Over-the-counter (OTC) trading involves securities that are not listed in the centralized exchanges, such as NYSE, Nasdaq, or other exchanges. These can include the trade of equities, bonds, commodities, or other instruments and derivatives. Investors, traders, and companies utilize these markets to gain liquidity, profit from trades, and promote equities that are otherwise unavailable to trade in centralized exchanges or other markets.
The OTC marketplace can be ideal for equities or instruments that do not meet the stringent requirements of formal exchanges. However, the main challenge in these markets is the lack of volume and liquidity compared to exchanges. OTC trades are also susceptible to speculative movements and volatility as an effect of current events. And because these securities are not subject to stringent regulatory requirements, there is less transparency, which can be a concern for institutional investors, thus limiting their involvement in such transactions.
One potential alternative that has emerged in this space is the tokenization of securities, which involves digitizing existing securities and assets and trading these on decentralized exchanges. This can include equities, although tokenized securities can also involve other asset classes such as real estate, commodities, and virtually any asset that can be digitized into token form.
As a means of trading and finance, this offers better flexibility and ease of access. Security tokens also work within the frameworks of regulatory compliance, and various jurisdictions around the world are working toward improving their regulatory environments to better support decentralized exchanges.
“Tokenizing has simplified the capital market funding process,” says Stephen Inglis, Chief Executive Officer of InPortal, a Puerto Rico-based merchant bank. “Blockchain ledger technology is more efficient for recording transactions and keeping a company’s capitalization table up to date.”
He adds that tokenization also shifted the paradigm of fundraising and dealing with investors. “We have been able to attract a broader base of investors. Tokenization has significantly reduced legal costs and allowed us to communicate with our investors.”
Tokenization of securities provides flexibility in investing in various asset types, thus opening opportunities otherwise not available through traditional equities and financial instruments.
“Tokenizing shares in our real estate fund allows investors to invest smaller amounts of capital, therefore giving a wider number of investors the opportunity to participate in an asset class that generally is limited to professionals,” says Andy Strott, Founder and Chief Executive Officer at Resolute.Fund Inc., a real estate investment management firm that launched a tokenized real estate fund on the blockchain.
“Allowing investment via fiat and cryptocurrencies opens this opportunity to all. Combined with the efficiency, transparency, and security of the blockchain, our processes are reduced significantly,” he adds.
Transparency, liquidity, and accessibility are the key highlights of tokenized securities. “We foresee that tokenization could make the financial industry more accessible, cheaper, faster and easier, thereby possibly unlocking trillions of euros in currently illiquid assets, and vastly increasing the volumes of trades,” states a research paper published by Deloitte.
The establishment of a new token economy offers the potential for a more efficient and fair financial world by greatly reducing the friction involved in the creation, buying, and selling of securities.
“In the future, the majority of securities and illiquid assets will be tokenized. It's more simple to track info and data. It's more secure. It opens different ways to deal, monetize and trade. And even more important, it will help to automatize the solution of legal disputes,” says Niccolo Filippo Veneri Savoia, Founder and CEO of Look Lateral Inc., a global art ecosystem running on blockchain technology.
By establishing transaction records, capitalization tables, and smart contracts on blockchain technology, trading in securities can be executed and recorded without complicated processes and requirements. However, some obstacles need to be overcome if tokenization and the token economy will take off. There needs to be more established and comprehensive regulatory frameworks to fully realize the potential of tokenized securities.
Although tokenized securities can potentially solve the challenges of capital fundraising and investment, it will require regulation to unlock institutional money. “We cannot attract institutional investors without clear regulations and important partnerships,” Savoia says. This is because investor trust hinges on compliance with regulatory frameworks that protect the interest of the investment community.
One particular challenge here is regulatory fragmentation across different jurisdictions. This has prompted many issuers of digitized assets into compliance with frameworks that are more attuned to traditional securities markets.
“Regulations or lack of tokenization regulations in many jurisdictions is the challenge,” says Aaron Tsai, Founder and Chief Capitalist at MAS Capital Inc. and MAS Capital Exchange (MASEx), a global exchange for digitized securities. “Cross jurisdiction token transfers and secondary exchange trading of tokens create regulatory uncertainty and risks for exchanges that operate in multiple jurisdictions.”
He adds that regulators, exchanges, and issuers will need to collaborate to ensure the secure and safe utilization of new technologies and trading mechanisms. “Regulators and governments should allow issuers and industry participants to experiment with the STOs and focus on fraud prevention, and not to limit the use of the new technologies.”
Although it may seem counterintuitive to encourage regulations on a technology that is decentralized and independent, it is important to consider that there are risks involved if safety frameworks are not provided to ensure the integrity of transactions in such technology.
Over-the-counter markets may be a classic approach in trading equities and other instruments, but tokenization of securities has been deemed as a viable innovation that enables better efficiency and access to capital. It simplifies the capital market funding process, opens access to institutional capital, and also attracts a broader base of investors on a global scale.
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