The Evolution of Secondary Trading for Securities
A critical benefit that tokenization provides over traditional security issuances is improved optionality around secondary trading.
Liquidity for traditional securities is hamstrung by two key factors. First, traditional securities are difficult to transfer. Second, traditional security issuances typically operate in an outdated paradigm that fails to take advantage of the benefits on offer from new technologies.
Speaking to the first point, transferring securities is often complex and involves multiple steps. This results in longer settlement times and contributes to reduced liquidity. Speaking to the second point, the means by which securities are traded is outdated. Many aspects of the securities trading infrastructure are built on legacy technology systems that have not kept pace with digital innovation. While there have been advancements like electronic trading platforms, the underlying settlement and clearing processes often still rely on dated technologies, leading to inefficiencies and delays and creating unnecessary friction for retail, accredited, institutional, and international investors.
Tokenization solves for these limitations by enhancing trading flexibility and enabling fractional ownership of assets through digital tokens, broadening market access. By leveraging blockchain technology during the security issuance process, it is easier than ever to simplify transactions and streamline processes with a disparate group of key stakeholders. The result of this integration of technology is the automation of compliance and settlements, which leads to more efficient investments with less margin spent on operational expenses.
Background of Secondary Trading for Securities
Traditionally, securities were physical, paper-based documents, necessitating tangible certificates to affirm ownership. The validation of these certificates relied on human intermediaries such as lawyers and transfer agents. This means that any time that a holder of a security wants to trade it, a chain reaction involving all of these processes begins and the transfer is not cleared until the chain reaction is complete.
However, the value and desirability of a security are intrinsically affected by the extent to which the asset can be bought or sold on secondary markets (along with other factors such as market sentiment, economic indicators, company fundamentals, regulatory changes, technological advancements, and geopolitical events, each influencing its perceived risk and potential return).
The liquidity of investments, particularly in sectors like real estate, has often been a pain point due to the cumbersome nature of traditional trading mechanisms. The market for private real estate deals is traditionally exclusive. Markets that are only semi-liquid can misprice assets. Semi-liquid markets can cause unexpected tax events due to valuation changes and trigger loan to value issues.
Similarly, trading securities on Over-the-Counter (OTC) desks, while offering a degree of flexibility, comes with its own set of challenges including significant fees, complex settlement processes, and the intricacies involved in settling trades.
Liquidity and Tokenization
A basic premise of blockchain technology is that all participants in a financial network are able to trust that transactions are happening in accordance with the metadata recorded on a given decentralized ledger. This only happens through standardization. Standardized security token standards directly elevate the level of liquidity available to those investments and therefore enables securities to be liquid and accessible.
This is achieved through the adoption of token standards, such as the ERC 1404, which facilitate the type of programmatic implementation of transfer rules and transfer restrictions, enabling compliance and a more controlled and streamlined trading environment. Moreover, the standardization fosters interoperability, simplifying the way systems for trading securities are able to be extended by other ecosystem participants.
The use of blockchain for the issuance and management of securities is important as it diversifies the trading venues available to security issuers and managers. So, not only does OTC trading persist for security tokens, but there are also seamless integrations with Alternative Trading Systems (ATS) and specialized exchanges, such as INX, which are dedicated to security tokens. This means tokenization of securities provides pathways to exchanges that simply are not available for legacy securities.
Security tokens evolve the processes demanded by traditional securities through advanced on-chain AML/KYC processes and API-driven interfaces. The integration of on-chain AML/KYC ensures an automated standard of compliance and security, streamlining the validation process for investors and regulators and reducing operational costs for issuers.
In addition, the process for checking and verifying the accreditation status of an investor can be handled automatically through the same interface. And lastly, the adoption of API-driven interfaces simplifies the interaction with transfer agents and other traditional entities, ensuring seamless and efficient transactions while maintaining the robustness of legacy systems.
Emerging Frontiers of Secondary Trading
Evaluating the tokenization of securities at an ecosystem level unveils further exciting prospects. Security tokens offer immediate benefits over their incumbent equivalents by reducing the gap between legal rules and technical rules through the implementation of token standards, simplifying the legal procedures involved in issuing securities, and providing more intuitive interfaces for managing these assets.
Reimagining the Future of Secondary Trading
Looking ahead, the future of securities trading seems poised for a transformative leap, driven by the advancements in tokenization and blockchain technology. Examples of these burgeoning developments include instant clearing, compliant trade automation for private markets, and the adaptation of powerful automated market maker design patterns from DeFi to security tokens.
Evaluating the tokenization of securities at an ecosystem level unveils additional exciting prospects. Security tokens offer immediate benefits over their incumbent equivalents by reducing the gap between legal rules and technical rules through the implementation of token standards, simplifying the legal procedures involved in issuing securities, and providing more intuitive interfaces for managing these assets.
Envision a scenario where the trading of securities is not only instantaneous and global but also fully transparent and accessible. In this scenario the swift growth of global trade, the fractionalization of assets and lower minimum purchase prices create access to better returns for retail investors, as well as access to investments that had only previously been available to institutional investors.
The integration of AI and machine learning could further refine investment strategies, offering predictive analytics and personalized investment solutions. This would improve real-time analysis and predictive insights, allowing traders to make more informed decisions swiftly. AI's capability to perform sentiment analysis by processing vast amounts of textual data from news and social media offers a nuanced understanding of market dynamics. Additionally, AI-driven platforms reduce operational costs by automating tasks traditionally performed by humans and can offer 24/7 market monitoring.
In this future, trading of securities would enable the growth of a fluid, dynamic, and interconnected global market where securities are traded 24/7. The use of transfer groups, transfer rules, and transfer restrictions ensures that anyone who is legally eligible to buy or sell a token would be eligible to do so. The culmination of these technologies will not only democratize investment opportunities but also enhance market efficiency, liquidity, and accessibility.
As securities and the means by which they are traded continue to develop, the advent of security tokens and the subsequent refinement of secondary trading mechanisms mark a significant evolution in the investment landscape for security tokens. By addressing the inherent limitations of traditional securities trading through enhanced liquidity, streamlined processes, and innovative incentive structures, tokenization is poised to redefine the paradigms of investment, opening new horizons for investors and issuers alike.