Secondary market liquidity for a restricted token

Graduate · enrolled learners

This lesson opens with The auction-rate securities freeze, February 2008.

What happened

Auction-rate securities were long-term bonds and preferred shares whose interest rate was reset every week or few weeks through small auctions run by a handful of broker-dealers, and because a holder could sell at each auction, the instruments were marketed to companies and individuals as safe, cash-like and liquid, as good as money in the bank. That liquidity, though, rested entirely on the dealers choosing to run and support the auctions. In February 2008, amid the credit crisis, the dealers stopped stepping in, and the auctions began to fail across the market, so around 330 billion dollars of these securities became frozen overnight: holders who believed they held cash-equivalents suddenly could not sell at all. The instruments had not defaulted; the mechanism that gave them liquidity had simply been withdrawn, and regulators later forced the dealers to buy back tens of billions from investors for having sold them as liquid. The liquidity was never a property of the securities; it was a service a few dealers provided, and it vanished the moment they declined to provide it.

The decision point

Secondary liquidity is the ability to sell an instrument to someone else rather than redeem it from the issuer, and whether it is real depends entirely on what supports it, because liquidity that rests on a single fragile mechanism, a few dealers, one market-maker, one venue, can vanish under stress exactly when holders need it. Auction-rate securities are the case: instruments marketed as cash-like and liquid because a few dealers ran the auctions, and when the dealers stepped away in 2008 around 330 billion dollars froze overnight, the securities themselves never having defaulted. For a restricted or tokenized security this is the central question about the promised secondary market, because a restricted token cannot be freely sold to anyone, only to eligible, whitelisted buyers, which already narrows its market, and any secondary liquidity it does have often rests on thin support, one exchange listing it, one market-maker quoting it, a small pool of eligible buyers. If that support is fragile, the token's liquidity is the auction-rate promise on-chain: real in calm markets and gone in a stressed one. So the decision when assessing or structuring a tokenized asset's secondary market is to look through the promise to the mechanism, asking whether the liquidity rests on robust, diversified infrastructure, several venues, several market-makers, a genuine population of eligible buyers, or on a single support that can withdraw, and to disclose the difference honestly, because selling a restricted token as liquid on the strength of a fragile secondary market is exactly what the auction-rate dealers did, and the liquidity that depends on one party's continued willingness is not liquidity a holder can count on when the stress that makes them want to sell is the same stress that makes that party step away.

Recorded loss

$330,000,000,000

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