Can Tokenization Really Make Illiquid Assets Liquid?

Tokenization is often presented as a major breakthrough for assets that are traditionally difficult to buy or sell. Real-world assets such as real estate, private equity, art, commodities, infrastructure and other real estate-based products can require a lot of capital and can be months in time for their transfer. The goal of tokenization is to make participation more inclusive and transactions more efficient, by representing the asset or an economic interest in an asset with these digital tokens.

But an important question remains: Can tokenization really make illiquid assets liquid?

This is not a solution as easy as placing an asset on a blockchain. Tokenization can enable increased accessibility, fractional ownership, transferability and transaction efficiency. But true liquidity relies on market demand, legal rights, legal regulations, trading setup, and sellers and buyers.

Why Are Some Assets Illiquid?

To realize the advantages of tokenization, it is crucial first to understand what makes some assets so impenetrable that it's impossible to trade them.

Real estate is a common example. The typical elements of selling a real estate asset include securing a decision on a price, negotiating, finishing due diligence, legal preparation and transfer of possession. This may take weeks or months.

The same problems can be applicable to shares traded by private companies. These can be transfer restrictions and a restricted number of potential buyers. Art and collectibles can also be hard to value because the value depends highly on market demand, and on individual-specific requirements.

Another major challenge is the amount of capital required to invest in certain assets. Buying an entire commercial property or infrastructure project may be beyond the budget of many investors, which can significantly limit the pool of people able to participate.

These are some of the reasons behind the lack of liquidity. It isn't just that there are paper records of property ownership instead of digital records. The problem is it is hard to find a sucker willing to pay a dollar when the price is that much.

How Tokenization Attempts to Improve Liquidity

The concept of tokenization reflects a shift in representation and management of ownership or economic interests.

The tokenization structure can facilitate the disaggregation of exposure into smaller digital parts within a large asset class than treating it as a single investment. For instance, a property might have thousands of tokens, with each token reflecting a specific economic or legal interest in the property.

This may make investing more accessible for investors and, potentially, widen the investor base.

Blockchain infrastructure can also enable programmable transactions, digital ownership data records and automated settlement procedures. These functions can lessen some of the friction when it comes to transfers of assets the traditional way.

However, there is a key difference:

Making an asset easier to transfer does not automatically make it liquid.

Fractional Ownership Is Not the Same as Liquidity

Fractionalization is one of the most popular benefits of tokenization.

For a home that is very costly, you may need a significant capital level to buy the home outright. Smaller investments may enable more investors to have been involved.

This will make things more accessible. Accessibility and liquidity have to do with different things.

Suppose you were managing a property which has 10,000 interests. Even in the event that just a handful investors wish to buy those tokens, those who hold them will not be able to sell. Technically the tokens might be capable of transfers, but the market might remain dormant.

That's why tokenization shouldn't be considered a ‘magic bullet' to solve illiquidity.

Transferability vs. Real Market Liquidity

When talking about tokenized assets, there are a number of concepts that are lumped together.

Transferability means an asset or token can be transferred from one participant to another.

Accessibility refers to investment requirements or transaction processes that have been lowered which allows more investors to potentially participate in an investment.

Liquidity is the term used for when you are able to be able to bid or sell an asset without buying it at a much lower price or, selling it at a much higher price, solely due to the absence of other buyers.

It is possible to have a tokenized asset with high transferability and low liquidity.

For instance, a token may be transferable between approved investors and only a few investors may be willing to purchase it. Then, blockchain technology has facilitated digital transfer, but not a substantial market.

What Actually Creates Liquidity?

There are a few factors that dictate whether or not a tokenized asset will acquire meaningful liquidity.

A Large Enough Market

A healthy market requires a sufficient number of buyers and sellers to support consistent trading activity. Even the most sophisticated tokenization infrastructure can't generate continuous trading if there is no one on the market to buy and sell tokens.

Secondary-Market Infrastructure

Liquidity largely is a function of whether an investor has access to a suitable trading venue for their interests.
The primary issuance of tokens is just the start. Investors must also have a way to get out of their investment.

Reliable Valuation

The buyer must be certain of the asset's value. This can be more difficult for such items as private businesses, real estate and collectibles where public markets do not always determine prices.

Legal Rights

A digital token needs to be linked to valid legal rights. Just setting up a token doesn't always mean that the owner owns the physical asset.

Therefore, the legal framework behind the token is as important as the blockchain infrastructure for it.

Regulatory Compliance

The rules governing tokenized assets can vary depending on the asset type and the jurisdiction. Requirements related to securities laws, investor eligibility, KYC, and AML compliance may all apply.

The requirements may impact the individuals who can obtain or transfer a token and therefore have a possible effect on its liquidity.

The Secondary-Market Challenge

The secondary market is one of the major issues with RWAs.

The primary mechanism of the market is to create and sell the tokens to investors. However, when an investor wants to exit, what happens then?

If the intention is to at least get a reasonable amount of liquidity, someone else must be willing and legally able to acquire the position as well.

This creates a simple but important relationship:

Tokenization creates digital representations. Markets create liquidity.

If there is no trading volume; tokenized assets can still be hard to sell even though transactions take place fast with underlying blockchain technology.

The quality of the secondary market is affected by market depth, investors' demand, pricing mechanisms, settlement infrastructure, and transfer rules.

Can Tokenization Reduce the Liquidity Discount?

Sometimes illiquid assets can be available with trading discounts, as the investor appreciates that he may not be able to pull out his investment easily.

Tokenization platform development may help to limit some of these restrictions by creating smaller tokens, tokens that are more easily transferable, and enable more stakeholders to invest.

Additionally, quicker settlement processes and digital transaction records can help reduce administrative work and make asset transfers more efficient.

Just because a transaction was tokenized, however, does not mean that all assets will be valued and be as easy to trade as heck. The underlying asset must have a bad demand, and tokenisation can't fix that.

Real Estate Shows Both the Potential and the Limitations

Let's take an example of real estate.

Generally, the buyer of real estate is required to invest a lot of money and wait for a long time to enter into a transaction with a buyer.

A tokenized structure would break up the economic interest in smaller chunks so lots of investors can access it.

Theoretically this can lead to a wider range of investors and greater opportunities for transfers.

However, there are some obstacles to overcome. Property valuation can be very complex. Properly established rights of ownership are necessary. Investment restrictions for the investors might be in place. Rules and requirements may restrict participation. Most of all, there still needs to be demand for the interest tokenized.

That means, tokenization can fundamentally alter how real estate is accessed, but can’t always assure a sustainable market for every asset.

What Tokenization Cannot Solve

Its own use is insufficient to solve all the problems.

Investor demand is not something that can be created by tokenization. It is unable to set forth a fair market value automatically. Can't remove legal constraints. It will not guarantee that the underlying asset is an attractive asset.

It cannot additionally boost an unimaginable investment into a liquid one simply because it is represented with digital tokens.

Hence, for the tokenization to be successful, smart contracts and blockchain infrastructure are not enough. Everything from the underlying asset, legal framework to compliance model, investor experience, and market infrastructure should all make sense.

So, Can Tokenization Really Make Illiquid Assets Liquid?

Potentially but not automatically.

Some assets may be more easily transferred and accessible with tokenization. Perhaps fractional ownership can make it more feasible for more people to buy a stake, and digital infrastructure can eliminate some of the transaction friction.

The real liquidity relies on what goes around the token, however.

A helpful concept to use:

Tokenization + Legal Rights + Investor Demand + Market Infrastructure + Compliance + Price Discovery = Potential Liquidity
The blockchain is only a part of the solution, not the whole one.

Getting the token right is therefore only one part of the solution: more important perhaps will be to develop viable markets for tokens of real-world assets. For investors, if the underlying asset has enough appetite for investment, possesses legal security, can play a game inside a compliant playing information, and has a realistic probability to get into and also out of a situation, then tokenization can be actually a viable liquidity enabler.

In the end, tokenization is not a source of liquidity. It fosters liquidity which may become possible through infrastructure.