When examining the unique benefits tokenization provides compared to legacy financial instruments, perhaps the most compelling benefit is the removal of the illiquidity discount.
By removing strategically unnecessary lock-up periods, utilizing technology to transact securities more efficiently, and subsequently offering the possibility of fractionalized ownership, tokenization provides a competitive advantage to issuers compared to traditional finance frameworks. These benefits enable new opportunities for both primary issuances and secondary trading.
If you have not been in theoretical ins and outs of finance, the very concept of illiquidity might seem confusing. In the rest of this post, we break down the concept of illiquidity, highlight the benefits for removing unnecessary lock up periods, and discuss how the efficiency enabled by tokenization improves outcomes for both issuers and investors.
Let's dig in.
What is the Illiquidity Discount?
The illiquidity discount is defined as the forced, unwanted reduction in an asset’s price or value due to its illiquid nature, i.e., it cannot be sold without expending considerable time, effort, and money. 1
In real estate deals, funds, and other projects, the lack of liquidity that is available to investors, whether it is for legal reasons or strategic reasons is referred to as illiquidity. For example, traditional real estate deals typically require some type of lock up period; meaning an investor cannot sell or transfer their ownership for a set period of time (the lock up period).
In most cases, at least some length of a lock up period is mandated by regulation, based on the specific type of security issuance involved. For example, in a Reg D offering, investors are legally prohibited from selling securities for up to one year.2
Other times, lock up periods are mandated to achieve an issuer's strategic goals. Frequently, these more strategic lock up periods are implemented by issuers to hedge against risk during the uncertainty of long construction processes.
Strategic lock up periods are a safeguard that is most beneficial for projects that are opaque. Opaque projects typically lack an ability to report information pertinent to the health of a deal with the frequency or regularity that allows investors to make informed decisions. Now, however, with the proliferation of more readily accessible data, this type of lock up period is not as helpful as it was in the past.
Measuring Illiquidity
There is, however, a cost required in exchange for the protection provided by lock up periods. For each year an investment is locked up, there's a discount on the valuation that is incurred — usually for between 4-7% per year locked.3 This discount to the value of the investment is due to the lack of liquidity until the holding period is completed. In other words, an investor subject to a lock up period is unable to sell their interest in the project until the lock up period has ended.
For sophisticated investors, removing lock up periods means there is more optionality available – they may exit deals more easily and they may enter deals more easily.
For large-scale deals that have lots of information, proven track records, and otherwise reduced operational risk, the removal of a lock up period and the shift toward tokenization can increase the valuation of a project in a meaningful way.
Benefits from Improved Liquidity
The most direct benefit tokenization enables is liquidity.
Liquidity is derived from better deal terms, but it is enabled by blockchain technology. Representing investment securities on a decentralized ledger removes costly intermediaries and otherwise improves the transparency and efficiency of these transactions.
The fact that these ledgers are now designed so that they integrate with the people directly involved with the trade and transfer of these securities, including but not limited to Transfer Agents and those operating secondary markets, alternative trading systems, or even OTC desks.
Additionally, because the tools used to trade interests are set up programmatically, interests are able to be bought, sold, and traded with fewer headaches.
Benefits for Primary Issuances
The benefits of liquidity are directly reaped by investors in a few ways. The increase in valuations is a direct benefit for issuers looking to package better investments. At a conceptual level, the better deal terms enable more efficient flow of supply and demand. The market is able to receive investments faster and transfer interests with less headache. This is especially important in primary issuances.
Consider the following example: two identical multifamily developments are situated next door to each other. They are managed by the same company and they have comparable projections. The only difference is that the first project has a five year lockup period and the second has a one year lockup period. The price of the first will undoubtedly be lower than the second because investors are able to buy or sell their interest. The improved liquidity means the deal will be more marketable to investors because the valuation of the property will be higher. This means issuers will earn more money on the same deal terms just by offering more favorable terms on the deal and making use of technology to more efficiently transfer security interests.
Benefits for Secondary Trading
After investors have purchased tokens during a primary issuance, there are additional benefits liquidity enables during secondary trading. First, the efficiency of blockchain technology means the costs of entering into secondary transactions are lower. This is analogous to the same benefit in the primary issuance.
Importantly, a key differentiator for tokenized securities is that tokens may be fractionalized in more creative and custom ways than people typically transfer legacy securities. This means the audience of potential investors who are purchasing a security on a secondary market can be made up of a larger group of investors who purchase fractions of an investor's tokenized holdings.
Conclusion
The shift towards tokenization in financial investments represents a significant advancement over traditional methods, primarily by reducing or eliminating the illiquidity discount. This transformation is driven by the inherent liquidity, improved efficiency, and enhanced transparency provided by blockchain technology. By enabling more flexible lock-up periods and offering the possibility of fractionalized ownership, tokenization opens up new opportunities for both primary issuances and secondary trading. It creates a more dynamic and accessible market, where investors can engage with less friction and issuers can realize higher valuations. Ultimately, tokenization not only modernizes investment practices but also democratizes access to investment opportunities, paving the way for a more inclusive and efficient financial landscape.
References
- As defined here: https://www.wallstreetmojo.com/illiquidity-discount/
- An overview of Reg D is available here: https://www.investopedia.com/terms/r/regulationd.asp
- Aaron Stumph, "Locking in Value: An Alternative Approach to Measuring Illiquidity" Stout, Sept. 1, 2013. Available at: https://www.stout.com/en/insights/article/locking-value-alternative-approach-measuring-illiquidity.
