According to the prediction of the World Economic Forum, 10% of the world GDP will be stored on the blockchain by 2027. Today, it's pretty evident that the global community is redirecting to the side of capital markets tokenization, which has numerous benefits compared to the traditional financial system.
Financial markets before tokenization
By default, the traditional financial system suggests that private companies, i.e., those that are not traded on stock exchanges, account for over 99,9% of all the companies worldwide. Traditional private markets are closed for regular investors, even those possessing significant capital. Investments are mainly made by financial institutions, such as private equity- or venture funds.
Except for seriously restricted access, the market also has minimal liquidity, which means that selling shares of such a company takes a long time, involves a lot of intermediaries, and is a complicated process in general.
Such circumstances incentivize investors to invest long-term and, in most cases, significantly interfere with the companies' management, as they can't simply make an exit if they disagree with the direction in which the company is heading. Representatives of investment institutions often become members of the board of directors; some funds specialize in buying out the entire company, drastically changing its direction (which is called "strategic turnaround"), and then selling it again to the other investors.
The other incentive derived from the system is to invest predominantly in companies with enormous growth potential and correspondingly high risk. It doesn’t leave room for investing in relatively decent companies, as they would take too long to deliver returns through dividends while selling them is problematic due to low liquidity.
Even if the company conducts an IPO, the issued shares are first distributed among institutional investors who would trade between themselves and only let investors from the general market access those shares afterward.
The last issue of the traditional financial market is that all the significant operations have to be facilitated by a universe of intermediaries like brokers, investment banks, asset managers, custodians, and others. Of course, apart from further complicating a transactional process, all parties charge their commission.
Given these complexities, you may wonder why most companies remain privately held. The surface-level reason for that is the extremely high cost of going public, but there are other non-obvious pros and cons of going public, which we examined in one of our videos.
What is tokenization, and what is distinct about it?
Tokenization is a scope of technical and legal processes that transfer securities, such as stocks, bonds, etc., into the form of tokens on the blockchain. All transactions with them are processed similarly to how they are with cryptocurrency.
The key difference between financial market tokenization and centralized finance is that the latter suggests that information about the asset's ownership and transactions is stored on the servers of either the issuer or the custodian. To ensure the security and integrity of this information, the access to updating information in this server has to be restricted ― otherwise, it will be possible to write wrong ownership information in the ledger. This requires creating gatekeepers that process transaction requests, which makes transactions more complex and includes more manual labor into the transaction processing.
On the contrary, in the blockchain, information is processed on multiple connected servers. The safety and integrity of the securities register are enabled by decentralized blockchain cryptography, whereby servers collectively agree on what constitutes the "true" state of the transaction register. The incentive is not to limit the access but rather to broaden it to increase the network's resilience.
Because of this different model, conducting tokenization and holding operations with tokens would be a much more efficient strategy. There are three main benefits to it.
1. Better investor access to the private markets. As transaction fees are reduced and the process becomes simpler, it becomes practically feasible to allow access for hundreds or thousands of investors who can invest from any corner of the globe.
2. Increased liquidity of private markets. Firstly, as the transaction process becomes faster and fees are reduced, smaller transactions become feasible, making trades possible in more cases. Secondly, as the number of potential investors increases, finding a counterparty for a transaction becomes easier.
3. Automation of processes traditionally performed by intermediaries. For example, market making, traditionally performed by brokers-dealers, can now be conducted within the automated market-making protocols. The securities storage used to be the responsibility of custodians and depositories, while today, they can be stored directly in the blockchain. Another example is executing a securities lending and borrowing transaction: traditionally, it would require complex interaction between brokers, custodians, and other parties. Tokenization reduces the hustle to a minimum by using the so-called lending protocols.
What does tokenization actually change?
Tokenization impacts three groups of actors in finance ― businesses raising capital, investors, and financial intermediaries. Let's take a closer look at them.
Impact on issuers
First of all, businesses get access to more investors. Even while staying private, they can now raise money from a significantly broader circle of investors. Of course, you can also expect to get financing on better terms, as you as an issuer get an increased bargaining power because you have more investors to choose from. Furthermore, your tokenized securities are more attractive for investors themselves thanks to better liquidity ― the risk for investors is also reduced.
Secondly, it's the lower cost of capital. Access to more investors and automation of technical processes allow the involvement of fewer intermediaries into the STO issuance process compared to the traditional fundraising via IPO or equity crowdfunding.
Impact on investors
Firstly, they get better investment opportunities. Primarily, this is the benefit for unaccredited investors: now, there are significantly more companies and assets they have access to. According to the McKinsey report, private markets grow at least 50% faster than public markets, which means that these new investment opportunities are more attractive than public markets.
Secondly, it's easier to make an exit thanks to ample liquidity. Such an advantage reduces the risks of investing in private companies because you can exit whenever you need money. It also enables an investment strategy of putting money without explosive growth potential as you will be able to exit even if the company doesn't make it to IPO.
Thirdly, investors enjoy lower transaction costs, which is especially important for small investors.
Impact on the roles of financial intermediaries
Technical progress constantly shifts what companies offer and which markets they operate. Let's see how it will impact financial service providers such as brokers, investment banks, and asset managers.
First of all, financial intermediaries will benefit from the automation of internal operations. As the financial markets are strictly regulated, we shouldn't expect the total elimination of regulated institutions. For instance, a regulatory authority may demand decentralized liquidity pools to be operated and supervised by licensed actors. Therefore, brokers can still provide market-making services using decentralized finance technologies, which will increase their margins.
The second change is the possibility of acquiring new markets and audiences.
For example, automation will allow broker-dealers to shift downmarket. It means that now the service of market-making becomes profitable not only when provided to large enterprises with a $100 million market cap but can be offered even to companies with a market cap of $100 000.
Investment bankers who conduct underwriting and promote securities prior to IPO can now expand their investor networks, targeting not only institutional investors but individual ones as well. One day, Goldman Sachs will be promoting new IPOs on Twitter and having a queue of investors, similar to how Coinlist and Binance do.
Investment funds can now invest in crypto assets or create tokenized funds targeted at individual or retail investors.
Obviously, there are victims of the progress as well, so some functions of intermediaries will be eliminated. For instance, buying a private company's stock will be easier and will not require an intermediary broker charging a commission. Custodians are likely to become much less prominent as well. This creates additional competitive pressure for the financial service providers to divest from business units whose days are coming to an end and instead focus on those new opportunities.
The shift tokenization creates is significant and dramatic. If you would like to take advantage of this fast-growing industry regardless of the field your business is in, request a complimentary 30-minute consultation with our specialists.