higher because of overall greater accessibility. Essentially, “liquidity premium” is the difference between the public and private equity in terms of the value being placed on the fact that the shares are traded publicly.
And of course, attempting to sell anything second-hand (or on the secondary market), one runs the risk of having to settle for a heavy “illiquidity discount” – an X-% hit you’d have to take to exit an investment early or with certain conditions.
Dealing with Illiquidity Discount
There are several schools of calculating illiquidity discount. The easiest way to do it would be to look at historical yields of securities with similar durations of investments. The difference between the past average yields and the current ones would be a fair indicator of what the market liquidity premium in a given asset class is today.
Another way of calculating the liquidity risk premium is to compare two similar options, one being illiquid and the other being liquid. Let’s say, two corporate bonds with the same coupons and maturities are offered by two companies, but one bond is public, and the other is not. The publicly traded bond is obviously liquid, while the non-traded bond would be – you guessed it – illiquid. The illiquid bond is cheaper but has a higher yield to reimburse investors for its higher risk. The difference between the two would be considered a liquidity premium.
Public listing (availability on an exchange) makes a share more desirable than a share of a private company. Because of the confidence investors have in popular exchanges, the sheer number of market participants significantly reduces costs to trade through more volume, smaller spreads, and more subtle price impact.
In most cases, illiquidity discounts range between 20–30% for illiquid assets. For instance, the global real estate industry, incidentally valued (somewhat garishly) at $228 trillion, as an asset class has been historically highly illiquid. In an attempt to sell these assets, institutions will have to settle for a heavy liquidity premium discount in the process, sometimes as high as 50-60%.
Digital transformation and alternative assets markets
The digital transformation that private securities are currently undergoing brings investors a promise of greater efficiencies, broader access to capital, and, most importantly, liquidity options for the historically illiquid assets in the marketplace of unfathomable size.
Conservatively, the alternative assets market is estimated to grow to nearly $14 trillion by 2023, which means that enhancing liquidity options is not only a common-sense proposition, it’s an opportunity to unlock tremendous value for investors, issuers, and placement agents the world over.
Primarily, the private securities’ illiquidity today is in no way due to investors disinterest. On the contrary, the demand is all there. The problems are constant frictions in the process, high costs, endless delays and risks instilled by the manual transfer processes. Violations can result in severe penalties for brokers and issuers resulting in fund managers’ reluctance to let trades simply “run free,” hence prohibitions on secondary transfers that make early liquidation next to impossible for investors.
Solving liquidity and compliance issues with Distributed Ledger Technology (DLT)
The basic legal ownership structure of a digital security (security token) and a paper security resemble shares in a private company or LP interest in a private fund. However, instead of using a SaaS-based ledger system, spreadsheet, or something as outdated as a paper ledger to record the ownership, the records are made using a new type of database technology – the Distributed Ledger Technology (DLT) better known as “blockchain”, which can be programmed to introduce additional functionality into ownership rights.
By now, there are a number of platforms that are attempting to do just that: offer programmable securities that represent ownership rights to certain types of investors, prequalify both buyer and seller before launching a transaction and provide an automated compliance protocol. However, the option to fractionalize the ownership and automate its transfer facilitates compliant transactions between buyers and sellers thereby eliminating friction, reducing costs and risks from the process, allowing issuers/sponsors to relax transfer restrictions and introduce much greater levels of liquidity. Ultimately, fractional ownership made possible by asset tokenization on a blockchain is what will bring liquidity to markets. Not the 20th century liquidity, we’re talking universal access to the entire global asset pool, global financial inclusion through lowering the investment barrier for retail investors, instant tradability, rapid settlements, 24/7 markets. The list goes on and on, but let’s summarize:
Immutability: Blockchain technology makes a record of ownership immutable. For the world of private securities, this means streamlining the ownership records from many intermediaries into a distributed database. The blockchain technology offers a more secure ledger than other proprietary technology options providing substantial liquidity for any asset class.
Syndication: Blockchain-based issuance platforms, like Smartlands, allow issuers and broker-dealers to raise capital more efficiently and cost-effectively from a larger, potentially global investor base.
Divisibility: Leveraging the blockchain technology, investments can be incrementally divided to lower the investment barrier for retail investors – essentially, anyone who possesses a bank account or a crypto wallet.
Interoperability: An ecosystem of enabling technologies such as public open-source blockchains like Ethereum or Stellar has the same impact as using public internet protocols: digital securities issuers operate in conjunction with a wider ecosystem of exchanges, custodians, portfolio management tools, credit facility technologies, and many others creating a business network with an unprecedented level of trust.
Ultimate liquidity: It all comes down to this: direct transfer of ownership at blazing speeds, in a real-time settlement, and at no risk for either party. Issuers can now create programmable rules and allow secondary transfers to take place directly without manually approving trades. Automated compliance protocols check each request against the issuer and regulatory requirements, allowing only compliant transfers to happen. Essentially, all of the above amounts to near-free movement of value on various blockchains, which will inevitably facilitate the ultimate unlocking of the liquidity premium in the majority of asset classes.
About the author
Ilia Obraztsov is an experienced technologist, visioner and business leader skilled to deliver efficient and robust proprietary solutions that rapidly facilitate the transformation from the startup phase to a fully-funded global enterprise. Over his 10-year career in the technology sphere, Ilia has quickly moved through the ranks of the IT sector growing from a backend engineer in a Russia-based machine learning company to CTO of multiple California-based fintech startups. In this role, he specialized primarily in full-cycle product development – cloud solutions, storage design, fault-tolerant and high-load systems, security, event-driven architectures, distributed and scalable apps, blockchain, smart-contract and distributed ledger technologies. He is now CEO of Smartlands, a global digital securities issuance and investment platform headquartered in London, UK.
About Smartlands Platform
Smartlands Platform Ltd operates as a blockchain-based worldwide security token issuance platform for the real economy of the 21st century. Smartlands Platform Ltd benefits global financial markets by providing a unique proprietary solution for fractional ownership in virtually any asset class with a focus on higher-yield investments. Founded in 2017, Smartlands is based in London, UK. Like any investment platform, Smartlands cannot guarantee profits or revenues, and potential investors should obtain their own professional advice. For more information, please visit https://smartlands.io.
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