“Liquidity is a coward, it only exists when you don’t need it.” — Keynes
We shouldn’t tokenize the world. Not now. And not for the foreseeable future. Over the past six months, however, the concept of traditional asset tokenization has become incredibly popular. The concept is simple: representing ownership stakes in an asset through a tokenized mechanism that is digital in nature and easily tradeable. It’s effectively another form of securitization geared towards democratizing investments and enhancing operational efficiencies across the life cycle of those investments.
Stephen McKeon described asset tokenization like this: “The idea is that you have an online and on-chain ownership claim that’s representing a fractional ownership in a building, a private equity fund, basically any sort of real world asset. And because it’s on-chain, that changes the way they’re traded or settled.”
Security token offerings are sales of tokenized assets that ensure compliance with traditional securities laws. In this case, there is no confusion based on what the SEC and CFTC decide is a “security” or a “commodity” or something else entirely. Tokenized securities are registered as securities and are subject to the U.S. securities regulation that governs most assets.
The work done by Stephen McKeon, Joshua Stein, and others on traditional asset tokenization is pioneering and thoughtful, but the purpose of this post is to look at the other side of the “tokenize everything” axiom, which to date has received far too little attention.
What Problems Does Traditional Asset Tokenization Solve?
The hype around traditional asset tokenization is based on (1) the fractional ownership and (2) altered liquidity profiles of historically less liquid, alternative assets. For all intents and purposes, the asset class does not change. A direct investment in real estate remains just that. The wrapper that encompasses the investment is just different. The alleged value proposition focuses on unlocking the 20–30% illiquidity discount in less liquid, alternative investments.
The complexity of the public issuance process, the role of middlemen, and the manual process of trading illiquid assets adds costs to the equation. Furthermore, the inability to trade an illiquid asset freely in the public markets minimizes the ability of markets to provide an important function: price discovery. Tokenizing private securities can reduce transaction costs, increase settlement time, and improve security while avoiding the need for a middleman. Removing the reliance on banks and intermediaries also eradicates a single point of failure. Lastly, there’s a version of the future that enables interoperability across all assets, allowing someone to transfer value from PayPal to Venmo to a Schwab account seamlessly.
From an operational perspective, the benefits of tokenized securities are clear. Tokenizing ownership of alternative assets simplifies the exchange, transfer, reconciliation, custody (eventually), and management of those assets. Ensuring regulatory compliance of those assets through emerging platforms like Templum, Harbor, and CoinList may provide an interesting service for asset owners. Avoiding the expensive and costly public offering process dramatically simplifies the life cycle management of an asset.
What Does Illiquidity Give You?
“After working with private investments — which are mostly illiquid, and backed by investors in funds with 10-year lockups — I’m amazed at the benefits that come from parting with liquidity, and how little attention public market investors pay to the topic.” — Morgan Housel
For all of the alleged perks introduced more liquidity, illiquidity is not all bad. Contrary to popular belief, many investors would benefit from liquidity. Long before there were “hodlers,” there were staunch advocates of long-term, buy and hold investment approaches because they worked. And that idea didn’t originate with an over-served Reddit user. Buy and hold was borne from the understanding that markets are a voting machine in the short run and a weighing machine in the long run.
UBS, The Value of Illiquidity
There are several benefits of illiquidity that are being overlooked in discussions about tokenizing the world:
- People are bad investors. The impulse of the investor, whether they’re retail or institutional, is often wrong. Behavioral economics explores the shortcomings of the human intuition. Numerous academic studies have found that individual investors (1) underperform standard benchmarks, (2) sell winners and hold losers, (3) are impacted by short attention spans and past performance, (4) avoid past behaviors that generated pain, and (5) tend to be highly under-diversified. DALBAR studies suggest the same thing: “investment results are more dependent on investor behavior than on fund performance.” And investors often misbehave by trying to time the market and over trade. As a result, holding illiquid investments for the long-term is a behavioral hedge against bad decisions, because you’re inherently prevented from making them on a whim.
- Illiquidity implies a long-term investment horizon. In a world where skill has never been higher but the standard deviation of that skill across market participants has never been lower, finding an edge is harder than ever. Time horizon is one of the few arbitrage opportunities left, and illiquidity provides that long-term perspective. A study of over 230 hedge funds concluded that each month of illiquidity on average translates to approximately 20 bps of additional return. A similar study assessed 1,400 private equity funds over a 24 year period found that PE funds’ median return net of fees outperformed the S&P 500 by over 3% per year.
Mark Yusko*, Founder and CEO of Morgan Creek Capital, is a strong advocate of the endowment model of investing, which emphasizes the importance of avoiding asset classes with a low expected return. Instead, the focus is on a heavy exposure to alternative asset classes like private equity, direct lending, and infrastructure. Yusko explained the benefit of illiquidity in a diverse allocation across alternative asset classes:
“Of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment institutions to concentrate their resources upon the holding of ‘liquid’ securities. It forgets that there is no such thing as liquidity of investment for the community as a whole.” — Keynes (via Mark Yusko)“ This is one of the primary reasons for diversification and also one of the reasons that we favor having such a meaningful component of investor portfolio in truly illiquid (private) investments where you are compensated properly for that lack of liquidity.”
- There have been a myriad of efforts to “democratize private markets” to retail investors over the past few decades. The vast majority have failed. ETF wrappers and REITs have been successes. “Fractional shares” sound like a good idea, but they’re not practical for capacity constrained investment strategies. Andy Rachleff was asked if he’ll introduce access to private markets investments through Wealthfront. He referenced his time at Benchmark and Groucho Marx’s rule about clubs (if they’ll have you, don’t join). Same thing applies to private markets investments — if they’ll have you, you likely want to run the other way.
- We risk altering the risk/return profiles and correlations of different asset classes. One of the benefits of alternative asset classes is their value in as a source of diversification in a broader portfolio. A real estate asset has a different risk/return profile than a share of $AAPL. By allowing everything to be tokenized and thus trade in the secondary markets, how do those return profiles change? By increasing demand to an asset class that can’t support the trading volume, you inherently change the risk/return profile of individual assets and correlations to other assets, and thus the composition of a broader portfolio.
- If a token is thinly traded, does that mean it’s liquid? Tokenization introduces supply in an environment where demand is highly uncertain. Taking it one step further, there’s a difference between true demand and speculative demand. Problems emerge when people make long-term capital allocation decisions based on short-term market anomalies. If speculative demand for tokenized assets subsides (inevitably, it will), the “value” of such tokens is at risk regardless of the underlying assets are worth.
Liquidity invites speculation, and speculation often leads to ruin. Removing liquidity helps retail investors play a different game than a Citadel or RenTech. Market makers and high frequency traders may need more liquidity. The majority of retail market participants don’t.
For all of the fawning over the power and potential of blockchains and cryptoassets, there are many people who have moved down the spectrum of significance, away from the potentially groundbreaking promises of these innovations towards something much less interesting and exciting: the repackaging of existing assets under the guise of a new wrapper.
While there are certainly instances where traditional asset tokenization might make sense (i.e. real estate, businesses with irregular cash flow schedules), in its current state, tokenization is a distraction. It’s just a hammer looking for a nail.
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