Building Liquidity: A Security Token Exchange Operator’s Guide to Success

Welcome to A Security Token Exchange Operator’s Guide to Success, your blueprint for building a market leading security token exchange. We created this series to provide new exchange operators with a game plan for their launch, leveraging our team’s experience in operating, advising, and investing in a range of exchanges ourselves.

Liquidity is the heart of an exchange. As security tokens and the promise of liquid private securities become more prominent, we want to discuss how a security token exchange can build order book liquidity. Tokenized or not, liquidity will never just magically appear. This article discusses strategies to build liquidity through market makers – companies that consistently maintain buy and sell quotes on an exchange’s order book.

Finding Market Makers (or Getting Them to Find You)

Market makers tend to hide behind the scenes and are not usually the easiest companies to find through a Google search. Exchange operators will consequently need to connect with them through other means. The best way to find market makers for your security token exchange is to get an introduction from someone who already knows them, such as the Influential Capital team. Ask a friend who works in trading for an introduction or send us a message asking for introductions on social media. Once you find a partner who is connected to at least one market maker, you’ll find they are likely connected to many.

Another way to find market makers is to attract them through superb marketing and PR efforts. There are numerous PR firms that can help you place your exchange in front of market makers’ eyeballs. While there are various marketing and PR strategies, knowing your target audience is imperative to any successful plan. Communicate a message that will interest market makers, such as the incentives described in the next section. While running Coinsetter, I personally had several multi-billion dollar market makers reach out to us after publicly announcing an equity incentive program in a press release.

Incentivizing Market Makers

Market makers will analyze the profitability of quoting on your exchange before they agree to participate. Since security token exchanges inevitably lack trading volume at launch, you may need to incentivize market makers through other means. Incentives can take different forms, including monthly retainers, profit share arrangements, equity in the exchange, and maker-taker pricing.

In a retainer arrangement, the exchange will pay a fee to the market maker typically ranging anywhere from $5k to $20k per month. If you pursue this route, be aware that the market maker will become profitable as trading volume increases, so discuss an “exit” point in advance to determine when you will stop paying a monthly fee. You will also want to stipulate contractual guarantees, such as the bid/ask spread, how much liquidity they’ll provide at the top of the order book, and uptime.

Given startups’ need to conserve cash, it may be worth looking at alternative arrangements too. A profit share agreement requires less capital up front and later compensates the market maker with larger payouts. Profit shares can be structured around the exchange’s fees, the market maker’s profits, or both. Your exchange will gain more leverage in these conversations if you are able to contribute trading capital to a JV or margin to their trading account.

Equity is also great incentive. Incentivizing market makers with equity is a viable strategy that could likely result in a long-term partnership. Aligning the interests of both parties can give your exchange a competitive edge. Lastly, maker-taker pricing, a model that pays market makers when their resting orders are filled by other market participants, has become a standard in exchange startup strategy.

Regardless of which incentives you utilize for your security token exchange, you will almost certainly need to incentivize market makers to participate in these nascent markets.

Getting Market Makers Comfortable with Digital Assets

While most legacy market makers do not have a strong understanding of digital assets, they are almost always interested in opportunities to profit from inefficient markets. Providing resources for wallet security and the details of specific projects can make legacy market makers more comfortable with this emerging asset class.

Market makers will also look for data they can use to backtest their trading algorithms. They will find any “tick data” you provide for security token trading to be immensely valuable, whether it is from your exchange or another. Tick data provides detailed information on all trade orders received by the exchange and is used to test algorithms and gauge performance. In the absence of security token tick data, providing market makers with tick data of comparable asset classes is best. For example, tick data from relatively illiquid REITs traded on public markets could potentially be used as a proxy for Harbor’s The Hub at Columbia T-REIT tick data.

Our insider advice: begin recording tick data from day one. Record tick data from other exchanges too.

Market Making on Your Own

If you are unable to build enough liquidity from market makers or want more control over this aspect of your exchange, a final option is to act as a market maker yourself through a separate company. With this strategy, you can license off-the-shelf market making software to provide any amount of liquidity you choose. Be sure to understand the financial risks of market making, consult a securities lawyer to understand laws that may impact you, and never use customer funds as capital for your market making.

Even if you have market makers, supplementing their operations with your own liquidity can be a valuable strategy towards ensuring they offer competitive quotes. When your exchange does not have much liquidity, market makers will often widen their spreads. Your own quotes can act as pricing rails to ensure other market makers maintain tight spreads.

Influential Capital has just launched off-the-shelf market making software. If you’re launching an exchange, reach out to us to learn more.

Concluding Thoughts

Liquidity is a defining element of an exchange’s value. Since there are no strong liquidity centers in the STO market yet, your liquidity must be built from scratch. This is more challenging than simply sharing liquidity from another exchange, but it will turn into a competitive advantage for security token exchanges launching now. Exchange operators have the opportunity to become long-term market leaders and liquidity centers from which other exchanges pull liquidity down the road. Being first to market has its advantages.

Market makers are an essential part of building liquidity in your security token exchange. They are half the battle towards solving the “chicken and egg” user acquisition problem faced by exchange startups – the other half is attracting retail liquidity, which we’ll cover in another article in this series. Building long term partnerships with market makers who will support you during your launch is critical to your success.

Jaron is the CEO of Influential Capital. Previously he founded Coinsetter, one of the first digital asset exchanges launched in 2012, and acquired Cavirtex, a leading exchange in Canada—both acquired by Kraken in 2016. Before entrepreneurial life, Jaron was in private equity and investment banking.

Posted in: STO