What is the Role of Intermediaries in Token Markets?

Michael Ippolito & Rich Bryant | July 13, 2018

The market for crypto assets is one of the fastest growing and most exciting frontiers in today’s business landscape. What began as a small group of developers and early adopters has morphed into a melting pot that is already attracting top talent from adjacent industries.

As leaders from a diverse set of backgrounds ranging from financial services to internet giants to software pour into the burgeoning field of blockchain, it’s become clear that not everyone has the same shared vision for the future. Although this is a bit of an oversimplification, there are two ‘camps’ that are beginning to form. For the purposes of this article, let’s refer to the two groups as Wall Street and Silicon Valley.

The Crypto Evolved Conference hosted by ViableMkts in NYC in June discussed the complementary but divergent visions these two groups have for blockchain. The conference’s tagline was, “As Wall Street meets Silicon Valley, who will dominate the new cryptocurrency frontier?” No doubt this title was intended to add a bit of sex appeal to the summit, but it did drive some interesting discussion.

The traditional “grow users” vs “grow revenue” debate reared its head, as did the role of financial intermediaries in token markets. The bulk of the discussion was centered on finding a balance between the disruptive innovation native to Silicon Valley and the more methodical, cautious approach of Wall Street.

Interestingly, people in the crypto space were finally beginning to ask the question, “Is it really necessary to uproot all of the status quo? Or is it possible that there’s a good reason for institutions like financial intermediaries to exist?”

 

The Future of Token Markets

Let’s put one of the hot topics in the crypto space under the microscope for a minute. Many of you may have heard the ambitious phrase “tokenize everything,” which refers to the migration of real world assets onto blockchain environments. These assets could include everything from debt and equity securities, to less liquid investments like VC, real estate, stakes in private businesses and collectibles.

To borrow a metaphor from Anthony Pompliano, tokens are a form of programmable ownership. Their status as digital blockchain natives present a couple of serious advantages over other forms of ownership, including:

Lower Fees – Tokens are programmable, and thus do not rely on middlemen like brokers to change hands. This will eliminate or reduce many fees typically associated with financial transactions and increase liquidity.

Access to a Larger Investor Base – Many investment opportunities are limited by geography. When investment opportunities become open to anyone with an internet connection, there will be increase in capital inflows.

Automated Service Functions – Smart contracts will change the way transactions are mediated. Yes, we will still need lawyers, but their role will fundamentally change. ASF’s will result in faster, more efficient transactions.

Token markets are particularly exciting because they offer the potential to create liquidity in traditionally illiquid asset classes. Theoretically, friction and cost of token transactions could be reduced to such a degree that secondary markets for alternative assets would mimic the ease of trading on the NYSE today. Additionally, the programmability of tokens would allow for necessary provisions (like a lock-up period in the case of VC) to be included at minimal cost.

However, even the considerable advantages of tokens won’t be enough to create liquidity out of thin air. Tokenization won’t mean that the fundamental dynamics of supply and demand driven markets no longer apply. Just because the exchange of an asset has been simplified through tokenization, it does not mean there will always be a counterparty standing ready to effect a transfer of risk.

This is the reason we have underwriters like investment banks who underwrite securities issuance. This is also the reason we have market makers, who agree to assume risk in holding an asset until an end-user can be found.

The relationship between blockchain innovation and the existing financial services space doesn’t have to be binary. There is room for both to coexist peacefully. In fact, the best hope for “next-generation finance” probably relies on borrowing the best aspects of both industries. So let’s take a closer look at how this bright future could look in token markets.

 

Issuance and Primary Market Considerations

Disintermediated underwriting, or direct issuance of securities via blockchain, is a promising area of tokenized finance. However, in addition to matters of compliance, settlement and administration, traditional underwriters play important roles in the process of issuing new debt and equity securities. This role includes helping issuers navigate credit market conditions, preparing and executing a marketing plan and roadshow, gauging investor demand in terms of size and pricing and supporting smooth initial trading activity in the secondary market.

This function is all built on top of deep and mature relationships with sources of institutional capital. Corporate Treasurers and CFOs appreciate this type of professional advisory service – of course that advice can be a significant expense. Disintermediated underwriting has the potential to improve economics for both issuers and investors but it will be important for both parties to continue to receive the level of service and guidance that’s familiar to them and central to the capital markets function.

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Secondary Market Trading Considerations

Some of the challenges institutional participants face in trading and market-making in traditional financial instruments will also be considerations in the secondary trading of token-based securities.

This starts with the ability to transact in deep and transparent order books with two-sided interest and aggregated continuous pricing. Liquidity tends to migrate to assets that are also tradable in derivative form – that interplay between cash, futures and options is very powerful and can balance one-sided order flow and unlock liquidity.

Another critical area of risk management is how markets perform in times of stress – will market participants still show up to trade with their balance sheet when credit becomes scarce and cash becomes king? The further out the credit spectrum we go, the more liquidity matters and the harder it becomes to find.

Efficient, transparent markets facilitate the flow of capital and risk from one party to another – intermediaries have generally played an important role in the day-to-day functioning and operation of various markets across equities, fixed-income, commodities and currencies.

These days, institutional investors like to trade in the security or cusip of their choice, at the time of day they want, in the size they want, at or near the price they want. This is not always easy in commoditized high-grade markets like US Treasury bonds, let alone fractional ownership markets of alternative assets.

This dynamic is playing out right now on traditional exchanges, in central limit order books and on new session-based trading platforms like OpenDoor Trading that are experimenting with liquidity aggregation in interest rate products.

There is a strong argument that tokenization will increase the number of market participants by lowering capital requirements and barriers to entry, but this alone will not ensure liquidity, particularly the type of liquidity today’s institutional investor has come to require and expect.

 

What is the Role of Traditional Financial Institutions in a Blockchain World?

The blockchain movement has brought a tremendous amount of enthusiasm and disruptive innovation to global finance. This is exciting because if you look back in history, some of the greatest leaps in human history were accomplished by financial revolutions.

Rome’s creation of a national standard mint allowed it to fund the wars that would lead to an empire lasting almost a millennium. Look also at the Medici family, whose many innovations in banking played an integral role in the Italian Renaissance.

Blockchain will improve many aspects of our financial system, but it’s important we don’t get too far out over our skis. Blockchain has solved the problem of trust, but it has not presented a viable solution for risk. Until that time, we’ll still need intermediaries with large balance sheets to underpin market liquidity. Plain and simple.

But that doesn’t have to be a bad thing. If we can find a way to meld the current disruptive energy with an implementation that will be palatable to current market participants, it will result in an improved financial future for all of us. Or, at the very least, a realistic one.

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Michael Ippolito & Rich Bryant

Michael Ippolito is a Co-Founder of Blockworks Group Rich Bryant is an institutional trader & advisor to the NYU Stern Blockchain Digital Asset Forum