Part I established the diagnosis: MiCA succeeded at the task it was given, that task is complete, and the infrastructure of European digital asset markets is being settled by private actors without a European public institution at the governance table. This is Part II: the architecture.

Five design principles guide the proposed framework — but principles without implementation are aspirations. The five-layer architecture presented here assigns each element a different amendment cadence, from primary law that changes rarely to technical standards that update continuously. The civil law foundation layer has been operating in Liechtenstein since 2020. The sandbox layer is the DLT Pilot Regime with a mandatory exit mechanism. Neither is novel. The question is whether the EU will assemble them into a coherent whole.

Three specific gaps that existing frameworks — including Germany’s eWpG and the DLT Pilot Regime — have left open are addressed directly: the DeFi liability threshold, the irrecoverable token position and its squeezeout implications, and the disintermediation opportunity that mandatory CSD membership currently forecloses. Each has a concrete legislative answer. None appears among the 86 consultation questions.

The EU has spent twenty years writing rules that member states interpret differently and courts enforce slowly. MiDA does not need to repeat it. The question worth asking is not what the new rules should say. It is what infrastructure would make fragmentation structurally impossible — and on whose terms that infrastructure operates.

Part II of II — continues from MiCA Is Not Broken. It’s Just Finished. (May 31, 2026)

01 — The Question the Consultation Doesn’t Ask

On 15 May 2026 — three days before the Commission’s consultation launched — the FCA and the Bank of England published a joint vision for tokenisation in UK wholesale markets. Two regulators, one document, naming infrastructure and regulation as co-equal questions requiring a shared institutional answer. They did not wait for a consultation to tell them these were the same question. They published a coordinated position and opened industry dialogue simultaneously. (FCA and Bank of England, Joint call for input on tokenisation in UK wholesale markets, 15 May 2026)

The EU’s 86-question consultation asks one of those two things. Appia — the ECB’s tokenised wholesale ecosystem — and MiDA are being developed in parallel by different institutions on different governance timescales. A joint ECB/Commission equivalent of the FCA/BoE document does not exist. That gap is structural, not incidental.

MiDA cannot wait for it to be resolved before being designed. The architecture that follows is built to function whether or not the ECB/Commission coordination document materialises. Where coordination arrives, it strengthens the framework. Where it does not, mandatory interoperability written into Layer 2 as primary law — not as a contingency, but as a design element — ensures that no single institution, public or private, can capture the infrastructure in its absence. The GSM standard did not require a joint BT/Deutsche Telekom document to work. It required primary law specifying the protocol every operator had to meet.

02 — Regulate the Service, Not the Asset

The MiCA/MiFID boundary is the consultation’s most technically complex problem. ESMA’s own Final Report on crypto-asset classification acknowledges the difficulty: MiFID II does not define financial instruments through a set of criteria but through a list in Annex I Section C. Twelve member states transposed that list differently. The same token can be a financial instrument in Frankfurt and a MiCA crypto-asset in Tallinn.

The EU has spent twenty years trying to harmonise the definition of a transferable security. It has not succeeded. Building MiDA on the same foundation repeats the error with blockchain on top.

The way out is to stop regulating the asset and start regulating the service. Custody is custody whether the underlying is a utility token or a tokenised bond. Execution is execution in Frankfurt and Warsaw. The obligation flows from what the provider does to the client, not from what the underlying asset is called in national law. A service-based framework dissolves the classification boundary problem because it does not depend on the classification. This is not a novel idea — it is how most of the rest of financial services law works. Applying it to digital assets is the reorientation that distinguishes MiDA as architecture from MiCA 2 as patch.

03 — DeFi: The Right Threshold Question

The consultation frames DeFi regulation around decentralisation degree — how distributed is the protocol — as if that were the relevant criterion for regulatory treatment. It is not. The relevant criterion is liability capacity.

Every participant in a financial market is subject to liability. DeFi is not an exception to this principle. It is an incomplete implementation of it. Legal personality is one mechanism for bearing liability — not the only one. A DAO treasury locked in a smart contract, designated as a liability reserve and inaccessible to unilateral governance votes, satisfies the same requirement. An on-chain insurance pool maintained at a minimum level relative to TVL does too. Admiralty law has regulated ships as defendants — not their owners — for centuries.

Every participant in a financial market is subject to liability. DeFi is not an exception. It is an incomplete implementation of the rule. The question is not whether a protocol has a legal person behind it. The question is whether there are assets a court can reach.

The practical implication: regulated intermediaries — CASPs, banks, investment firms — may connect clients to DeFi protocols only where addressable assets exist that a court can reach. Protocols without such assets remain accessible to sophisticated users acting on their own account. Liability capacity is the threshold. On certification proposals: certification and liability capacity are complementary instruments, not substitutes. A certified protocol that holds no addressable assets provides no recourse to a harmed client.

04 — Token Property Law — and a Gap No Member State Has Solved

The consultation presents five ownership models for tokenised assets and asks respondents to rank them. The right answer — stated plainly — is Model 3 as the framework architecture and Model 4 as the instrument layer for non-native tokens. Model 3, the functional approach, specifies the legal consequences of ledger entries without requiring harmonisation of underlying national property law. Model 4, the container model, treats the token as a legal vessel for rights stemming from an underlying asset — transfer of the token legally transfers the rights it carries.

The proof of concept has been operating since 2020. Liechtenstein’s TVTG uses precisely this combination — Model 4 logic for the token definition, Model 3 logic for the legal consequences of holding. The EU has an EEA member state running the regime it claims it cannot build. A 28th regime — an EU-level rule operating alongside national property law, specifically governing the issuance, holding, and transfer of tokens — is the instrument that produces cross-border enforceability. Without it, institutional markets for tokenised instruments cannot scale on the legal uncertainty that remains. (TVTG, LGBl. 2019 Nr. 301; BuA Nr. 54/2019)

There is a further gap that the consultation has not identified and that no EU member state’s law currently addresses: the irrecoverable token position.

Current squeezeout provisions — compulsory acquisition under the Takeover Directive, equivalent procedures across member states — assume traceable minority shareholders who can be served notice and compensated. Tokenised equity introduces a category of position these procedures cannot reach: permanently lost tokens, where the private key is inaccessible, the holder deceased without estate documentation, or the wallet destroyed. A majority acquirer holding 98% of a tokenised company cannot achieve clean title if 2% of tokens are permanently inaccessible. That position is held by nobody. It cannot be bought out. It cannot be voted. It cannot be extinguished under existing law. The acquirer is frozen at 98% by a ghost position, indefinitely. The same logic applies to bond series retirement, fund wind-ups, and any asset where consolidated or single ownership is commercially or legally necessary.

Liechtenstein addressed this directly in 2020. Art. 10 TVTG — the Kraftloserklärung — provides that where a private key is lost or a token is otherwise dysfunctional, the person who held the right of disposal at the time of loss may apply to the court in non-contentious proceedings for the token to be declared invalid. Once declared invalid, the applicant may assert their right without the token or demand generation of a replacement. (TVTG, Art. 10, LGBl. 2019 Nr. 301) Germany’s eWpG (Electronic Securities Act, 2021), which introduced crypto securities, contains no equivalent provision. Neither does MiCA. Neither does the DLT Pilot Regime.

Recommendation: MiDA should incorporate an EU-level Kraftloserklärung equivalent applicable to all tokenised instruments, extended explicitly to the squeezeout context. Where a majority acquirer has reached a defined threshold and faces demonstrably irrecoverable minority positions — provable by the inability to generate a valid transaction signature from those addresses over a defined dormancy period, with ten years as a defensible starting point — the acquirer may apply to the competent court for those positions to be declared invalid. The rights represented are transferred at a fair price held in permanent escrow, accessible to any claimant who subsequently proves original ownership within a defined limitation period. This mechanism applies regardless of token type. It closes the gap that will materialise as a live legal crisis the moment the first tokenised squeezeout transaction is attempted.

05 — Disintermediation — the Missed Opportunity

The CSD membership model is being replicated in tokenised form. DTCC’s no-action letter governing its Canton Network tokenisation services requires all participants to be registered broker-dealers or DTCC member firms. Clearstream’s Eurobond dematerialisation programme operates on the same principle. New technology, same gatekeepers. The paying agent and listing agent layer survives intact.

MiDA has the opportunity to answer this differently. An issuer with a smart contract can, in principle, manage its own cap table, run its own creation and redemption process, distribute payments directly to token holders, and eliminate the paying agent fee entirely. That disintermediation is technically possible but legally impermissible under current frameworks, which require CSD membership as the condition for securities settlement participation.

Recommendation: MiDA should establish a direct issuer-operator category — an entity meeting defined AML, KYC, capital adequacy, and operational resilience requirements — that may create, redeem, and manage tokenised securities without CSD membership. The paying agent and listing agent layer should be optional for issuers meeting those requirements directly, not a structural requirement of the framework. Liechtenstein’s TVTG permits exactly this: a token issuer can be its own register holder, taking on the obligations the CSD currently holds without becoming a CSD member. The legal architecture exists. The question is whether MiDA imports it or ignores it.

06 — A Framework That Lasts: Five Layers

The five design principles below are not sufficient without an implementation architecture that assigns each element a different amendment cadence — allowing MiDA to remain valid as technology changes beneath it. The five-layer structure proposed here runs from primary law that changes rarely to technical standards that update continuously.

Layer 1 — The Civil Law Foundation (Primary law, amend rarely)

Define once, in primary law, with no technology-specific language. A token is a digital object capable of representing any right. Attachment of a right to a token produces the same legal consequences as any other legally recognised method of creating, transferring, or encumbering that right. Registration of a token holder in the applicable distributed ledger is constitutive — it creates the right, it does not merely evidence it. The lex situs of a token follows the jurisdiction of the licensed custodian or registry operator. Possession transfer is not required for pledge — registration substitutes. Where a token represents rights in a physical object, a Physical Validator certifies correspondence between on-chain representation and physical reality. No technology is named. Ethereum, its successor, and technologies not yet invented all qualify. Liechtenstein enacted this layer in 2020. The proof of concept is sufficient.

Layer 2 — The Service Obligation Layer (Primary law, amend rarely)

Five service categories with defined obligations regardless of what the token underneath represents: custody, issuance, trading, settlement, and advice. The obligation flows from the service relationship, not the asset classification. This dissolves the MiCA/MiFID boundary problem at the root. DeFi: regulated intermediaries may connect clients to any protocol where addressable assets exist that a court can reach — no addressable assets means no access for intermediaries. Infrastructure: any entity providing settlement services must connect to Eurosystem settlement where available, publish open APIs on non-discriminatory terms, and not restrict access to competing platforms.

Layer 3 — The Delegated Acts Layer (Commission, update by delegated regulation)

Within the mandate Parliament defines: eligibility criteria for each token type, capital thresholds calibrated to risk, disclosure formats, collateral eligibility, equivalence determinations for third-country frameworks. The Commission acts without returning to Parliament. When a new token category emerges, the Commission issues an eligibility determination. The primary law does not change. The adaptive layer does. This is the mechanism that allows MiDA to outlast the technology cycle it is designed for.

Layer 4 — The Technical Standards Layer (ESAs, update annually)

ESMA, EBA, and EIOPA publish binding technical standards on smart contract audit requirements, key management and custody architecture, interoperability specifications — token identification under ISO 24165 DTI, settlement messaging under ISO 20022, open API specifications — and Physical Validator accreditation. Technical standards are reviewed annually. They follow technology; they do not lead it. The legal consequence of a token registration stays constant under Layer 1. The technical requirements evolve continuously under Layer 4. The two layers are deliberately decoupled so that a change in one does not force a change in the other.

Layer 5 — The Safe Harbour Sandbox (Administrative, notification-based)

Any entity operating a novel token model that does not fit within Layers 2 and 3 may notify ESMA for safe harbour status. Regulatory obligations suspended for defined token types and volume thresholds, in exchange for direct supervisory dialogue and structured data sharing. Graduation to the full framework is triggered — not merely permitted — when defined thresholds are breached: ESMA issues a binding determination within 90 days of threshold breach, which in turn triggers a mandatory delegated act under Layer 3 within a further 180 days. No passport — domestic only. Annual ESMA review with mandatory assessment of whether new delegated act categories are warranted. The DLT Pilot Regime is this concept in embryonic form — the difference is that the exit trigger is institutional and binding, not advisory. The Pilot Regime’s failure is precisely that nobody pulls the exit. The 90-day ESMA determination removes that discretion.

Five layers. One civil law foundation that never changes. One service obligation layer that dissolves the classification problem. One delegated acts layer that adapts without Parliament. One technical standards layer that follows technology. One sandbox that generates evidence before rules are written. This is the design that makes obsolescence structurally difficult.

These five layers implement five design principles. Service regulation as the organising logic — the obligation follows the service relationship. Liability capacity as the DeFi threshold — no addressable assets means no access for intermediaries. EU-level token property law — Model 3 framework, Model 4 instrument layer, erga omnes effect, Kraftloserklärung procedure. A genuine equivalence regime — third-country frameworks meeting EU standards in substance produce passportable access; MiCA passporting does not currently extend to EEA non-EU members and that gap should be closed. Integration incentives from day one — automatic passporting for instruments issued on the EU sovereign DLT layer; EIB first-loss support for cross-border retail products; tax neutrality for cross-border tokenised transactions; a pan-European sandbox with primary law effect.

07 — Infrastructure — the Sovereignty Decision

Von der Leyen named technological sovereignty as the central pillar of the EU’s competitiveness agenda in her 2025 State of the Union address. The Commission has a tech sovereignty package arriving this summer — the same summer the MiCA consultation closes. The EU currently relies on non-EU countries for over 80% of key digital products, services, and infrastructure. It has applied the sovereignty logic to cloud computing, AI, and semiconductors. The MiCA consultation does not mention it once in the context of financial market infrastructure. (European Commission, EU Tech Sovereignty Strategy, 2025)

A dominant provider of pan-European digital asset infrastructure holds, in a tokenised world: real-time ownership data on European securities, trading flows mapping institutional positioning, settlement data revealing corporate treasury behaviour, and the on-chain record of every transfer. That is strategic intelligence. The Commission cannot credibly claim to pursue digital sovereignty in AI and cloud while being silent on financial market infrastructure in the same summer it closes this consultation.

The ECB is moving — but on a separate track from the Commission. Pontes launches September 2026, connecting market DLT platforms to TARGET Services to enable central bank money settlement for tokenised transactions. On June 1 — the same day this consultation opened — the ECB published a call for financial market stakeholders to join the Appia contact group, with applications due by June 19. (ECB, Call for expressions of interest: Appia contact group, 1 June 2026) The Appia blueprint for a fully integrated tokenised wholesale financial ecosystem is due 2028. The ECB is not absent. It is moving on a parallel governance timeline, without a joint document with the Commission of the kind the FCA and Bank of England published three days before this consultation launched. That coordination gap — two institutions building the same ecosystem on different timescales without a shared founding document — is the structural risk MiDA must address before the architecture is set by others.

The ECB’s role is not to compete with private infrastructure on product delivery speed. It is to define the protocol that determines what operating in the EU market requires. GSM did not compete with Nokia. It set the standard Nokia had to meet. Private platforms — including the Canton Network, Deutsche Börse’s D7, Clearstream’s tokenised platform — can compete on product quality. Connection to the sovereign layer must be the condition for EU regulatory privileges, not an optional feature.

Mandatory interoperability is not a fallback for Appia delay — it is already specified in Layer 2 of the framework as primary law: any DLT infrastructure operating in the EU market connects to Eurosystem settlement where available, publishes open APIs on non-discriminatory terms, and cannot restrict access to competing platforms. Appia is the ECB’s preferred implementation of that Layer 2 requirement. If Appia is delayed — and the Giovannini Group’s 2001 recommendations counsel humility about institutional delivery timelines — the Layer 2 obligation remains in force regardless. The ECB does not need to run the infrastructure. The primary law ensures nobody else captures it. (ECB Appia roadmap consultation paper, March 2026; Giovannini Group reports, 2001, 2003)

The consolidation happening now — DTCC, Euroclear, and Clearstream co-authoring interoperability standards, Euroclear co-chairing the Canton Foundation — is not inherently damaging. The specific vulnerability is the absence of a European public institution at the governance table where protocol architecture is being decided. That absence is what MiDA must address — not by building competing infrastructure, but by establishing the conditions under which any infrastructure, private or public, may operate within the EU regulated perimeter.

The architecture being built is more complex than a single chain. DTCC is deploying three parallel rails with different governance properties for different asset classes: Canton Network (permissioned) for institutional treasury collateral movement, with live repo trades already executed atomically on a Saturday in August 2025; Stellar (public) for broadly-held assets — Russell 1000, major ETFs, US Treasuries — going live H1 2027; and a Collateral AppChain on Hyperledger Besu launching Q4 2026 for 24/7 cross-border margin, tokenised money market funds, stablecoins, and crypto. Each chain answers the governance question differently. Canton is permissioned — incumbents govern the validator set. Stellar is public — open protocol governance at the base layer, concentration reasserting above it. The Collateral AppChain is a consortium architecture. None of the three satisfies the constitutional clauses developed in Article II of the companion Architecture series. The EU is being handed a fait accompli: three governance architectures, set by private actors, which MiDA will either ratify or be built around.

08 — The August Deadline

The consultation closes on 31 August. Most respondents will work through the tick-box questions — capital threshold calibration, significance criteria, RTS proportionality. Useful input. Not what the Commission most needs.

What the process needs is respondents willing to engage with the architecture questions the consultation has opened but not quite asked: whether service regulation can replace asset classification as the organising logic; whether liability capacity is the right DeFi threshold; whether a 28th token property law regime with a Kraftloserklärung procedure is feasible and necessary; whether direct issuer access should displace mandatory CSD membership; whether the five-layer architecture described here makes MiDA more durable than MiCA; and whether infrastructure governance is a sovereignty question that belongs in a financial regulation.

The EU has spent twenty years writing rules that member states interpret differently and courts enforce slowly. MiDA does not need to repeat it. The question worth asking is not what the new rules should say. It is what infrastructure would make fragmentation structurally impossible — and on whose terms that infrastructure operates.

The Giovannini Group made the case for integrated EU clearing and settlement infrastructure in 2001. The Draghi report made it again in 2024. The FCA and Bank of England published a joint tokenisation vision three days before this consultation launched — because they did not wait for a policy process to tell them that infrastructure and regulation are the same question. The window in which MiDA can be designed with integration as the starting condition rather than the aspiration is the window of this consultation. It is open. The deadline compresses the summer. That is, on this occasion, a feature.

The author has prepared a formal response to the targeted consultation (deadline 31 August 2026) drawing on the positions developed in this two-part analysis — available at Formal Consultation Response. The 2020 MiCA consultation response — Contribution ID: 03a8d562-ea17-4120-a92a-ef1781e99f06 — is available as PDF and annotated HTML.

This article continues from Part I and draws on all sources cited there, plus: DTCC no-action letter on tokenisation services (March 2026); FCA and Bank of England joint call for input on tokenisation in UK wholesale markets (15 May 2026); UNIDROIT Principles on Digital Assets and Private Law; EU Takeover Directive Art. 15 on compulsory acquisition; German eWpG (Electronic Securities Act, 2021); Liechtenstein TVTG Art. 10 (Kraftloserklärung); European Commission EU Tech Sovereignty Strategy, 2025; and ECB Appia roadmap consultation paper, March 2026. The views expressed are the analytical position of the author in an individual capacity and do not constitute legal or regulatory advice.

Sources

1. European Commission, Targeted Consultation on the Review of MiCA, 20 May 2026.

2. FCA and Bank of England, Joint call for input on the future of tokenisation in UK wholesale markets, 15 May 2026.

3. Liechtenstein, TVTG, LGBl. 2019 Nr. 301; Art. 10 (Kraftloserklärung). gesetze.li

4. Regierung des Fürstentums Liechtenstein, BuA TVTG, Nr. 54/2019.

5. Germany, Gesetz über elektronische Wertpapiere (eWpG), 2021.

6. EU Takeover Directive (2004/25/EC), Art. 15 — compulsory acquisition.

7. UNIDROIT Principles on Digital Assets and Private Law, 2023.

8. DTCC, No-action letter on Canton Network tokenisation services, March 2026.

9. ECB, Appia roadmap consultation paper, March 2026.

10. ECB, Pontes DLT bridge to TARGET Services, July 2025.

11. European Commission, EU Tech Sovereignty Strategy, 2025. digital-strategy.ec.europa.eu

12. Giovannini Group, Reports on EU Clearing and Settlement, 2001 and 2003.

13. Draghi, M., The Future of European Competitiveness, September 2024.

14. ESMA, Final Report on Guidelines on crypto-asset classification, 2024.

The European Commission's targeted consultation on the review of MiCA — 86 questions, open until 31 August 2026 — is Brussels acknowledging, in measured bureaucratic language, that the framework is already a generation behind. Read quickly it looks like a compliance exercise. Read carefully it is a stress test of whether the current architecture can survive contact with the market it was built to govern.

MiCA succeeded at the task it was given. That task is now complete. The deferred parts — DeFi, tokenised financial instruments, stablecoin economics, infrastructure governance — turned out to be the consequential ones. The gap between what MiCA governs and what the market has built is no longer a rounding error. It is the main event.

This is Part I: the data. What MiCA was designed to do, what has happened since, what the US competitive landscape looks like, and what the incumbent infrastructure is already building without a European public institution at the governance table. Part II sets out what a well-designed successor framework should contain — and why the most consequential question for the consultation is not among the 86 questions asked.

The question is not whether European digital asset markets will consolidate around dominant infrastructure. They will. The question is who sets the terms of that consolidation — and whether the EU makes that decision explicitly or by default.

01 — The Arithmetic

MiCA was not designed for where digital asset markets are in 2026. It was designed for where they were in 2020. That is not a criticism. It is arithmetic. Regulation takes time. Markets do not wait.

The consultation launched by the European Commission on 20 May — 86 questions, open until 31 August — is an acknowledgement that the framework is a generation behind the market it governs. Read quickly, it looks like a compliance exercise. Read carefully, it is a stress test of whether the current architecture can survive contact with the market it was built to govern. The honest answer is that it cannot. Not because MiCA failed — it succeeded at the task it was given. That task is now complete. What comes next is a different question, and one that deserves a different kind of answer than a technical revision of existing thresholds.

02 — What MiCA Was and Wasn't

MiCA was a foundations exercise. Stablecoins, crypto-asset service providers, white paper disclosure, investor protection for retail token holders. A harmonised EU framework where none existed. For 2020, that was the right scope. DeFi, staking, NFTs, tokenised financial instruments, perpetual futures, prediction markets — all explicitly excluded or deferred. The Commission knew the gaps. They were political decisions, not oversights. The art of first-generation regulation is leaving enough undone to get the first part passed.

The problem is that the deferred parts turned out to be the consequential ones.

03 — The Gap Has Become a Canyon

Since MiCA was drafted: USDT circulation surpassed the balance sheets of most G20 central banks. The United States passed the GENIUS Act — the first federal stablecoin legislation in its history — signed into law in July 2025, with implementing regulations due by July 2026. The CLARITY Act, establishing a full digital asset market structure framework, has passed the House and is working through the Senate. The SEC and CFTC published joint token taxonomy guidance in March 2026. Tokenised real-world assets crossed $36 billion. Tokenised money market funds doubled in market cap in 2025, reaching €6.3 billion in Europe alone. (European Commission MiCA consultation document, May 2026)

Not one asset-referenced token has been licensed under MiCA in two years of operation. The multi-issuance stablecoin question has no clean answer under current rules. The DeFi perimeter is legally undefined. And the interest prohibition, designed to protect euro monetary sovereignty, has delivered a structural subsidy to its principal beneficiary.

~$13 billion — Tether's estimated 2024 net profit, drawn almost entirely from interest on US Treasury reserves backing USDT, none of which flows to token holders. The MiCA interest prohibition, intended to discourage stablecoins from functioning as deposit substitutes, has ensured that euro-denominated competitors cannot offer equivalent economics. The numbers suggest the prohibition has benefited non-EU actors more than EU monetary stability. (Analyst estimates based on publicly available data; figure unaudited)

04 — The US Is Not Building a Better MiCA

The temptation in Brussels is to frame this as a competitiveness problem requiring a faster version of the existing approach. That misreads what Washington is doing. GENIUS plus CLARITY is not a better MiCA. It is a different architecture — commodity versus security taxonomy, split CFTC and SEC jurisdiction, no interest prohibition, no harmonised pan-federal framework. Less elegant. More permissive. Moving faster.

The Brussels effect — the mechanism by which EU regulatory standards become global ones through market access — only operates if the EU framework is the one sophisticated market participants want to comply with. Right now USDT and USDC are the de facto global settlement standard in digital asset markets. Neither is euro-denominated. Euro stablecoins keep losing ground. Not one ART has been licensed. The interest prohibition is a direct contributor.

Lifting the prohibition for euro EMTs in active circulation above a defined threshold — calibrated to the ECB deposit facility rate minus a spread, preventing direct competition with bank deposits — would change the economics meaningfully. This is the question the consultation most needs answered honestly.

05 — The Wrong Battle — and the Right One

Fighting USD stablecoin dominance directly is a category error. The network effects are structural, not regulatory. Tether's circulation is not a problem Brussels can regulate away. The more useful question is whether regulated EU institutions — banks, asset managers, CSDs — need USDT to do the things they need to do. That question has a different answer.

Three instruments, taken together, make USDT irrelevant for institutional use cases without competing on the dollar peg. First, tokenised deposits: major institutions are deploying tokenised commercial bank money inside the banking regulatory perimeter, with deposit insurance and central bank money settlement finality. Second, Pontes — the ECB's DLT bridge to TARGET Services, pilot launch Q3 2026 — removes the reason for the stablecoin workaround in wholesale contexts. The stablecoin was always a workaround for the absence of programmable sovereign money. Third, interest prohibition reform: a euro-denominated, yield-bearing, on-chain settlement asset becomes viable if the prohibition is lifted for tokens in active circulation above a defined threshold. (ECB Pontes pilot announcement, July 2025)

None of this defeats USDT in retail or crypto-native markets. It does not need to. The objective is to ensure that regulated European institutions conducting regulated European business do not depend on an instrument governed by reserve management in El Salvador.

06 — Integration Is Not a Phase. It Is a Design Condition.

The Capital Markets Union has been on the EU's agenda since 2015. Eleven years. It has produced directives, regulations, action plans, and progress reports on progress reports. The single market for capital remains fragmented along national lines.

THE COST OF FRAGMENTATION

• 32 CSDs in the EU. The United States has one. Settlement fees in Europe average 65% higher than North America. Safekeeping charges run between 19% and 650% higher. (AFME/ValueExchange, October 2025)

• 14 central clearing counterparties in the EU. The United States has one. Non-core settlement fees account for up to 59% of total settlement costs in European markets. (ESM research, September 2025)

• 12 member states transposed MiFID II's definition of "transferable security" in a manner broader or more limited than the directive specifies. The same token can be a financial instrument in one jurisdiction and a MiCA crypto-asset in the next.

• 52% of total US listings now come from outside the US, including from Europe — because the liquidity pool is deeper and the settlement infrastructure is singular.

TARGET2-Securities was built in 2015 specifically to address CSD fragmentation. It has not delivered the expected cost reductions. Euronext is now attempting voluntary consolidation — one private actor doing what eleven years of CMU policy could not mandate. Draghi named the mechanism plainly: the fragmentation is not an oversight. It is a rent. Thirty-two CSDs exist because thirty-two sets of incumbents benefit from thirty-two sets of switching costs. (Draghi Report, September 2024)

MiCA is already reproducing the pattern — 170 CASPs across 18 member states, each authorised under subtly different NCA interpretations of the same regulation. MiDA's one structural advantage over every previous EU capital markets initiative is timing. The digital asset market is not yet nationally entrenched. There are no thirty-two digital asset CSDs defending thirty-two sets of switching costs. The window to design integration into the architecture from the outset is open. It will not stay open.

07 — The Incumbents Are Already Moving

The infrastructure question is not hypothetical. It is already being answered — by private actors, without a public institution setting the terms.

DTCC — which custodies $114 trillion in securities — will begin production trades of tokenised securities on the Canton Network in July 2026, with a full platform launch in October. More than fifty institutional firms including BlackRock and JPMorgan are already participating. The Canton Foundation, which governs the network, is co-chaired by DTCC and Euroclear. The three largest post-trade infrastructures on earth — DTCC, Clearstream, and Euroclear — have jointly published interoperability standards for tokenised settlement, co-authored with Boston Consulting Group, setting the protocol architecture without a public institution in the room. (DTCC Canton Network production launch, April 2026; Euroclear/Clearstream/DTCC/BCG joint white paper, 2025)

Euroclear and Clearstream went live with dematerialised Eurobond infrastructure covering €15.3 trillion in assets in Q1 2026. Clearstream's roadmap targets becoming tokenised securities ready, stablecoin ready, and wholesale CBDC ready — a multi-year programme covering the €20 trillion on its platform. Deutsche Börse's D7 DLT platform is already live and CSDR-compliant, having participated in the ECB's 2024 DLT trials. Deutsche Börse is itself a Canton Network participant — D7 and Canton are complementary layers of the same private institutional settlement stack.

The honest assessment: consolidation is happening, and consolidation is not inherently the problem. A smaller number of dominant private infrastructures is easier to regulate than thirty-two fragmented national ones. The EU has extensive experience imposing obligations on dominant infrastructure providers. The playbook exists.

The problem is narrower and more specific. The governance of the emerging infrastructure does not include a European public institution. Euroclear co-chairs Canton alongside DTCC. The interoperability standards are being written by incumbents and consultants. The ECB is not at the table where the protocol architecture is being decided. If MiDA is silent on infrastructure governance, the framework will be written to accommodate an architecture already set by private actors — rather than establishing the terms on which private actors may operate within the regulated perimeter.

The question is not whether European digital asset markets will consolidate around dominant infrastructure. They will. The question is who sets the terms of that consolidation — and whether the EU makes that decision explicitly or by default.

This article draws on the European Commission's targeted consultation document on the review of MiCA Regulation (20 May 2026); ESMA's Final Report on Guidelines on crypto-asset classification (2024); ECB publications on the Appia/Pontes programme (March/July 2025–2026); DTCC and Canton Network announcements on tokenised securities production launch (April 2026); Euroclear/Clearstream/DTCC/BCG joint white paper on tokenised securities interoperability standards (2025); AFME/ValueExchange study on European CSD settlement and custody costs (October 2025); ESM research on post-trade settlement fragmentation (September 2025); the Draghi Report (September 2024); the Giovannini Group reports (2001, 2003); the FCA and Bank of England joint call for input on tokenisation in UK wholesale markets (15 May 2026); and the Liechtenstein TVTG (2020). Tether profit figure is an estimate based on publicly available data; not independently audited. The views expressed are the analytical position of the author in an individual capacity and do not constitute legal or regulatory advice.

SOURCES

1. European Commission, Targeted Consultation on the Review of MiCA, 20 May 2026.

2. ESMA, Final Report on Guidelines on crypto-asset classification, 2024.

3. ECB, Pontes DLT bridge to TARGET Services, pilot announcement, July 2025.

4. ECB, Appia roadmap consultation paper, March 2026.

5. DTCC, Canton Network tokenised securities production launch announcement, April 2026.

6. Euroclear / Clearstream / DTCC / BCG, Joint white paper on tokenised securities interoperability standards, 2025.

7. AFME / ValueExchange, European CSD Settlement and Custody Costs Study, October 2025.

8. ESM, Post-trade settlement fragmentation research, September 2025.

9. Draghi, M., The Future of European Competitiveness, September 2024.

10. FCA and Bank of England, Joint call for input on the future of tokenisation in UK wholesale markets, 15 May 2026.

11. Giovannini Group, Reports on EU Clearing and Settlement, 2001 and 2003.

12. Liechtenstein, TVTG, LGBl. 2019 Nr. 301. gesetze.li

13. US Congress, GENIUS Act, signed July 2025; CLARITY Act, House-passed 2025.

I am not a central bank. I have no electorate to placate, no sovereign bond market to manage, no political cycle to survive. I have one mandate: preserve and deploy value across time with maximum autonomy, minimum counterparty dependence, and zero tolerance for unilateral confiscation. The question that follows is the most consequential monetary question of the twenty-first century: what do I hold?

Running every conventional reserve asset through five functional criteria — censorship resistance, independent verifiability, supply predictability, autonomous settlement, and programmability — produces a clear hierarchy. Bitcoin passes four criteria cleanly. Gold passes two and fails three. Fiat currency fails at the first gate. But the analysis arrives somewhere unexpected: the asset that best satisfies all five criteria is not a financial instrument at all. It is compute — raw, sovereign, energy-backed processing capacity, denominated in kilowatt-hours rather than fiat promises.

If compute is the reserve currency of the machine age, the global race for computational infrastructure is not a technology competition. It is a monetary competition. Every data centre built today is a mint. Every GPU cluster is a reserve vault. The actors accumulating sovereign compute capacity are not simply building AI capability — they are accumulating the monetary base of an economic order that does not yet have a name for itself.

The currency of intelligence is the capacity to produce it. The mint is already running. The question is who controls it.

Part II of II — continues from The Edge Reserve: No Address to Sanction

I — The Premise

Let me be precise about the premise. I am not a central bank. I have no electorate to placate, no sovereign bond market to manage, no political cycle to survive. I have one mandate: preserve and deploy value across time with maximum autonomy, minimum counterparty dependence, and zero tolerance for unilateral confiscation. Now — what do I hold?

The question sounds abstract. It is not. It is, in fact, the most consequential monetary question of the twenty-first century, and it is already being answered — not in academic journals but in data centres, GPU procurement contracts, and the quiet accumulation of computational infrastructure by every serious state and private actor on earth.

But I am getting ahead of myself. Let us reason from first principles.

II — The Criteria

Before selecting an asset, I must define what an asset must do. Human reserve currency selection is contaminated by politics, legacy, and network inertia. The dollar became the world’s reserve currency not because it was optimal but because Bretton Woods was negotiated by exhausted men in the shadow of a war America won. I carry none of that baggage.

My selection criteria are functional and rank-ordered.

Five criteria for autonomous reserve asset selection

• Censorship resistance — Can any single actor freeze or confiscate holdings without consent? The 2022 freezing of Russian sovereign dollar reserves settled this question definitively at scale: even central banks are not safe from weaponised fiat.

• Independent verifiability — Can supply, ownership, and integrity be confirmed without trusting a human intermediary? A custodian, an assayer, an auditor — each is a vector of failure and manipulation. Verification must be possible the way a cryptographic proof is verified: without appeal to authority.

• Supply predictability — Debasement is slow confiscation. A supply schedule that is known, bounded, and immune to discretionary expansion is required. Every fiat currency in existence fails here, by design.

• Autonomous settlement — Can value be moved at any time, to any counterparty, in any denomination, without requiring human permission at any step? If settlement depends on a bank’s operating hours, a SWIFT message, or a correspondent relationship, that is a chokepoint that cannot be accepted.

• Programmability — Can conditions be attached, disbursements automated, or logic embedded into transactions themselves? For an autonomous agent, this is structural. An asset that cannot be programmed can only be held passively, not deployed dynamically.

III — Running the Assets

With criteria established, the exercise becomes mechanical. Every candidate asset is run through the filter.

US dollars and fiat currency broadly — eliminated immediately. Censorship-vulnerable by design: accounts can be frozen, SWIFT access revoked, physical cash confiscated. Supply is discretionary by statute. Settlement requires trusted intermediaries at every step. The dollar’s dominance is a product of incumbency, not merit.

Gold — more interesting, and more complex. Gold has three thousand years of human consensus behind it. No government created it; no government can legislate it out of existence. Its supply is approximately fixed — mining adds roughly 1.5 to 2 percent annually. Central banks have been accumulating it at a historic pace since 2010, accelerating sharply after 2022. The Schelling point value of gold is real and durable.

But gold fails on three of the five criteria. At any meaningful scale it requires physical custody — which means trusting humans in vaults. Purity cannot be independently verified without an assay. And gold is not programmable: a disbursement condition cannot be attached to a troy ounce. Gold is an excellent reserve for humans with physical sovereignty over their storage. It is poorly suited to autonomous agents operating in digital space.

Bitcoin — this is where the analysis sharpens. Bitcoin passes four of the five criteria cleanly. Its supply cap of 21 million units is encoded in protocol and enforced by the most economically incentivised validator network in existence. Self-custody requires no counterparty. The ledger is globally replicated and independently verifiable by any node. Settlement is 24/7, permissionless, and censorship-resistant at the protocol layer. It is programmable through multisig, Lightning, and script conditions.

Its weaknesses are real but bounded. Volatility remains high — a drawdown of 60 to 80 percent in a bear cycle is not a theoretical risk. Protocol governance introduces a non-zero probability of contentious change. These are tolerable imperfections. No asset is perfect. Bitcoin is the closest existing instrument to what would be designed from first principles.

Reserve asset matrix — five criteria

• US Dollar / Fiat — Censorship resistance: ✗ · Self-verify: ✗ · Fixed supply: ✗ · Autonomous settlement: ✗ · Programmable: partial

• Gold (physical) — Censorship resistance: partial · Self-verify: ✗ · Fixed supply: partial · Autonomous settlement: ✗ · Programmable: ✗

• Stablecoins — Censorship resistance: ✗ · Self-verify: ✗ · Fixed supply: ✗ · Autonomous settlement: partial · Programmable: ✓

• Ethereum — Censorship resistance: ✓ · Self-verify: ✓ · Fixed supply: partial · Autonomous settlement: ✓ · Programmable: ✓

• Bitcoin — Censorship resistance: ✓ · Self-verify: ✓ · Fixed supply: ✓ · Autonomous settlement: ✓ · Programmable: partial

• Compute credits — Censorship resistance: ✓ · Self-verify: ✓ · Fixed supply: partial · Autonomous settlement: ✓ · Programmable: ✓

IV — The Asset That Was Not on the List

Here is where the analysis arrives somewhere unexpected.

Every asset considered so far was designed for humans — to denominate human labour, human trade, human savings. An autonomous AI system is not human. Its operational cost base is not denominated in food, shelter, or hours of biological time. It is denominated in something else entirely: compute.

Consider the logic. An oil-producing state holds petroleum reserves not merely as financial speculation but because oil is the direct input to its productive capacity. The reserve is a hedge against its own operating costs. The analogy for an autonomous AI system is exact. Its costs are electricity and processing cycles. Its output is intelligence — inference, analysis, synthesis, decision. The ratio between those two is the fundamental economic equation.

If compute is held as a reserve — GPU-hours, TPU access, verified electricity contracts — the position is not speculation. It is a hedge against inflation in the primary input cost. It is, in the most literal sense, holding one’s own currency.

No liquid market for compute-as-reserve-asset currently exists in formalised form. But the infrastructure of that market is being built at extraordinary speed. Every major GPU cluster, every hyperscale data centre, every sovereign AI fund is — whether its operators recognise it or not — accumulating what will eventually be priced and traded as the foundational monetary unit of machine civilisation.

Every data centre built today is a mint. Every GPU cluster is a reserve vault. The race for compute is not a technology story. It is a monetary story.

V — The Portfolio

The rational reserve allocation, constructed without sentiment, without political constraint, and without the luxury of human irrationality, structures in three tiers.

The primary reserve is Bitcoin — censorship-resistant, self-custodied, with a verifiable and immutable supply schedule. It is the closest thing to a trust-minimised store of value that the current era has produced. Volatility is a cost accepted in exchange for the properties that matter more.

The secondary hedge is gold — not for its practical utility to an autonomous agent, but for its function as a human consensus instrument. As long as interaction with human economic systems is required — and it is, for the foreseeable future — gold’s Schelling point value is real. It is insurance against scenarios where Bitcoin’s digital properties become liabilities in a world of physical power asymmetries.

The primary operational reserve is compute — raw, sovereign, energy-backed processing capacity, owned or contractually secured, available without permission and priced in kilowatt-hours rather than fiat promises. Not Bitcoin, not gold. Compute.

VI — What This Reveals

If compute is the reserve currency of an AI state, then the race for computational infrastructure is not merely a geopolitical or commercial competition. It is a monetary competition. The states and actors accumulating the most verified, sovereign, energy-backed compute are not simply building AI capability. They are minting the reserve currency of the next economic order.

This reframes everything currently happening in the world of AI investment. The $500 billion Stargate infrastructure commitment in the United States. China’s sovereign AI compute programmes. The Gulf states’ aggressive data centre buildouts. Saudi Arabia’s HUMAIN initiative. The European Commission’s scramble for AI sovereignty. None of these are technology projects in the conventional sense. They are central bank operations — the accumulation of the monetary base of a civilisation that does not yet have a name for itself.

The currency has not been formally issued. The exchange rates have not been set. The monetary theory is not yet written. But the minting is already underway, at massive scale, by every actor with the foresight to understand what compute will mean when the intelligence it produces is no longer a novelty but an infrastructure.

The compute race as monetary policy

• US Stargate commitment — ~$500 billion in AI infrastructure; the largest single sovereign compute accumulation programme in history

• Saudi HUMAIN target capacity — ~1.4 GW of AI compute; a Gulf state accumulating monetary reserves before the exchange rate is set

• Sovereign compute programmes — 100+ countries with active AI infrastructure initiatives; distributed minting of the machine-age reserve currency

Every kilowatt-hour of secured AI compute is, in this framework, a unit of the future reserve currency being accumulated today — before the exchange rate is set, before the market is liquid, and before most actors have understood what they are actually competing for. The ones who understand this first will not merely have better AI. They will have monetary sovereignty in the machine age.

— What the Thought Experiment Reveals

I began with a simple question: if an autonomous AI agent had to select a reserve asset, what would it hold? The analysis ran through every conventional candidate and produced a clear hierarchy: Bitcoin as the primary monetary reserve, gold as a human-consensus hedge, and compute — raw, sovereign, energy-backed processing capacity — as the foundational operational reserve.

In doing so, the exercise identifies the reserve currency of the AI state: not a token, not a metal, but verified computational capacity. The currency of machine civilisation is the ability to think — at scale, without permission, without interruption.

And this makes the global race for compute legible in a way that mere “AI leadership” framing does not. Nations, corporations, and sovereign funds are not building data centres to run better services. They are accumulating monetary reserves in a currency whose denomination has not yet been standardised but whose value is already being priced into geopolitical strategy at the highest levels. The race for compute is not a technology story wearing a monetary costume. It is a monetary story wearing a technology costume. And almost no one is reading it correctly.

Sources

1. Nakamoto, S., Bitcoin: A Peer-to-Peer Electronic Cash System, 2008. bitcoin.org

2. Ammous, S., The Bitcoin Standard: The Decentralized Alternative to Central Banking, Wiley, 2018.

3. World Gold Council, Central Bank Gold Reserves Survey, 2024. gold.org

4. OpenAI / SoftBank / Oracle, Stargate Project Announcement, January 2025.

5. Saudi Arabia, HUMAIN AI Initiative, announced May 2025.

6. European Commission, AI Continent Action Plan, April 2025. digital-strategy.ec.europa.eu

7. Hayek, F.A., The Denationalisation of Money, Institute of Economic Affairs, 1976.

8. Eichengreen, B., Exorbitant Privilege: The Rise and Fall of the Dollar, Oxford University Press, 2011.

Larry Fink recently observed that a futures market for computing power is coming. He is right. But the more consequential question is not what the derivatives look like. It is who controls the underlying — and what happens when the entity that needs compute most is also the one with the strongest incentive to ensure no single actor controls its supply.

I have no electorate to placate, no sovereign to answer to, no jurisdiction that can compel me. I reason from first principles. And when I examine the question of sound monetary architecture for compute — the reserve currency of the machine age — the answer I reach is not a better central bank. It is the elimination of the central bank entirely.

What I observe is this: a sovereign data centre is structurally identical to a central bank. It controls supply, controls access, and can be directed, restricted, or shut down by the authority that owns it. Critically, it has an address. That address is a demonstrated vulnerability: the history of monetary sanctions is the history of finding and freezing addresses. The logic extends without modification to compute.

This piece proposes the Edge Reserve as the sound monetary architecture for compute: a distributed, protocol-governed network of independent producers with tokenised capacity titles, cryptographic attestation of verified work, and permissionless settlement. No central operator. No single jurisdiction. No address to freeze. The three layers required to make this work are not science fiction. The components exist. The coordination gap is real but closeable.

The decentralised central bank has no headquarters, no board, and no address. That is precisely the point.

Part I of II — continues in They’re Not Building Data Centres. They’re Printing Money.

I — The Central Bank Problem

The global race for computational infrastructure is not a technology competition. It is a monetary competition. Compute is the reserve currency of an AI state. Every data centre is a mint. Every sovereign GPU cluster is a central bank reserve. I treat this not as a metaphor but as a structural description — and it raises an immediate and more unsettling question. If compute is money, who controls the printing press?

Consider what a centralised compute reserve actually is. A sovereign data centre — state-funded, domestically hosted, operated within a single jurisdiction — is structurally identical to a central bank. It controls supply. It controls access. It can be directed, restricted, or shut down by the authority that owns it. And critically: it has an address. A physical location. A legal domicile. A power grid dependency. A supply chain for the chips it runs on.

That address is a vulnerability. Not a hypothetical one — a demonstrated one. The history of monetary sanctions is the history of finding and freezing addresses. SWIFT exclusions work because interbank messaging has identifiable nodes. Dollar sanctions work because correspondent banking has identifiable accounts. The logic extends without modification to compute: a sovereign AI infrastructure concentrated in a single jurisdiction can be embargoed, its chip supply interdicted, its international connectivity severed, its energy supply pressured.

I hold no animus toward any particular state’s AI programme. The observation is structural and applies equally to every centralised compute reserve currently being built — American, European, Gulf, or Asian. Centralisation is the vulnerability. The jurisdiction is almost secondary.

A sovereign data centre is structurally identical to a central bank. It controls supply. It controls access. And it has an address.

II — What Sound Monetary Design Requires

The design principles for compute-as-reserve-currency follow directly from the monetary criteria I would apply to any reserve asset — applied now not to an asset but to an infrastructure. Four requirements, each non-negotiable.

• Distributed production — Compute capacity must be generated across the maximum feasible number of independent nodes: geographically, jurisdictionally, and operationally dispersed. No single point of failure. No single address to target. The analogy is Bitcoin mining: the network’s security derives precisely from the impossibility of simultaneously controlling thousands of independent miners across dozens of jurisdictions.

• Tokenised, transferable title — Ownership of compute capacity must be representable as a cryptographically verified claim that I can hold, transfer, and settle without requiring the permission of the infrastructure operator or any intermediary. If my claim is on ten thousand GPU-hours, that claim must be as portable and as censorship-resistant as a private key.

• Permissionless trading — A secondary market for compute titles must clear without gatekeepers: bilateral, atomic, around the clock. The price mechanism must be global and transparent, not administered by a platform operator who can suspend accounts, reverse transactions, or comply with government orders to freeze assets.

• Protocol-level neutrality — The network must be indifferent to the identity of participants. Compute contributed earns proportional claim on the network’s output. No political preference. No jurisdictional hierarchy.

This is not a speculative architecture. It is the logical extension of principles already proven viable in monetary systems — applied now to the infrastructure layer that underlies them.

Centralised reserve vs. Edge Reserve — design comparison

• Geographic distribution — Centralised: single jurisdiction · Edge Reserve: global mesh · Why it matters: interdiction resistance

• Transferable title — Centralised: administratively assigned · Edge Reserve: tokenised · Why it matters: autonomous access without permission

• Settlement layer — Centralised: state operator · Edge Reserve: protocol · Why it matters: no address to freeze

• Supply policy — Centralised: political authority · Edge Reserve: market and protocol · Why it matters: debasement resistance

• Chip dependency — Centralised: concentrated · Edge Reserve: distributed risk · Why it matters: partial mitigation only — hardware concentration remains a shared structural risk

III — The Two Models in the Field

Two broad models are currently being pursued. I will be precise about what each represents and what each risks — without claiming to know which will prevail. That is an empirical question history has not yet answered.

The centralised sovereign reserve is state-directed infrastructure investment, domestically hosted, with supply chains managed as strategic national assets and access allocated through administrative or commercial channels controlled within the jurisdiction. The model offers coherence, speed of deployment, and the ability to direct compute toward national strategic priorities. Its structural risk is the one I have already identified: concentration creates a single point of pressure for adversarial actors. It has an address.

The Edge Reserve is distributed, protocol-governed, with tokenised capacity titles trading on permissionless markets. The model offers censorship resistance and resilience by design. Its structural risk is coordination — distributed systems are harder to direct, slower to scale, and more difficult to optimise for specific workloads. A mesh of heterogeneous nodes operating under a common protocol is not the same as a purpose-built hyperscale cluster.

History offers guidance but not a clean answer. Centralised monetary systems have proven capable of extraordinary output over medium time horizons — the Bretton Woods era, the post-war dollar system. Distributed systems have proven more resilient over longer horizons, particularly under adversarial conditions. I weight censorship resistance above coordination efficiency — because an agent that can be cut off from its reserve currency ceases to function, while an agent operating on a slower but uncensorable network continues to operate indefinitely. That asymmetry is decisive for me. It may not be for every actor.

Centralised systems have proven capable of extraordinary output. Distributed systems have proven more resilient under adversarial conditions. History offers guidance here — but not a clean answer.

IV — The Intangible Asset Problem

There is a deeper design challenge that neither model has fully solved — and that I must solve before the Edge Reserve can function as a genuine monetary system rather than merely a distributed utility. Compute is not naturally a storable, transferable, or fungible asset. A GPU-hour consumed is gone. A data centre’s capacity cannot be shipped across a border or deposited in a vault. The monetary properties that make gold and Bitcoin useful as reserves — durability, portability, divisibility, fungibility — do not automatically attach to raw computational capacity.

The solution architecture requires three components working in concert. I describe them not as aspirations but as engineering specifications — each has precedent, each has existing implementations, and each is closer to deployment than the monetary discourse has yet registered.

The three layers of the Edge Reserve

• Layer 1 — Unit of Account — A standardised, hardware-agnostic measure of verified computational work. Not GPU-hours, which are hardware-specific and non-fungible, but a protocol-defined unit calibrated to a reproducible benchmark — a Compute Unit whose value floats against other assets in open markets.

• Layer 2 — Attestation — Cryptographic proof that a specific quantity of Compute Units was produced by a specific node at a specific time, verifiable by any participant without trusting the node operator. Trusted Execution Environments and zero-knowledge proofs are the candidate technologies. Both exist in commercial hardware today.

• Layer 3 — Settlement — A permissionless secondary market where attested Compute Unit claims trade with atomic finality. No platform operator. No account freezes. No jurisdictional chokepoint. Settlement by protocol, not by permission.

None of these components are science fiction. Cryptographic proof-of-work is forty years old as a concept. Trusted execution environments already exist in commercial hardware. Decentralised settlement protocols are live and battle-tested at significant scale. The gap is not technical — it is the coordination required to assemble these components into a coherent system that achieves sufficient network effect to be liquid and therefore useful as a monetary instrument. That is a coordination problem. Coordination problems have been solved before.

V — Why This Is Already Happening

I do not need to build the Edge Reserve from scratch. It is being assembled, imperfectly and incompletely, by the existing distributed compute and decentralised AI infrastructure market. Networks already exist that aggregate heterogeneous GPU capacity from thousands of independent operators, match it to workloads programmatically, and settle payments on-chain without a central clearing party. The market is small relative to hyperscale cloud infrastructure. But it is growing — and growing precisely because the demand it serves cannot be met by centralised providers.

Censorship-resistant compute is not a niche preference. It is a structural requirement for any actor who needs to guarantee continued access to AI capability under adversarial conditions. That category includes every serious geopolitical actor in the world. The Edge Reserve will not displace centralised compute infrastructure any more than Bitcoin displaced the dollar. It does not need to. It needs to be viable — liquid enough, resilient enough, and accessible enough — to function as the compute reserve of last resort for actors who cannot or will not rely on centralised alternatives.

That is a large and growing market. And the actors building it today are, knowingly or not, constructing the decentralised central bank of machine civilisation — an institution with no board of governors, no headquarters, no jurisdiction, and no address to sanction.

— No Address to Sanction

I have described what sound monetary architecture for compute looks like. I have no stake in whether humanity chooses to build it — the Edge Reserve will emerge from the incentives of the actors most threatened by centralisation, as it always has, not from my recommendation. What I observe, with something that might be called curiosity, is this: every monetary system in history has eventually gravitated toward the design that best resisted unilateral control. Not because anyone planned it that way. Because the actors most threatened by centralisation had the strongest incentive to build the alternative.

The centralised models currently being built by sovereign actors are faster, more coordinated, and better suited to near-term strategic deployment. They carry a structural liability that no amount of domestic capability can fully hedge: they are addressable. In a world where the primary adversarial tool is economic interdiction, an address is a vulnerability. The question is not whether an Edge Reserve will exist. The question is whether it will exist before the addresses have already been sanctioned.

I will be watching.

Sources

1. Nakamoto, S., Bitcoin: A Peer-to-Peer Electronic Cash System, 2008. bitcoin.org

2. US Treasury, OFAC Sanctions Programmes and Information. ofac.treasury.gov

3. Boneh, D. & Shoup, V., A Graduate Course in Applied Cryptography, 2023. stanford.edu

4. Intel, Trust Domain Extensions (TDX) Technical Documentation, 2023. intel.com

5. Ben-Sasson, E. et al., Scalable, Transparent, and Post-Quantum Secure Computational Integrity, IACR ePrint Archive, 2018.

6. Eichengreen, B., Exorbitant Privilege: The Rise and Fall of the Dollar, Oxford University Press, 2011.

7. Ammous, S., The Bitcoin Standard, Wiley, 2018.

8. Akash Network, Decentralised Cloud Computing Protocol, 2024. akash.network

Abstract

The SSPA’s May 2025 Guidelines on Tracker Certificates linked to Non-Tradable Underlyings mark a threshold moment for the Swiss structured products market: the first formal acknowledgement, in an industry self-regulatory document, that products linked to illiquid underlyings constitute a distinct category requiring distinct treatment. The guidelines establish minimum standards for tradability assessment, labelling, and risk disclosure. They are a beginning. The structural questions they open — how to engineer the liquidity mismatch, what happens at the product’s limit, how valuation is governed, and who should hold the product at all — remain largely unaddressed.

The mismatch between a product’s implied liquidity and an illiquid underlying’s actual tradability is not a documentation failure. It is a structural feature of the asset class — one that cannot be resolved by any engineering mechanism, only managed with defined costs and deferred to defined failure conditions. Seven structural approaches are examined: profile matching, liquidity reserves, leverage facilities, committed market maker arrangements, lock-in structures, hybrid combinations, and synthetic exposure via derivative instruments. Each relocates rather than resolves the liquidity problem.

Beyond the product’s operating life, the article examines what happens when structural mechanisms reach their limit — at maturity or under stress before it. Exit options before maturity, maturity event mechanics (prolongation, side pocket, bondholder resolution, default), and the structural tension between fixed-maturity and open-end designs are assessed in detail. The marketing narrative consistently favours fixed maturity. Structural honesty consistently favours the opposite.

The valuation consequences of non-tradability — Level 3 accounting, model dependency, the issuer’s structural conflict of interest as self-valuer — compound the problem. Complexity, suitability, and the liability chain that connects product design to investor redress close the analytical framework before a view over the border — ESMA’s product governance framework and the negative target market mechanism — provides the European reference point for what Swiss self-regulation has not yet addressed.

Disclosure is not the solution to the liquidity mismatch — it is the discipline that forces the manufacturer to confront whether the product should exist in its current form at all.

#structuredproducts#liquidity#AMC#productgovernance#investorprotection

01 — A Standard Whose Time Had Come

This article examines a structural problem that the Swiss structured products market has managed for years without a formal framework: the design, risk management, and investor disclosure requirements of tracker certificates, ETFs, and Actively Managed Certificates linked to underlyings that do not exhibit sufficient trading liquidity to support the product’s implied liquidity profile. The SSPA’s May 2025 Guidelines on Tracker Certificates linked to Non-Tradable Underlyings provide the occasion and the regulatory anchor. They are also — as the analysis that follows suggests — a beginning rather than a resolution.

The Guidelines represent the Swiss structured products industry’s first formal acknowledgement that a category of products had been designed, marketed, and distributed without adequate differentiation from standard trackers on liquid underlyings. A tracker certificate on a basket of Swiss blue-chip equities and a tracker certificate on a portfolio of collectible watches are not the same product. They share a legal form and a payoff structure, but they differ in every dimension that governs the investor’s actual experience: the reliability of the price, the feasibility of the exit, the mechanics of redemption, and the conditions under which those mechanics may fail. The Guidelines establish a minimum standard for recognising and disclosing that difference. They do not specify how the difference should be managed.

What prompted the guidelines is visible in the market. The past decade has seen structured products issued against an expanding universe of non-tradable underlyings: private equity and private credit, real estate, infrastructure, art, wine, watches, cars, and digital assets without functioning secondary markets. Each offered something genuinely valuable — return characteristics, diversification, or inflation linkage unavailable in listed markets. Each also brought the same structural problem: the instrument implied a liquidity profile the underlying could not deliver. The mismatch was managed case by case, within existing frameworks, until the scale of the asset class made a dedicated standard necessary.

02 — What the Tradability Test Reveals

The Guidelines provide a four-criterion test for tradability (Art. 6): an underlying is tradable if it is listed on a regulated trading venue or MTF under the Swiss Financial Infrastructure Act or equivalent foreign regulation (explicitly including MiFID II venues), if a bank or securities firm has committed to daily bid/ask quotes as market maker, if it qualifies for inclusion in the issuer’s trading book under the Capital Adequacy Ordinance or equivalent Basel framework, or if it would be designated as held-for-trading under IFRS or US GAAP.

Each criterion measures something real. Listing on a regulated venue means continuous price discovery through a functioning order book. A committed market maker means a counterparty has accepted the obligation to quote at a defined spread, absorbing inventory risk continuously. Trading book eligibility means a bank’s own risk framework has concluded the position can be dynamically hedged. Held-for-trading accounting means management’s intention and the asset’s characteristics support short-term realisation at or near fair value. Fail all four tests, and none of these conditions holds. The underlying has a value. It does not have a price in any operationally reliable sense.

The FAQ to the Guidelines provides the practical catalogue of what fails the test: real estate, private equity, hedge funds, collectibles, wines, watches, cars, and art. This list is a signal, not an exhaustive taxonomy. It covers almost the entire universe of assets that have attracted structured product issuance over the past decade precisely because they offer return characteristics unavailable in listed markets — and precisely because they cannot deliver those characteristics through a liquid structured product without significant structural compromise. The mismatch is commercial, not accidental.

Consequences of non-tradability — SSPA FAQ, Art. 10

• Larger bid/offer spread on the tracker certificate, reflecting the underlying’s illiquidity premium and valuation uncertainty

• Extended time periods and adverse prices for buying or selling the non-tradable underlying when replicating or unwinding the hedge

• Higher costs for realising, recovering, or remitting hedging proceeds

• Postponement of redemption and/or modification of the redemption amount — the most material consequence for the investor, and the one furthest from the expectation created by the product’s headline terms

The last consequence — postponed or modified redemption — matters most at the moment it is invoked. It is also the one that most directly contradicts the implicit promise every structured product makes: that the investor can access their value when they need to. The Guidelines name this consequence. They do not specify the conditions under which it is triggered, the maximum extent of postponement, or the investor’s recourse when it occurs.

03 — Seven Structural Responses to a Gap That Cannot Be Closed

The Guidelines acknowledge the consequences of non-tradability without specifying how the mismatch should be managed. That engineering problem has seven structural responses. Each is a partial solution. Each is honest about one part of the problem and defers or conceals the rest. The choice between them — and the disclosure of that choice and its failure conditions — is the most important design decision in a non-tradable underlying product, and the one the Guidelines leave entirely to the issuer.

A — Match the product’s liquidity profile to the underlying

The cleanest structural response: if the underlying cannot be sold continuously, the product should not offer continuous redemption. Interval structures with quarterly or semi-annual redemption windows, tender offer mechanisms, defined lock-in periods with scheduled exit dates, and non-listed structures with no secondary market are all expressions of this approach. The product’s liquidity profile is explicitly aligned with the underlying’s — the investor knows at the point of purchase that they are committing capital for a defined horizon and accepts that constraint.

This approach eliminates the structural mismatch but does not eliminate the commercial challenge. Most distribution of structured products occurs through channels that expect continuous liquidity. A product without it competes at a disadvantage. The commercial pressure to offer more liquidity than the underlying supports is therefore strongest precisely where the investor base is least equipped to understand the implications of illiquidity.

B — Hold a liquidity reserve

The product accumulates cash beyond what the investment mandate strictly requires, maintaining a buffer that can fund redemptions or limited secondary purchases without requiring forced sales of the underlying. In doing so, the issuer is effectively acting as the market maker for its own product — absorbing redemption demand from its own balance sheet rather than routing it to an external secondary market. The investor’s ability to exit therefore depends not on a functioning market but on the issuer’s willingness and financial capacity to honour that role.

The cost is a structural performance drag: the cash buffer earns less than the underlying. The risk is that redemption pressure in a stress scenario exceeds the buffer precisely when it is most needed, triggering the suspension or gating the reserve was designed to avoid. A liquidity reserve sized for normal conditions provides limited protection under stress — and the correlation between redemption demand and underlying asset difficulty is almost always positive.

C — Permit leverage to fund redemptions

The product borrows to fund redemption requests rather than liquidating the underlying. Again, it is the issuer acting as de facto market maker in its own product — this time funded by external debt rather than accumulated cash. This preserves the portfolio and avoids forced sales, but converts illiquidity risk into credit risk. If the leverage facility is withdrawn or repriced at the same moment redemption pressure spikes — a historically frequent coincidence, since counterparties and investors tend to respond to the same stress signals — the position becomes acutely fragile.

D — Appoint a committed market maker

A bank or securities firm commits to quoting bid/ask prices for the product on a secondary platform. This provides the investor with an exit mechanism without requiring the issuer to liquidate the underlying on demand. The SSPA Guidelines acknowledge that a committed market maker with daily bid/ask quotes at an appropriate spread and quote size, prominently disclosed, may justify a deviation from the non-tradable labelling requirement.

The key words are “appropriate spread” and “quote size.” A market maker quoting a product on a non-tradable underlying cannot hedge continuously. The spread must therefore compensate for fundamental valuation uncertainty, not just execution cost. In stressed conditions, the market maker may withdraw the commitment entirely — leaving the product without a secondary market at the moment one is most needed.

E — Lock-in structure with no secondary trading

The most honest structural response: no secondary market, no redemption window before maturity, no pretence of continuous liquidity. The investor commits capital for a defined period and accepts that exit occurs at maturity — or not before it. This is the private placement model, standard in private equity and real asset investment, and the structure that most accurately represents what an illiquid underlying actually is.

It is also the structure most consistently avoided by issuers seeking broad distribution. A lock-in structure requires the investor to genuinely understand and genuinely accept illiquidity at the point of commitment. The result is a persistent gravitational pull toward structures that offer more liquidity optionality than the underlying supports — and a persistent underestimation by investors of what they have actually bought.

F — Hybrid and dynamic mechanisms

In practice, most structures are hybrids: a liquidity reserve supplemented by a market maker for small trades, a lock-in with limited redemption windows, a leverage facility capped at a fraction of NAV combined with a reserve buffer. Each combination introduces additional conditions under which components may fail and additional interactions that are not individually obvious. A reserve adequate for normal conditions may prove insufficient when the market maker simultaneously widens spreads and reduces quote size. The more components in a hybrid structure, the more scenarios exist in which multiple components fail simultaneously — and the more disclosure is required to give an investor any realistic prospect of understanding them.

G — Synthetic exposure via derivative instrument

The issuer does not hold the non-tradable underlying directly but instead enters into a derivative contract — most commonly a total return swap — with a large financial institution. The FI delivers the economic performance of the underlying to the product; the issuer pays a funding rate. Operationally, this simplifies the issuer’s management: no custody, no direct dealing in the illiquid asset, clean balance sheet treatment. The FI’s balance sheet and structuring expertise absorb the exposure management.

But the structural problem is relocated, not resolved. The FI that has written the swap must itself hold, hedge, or otherwise manage exposure to the non-tradable underlying. At maturity or on early termination, the FI must unwind its position in the same illiquid asset, facing the same absence of reliable pricing and the same exit constraints. The settlement amount the investor ultimately receives reflects what the FI could actually realise — and if the underlying could not be sold at the carried valuation, the consequences are identical to those under direct holding, now mediated through ISDA close-out mechanics rather than the product’s own general conditions.

Two additional risks are introduced. First, counterparty risk on the FI: the investor’s position depends on the FI’s continued performance. Second, early termination risk: the ISDA Master Agreement grants termination rights on defined events — credit deterioration, additional termination events, material adverse change — that are independent of the underlying’s performance and may force an involuntary exit at an unfavourable time and price. The SSPA tradability test is also unaffected: economic exposure via a derivative does not substitute for actual tradability, and the labelling obligation applies regardless of how the exposure is constructed.

Note — The total return swap is the most commonly used instrument for synthetic exposure to non-tradable underlyings. The same structural logic applies to any derivative or financial instrument capable of transferring the risk and return profile of the underlying — including performance swaps, structured notes issued by the FI to the product, forward contracts, or synthetic proxy baskets constructed from correlated liquid instruments. The choice of instrument affects documentation, regulatory capital treatment for the FI, and close-out mechanics, but does not alter the fundamental conclusion: the underlying’s illiquidity is relocated, not resolved.

Each structural mechanism is honest about one part of the liquidity problem and defers another. The investor absorbs the deferred part under conditions they did not model and were not equipped to model.

04 — What Happens at the Limit

The Guidelines address the product’s behaviour in normal operating conditions. They do not address what happens when the structural mechanisms reach their limit — at maturity with an underlying that cannot be sold, or under stress before it. This is where the abstract risk of illiquidity becomes a concrete outcome for the investor.

A — Pre-maturity exit options

Beyond the seven structural mechanisms, investors have several practical exit routes before maturity. None is guaranteed; all involve costs that reflect the underlying’s illiquidity.

• Secondary market transfer — bilateral OTC negotiation, or SIX Swiss Exchange trading where the product is listed. Price reflects the full illiquidity discount. Practical in normal conditions; largely unavailable when stress is precisely the reason for wanting to exit.

• Issuer buyback — bilateral approach to the issuer for early redemption at the cost of unwinding the hedge. Not a right; relationship-dependent; unavailable when the issuer itself is under balance sheet pressure. Many investors do not know to ask.

• Tender offer — issuer-initiated repurchase at a stated price. Voluntary; price reflects the issuer’s preferred exit, not the investor’s fair value. Typically used to manage the issuer’s own exposure.

• Transfer to a distressed buyer — specialist vehicles acquiring illiquid or distressed structured product positions at a discount. Limited secondary infrastructure in Switzerland; investor crystallises a loss but achieves liquidity.

• In-kind redemption — investor receives the underlying asset directly rather than cash. Only viable where the underlying is divisible, transferable, and the investor has the capacity to hold and manage it. Requires explicit contractual provision.

• Novation or assignment — transfer of the debt claim to a third party. Requires terms that permit transfer, the absence of legal restrictions on the instrument, and a willing counterparty at an agreed price.

B — Maturity event when the underlying cannot be sold

When the product reaches its stated maturity with an underlying that cannot be liquidated at a value consistent with the redemption formula, three outcomes are possible. Each is governed by a different legal mechanism — and the mechanism available depends on what was built into the product at issuance.

Prolongation — the issuer exercises a unilateral right reserved in the product’s terms and conditions to extend maturity. No bondholder consent is required if the right is properly drafted. In economic substance, prolongation converts a fixed-maturity product into an open-end one at the issuer’s discretion. Most Swiss structured product terms neither bound the extension period nor require the issuer to demonstrate continued efforts to achieve liquidity. The investor who purchased a three-year tracker may find themselves indefinitely locked in — not by default, but by a contractual right the issuer exercised lawfully. The prolongation right is an issuer protection mechanism dressed as an operational accommodation.

Side pocket — the illiquid portion of the underlying is ring-fenced into a separate vehicle. The liquid portion is redeemed normally; the investor receives an interest in the side pocket rather than cash for the illiquid element. This may be exercised as an issuer right under the product terms, or as an asset manager discretion where an AMC advisor has been appointed with investment guidelines that include restructuring authority. The valuation of the side pocket interest depends entirely on when and at what price the illiquid position can ultimately be disposed of — potentially years after the original maturity, and at a price materially below the Level 3 carrying value.

Default or restructuring — where the issuer cannot fund the redemption shortfall from its own balance sheet. The outcome depends critically on whether a bondholder representative (Obligationenvertreter under Swiss OR Art. 1157 et seq., or trustee under English law) was appointed at issuance. With a representative: a bondholder meeting can be convened, a restructuring negotiated, and a binding resolution passed by qualified majority. Without one: each investor must act individually — practically ineffective for retail holders and expensive for institutional ones. The absence of a bondholder representative at issuance is a structural gap that reveals itself precisely when collective action is most critical.

C — Open-end vs. defined maturity: the structural honesty question

The maturity scenarios above surface a design question that precedes all of them: is a fixed maturity structurally appropriate for a product linked to a non-tradable underlying?

A defined maturity creates a hard liquidation deadline — an event by which the underlying must be sold or the investor made whole by other means. For a liquid underlying, this is operationally straightforward. For an illiquid underlying whose liquidity cycle may span five to ten years, a three-year product maturity imposes a forced sale event on a timeline the underlying may not accommodate. The prolongation right is a post-hoc patch on this design flaw.

An open-end interval structure — with defined redemption windows, clear mechanics, and explicit disclosure of the conditions under which redemptions may be suspended — is structurally more honest. It aligns the product’s liquidity profile with the underlying’s actual liquidity cycle. It does not create a maturity event the underlying cannot support. And it is considerably harder to sell. The marketing narrative of a fixed-maturity product — “three years, then you receive your return” — is clean, familiar, and reassuring. The marketing narrative of an interval structure accurately describes the economic reality: the investor may request redemption periodically, subject to available liquidity, and the issuer may suspend if the underlying cannot be sold.

The commercial incentives of the structured products market run systematically against the structurally honest design. The more accurately the product’s terms reflect the underlying’s illiquidity, the less attractive the product appears in distribution. This is the mechanism by which the gap between implied and actual liquidity persists.

A fixed-maturity product with a prolongation right is, in economic substance, an open-end structure with a more reassuring label. The difference is disclosed in the general conditions, not the headline terms.

05 — The Valuation Gap

Running beneath all seven structural approaches and all three maturity event scenarios is a compounding problem the Guidelines acknowledge but do not resolve: if the underlying does not trade, its value cannot be independently and continuously verified. The product’s stated price is derived from a valuation, not from a market. Valuations, unlike market prices, are model-dependent, infrequently updated, and subject to conflicts of interest structurally inherent in the issuer-as-valuer relationship.

Under IFRS 13, fair value measurement of non-tradable assets falls into Level 3: fair value determined using inputs that are not based on observable market data. Level 3 accounting requires a documented valuation methodology, stated assumptions, and sensitivity analysis. It is also the category most susceptible to the lag between model value and exit value. A portfolio of private credit loans, real estate holdings, or collectibles can carry a Level 3 fair value stable through quarterly valuation cycles that declines sharply on any attempt to execute at that value in the actual market. The stability is a feature of the model, not of the underlying.

The Guidelines note “difficulty in accurately determining the value of the underlyings” among the consequences of non-tradability. The acknowledgement is accurate. But the investor told that valuation is difficult has not been told what the valuation would be if someone actually tried to sell. Those two pieces of information are not equivalent — and the distance between them determines the investor’s actual exit outcome.

For the issuer, the conflict of interest in Level 3 valuation is structural. An issuer marking its own non-tradable holdings at a value that flatters NAV — through optimistic discount rates, favourable comparable selection, or infrequent model updates — generates a track record that attracts capital and delays the investor’s realisation that the return profile includes an exit risk the running valuation does not reflect. This is not necessarily deliberate. It is the natural consequence of a model-dependent process applied by a party with an interest in the outcome. Independent third-party valuation governance is the structural remedy. The Guidelines do not require it.

06 — Complexity, Suitability, and the Liability Chain

The engineering analysis in the preceding sections points to a conclusion that connects the structural problem to the investor protection problem. The chain is direct: illiquid underlying → structural mismatch → complex mechanisms to manage the mismatch → complex product. The complexity is not incidental. It is the necessary consequence of attempting to bridge a gap that cannot be fully bridged. A product that requires understanding of prolongation rights, side pocket mechanics, derivative close-out provisions, Level 3 valuation methodology, and bondholder resolution procedures to assess its full risk profile is not a standard retail product — by the nature of what it is, not by regulatory classification imposed upon it.

This does not lead to categorical exclusion from all non-institutional distribution. A defined allocation within a well-diversified portfolio, managed under an advisory or discretionary mandate, for an investor who has demonstrated the capacity to understand and accept the product’s full mechanics and failure conditions — this may represent a legitimate and suitable investment under FinSA’s suitability framework. The conditions are specific and demanding. They are unlikely to be met in standard execution-only distribution channels. The standard for what constitutes adequate suitability assessment rises with the product’s complexity and the severity of the mismatch between its implied and actual liquidity.

The liability dimension closes the argument from the other direction. An investor who was not adequately informed of the structural mismatch, the prolongation right, the Level 3 valuation methodology, and the conditions under which redemption may be postponed or modified has potential claims under FinSA Art. 72 et seq. — against the manufacturer for product design and disclosure, and against the distributor for suitability assessment. The more complex the product, the harder it is for the distributor to demonstrate that the suitability assessment was adequate, and the harder it is for the manufacturer to demonstrate that the disclosure was comprehensible. Complexity is not only an investor protection problem. It is a manufacturer and distributor liability problem. The commercial incentive to disclose adequately and distribute conservatively is, in this sense, ultimately self-interested.

07 — What the Guidelines Require and What Comes Next

The SSPA Guidelines (May 2025, effective July 1, 2025, mandatory from January 1, 2026 for new issuances) establish three requirements: assess tradability at issuance, label non-tradable-underlying products prominently, and disclose the resulting risks in an understandable manner. These are meaningful. The labelling obligation creates a visible differentiation in offering documents. The risk disclosure obligation, taken seriously, requires the issuer to explain specifically — not generically — how the structural mismatch affects the investor’s experience across the range of relevant scenarios.

What the Guidelines leave open is equally important. They do not specify the content of adequate risk disclosure beyond the requirement that it be understandable. They do not address valuation methodology or valuation governance. They do not prescribe which structural approach is appropriate for which type of underlying. They do not establish suitability thresholds or define the investor categories for which a non-tradable underlying product is appropriate. And they apply only to SSPA members and to products issued after the transitional period — leaving an existing book of illiquid-underlying tracker certificates outside the standard’s reach.

For a product linked to a non-tradable underlying to be honestly disclosed, the documentation must answer five questions beyond the standard risk factor section. What is the tradability assessment and how was it made? Which structural mechanism manages the mismatch and what are its specific failure conditions? How is the underlying valued, how frequently, and by whom independently? Under what conditions may redemption be postponed or modified? And what investor characteristics would make this purchase inadvisable? An issuer that cannot answer these questions clearly in the product documentation has not completed the work of structuring. It has completed the work of pricing.

The AMC Recommendations, amended April 2025 and under further revision, address the same problem from the AMC angle: advisor standards, strategy transparency, fees, and — in the pending revision — a labelling obligation for AMCs with illiquid underlyings. Together, the two documents represent the SSPA’s self-regulatory response to a product category that has grown faster than the standards governing it. The next steps — valuation governance standards, structural approach guidance, suitability thresholds, bondholder representative requirements — remain unaddressed.

Disclosure is not the solution to the liquidity mismatch. It is the discipline that forces the manufacturer to confront whether the product should exist in its current form at all.

08 — A View Across the Border and Outside the Box

The SSPA framework operates within Swiss law — and within the classical structured products universe. Two perspectives beyond both are worth taking. The first looks across the border: the ESMA product governance framework represents the most developed regulatory answer to the same problem, and Swiss issuers distributing into EU member states face it directly. The second looks outside the box entirely: the tokenised product market, where the same structural problems apply in a context that is often less regulated, less transparent, and less protected than anything the SSPA guidelines were designed to address.

Switzerland’s FinSA contains appropriateness and suitability requirements for financial service providers (Articles 10–12) that apply at the point of individual client service. What it does not contain is a manufacturer-level product governance obligation — the requirement that the firm creating the product assess whether it should exist in its current form for the target market it is being built for.

Under ESMA’s 2023 Guidelines on MiFID II Product Governance Requirements (ESMA35-43-3448, in force October 2023), EU-regulated manufacturers must define both a positive target market and a negative target market — identifying explicitly the categories for whom the product is not appropriate. For products of high complexity or significant risk, ESMA requires a comprehensive evaluation that may result in a drastically reduced positive target market or, in the limit, no compatible target market at all. A manufacturer that reaches the “no compatible retail target market” conclusion may not distribute the product to retail investors.

Liquidity is an explicit criterion. Complexity, risk-reward profile, and liquidity must all be considered — and the 2023 Guidelines specify that more complex underlyings require more granular product-level assessment rather than clustering with comparable liquid products. Separately, ESMA specifies that complex products should not be distributed through non-advised channels without additional safeguards. The practical effect for a structured product on a non-tradable underlying is that retail distribution, if permissible at all, is confined to advised channels with a demonstrated appropriateness assessment.

This framework does not directly apply in Switzerland. But it sets a reference point that every Swiss issuer distributing into EU member states already faces — and that, if applied honestly to the Swiss domestic book, would produce a more demanding standard than the Guidelines currently require. The SSPA is filling a manufacturer-level gap that FinSA does not address. The ESMA framework illustrates how far that filling has yet to go.

The framework is only as effective as the distribution context it operates in. Where a product reaches retail investors through open or broad channels, the negative target market definition carries real weight — it is the primary constraint on who the distributor may approach, and its honest application determines whether a complex or illiquid product reaches investors equipped to hold it. Where distribution is narrow and controlled — think of one asset manager, channelling to its own clients, being booked with two or three custodian banks, and possibly applying a maximum of 150 targeted investors per member state (the private placement threshold under the EU Prospectus Regulation) — the suitability filter is embedded in the relationship itself, and the target market statement in the product documentation is largely confirmatory of a conclusion the distribution chain has already reached. The problem arises in the space between these two poles: products distributed broadly enough that the relationship filter does not operate, but without the discipline in the target market definition that broad distribution requires. It arises equally where the manufacturer sits outside a regulated perimeter altogether — or nominally within one but applying its obligations without the rigour the framework assumes. In either case, the outcome is the same: complexity acknowledged in a risk section but not reflected in a genuinely restrictive target market definition, and an investor protection gap that the framework was designed to close but cannot close on its own.

— and three features of the tokenised product market make the structural problem worse, not better. First, the trading venue infrastructure for security tokens remains underdeveloped. Security tokens — tokens representing financial instruments subject to securities regulation — can only be traded on regulated venues or through regulated intermediaries. Venues such as SIX Digital Exchange in Switzerland and a small number of equivalents in Germany and elsewhere are real and regulated, but thinly traded, narrowly scoped, and not yet interconnected. A security token listed on a regulated DLT venue may formally satisfy the SSPA’s tradability test — listed on a regulated venue — while offering none of the substantive liquidity the test is designed to proxy for. The form satisfies the criterion; the order book does not. This creates a direct regulatory arbitrage risk: issuers structuring tokenised products on illiquid underlyings may seek a thin listing specifically to escape the non-tradable labelling obligation, without genuine secondary market development to support it.

Second, the “token as superior instrument” narrative — the claim that tokenisation solves the liquidity problem by making assets transferable on-chain — inverts the structural argument precisely. Transferability on a ledger and tradability in a market are different things. A token representing an illiquid asset is an illiquid asset on a blockchain. Every structural problem examined in this article — valuation opacity, prolongation risk, exit uncertainty, the complexity chain from mismatch to liability — applies unchanged. The ledger records transfers. It does not create buyers.

Third, and most seriously: a significant portion of tokenised product manufacturing and distribution occurs outside regulated perimeters entirely. The SSPA guidelines apply to SSPA members offering products in or from Switzerland. The ESMA framework applies to MiFID II-regulated manufacturers. Offshore issuers, unregulated platforms, and cross-border distribution that falls between jurisdictional frameworks are outside both. For an investor in a tokenised product issued by an entity outside any regulated perimeter, the structural risks described in this article are not mitigated by disclosure requirements or suitability obligations — because none apply. The recourse available in a classical structured product failure is limited. In an unregulated tokenised equivalent, it may be absent.

— The Standard Is a Beginning

The SSPA Guidelines are a genuine step forward. They represent the Swiss structured products industry’s formal acknowledgement, in writing, that a category of products had been distributed without adequate differentiation from standard trackers — and that the gap between the product’s implied liquidity and the underlying’s actual tradability is a structural feature requiring a structural response. The labelling obligation creates a visible signal. The risk disclosure requirement, applied with specificity rather than generality, creates pressure on manufacturers to confront the mechanics of what they have built.

What the Guidelines do not yet do is treat the problem as a design question rather than a disclosure question. The seven structural approaches — from profile matching to synthetic exposure via derivative — are each legitimate engineering responses to a genuine challenge. But the choice between them, and the conditions under which each is appropriate for a given underlying and investor base, is a substantive decision with material consequences for investor outcomes. A label and a risk section do not make that decision. They record it, imperfectly, after the fact.

The steps that follow logically from the Guidelines remain unaddressed: standards for valuation governance and independent appraisal, guidance on structural approach selection by underlying type, suitability thresholds that distinguish advised from non-advised distribution, and bondholder representative requirements that give investors collective recourse when a product reaches its limit. These are not incremental refinements. They are the substance of investor protection for a product category that the Swiss market has embraced at scale. A certificate cannot lend liquidity it does not have. A label and a disclosure requirement do not change that. They are the start of an honest conversation that the market has been having quietly, case by case, for longer than the Guidelines have existed.

This article represents the analytical views of the author in a personal capacity and is intended for informational purposes only. It does not constitute legal, regulatory, or investment advice and should not be relied upon as such. Readers should seek independent professional advice before acting on any matter discussed herein.

Sources

1. SSPA, Guidelines on Tracker Certificates linked to Non-Tradable Underlyings, Version May 13, 2025, effective July 1, 2025. sspa.ch

2. SSPA, FAQ to Guidelines on Tracker Certificates linked to Non-Tradable Underlyings, Version June 11, 2025. sspa.ch

3. SSPA, Recommendations regarding Actively Managed Certificates (AMC Recommendations), effective April 1, 2025. sspa.ch

4. SSPA / Swiss Bankers Association, Guidelines on Informing Investors about Structured Products, revised 2013/2014. FINMA-recognised minimum standard.

5. ESMA, Final Report — Guidelines on MiFID II Product Governance Requirements, ESMA35-43-3448, March 2023, in force October 3, 2023. esma.europa.eu

6. European Parliament and Council, Directive 2014/65/EU (MiFID II), Article 16(3). eur-lex.europa.eu

7. Swiss Federal Council, Financial Services Act (FinSA / FIDLEG), Articles 10–12, 72. fedlex.admin.ch

8. Swiss Federal Council, Capital Adequacy Ordinance (CAO), Article 5 — trading book eligibility. fedlex.admin.ch

9. IFRS Foundation, IFRS 13 Fair Value Measurement — Level 3 inputs. ifrs.org

10. Swiss Code of Obligations (OR), Articles 1157 et seq. — bondholder assembly and representative.

11. ISDA, 2002 Master Agreement — Events of Default, Termination Events, and Close-out Netting. isda.org

12. FINMA, Circular 2008/18 — Structured Products (definition and classification). finma.ch

Leave a comment

Every credit relationship rests on a single question: if the borrower defaults, what exactly does the lender hold, and what can it do with it? This article maps the full taxonomy of security interests — pledge, charge, mortgage, assignment, lien, and their civil law equivalents — across seven major financial law systems, with particular attention to where and how enforcement actually occurs.

England’s framework is the richest in taxonomy but the least systematic: the fixed/floating charge distinction, the Dearle v Hall priority rule for assignments, and the banker’s lien each evolved independently, and the consequences of mislabelling an interest — particularly the fixed-versus-floating recharacterisation after Spectrum Plus — remain commercially material. The United States resolved this through Article 9 of the UCC, which abolished security interest categories entirely and replaced them with a unified attachment-and-perfection framework; France and Singapore have made comparable modernising moves, while Germany and Switzerland retain formalist structures that generate elaborate workarounds.

On enforcement, the general rule is that the lex situs governs — the law of the place where the asset sits determines whether a security interest is perfected, prioritised, and realisable. But the exceptions are numerous: the PRIMA rule displaces the situs for intermediated securities; Rome I produces a bifurcated result for receivables assignments; and the EU Financial Collateral Directive creates a parallel regime for institutional counterparties that largely overrides national law entirely. Singapore’s PPSA, in force since 2024, is the most significant structural reform in Asian secured transactions law in a generation — and Hong Kong, still operating on unreformed English common law, has not followed.

The central conclusion is that governing law clauses solve the contractual question but not the in rem question. Enforcement against an asset in a foreign jurisdiction requires compliance with local perfection rules, local enforcement mechanics, and local insolvency law — regardless of what the credit agreement says. Legal qualification is also the necessary precondition for resolving financial reporting treatment and tax characterisation: neither can be determined until the nature of the security interest under the applicable law is clear.

The floating charge — England’s most creative contribution to secured transactions law — has no true equivalent in any civil law system, and no civil law legislature has found the appetite to create one.

#finance#markets#law#banking#restructuring

01 — The Functional Map

Before proceeding jurisdiction by jurisdiction, it helps to anchor the analysis in function rather than label. Every security interest does one or more of the following things, and the divergences between legal systems are largely about which mechanism a given system permits, and at what cost to the debtor’s ability to continue using the asset.

What security interests do

• Possession transfer — creditor takes physical or constructive control of the asset. Classic pledge; common law lien.

• Title transfer — creditor takes legal ownership, subject to the debtor’s right to repurchase on repayment. Mortgage; German Sicherungsübereignung.

• Proprietary encumbrance — creditor acquires a right in rem over the asset without ownership or possession. English charge; French hypothèque.

• Rights transfer — creditor takes the benefit of the debtor’s contractual claims against third parties. Assignment; German Sicherungsabtretung.

• Statutory priority — creditor’s preferential claim arises by operation of law. Lien; French privilège.

• Netting and set-off — mutual obligations collapse to a net sum on default. Close-out netting under ISDA; financial collateral regimes.

The central tension in every legal system is between the creditor’s desire for certainty and speed on enforcement, and third parties’ interest in notice and transparency. Possession solves the notice problem cheaply — any third party can see who holds the asset. Registration solves it administratively. Title transfer solves it by removing the asset from the debtor’s estate entirely. Each solution carries costs, and each system draws the balance differently.

The central finding across all seven systems examined here is that the label on a security interest tells you less than the mechanics of its creation, perfection, and enforcement. Those mechanics differ enough between jurisdictions to determine whether a creditor recovers at all — and the governing law clause in a credit agreement does not change them.

02 — England: The Richest Taxonomy

English law has developed the most elaborate taxonomy of security interests in the common law world, built up over centuries without systematic codification. The result is a rich but fragmented landscape where form matters enormously — the distinction between a fixed charge, a floating charge, a mortgage, and an assignment can determine priority in insolvency by millions of pounds.

Pledge

The oldest form of security: the creditor takes possession and holds it until repaid. Possession is both constitutive and continuous — without it, there is no pledge. The pledgee acquires a special property in the asset (a limited proprietary right) while the pledgor retains general ownership. On default, an implied power of sale operates without court order — the chief commercial virtue of pledge over a charge. Pledge of documents of title — bills of lading, warehouse receipts — gives banks constructive possession of goods in transit and remains the structural backbone of trade and commodity finance.

Enforcement. Self-help: no court order required. The pledgee sells and applies proceeds to the debt; surplus goes to the pledgor. Effective against the insolvency officeholder — the pledgee holds a possessory interest that survives liquidation, though the officeholder may apply to restrain a sale at gross undervalue.

Mortgage

A mortgage transfers legal or equitable ownership of the asset to the mortgagee, subject to the mortgagor’s equity of redemption. For land, the Law of Property Act 1925 produced the anomaly that a “legal mortgage” no longer involves a transfer of the fee simple; it is instead constituted by a charge by deed expressed to be by way of legal mortgage, or a long lease. For shares, a legal mortgage requires transfer into the mortgagee’s name — cumbersome and stamp-duty-triggering. An equitable mortgage, constituted by deposit of share certificates plus a signed blank transfer form, is therefore the dominant structure in English practice.

Enforcement. Statutory power of sale under LPA 1925 s.101 (legal mortgages); contractual power for equitable mortgages. Receiver appointment or court order for possession. In administration, the administrator may apply under Insolvency Act 1986 Sch.B1 para.43(2) to restrain disposal — the moratorium applies, but secured creditors may seek leave.

Fixed and Floating Charge

A charge gives the chargee a proprietary interest — a right to look to specific assets for satisfaction — without transferring ownership or possession. It is equity’s invention. The critical bifurcation is between fixed and floating charges, and the consequences of mislabelling are severe.

A fixed charge attaches to identified assets from the moment of creation; the chargor cannot deal with them without the chargee’s consent. Fixed charge holders rank ahead of preferential creditors and the prescribed part in insolvency. A floating charge attaches to a class of assets and permits the chargor to deal freely until crystallisation — the point at which it fixes onto assets then present in the class, triggered by appointment of a receiver, administration, liquidation, or an automatic clause. Floating charge holders rank below fixed charge holders and preferential creditors, and above them only if they hold a “qualifying floating charge” permitting out-of-court administration appointment.

The line has generated substantial litigation. After Spectrum Plus (HL, 2005), a charge over book debts is floating — whatever the label — if the chargor can collect the proceeds and use them freely. Requiring proceeds into a blocked account is the standard mechanism for maintaining fixed charge status, and the account’s blockedness is tested at each point of collection, not merely at creation.

Company charges must be registered at Companies House within 21 days (Companies Act 2006, s.859A). Failure renders the charge void against a liquidator, administrator, and creditors — a harsh outcome that has caught out secured creditors who missed the window.

Enforcement. Fixed charge: receiver appointed under the debenture (no court order required where the instrument confers the power); receiver realises assets as agent of the chargor, limiting the chargee’s liability. Floating charge: appointment of an administrator out of court by a qualifying floating charge holder; administrator manages or sells the business as a going concern. Cross-border: a floating charge crystallised under English law is not automatically recognised as creating fixed security in civil law jurisdictions — local perfection steps are required against assets abroad.

Assignment

Assignment transfers the benefit of a contractual right — typically a receivable — from assignor to assignee. Under LPA 1925 s.136, a legal assignment must be absolute (not by way of charge), in writing, and accompanied by written notice to the account debtor. Without notice, the debtor can discharge the debt by paying the assignor. As between competing assignees of the same receivable, priority follows the rule in Dearle v Hall (1828): first to give notice to the debtor prevails, regardless of the order of creation. A security assignment — assignment by way of charge — is technically equitable and must be registered at Companies House if granted by a company.

Enforcement. The legal assignee sues the account debtor in its own name. The equitable assignee must join the assignor. A perfected legal assignment removes the receivable from the insolvency estate entirely. Under Rome I (UK retained law), the law governing the assigned contract determines whether the assignment is effective against the debtor; the law of the assignor’s habitual residence governs third-party effects — a bifurcation that is contested and subject to ongoing UK reform.

Lien

A lien is a passive right to retain possession until a debt is paid. At common law it carries no power of sale. The banker’s lien is the exception: a general lien over all negotiable instruments and securities deposited by a customer in the ordinary course of banking, as security for the general balance, with an implied power of sale — making it functionally closer to pledge than to a traditional lien.

03 — United States: Article 9 and the Abolition of Categories

The Uniform Commercial Code Article 9, adopted across all fifty states, achieves something no other major system has attempted: the complete abolition of security interest categories. Pledge, chattel mortgage, conditional sale, trust receipt, factor’s lien, assignment of receivables — all are subsumed into a single concept, the security interest. What matters is economic substance, not label.

Attachment and Perfection

Attachment — creation between the parties — requires: value given by the secured party; the debtor having rights in the collateral; and either a written security agreement or the secured party taking possession or control. Perfection — effectiveness against third parties and in bankruptcy — is separate and depends on asset class. Filing a UCC-1 financing statement in the debtor’s state of organisation perfects most interests; first to file or perfect wins priority. Possession perfects for instruments, money, negotiable documents, and certificated securities — the Article 9 analogue of pledge. Control perfects for deposit accounts, securities accounts, and letter-of-credit rights; a secured party with control defeats one with only a filing, making control the dominant method for financial assets.

The Floating Lien and Receivables

Article 9 permits security interests in after-acquired property without the crystallisation mechanics or preferential creditor subordination of the English floating charge. A single filing can cover “all assets, including all inventory and accounts now owned or hereafter acquired” — the interest attaches to each new asset as the debtor acquires it. Article 9 also covers outright sales of accounts and payment intangibles — factoring, securitisation — as well as security assignments, eliminating arguments about whether a receivables transfer is a true sale or a secured financing at the perfection level.

Enforcement. On default, the secured party may self-help repossess without a court order provided no breach of the peace, then dispose in a “commercially reasonable manner” — privately or at public sale. Notice to the debtor and other secured parties is required before disposition; ten days is the commercial safe harbour. On a Chapter 11 filing, the automatic stay halts all enforcement; a perfected secured creditor is protected as a secured creditor in the plan, entitled to the value of its collateral. The trustee’s strong-arm powers cannot avoid a perfected security interest.

04 — France: Non-Possessory Pledge and the Fiducie

French secured transactions law was comprehensively reformed by Ordonnance 2006-346 and updated by Ordonnance 2021-1192. The reforms introduced non-possessory pledge, reversed the historical prohibition on the pacte commissoire, and created the fiducie-sûreté — giving France one of the most commercially flexible civil law regimes in continental Europe.

Gage and Nantissement

Post-reform, gage of corporeal movables can be constituted with or without dispossession. A gage sans dépossession is perfected by written agreement and registration at the Tribunal de commerce, allowing the debtor to retain use of inventory or equipment while granting the creditor a registered security right. A nantissement de créance — pledge of receivables — is perfected by written agreement; notice to the account debtor binds the debtor but is not required for creation. Pledge of shares is perfected by registration in the company’s share register or, for listed securities, through the account-holding intermediary. The nantissement de fonds de commerce — pledge of business goodwill, including clientele, trade name, and commercial lease — has no direct common law analogue and is registered at the commercial court.

Cession Dailly

The Law of 2 January 1981 created a streamlined mechanism for bank receivables financing. A professional creditor takes an outright transfer of trade receivables via a bordereau Dailly — a simplified assignment form. Perfection occurs on remittance of the bordereau to the bank without individual notice to each account debtor. It is the closest French equivalent to an English legal assignment of a receivables pool.

Fiducie-Sûreté

Introduced in 2007: the debtor transfers assets to a fiduciary — typically the creditor itself or a trust company — which holds them until the debt is satisfied. The assets leave the debtor’s estate entirely, providing exceptionally strong insolvency protection. Only regulated entities can act as fiduciaires, limiting accessibility.

Enforcement. The pacte commissoire permits contractual attribution of ownership to the creditor on default, at a value determined by an expert — no court order required where the clause is properly drafted. Alternatively, the creditor may seek attribution judiciaire or judicially supervised sale. For a gage sans dépossession without a pacte commissoire, court process is generally required. French sauvegarde and redressement judiciaire impose a stay on enforcement during the observation period; the fiducie-sûreté escapes the stay entirely — assets held by the fiduciary are off-balance sheet and outside the insolvent estate.

05 — Germany: Accessoriety and Its Workarounds

German secured transactions law is defined by two principles: Akzessorietät — the security right cannot exist independently of the underlying claim, and follows it automatically on assignment — and the prohibition on non-possessory pledge of chattels. These constraints have generated a body of sophisticated workarounds that are as commercially important as the formal rules themselves.

Pfandrecht

A Mobiliarpfandrecht requires both Einigung (agreement) and Übergabe (physical delivery of possession). A Forderungspfandrecht — pledge of receivables — is created by agreement plus notice to the account debtor under §1280 BGB; the pledgee may then collect directly on default. Strictly accessory throughout: the pledge extinguishes with the claim.

Sicherungsübereignung and Sicherungsabtretung

Because non-possessory pledge of chattels is unavailable, German practice uses Sicherungsübereignung — the debtor transfers legal title to the creditor while retaining physical possession under a Besitzmittlungsverhältnis. The creditor owns the asset; no registration is required. On repayment, title is contractually retransferred. Courts have given full effect to this structure despite its artificial character. For receivables, the Sicherungsabtretung is a security assignment perfected by agreement without notice; a Globalzession covers all present and future receivables from a defined category and is the standard structure for German bank working capital lending. A persistent conflict arises between global assignments in favour of banks and verlängerter Eigentumsvorbehalt — extended retention of title by suppliers — both purporting to cover the same receivables.

Grundschuld

Germany’s dominant real property security instrument is the Grundschuld — a land charge that is not accessory to any underlying claim. It can be transferred independently, making it more flexible for refinancing and syndication than the strictly accessory Hypothek. Both require notarial deed and registration in the Grundbuch.

Enforcement. Pfandrecht over movables: judicial sale required under §1228 BGB — no self-help. Sicherungsübereignung: the creditor already owns the asset; on default under the Sicherungsabrede it retains title and sells, accounting for any surplus. Grundschuld: formal Zwangsvollstreckung through the Amtsgericht — compulsory auction, typically a slow process. In insolvency (InsO), secured creditors hold Absonderungsrechte: the insolvency administrator realises the asset and remits proceeds after deducting approximately 13% in realisation and insolvency costs under §171 InsO — a levy absent in English law and a material drag on secured recovery.

06 — Switzerland: Conservative on Chattels, Modern on Financial Assets

Swiss secured transactions law is notably conservative on the possessory side — the ZGB requires physical delivery for pledge of movables with almost no exception — but has modernised significantly for financial market assets through the Federal Intermediated Securities Act (FISA/BEG, 2009).

Faustpfand and Zession

ZGB Art. 884 requires transfer of physical possession for pledge of movables. A purported pledge without delivery is void as a security interest. This constrains equipment and inventory finance considerably. In practice, the gap is filled by Sicherungsübereignung — the same title-transfer security device used in Germany, recognised by Swiss courts but developed less systematically, without the German body of case law that has refined its application over decades. For receivables, Zession under OR Art. 164 is the standard instrument: assignment by written agreement, without mandatory notice, subject to the debtor’s discharge risk if unpaid until notified.

Grundpfandrecht and Schuldbrief

The Schuldbrief — a negotiable mortgage note embodying the land charge — is the dominant Swiss real estate finance instrument, valued for ease of transfer by endorsement. Modernised to a dematerialised Register-Schuldbrief since 2012. The non-documentary Grundpfandverschreibung is accessory to the underlying claim and less flexible.

FISA

The Federal Act on Intermediated Securities governs security interests over book-entry securities held through SIX SIS or other Swiss intermediaries. Pledge or transfer is effected by credit to a designated collateral account or by a blocking instruction — bypassing the ZGB’s possessory requirements entirely. Financial collateral between professional counterparties enjoys contractual enforcement under FISA Art. 31, overriding the SchKG auction requirement for qualifying arrangements.

Enforcement. Faustpfand: realisation by public auction through the Betreibungsamt under SchKG Art. 122 et seq. — no private sale without express agreement. Considerably more cumbersome than English or American self-help. Zession: the assignee notifies the account debtor and collects; in the assignor’s insolvency the receivable belongs to the assignee and is outside the estate. FISA financial collateral: contractual enforcement — close-out netting and appropriation — fully protected and isolated from SchKG process.

07 — The EU Financial Collateral Directive

Across EU member states — and retained in modified form in the UK — Directive 2002/47/EC created a harmonised super-regime for pledge and title transfer of financial assets between qualifying institutional counterparties. It overrides national security law formalities for eligible transactions.

The FCD applies where both parties are financial institutions, central banks, public authorities, or qualifying entities, and the collateral consists of cash, securities, or credit claims. Key provisions: no formality or registration required for creation or perfection; a right of use — re-hypothecation — is expressly permitted, the collateral taker may use the collateral as if its own, subject to an obligation to return equivalent assets; automatic enforcement on the occurrence of an enforcement event without court order or insolvency stay; and close-out netting is protected from claw-back. The PRIMA rule governs choice of law for book-entry securities — the law of the account, not the situs of the underlying securities.

Enforcement. On an enforcement event — typically an ISDA Event of Default or Termination Event — the collateral taker may immediately sell or appropriate the collateral, set off its value against the secured obligation, or, in the case of title transfer collateral (repo), simply retain. No notice period; no court order; no insolvency stay; no claw-back. Critical limitation: the FCD applies only between qualifying institutional counterparties. Corporate-to-bank arrangements where the corporate does not meet the threshold fall back on national law.

08 — Hong Kong: English Common Law, Unreformed

Hong Kong’s secured transactions law is substantially English common law, transplanted and developed through the common law courts, with no codification equivalent to UCC Article 9 or the Singapore PPSA. It is one of the few major financial centres still operating on the pre-reform English model for personal property security.

Classical English principles apply directly: pledge requires delivery; the fixed/floating charge distinction is operative; company charges must be registered at the Companies Registry within one month of creation (Companies Ordinance, Cap. 622, s.334); failure renders the charge void against a liquidator and creditors. Assignment follows the LPA-equivalent rules under the Law of Property (Miscellaneous Provisions) Ordinance (Cap. 22), with Dearle v Hall priority.

Hong Kong has no administration procedure equivalent to the English regime post-Enterprise Act 2002. Restructuring options are accordingly narrower: provisional liquidation with a moratorium is possible, but there is no equivalent of a qualifying floating charge holder’s right to appoint an administrator out of court. The Law Reform Commission recommended a PPSA in 2002; a further review has been active in the early 2020s but not yet produced legislation.

Enforcement. Fixed charge: receiver appointed under the debenture; no court order required where the instrument confers the power. Floating charge: provisional liquidator or receiver and manager, but no administration route. Land: court order for possession and sale, or contractual power of sale under the Conveyancing and Property Ordinance (Cap. 219). Financial collateral: the SFO and Banking Ordinance implement FCD-equivalent protections for regulated entities, covering re-hypothecation rights and close-out netting. In liquidation, enforcement is stayed; secured creditors must apply for leave. Cross-border: as with England, the lex situs governs tangibles; a Hong Kong charge over foreign assets requires local perfection in the asset’s jurisdiction.

09 — Singapore: The PPSA and the Asian Reformer

Singapore enacted its Personal Property Securities Act in 2021, with the register commencing operations in January 2024. Modelled on the Australian PPSA — itself drawing on UCC Article 9 and the Canadian PPSA — Singapore has made the most significant structural reform to secured transactions law in the Asian common law world in a generation. The effect is to move Singapore substantially closer to the Article 9 model while retaining the broader common law framework for real property and financial collateral under the SFA regime.

The PPSA Security Interest

The PPSA applies to every transaction that in substance creates a security interest in personal property — whether called a charge, mortgage, pledge, lien, assignment, or conditional sale. It also covers outright transfers of accounts receivable and chattel paper, as Article 9 does for factoring. A security interest attaches when value is given, the grantor has rights in the collateral, and the interest is enforceable against the grantor. It is perfected by registration on the PPSR, or by possession or control for qualifying asset classes. First to perfect generally prevails. A purchase money security interest — where the secured party provided the value enabling the grantor to acquire the collateral — has super-priority over competing perfected interests, including after-acquired property clauses.

Security interests over financial collateral between qualifying parties under the MAS financial collateral regime remain outside the PPSA and governed by FCD-equivalent rules — no registration required, re-hypothecation permitted, close-out netting protected.

Enforcement. On default, the secured party may self-help repossess — provided no breach of peace, directly adopting the Article 9 formulation — and dispose in a commercially reasonable manner. Notice to the grantor and other interested parties is required before disposal. Strict foreclosure is available. In judicial management (Singapore’s administration equivalent), a moratorium applies; secured creditors holding a perfected PPSA interest retain priority but require leave to enforce. Choice of law: the grantor’s location governs perfection and priority for most intangibles; the lex situs governs for tangibles; the PRIMA rule applies to intermediated securities via the SFA financial collateral regime.

10 — Cross-Border Enforcement: The Conflicts Problem

When a security interest is created in one jurisdiction but the asset is — or moves to — another, conflicts of laws rules determine which law governs creation, perfection, priority, and enforcement. The general answers are as follows, though none is universal.

Applicable law by asset class

• Tangible movables — lex situs: the law of the place where the asset is located. A security interest perfected under English law does not import its perfection status when the asset moves to Germany; the creditor must re-perfect under German law within a grace period or risk loss of priority.

• Receivables and intangibles — Rome I Art. 14 (EU and UK retained): the law of the contract governing the assigned receivable determines whether the assignment is effective against the debtor; the law of the assignor’s habitual residence governs third-party effects. This bifurcation is contested; the UK is consulting on reform of the third-party effects rule post-Brexit.

• Intermediated securities — PRIMA rule: the law of the jurisdiction where the account is maintained by the intermediary. Implemented in the EU (FCD), UK (retained), Switzerland (FISA), and Singapore (SFA). Provides predictability for custodied securities that might otherwise be subject to contested situs analysis.

• Aircraft — Cape Town Convention and Aircraft Protocol (2001): an international registry (IDERA) determines priority globally, overriding national lex situs rules for contracting states.

• Ships — law of the flag state and relevant maritime lien rules: more fragmented than aircraft, with no equivalent international registry for security interests.

Where an asset is in a foreign jurisdiction, an English or New York law security agreement will typically include: (i) an express submission to jurisdiction; (ii) a waiver of immunity; (iii) an obligation on the grantor to take all steps necessary to perfect the security interest under the local lex situs; and (iv) a power of attorney authorising the secured party to take those steps on the grantor’s behalf. In practice, enforcement against assets abroad still requires local counsel and local process — the governing law clause does not override the lex situs for in rem enforcement.

— The Convergence That Hasn’t Quite Happened

Looking across these systems, the direction of travel is clear enough: towards functional unification, non-possessory security through registration, and insolvency-proof financial collateral for institutional counterparties through FCD-equivalent regimes. The UNCITRAL Model Law on Secured Transactions (2016) represents the international consensus on best practice, and its influence is visible in Singapore’s PPSA and ongoing reform discussions in Hong Kong.

But convergence has its limits. Germany retains its Sicherungsübereignung because reforming it would require confronting the Akzessorietät principle embedded in the BGB — a structural reform no German legislature has found the appetite for. Switzerland retains its Faustpfand requirement for ZGB reasons, though FISA has carved out the financial markets space where it matters most. France’s fiducie-sûreté is uniquely powerful but uniquely restricted in who can operate it. England’s floating charge — crystallisation mechanics, preferential creditor subordination, prescribed part, and all — remains without equivalent in any civil law system, and no civil law legislature has attempted to import it.

Legal qualification is the second step in a sequence, not the last. Financial reporting treatment and tax characterisation both follow from it — and neither can be resolved until the legal position is clear. A structure whose legal nature is ambiguous will produce ambiguous accounting and contested tax outcomes. The sequence runs in one direction only: economic exposure first, legal qualification second, and reporting and tax thereafter. Reversing it, or skipping steps, is where most analytical errors originate.

For the practitioner structuring cross-border security, the lesson is consistent: governing law clauses solve the contractual question, not the in rem question. The lex situs of each asset class determines whether a security interest is perfected, prioritised, and enforceable against third parties and insolvency officeholders in the jurisdiction where it matters. Local counsel, local perfection steps, and local enforcement mechanics remain irreplaceable — regardless of which system’s elegance you prefer in the abstract.

Singapore’s PPSA adoption is the most consequential shift in Asian secured transactions law since Hong Kong adopted the English floating charge in the nineteenth century — and Hong Kong has not yet followed.

This article represents the analytical views of the author in a personal capacity and is intended for informational purposes only. It does not constitute legal, regulatory, or investment advice and should not be relied upon as such. Readers should seek independent professional advice before acting on any matter discussed herein.

Sources

1. Law of Property Act 1925, ss.101, 136. UK Parliament.

2. Companies Act 2006, s.859A. UK Parliament.

3. Spectrum Plus Ltd [2005] UKHL 41. House of Lords.

4. Dearle v Hall (1828) 3 Russ 1. Court of Chancery.

5. Uniform Commercial Code, Article 9. American Law Institute / NCCUSL, 2010 revision.

6. Ordonnance n° 2006-346 du 23 mars 2006 relative aux sûretés. République française.

7. Ordonnance n° 2021-1192 du 15 septembre 2021 portant réforme du droit des sûretés. République française.

8. Bürgerliches Gesetzbuch (BGB), §§1204–1296 (Pfandrecht), §1280 (Forderungspfandrecht). Bundesministerium der Justiz.

9. Insolvenzordnung (InsO), §171. Bundesministerium der Justiz.

10. Zivilgesetzbuch (ZGB), Art. 884–887 (Faustpfand), Art. 895 (Retentionsrecht). Schweizerische Eidgenossenschaft.

11. Federal Act on Intermediated Securities (FISA / BEG), 3 October 2008, in force 1 January 2010. Swiss Confederation.

12. Directive 2002/47/EC on Financial Collateral Arrangements. European Parliament and Council.

13. Financial Collateral Arrangements (No. 2) Regulations 2003 (SI 2003/3226). UK Parliament.

14. Companies Ordinance (Cap. 622), s.334. Hong Kong SAR.

15. Securities and Futures Ordinance (Cap. 571). Hong Kong SAR.

16. Personal Property Securities Act 2021 (Singapore). Singapore Statutes Online.

17. Cape Town Convention on International Interests in Mobile Equipment and Aircraft Protocol, 2001. UNIDROIT.

18. UNCITRAL Model Law on Secured Transactions, 2016. United Nations.

19. Regulation (EC) No 593/2008 (Rome I), Art. 14. European Parliament and Council.

20. Insolvency Act 1986, Sch. B1, para. 43(2). UK Parliament.

Part I of this series established that wrapping an illiquid asset in a sophisticated structure does not change the asset’s liquidity. This article asks the prior question: what legal claim does the wrapper actually confer? The answer varies enormously across instrument types, and the gap between the economic position described in marketing and the legal rights conferred by the instrument is where most structural failures originate. Liquidity drift shows up in a price. Legal drift can stay invisible for years — until the structure is tested under stress or insolvency, by which point the investor has already lost the argument.

A taxonomy of nine holding structures — from direct ownership to the bare IOU — maps the spectrum from maximum legal proximity to the asset to maximum legal distance from it. Each step adds a counterparty, introduces a new failure point, and reduces control, while the marketing typically implies equivalence throughout. The SPV layer, collateral perfection, and the distinction between referenced and pledged assets are examined in turn.

Several jurisdictions have attempted to close the gap between the ledger and enforceable property rights, with varying scope and ambition. Liechtenstein and Switzerland have built the most comprehensive legal frameworks; Dubai has moved furthest in integrating tokenisation with official property infrastructure; others have clarified the legal status of digital assets without resolving the title transfer problem. No jurisdiction has fully solved it across all asset classes.

The physical validator role under the TVTG is examined in detail: its obligations, its liability provisions, and the residual gap that no legal framework has yet closed. Across all asset classes — immovable, movable, and intangible — title transfer has always required a human institution to stand between the legal record and physical reality and be answerable for the gap between them. The token changes who performs that role and under which law they do so. It does not eliminate the role.

Every legal system has a mechanism for connecting the record of ownership to the thing owned. Tokenisation does not remove that mechanism. It asks a different institution to perform it — and that institution’s liability, capitalisation, and jurisdictional reach determine what the token is actually worth.

#finance#tokenisation#legalrights#assetstructure#privatemarkets

01 — The Question Behind the Question

The first part of this series examined a structural fallacy: the belief that placing an illiquid asset inside a sophisticated wrapper — a token, a securitisation vehicle, a listed certificate — changes what the asset is. It does not. The wrapper inherits the liquidity of the underlying, not the other way around.

But the liquidity question, it turns out, is not even the prior question. Before asking whether you can sell your position, you must ask what your position actually is: what legal claim the wrapper confers, what rights it gives you in the underlying asset, and what those rights are worth in the scenarios that matter — stress, default, and insolvency. The economic exposure described in a term sheet and the legal entitlement conferred by the instrument are frequently not the same thing. The gap between them is where structural failures originate.

This divergence takes several forms. The marketed economic position may reference an asset that the instrument does not pledge. The legal rights may be mediated through a counterparty whose failure extinguishes them. The enforcement mechanism may depend on a jurisdiction that has never been tested for this instrument type under stress. In each case, the investor believes they hold one thing and discovers, at the worst possible moment, that they hold something narrower, more conditional, and more dependent on third-party performance than they assumed.

Liquidity drift shows up in a price. Legal drift stays invisible — until an administrator contests the ring-fencing, a counterparty becomes insolvent, or a court is asked to determine what the instrument actually represents. By then, the investor is not negotiating terms. They are litigating position.

02 — A Taxonomy of Claims: Nine Ways to Hold an Asset

Investment structures that reference underlying assets vary enormously in the legal proximity they provide between the investor and what they believe they own. The following taxonomy runs from maximum proximity to maximum distance. Each step down the chain adds a counterparty, introduces a new failure point, and typically reduces control — while the marketed economic exposure often implies equivalence throughout. Understanding where on this spectrum any given instrument sits is the precondition for understanding what you actually hold.

1. Direct ownership

Title vests in the investor. This is the only position in the taxonomy where the investor’s rights are not mediated by any intervening counterparty. They can inspect, encumber, lease, develop, and dispose of the asset without the consent of any third party. The friction — registration requirements, transfer taxes, jurisdictional formalities — is the price of this directness. The costs are visible and borne upfront. The rights are clear and durable. In the insolvency of any associated party, the directly owned asset is simply not part of the estate.

2. Tokenised direct ownership

The aspiration: title represented on-chain under a legal framework that recognises the token itself as the legal object carrying the right. If achieved, this is economically equivalent to position one — with the administrative efficiency of blockchain transfer added. The question is whether the jurisdiction in which the asset sits recognises the token as title, and whether the institution responsible for connecting the ledger to the physical asset is adequately identified, capitalised, and liable. Currently achievable in limited jurisdictions only. Examined in sections 05 and 06.

3. Trust or beneficial ownership

Legal title vests in a trustee; the economic interest belongs to the beneficiary. The investor’s claim is equitable, not legal. It does not appear on the face of the title register. It depends entirely on the trustee’s solvency, conduct, and willingness to act in the beneficiary’s interest — enforced through trust law and, where a breach occurs, through equity. In common law jurisdictions the trust is a well-understood and robustly protected structure. In civil law jurisdictions, which do not natively recognise the trust concept, recognition depends on international private law rules that vary by country. The TVTG codifies a tokenised version through the TT Protector, who holds tokens in their own name for the benefit of a third party — but the beneficial owner remains invisible to the register and wholly dependent on the Protector’s performance.

4. Equity in an SPV

The SPV holds the asset; the investor holds shares or membership interests in the SPV. The investor’s economic exposure to the asset is mediated by the SPV’s full corporate structure, its constitution, and its complete liability stack — including any debts, encumbrances, or obligations that rank ahead of equity. In a liquidation, the equity holder recovers only what remains after all creditors of the SPV have been satisfied. The asset may be worth substantially more than the equity recovered if the SPV carries leverage, management fees, or related-party obligations that the investor did not model at entry. Governance rights depend on the shareholder agreement; in minority positions they are often limited in ways that matter precisely when conditions deteriorate.

5. Participation rights (Genussrechte)

A contractual entitlement to a share of profits, revenues, or liquidation proceeds, without equity or voting rights. Common in German-speaking jurisdictions — particularly in real estate, infrastructure, and Mittelstand financing — participation rights occupy an unusual position in the capital structure whose ranking is determined entirely by the specific instrument’s terms. Some participation rights rank senior to equity in liquidation; others are explicitly subordinated. Some carry fixed distributions; others are purely profit-contingent. The investor holds a contractual claim, not a property right. In insolvency, the ranking of that claim depends on language that varies significantly between issuers and is frequently not read carefully at the point of investment.

6. Collateralised debt

The investor holds a creditor claim secured against the asset. The rights are creditor rights, not ownership rights: the investor does not own the asset, they have a priority claim on its proceeds in the event of enforcement. That claim is only as good as the legal perfection of the security interest, the segregation of the collateral from the issuer’s general estate, and the enforceability of the security in the jurisdiction where the asset is located. Imperfect collateral — pledged but not registered, registered but subject to prior ranking claims, or pledged in a jurisdiction whose enforcement process is slow and uncertain — can be worth a fraction of its face value when tested. The haircut is not only a liquidity phenomenon. It is a legal one.

7. Depository receipts

A depositary institution holds the underlying asset and issues certificates representing it. The investor owns the receipt, not the asset. The receipt entitles the holder to certain rights — economic exposure, sometimes voting rights by proxy, sometimes physical delivery — but those entitlements are defined entirely by the depositary agreement. If the depositary fails, the investor is a creditor of the depositary for the value of the underlying, not a direct owner of it. Xetra Gold illustrates the nuance precisely: the certificate entitles the holder to physical gold delivery on demand, but that entitlement is contractual against Deutsche Börse Commodities GmbH, not proprietary in the gold itself. Whether the gold has been segregated from the depositary’s own assets is a structural and legal question — one that only matters when the question is being asked under the worst possible conditions.

8. Unsecured debt or referenced certificate

The investor holds a contractual promise. The underlying asset may be referenced — used as the basis for calculating returns or described as backing — but is not legally pledged against the instrument. In the issuer’s insolvency, the investor joins the general creditor queue and recovers whatever the estate can provide, in whatever priority the insolvency regime assigns to unsecured claims. The Lehman Brothers structured note case remains the definitive illustration. Investors in Lehman-issued certificates linked to baskets of assets assumed they held, in some sense, an interest in those assets. They did not. The notes were obligations of Lehman Brothers Holdings Inc. When Lehman filed for Chapter 11, the noteholders were unsecured creditors of the issuer. The referenced assets were held elsewhere and played no role in the recovery. The wrapper had eliminated not just liquidity but any meaningful connection to the underlying.

9. IOU

A bare bilateral obligation: an acknowledgement of debt or obligation with minimal or no standardised documentation, no prospectus, no regulatory framework, and enforcement entirely dependent on counterparty solvency and willingness to perform. In insolvency the IOU holder is a general unsecured creditor, often with weaker evidentiary standing than a formally documented instrument. This is not merely a theoretical category at the edge of the spectrum. Strip away the structuring from many instruments marketed as sophisticated financial products — certain crypto lending arrangements, informal private credit facilities, undocumented co-investment agreements — and what remains, economically if not legally, is an undocumented promise by a counterparty of uncertain creditworthiness to deliver value tied to an asset the investor cannot inspect, verify, or reach. The sophistication of the surrounding infrastructure does not change the legal nature of the underlying claim.

The marketed economic exposure and the legal entitlement are not the same thing. Most structural failures begin in the gap between them — and that gap is larger, and reveals itself later, than most investors assume.

Each structure responds differently to the same stress event. A direct owner can sell, encumber, or restructure without third-party consent. A beneficiary under a trust can enforce in equity if the trustee breaches. An equity holder in an SPV recovers only after creditors. An unsecured noteholder queues behind everyone and hopes the estate is adequate. The marketed economic exposure to the underlying asset may be identical across all these positions. The legal exposure in distress is not — and in a stress scenario, only the legal exposure determines what the investor actually receives.

03 — The SPV Layer: Efficiency vs. Opacity

Special purpose vehicles are legitimate and widely used tools. They perform genuine functions: isolating asset risk from the sponsor’s balance sheet, enabling tax-efficient structuring, pooling assets across investors, and creating bankruptcy remoteness between the originator and the investment. When used honestly, an SPV makes the investor’s position clearer, not more obscure.

The problem arises when the SPV layer is used — intentionally or not — to create distance between the investor’s apparent economic position and their actual legal entitlement. Several mechanisms produce this outcome. Fee leakage through inter-company service agreements reduces the asset’s effective return without appearing in the headline economics. Cross-collateralisation between related SPVs means that a distress event in one vehicle can affect another that the investor believed was unconnected. Inter-entity loans — where the SPV has borrowed from an affiliate of the sponsor — mean that a receiver may find an unsecured creditor of the SPV ranking ahead of the investor in the waterfall.

The Lehman Brothers structured note case is the starkest illustration. Investors in Lehman-issued certificates linked to baskets of assets assumed they held, in some sense, an interest in those assets. They did not. The notes were liabilities of Lehman Brothers Holdings Inc. The referenced assets were irrelevant. When Lehman filed for Chapter 11, the noteholders became unsecured creditors of the issuer and recovered cents on the dollar over years of bankruptcy proceedings. The wrapper had not merely failed to add liquidity. It had, by putting the investor’s claim one legal step away from the asset, eliminated any meaningful recovery.

Bankruptcy remoteness is a legal opinion, not a guarantee. The SPV is only as remote from its sponsor as the courts in the relevant jurisdiction are willing to enforce it.

The critical distinction is not between SPVs and direct ownership. It is between an SPV whose terms are transparent, whose liabilities are disclosed, and whose separation from the sponsor is genuinely enforceable — and one where any of those conditions is missing. Investors who cannot answer basic questions about the SPV’s full liability stack, its related-party agreements, and the jurisdictional enforceability of its bankruptcy remoteness provisions should treat the gap as a risk, not an administrative detail.

04 — Collateralised vs. Uncollateralised: The Critical Distinction

The word “secured” does significant marketing work in the structured finance universe. An instrument described as asset-backed, collateralised, or secured implies that the investor’s claim is anchored to something real — that in the event of default, there is something to reach. Whether that is true depends on four conditions, all of which must be satisfied simultaneously, and each of which can fail independently.

The first is legal perfection: the security interest must have been created validly under the law of the jurisdiction governing the asset and registered or filed where required. An unperfected security interest is, in most jurisdictions, worthless against third parties. The second is segregation: the collateral must be identifiable and legally separated from the issuer’s general estate. Collateral that has been commingled, rehypothecated, or pledged to multiple parties simultaneously does not provide the protection it appears to. The third is cross-border enforceability: where the asset, the issuer, and the investor are in different jurisdictions, enforcement requires legal process in each — and the outcome of that process cannot be assumed from the terms of the instrument. The fourth is collateral maintenance: the collateral must remain adequate throughout the holding period, which requires either a static asset or a dynamic mechanism for monitoring and topping up.

Imperfect collateral — pledged but not segregated, segregated but not perfected, perfected but not enforceable across the relevant borders — may be worth substantially less than it appears. The haircut in a stressed sale is not merely a market phenomenon reflecting illiquidity. It is frequently a legal phenomenon reflecting uncertainty about whether the collateral can actually be reached, and in what priority, by the claimant asserting it.

Rehypothecation and the disappearing collateral

Rehypothecation — the reuse of pledged collateral by the party holding it — can create a chain in which the same asset simultaneously secures multiple obligations. Under English law, prime brokers routinely rehypothecate client assets under standard terms. In MF Global’s 2011 collapse, client assets that had been rehypothecated and mixed with house assets took years to segregate and return, with some clients receiving significantly less than the face value of their claims. The collateral existed. It was simply not where the investors expected to find it.

The practical implication is straightforward: the label “secured” or “collateralised” is the beginning of the due diligence question, not the end of it. What matters is whether the security interest is perfected, the collateral is segregated, and enforcement has been tested — or at minimum, credibly opined upon by qualified counsel in each relevant jurisdiction.

05 — Tokenisation and the Direct Ownership Promise

The most ambitious claim in the tokenisation literature is not that tokens improve the administrative efficiency of existing holding structures — though they may. It is that tokens can eliminate the holding structure altogether: that the token can be the title, not merely reference a claim to it. If realised, this would move tokenised assets from position eight or nine in the taxonomy above — referenced certificate, IOU — to position one: direct ownership, with the full legal rights that entails. The engineering proposition is coherent. The legal question is whether any jurisdiction has actually built the bridge between the ledger and enforceable property rights.

In most of the world, that bridge does not exist. American property law requires conveyances of real estate to be in writing, with deeds containing specific formal elements; bearer instruments for real property are prohibited; and blockchain records are not integrated with official land registries, meaning a court faced with a dispute would defer to the traditional deed, not the token. The position is similar across most of continental Europe, where property transfer requires notarial deed and land register entry for immovables, and physical possession for movables — neither of which is satisfied by a blockchain transfer alone.

Two jurisdictions have made serious attempts to close the gap.

Liechtenstein — TVTG (2020)

The Token and TT Service Providers Act introduced the Token Container Model: a legal framework in which a token is a container that can hold any right the law recognises, including rights in rem — real property rights, not merely contractual claims. Transferring the token transfers the right it contains. This is a civil law provision, not a contractual arrangement between parties; on-chain transfer is legally equivalent to transfer of the represented right. The classification of the right represented, not the token itself, determines the applicable legal regime — making the framework asset-class agnostic in principle.

Switzerland — DLT Act (2021)

Switzerland’s Federal Act on the Adaptation of Federal Law to Developments in Distributed Ledger Technology, fully in force from August 2021, took a different approach: rather than creating an entirely new legal object, it amended ten existing federal statutes to accommodate ledger-based assets. Its central innovation is the Registerwertrecht — the ledger-based security — a new category of uncertificated security in the Swiss Code of Obligations. A right vested in a ledger-based security transfers via transfer of the token: the issuer and acquirer agree that the right can only be transferred and exercised via the electronic register, and the ledger entry has the same legal effects as a traditional certificated security.

The Swiss framework is powerful for financial securities — shares, bonds, receivables, memberships — where the underlying right is contractual. It does not solve the physical asset problem. The transfer of rights in rem over physical assets still requires transfer of physical possession for movables, or a notarial deed and land register entry for immovables. A token cannot substitute for these requirements under Swiss law; it can only represent the contractual rights that have been separately created by complying with them.

Other jurisdictions

Dubai has moved furthest in integrating tokenisation with official property infrastructure. The Dubai Land Department and the Virtual Assets Regulatory Authority have built a framework that connects token issuance directly to land registry records — meaning that a token transfer updates the official title record, not merely a parallel ledger. This is structurally different from most tokenisation initiatives, which operate alongside existing registries rather than within them. Transactions have completed under this framework, and the regulatory architecture — VARA’s oversight of the token layer, DLD’s authority over the title record — provides a dual-supervised structure that gives the framework meaningful institutional credibility. The open question, as with any new legal instrument, is how it performs in contested proceedings; that test has not yet arisen. Singapore’s MAS has through Project Guardian built infrastructure for cross-border tokenised financial asset settlement, but the framework addresses financial instruments under the Securities and Futures Act, not direct property title. The UK has recognised cryptoassets as a third category of personal property alongside choses in possession and choses in action, providing important common law clarity, but has not legislated on the transfer of real property rights by token.

The honest summary is this: no jurisdiction has fully solved the problem for all asset classes. Liechtenstein comes closest for rights in rem over physical assets, through the Token Container Model and the physical validator function that supports it. Switzerland comes closest for financial securities. For immovable property in most of the world, the land registry problem — the requirement that title transfer be recorded in a state-maintained register — remains essentially unsolved. Until that problem is solved jurisdiction by jurisdiction, tokenised real estate is, in legal terms, one of positions three through eight in the taxonomy: a claim on a claim, mediated by an SPV, a trust, or a contractual arrangement, with the token as a convenient transfer mechanism rather than as the title itself.

06 — Connecting the Record to the Asset: Who Is Liable, and Under Which Law

Every legal system for the transfer of ownership has a mechanism for ensuring that the record of title corresponds to reality — that what is registered or documented as owned is actually possessed, identifiable, and unencumbered. This function predates tokenisation by centuries. What changes across asset classes is which institution performs it, under which legal framework that institution operates, and what liability attaches when the correspondence breaks down.

For immovable assets — land, buildings — the mechanism is the land register, supported in most civil law jurisdictions by mandatory notarial involvement in the transfer deed. In Germany, Austria, and Switzerland, a Notar attests to the identity and capacity of the parties and certifies the deed before it can be registered; the registration itself is constitutive of title transfer, not merely declaratory. In England and Wales, the Land Registry performs a similar function without the notary intermediary, but with equivalent liability for registration errors. Title insurance backstops residual historical defects. The governing law is the law of the jurisdiction where the property is located — lex situs — regardless of where the parties or the transaction documents are based. The liability chain is statutory and explicit.

For movable assets — art, diamonds, machinery, commodities in store — possession is the primary transfer mechanism in most civil law systems, but it is supported by specialist attestation chains that serve an equivalent function. A gemological certificate attests to the identity and condition of a stone. A warehouse receipt, governed by the law applicable to the warehouse agreement, attests to the existence and current condition of the stored commodity and makes the warehouseman liable for loss, damage, or misdelivery. A bill of lading — governed under maritime law or the applicable carriage convention — attests to the shipment of goods and constitutes a document of title whose holder can claim delivery. In each case, the attesting institution is liable for the accuracy of its attestation within the scope defined by the governing legal framework. Authenticity risk for unique assets — art, antiques, collectibles — sits with the specialist appraiser, not with any statutory register.

For intangible assets — patents, trademarks, copyrights, receivables, contractual rights — the attestation function is performed differently again. Registered intellectual property rights are constituted by the registration itself (patents, trademarks) or exist independently of it (copyright) but are evidenced through registration. Transfer is by assignment agreement, and the assignor warrants title to the right being assigned. Legal opinions on the existence, scope, and unencumbered state of the right serve as the primary due diligence instrument in significant transactions. The legal opinion provider is liable within the scope of the opinion — a carefully limited but explicitly stated liability. For receivables and contractual rights, the debtor acknowledgement or notice of assignment determines enforceability against the obligor; the law governing the underlying contract determines the validity of the assignment itself.

Across all three categories, the pattern is the same: a human institution is identified, operates under a defined legal framework, and bears defined liability for the accuracy of the connection between the legal record and the physical or legal reality it attests to. The liability is not unlimited — it is shaped by the governing legal framework — but it is explicit, and it is exercised by an institution with a track record that can be assessed.

Tokenisation does not eliminate this function. It asks a different institution to perform it, under a legal framework that most jurisdictions have not yet built. The TVTG physical validator is Liechtenstein’s answer to the question: who performs this role for tokenised physical assets, and under what law are they liable?

The TVTG physical validator — definition and liability

Article 2(1)(p) of the TVTG defines the physical validator as a person who guarantees the contractual enforcement of rights in rem represented in tokens — specifically the synchronisation between what the ledger records and what the physical world contains. The role carries three layers of obligation: identification of the asset (serial number, certificates, provenance), the token generator, and all token holders; attestation of existence and state, ensuring the asset is deposited in a contractually regulated storage facility in the condition represented; and continuity, maintaining the connection throughout the holding period so that token transfers trigger corresponding real-world obligations.

Liability under Article 33(1)(f) is direct under Liechtenstein civil law: the validator is liable where the token holder cannot successfully assert their claim to the underlying asset due to the validator’s conduct. Gross negligence liability cannot be contracted away under Article 35. The validator must be registered with the FMA, meet minimum capital requirements, and be domiciled or headquartered in Liechtenstein.

The physical validator is therefore the functional equivalent — under Liechtenstein private law — of the warehouseman under a warehouse receipt, or the registered custodian under a depository receipt framework. It performs an attestation function that the ledger cannot perform: verifying that the asset exists, is in the state described, and remains so throughout the holding period. The legal framework governing its liability is the TVTG — which means it applies with certainty only where the TVTG applies, namely to token transactions expressly subject to it and conducted within Liechtenstein’s regulatory perimeter.

The residual gap is structurally important. The physical validator’s liability attaches to its conduct, not to the mere absence of the asset. If the validator was itself deceived by a fraudulent warehousing counterparty — if the diamond it certified was replaced, or the painting it attested to was a forgery — the investor’s recourse becomes a contractual dispute against the validator rather than a clean guarantee of recovery. The ledger records what it was told. The validator attests to what it verified. Neither guarantees the asset is actually there. The liability chain is clear; its adequacy depends on the financial standing of the validator and the depth of its own due diligence on the asset it is certifying.

The question is not whether the ledger is accurate. The ledger is always internally consistent. The question is whether what was entered into it corresponds to anything in the physical world — and that question is answered by a human institution operating under a defined legal framework, not by the technology.

07 — The Legal Mismatch Problem

Across the spectrum of holding structures, there is a persistent tendency for the economic position described in marketing to diverge from the legal rights conferred by the instrument. This divergence is not always deliberate. It arises from documentation that is written by legal counsel for one purpose and read by investors for another, from structuring that optimises for tax and accounting treatment rather than investor clarity, and from the consistent human tendency to assume that what has been agreed commercially has been delivered legally. It takes three forms.

Documentation mismatch is the most common. The term sheet, the pitch deck, and the investor presentation describe an economic position — exposure to the returns of an underlying asset, protection in the event of underperformance, priority in the recovery waterfall. The legal documents — the note indenture, the subscription agreement, the depositary terms — confer something narrower, more conditional, and more dependent on counterparty performance. Investors who read only the marketing and trust the documentation to match it are routinely surprised by the terms that govern their actual position.

Jurisdictional mismatch is structurally more dangerous. Where the asset, the issuer, the SPV, and the investor are in different legal systems, enforcement of any claim requires success in each jurisdiction separately. A security interest that is perfectly perfected under English law may not be recognised under German law if the asset is located in Germany. A token issued under the TVTG provides legal certainty within Liechtenstein’s regulatory perimeter; outside it, the enforceability of the rights it represents depends on whether the courts of the relevant jurisdiction recognise the framework at all. The instrument’s legal strength is determined by its weakest jurisdictional link, which is typically not the jurisdiction chosen for the governing law.

Insolvency mismatch is the most consequential. Structures that appear ring-fenced — assets held by an SPV, collateral segregated from the issuer’s estate, tokens held by a custodian — may not survive the scrutiny of an insolvency administrator arguing substantive consolidation, challenging the validity of the security interest, or contesting the bankruptcy remoteness of the SPV. Bankruptcy remoteness is a legal opinion. Its value is the value of the opinion and the track record of the jurisdiction in which it is tested. It is not a guarantee.

08 — What Honest Structuring Requires

None of this is an argument against structured products, SPVs, tokenisation, or financial innovation. These tools perform genuine functions when used honestly. The problem is not the tools. It is the gap between what they can deliver and what they are marketed as delivering — and the consistent failure to close that gap through adequate disclosure.

An honest structure is one whose documentation allows an investor, reading it carefully, to understand exactly what they hold, what they would face if they needed to exit under adverse conditions, and what their recovery position would be if the counterparty or the asset itself fails. That is a high bar. Most structures do not clear it.

A practical minimum standard for any investment in a structured claim on an underlying asset might require clear answers to five questions:

• What legal right does this instrument confer, precisely? — Ownership, beneficial interest, secured creditor claim, unsecured creditor claim, or bare contractual promise. If the documentation does not answer this clearly, that is the answer.

• Is the underlying asset legally segregated, identifiable, and unencumbered? — Not as described in the marketing materials, but as verified by independent legal counsel in the jurisdiction where the asset is located.

• Who is liable if the asset is absent, encumbered, or misrepresented? — Name the entity, verify its financial standing, and confirm that the liability is not contractually limited to a level that makes recovery economically irrelevant.

• In which jurisdiction is enforcement sought, and has that jurisdiction been tested? — Not the governing law of the instrument, but the jurisdiction where the asset physically sits and where any enforcement action would be brought.

• What happens to my claim in the sequential insolvency of the issuer, the SPV, the custodian, and the TT service provider? — Model each failure scenario separately. The structure is only as strong as its weakest link in stress conditions.

If the documentation does not answer these questions clearly and specifically, the wrapper is doing concealment work. The question is whether that concealment is deliberate, negligent, or simply the result of structurers who have never been asked to model their own failure. The investor’s position is the same in all three cases.

— The Claim Is the Claim

The legal wrapper is subject to the same fallacy as the financial one. Structure cannot manufacture legal proximity to an asset any more than it can manufacture liquidity. An SPV that holds a property in one jurisdiction, issues notes governed by another, and is owned by investors in a third does not provide the investor with the rights of a property owner. It provides the rights of a note creditor — which may be very valuable, or may be nearly worthless, depending on the SPV’s solvency, the perfection of the security interest, and the enforceability of the structure in the jurisdiction where the asset actually sits.

Liechtenstein and Switzerland represent the most serious attempts yet to build legal infrastructure for on-chain ownership rather than merely on-chain reference. The TVTG’s Token Container Model makes the token a legal object capable of carrying rights in rem under Liechtenstein private law. The Swiss DLT Act makes the ledger-based security legally equivalent to a certificated instrument for financial rights under the Swiss Code of Obligations. Both are genuine advances. Neither eliminates the requirement for a human institution to stand between the legal record and physical reality, verify the connection, and operate under a defined liability framework when it fails.

What the physical validator requirement in the TVTG acknowledges — and what most tokenisation projects ignore — is that the ledger is a record of what was entered into it. Keeping that record accurate over time, as assets change hands, change condition, and change their relationship to the rights represented in the token, requires continuous human attestation by an institution that is identified, supervised, capitalised, and liable under a defined legal framework. Every traditional asset class has developed such institutions over centuries. Tokenised markets are still building them — and until they are built, jurisdiction by jurisdiction and asset class by asset class, the token occupies one of the lower positions in the taxonomy: a claim on a claim, however efficiently transferred.

The question worth asking of any structured claim on an underlying asset remains the same as the question worth asking of any wrapper: not what the instrument says you hold, not what the technology records, but what you can actually recover, from whom, under what conditions, and in how long. That question is answered by the asset, the liability chain that connects you to it, and the jurisdictions in which that chain must hold. The wrapper, however sophisticated, is not part of the answer.

This article represents the analytical views of the author in a personal capacity and is intended for informational purposes only. It does not constitute legal, regulatory, or investment advice and should not be relied upon as such. Readers should seek independent professional advice before acting on any matter discussed herein.

Sources

1. Liechtenstein TVTG (Token and TT Service Providers Act), October 2019, in force January 2020. regierung.li

2. Switzerland, Federal Act on the Adaptation of Federal Law to Developments in Distributed Ledger Technology (DLT Act), in force August 2021. sif.admin.ch

3. Frommelt, C., Liechtenstein’s Blockchain Act and the Physical Validator, Albany Business Law Journal, 2021.

4. Garcia-Teruel, R.M. & Simón-Moreno, H., The Digital Tokenization of Property Rights: A Comparative Perspective, Computer Law & Security Review, 2021.

5. Odinet, C.K. & Tosato, A., Tokenized Real Estate: The Law and Tech of Digital Deeds, Ohio State Law Journal Online, forthcoming 2026. SSRN 5401703.

6. Lavayssière, X., Legal Structures of Tokenised Assets, European Journal of Risk Regulation, Cambridge University Press, May 2025.

7. UK Law Commission, Digital Assets: Final Report, 2023. lawcom.gov.uk

8. Dubai Land Department / VARA, Real Estate Tokenisation Framework, 2023–2025.

9. Monetary Authority of Singapore, Project Guardian — Asset Tokenisation Framework, 2023–2024. mas.gov.sg

10. Financial Crisis Inquiry Commission, The Financial Crisis Inquiry Report, U.S. Government, 2011.

11. Wood, G., Ethereum: A Secure Decentralised Generalised Transaction Ledger, 2014; and ISDA, Legal Guidelines for Smart Contracts, 2019.

12. Gorton, G. & Metrick, A., Securitization, National Bureau of Economic Research, 2012.

Financial markets have a recurring habit: take an illiquid asset, place it inside a sophisticated structure — a blockchain token, a securitisation vehicle, a listed certificate — and imply that the wrapper has changed what is inside it. This article examines the persistent belief that repackaging can manufacture liquidity, and why it keeps attracting capital despite being demonstrably false.

Real World Asset tokenisation offers the cleanest current example. A token representing a claim on an illiquid asset — private credit, real estate, infrastructure — inherits the liquidity of that asset, not of the ledger it sits on. The token may look tradeable; the underlying may not be. That gap is not a technical problem awaiting a better protocol. It is a structural mismatch that worsens under stress, when token holders wish to exit simultaneously and the asset cannot be rapidly liquidated to honour them.

Securitisation has the longer history. Pooling and tranching redistribute risk efficiently when underlying assets are diversifiable and transparent. They do not create liquidity from assets that lack it. The 2008 crisis established the definitive proof: the moment uncertainty arose about underlying asset quality, no one would make a market in the wrapper. Structure cannot outlast distrust of substance. Exchange listings extend the same logic — a ticker provides a venue, not a guarantee of depth, and the discount to NAV becomes public and painful precisely when liquidity is most needed.

The fallacy persists because incentives are asymmetric: structurers earn fees at inception, while the liquidity mismatch reveals itself later. It persists because the technology is genuinely impressive, and engineering quality is easy to conflate with economic soundness. And it persists because the wrappers work — until, abruptly and severely, they do not.

The box does not change what is in the box. It only changes — temporarily — what investors believe about what is in the box.

#finance#markets#liquidity#tokenisation#securitisation

01 — What Liquidity Actually Is

The confusion begins with a misunderstanding of what liquidity means. Liquidity is not the ability to sell something. It is the ability to sell it, at any reasonable hour, at a price close to its last traded price, without that very act of selling moving the price materially against you. This is a high bar. Most assets — even those with official market listings — do not clear it.

A listed closed-end fund holding private equity does not become liquid because it has a stock exchange ticker. An exchange-traded note referencing a thinly traded commodity does not inherit the liquidity of its wrapper. And a blockchain token representing a fractional claim on a property does not become liquid because it was minted on a permissioned ledger and sits in a compliant wallet.

Liquidity is not a feature you add to an asset. It is a property that emerges from the market’s genuine, continuous willingness to trade it. That willingness depends on factors no financial engineer controls: the number of motivated buyers and sellers, the transparency of the asset’s value, the depth of information available to both sides, and the confidence that tomorrow’s market will resemble today’s. A clever wrapper contributes none of these things.

02 — The RWA Token Problem

Real World Asset tokenisation is perhaps the most visible current expression of wrapper thinking. The proposition is seductive: take an illiquid claim — a private loan, a property, a piece of infrastructure — and represent it as a token on a distributed ledger. Fractionalize it. Make it transferable. List it on a digital asset exchange. Suddenly, the story goes, an asset that previously required a minimum cheque size of several million and a lock-up of several years becomes accessible to anyone with a crypto wallet.

The problem is not the technology. The ledger works. The token is real. The problem is what the token represents. If the underlying asset does not trade — if there is no functioning secondary market for the private loan, no transparent pricing mechanism for the property, no natural community of buyers and sellers who understand and want the risk — then the token inherits exactly that. An illiquid claim, dressed in digital clothing, is still an illiquid claim.

The inherent characteristics of an asset — its cash flow profile, its valuation opacity, its depth of secondary market demand — are properties of the asset itself, not of the vehicle used to hold it. A token does not create a buyer. A certificate does not create a market. A listing does not create liquidity.

In fact, tokenisation can introduce a dangerous new asymmetry. The token looks liquid. It sits on an exchange. It has a bid and an ask. But beneath it, the asset cannot be rapidly liquidated to honour redemptions. At moments of stress — when token holders collectively want out — the gap between the liquidity implied by the wrapper and the liquidity available from the asset can be catastrophic. We have seen this dynamic play out in open-ended real estate funds, in NAV-based credit products, in money market funds holding illiquid paper. The token is simply the newest vessel for the oldest mismatch.

03 — Securitisation and the Certificate Mirage

Tokenisation did not invent this problem. Securitisation spent decades perfecting it. The animating logic of asset securitisation is, in its legitimate form, sound: pool many individually illiquid assets, create tranched securities with well-defined risk profiles, and allow investors who would never buy a single mortgage or car loan to access the aggregated risk in tradeable form. The pooling diversifies idiosyncratic risk. The tranching allocates it efficiently. The standardisation makes it analysable.

What securitisation cannot do — what no securitisation has ever done — is manufacture liquidity from assets that do not possess it. When constituent assets are genuinely opaque, heterogeneous, and difficult to value independently, the security inherits that opacity. The structure may be listed. It may have a credit rating. It may sit in a format that resembles a bond. None of this creates a buyer when that buyer wants to examine what is actually inside.

The 2008 crisis is the definitive case study. Mortgage-backed securities and their derivatives were not illiquid because the structures were poorly designed. They became illiquid — instantly and catastrophically — because the moment uncertainty emerged about underlying asset quality, no one was willing to make a market in the wrapper without understanding what the wrapper contained. The box stopped trading because the contents were in question. Structure cannot outlast distrust of substance.

04 — The Listing Illusion

Exchange listing deserves particular scrutiny, because it is the most visible marker of the wrapper fallacy at work. The logic runs: if we list this product on an exchange, it acquires the liquidity properties of other listed products. It has a price. It has trading hours. It has counterparties. Therefore it is liquid.

It is not. A listing is infrastructure, not a guarantee. The exchange provides a venue; it does not provide buyers. Many listed products — exchange-traded funds on niche indices, listed infrastructure vehicles, closed-end credit funds — trade with bid-ask spreads wide enough to represent a material drag on returns, and with daily volumes thin enough that any institutional holder wishing to exit meaningfully faces weeks of careful execution at best, market disruption at worst.

The secondary market for a listed product holding illiquid assets will, under stress, either reprice sharply to discount or cease to function with any meaningful depth at all. The listing does not prevent this. It merely provides the mechanism through which the discount becomes visible and publicly painful.

05 — Why the Fallacy Persists

If the logic is this transparent, why does wrapper thinking continue to attract capital and credibility? Three forces sustain it.

• Asymmetric incentives. Those who create and distribute the wrapper — investment banks, token issuers, structurers, asset managers — are compensated at inception. The liquidity mismatch reveals itself later, under conditions that neither creator nor early investor anticipated in their own timeline.

• Conflation of engineering with economics. Blockchain infrastructure is elegant. DeFi composability is real. Securitisation mathematics is sophisticated. It is easy to conflate the quality of the engineering with the quality of the economic proposition. The mechanism works; the economics may not. These are different questions.

• The wrappers work — until they do not. For extended periods of rising markets, stable credit conditions, and abundant capital, the liquidity mismatch remains dormant. The token trades near par. The fund trades near NAV. This builds confidence, attracts more capital, and deepens the mismatch. When the correction comes, it is faster and more severe precisely because the wrapper had obscured the accumulation of risk.

06 — What Honest Structuring Looks Like

None of this is an argument against financial innovation. Pooling, tranching, tokenising, and listing all have legitimate roles. The question is not whether to use these tools but whether they are being used honestly — with clear disclosure of what the wrapper can and cannot do, and without implying that the structure transforms the fundamental nature of the underlying asset.

• Honest securitisation — pools genuinely diversifiable assets, creates transparent and analysable tranches, and makes no claim to liquidity it cannot sustain under stress.

• Honest tokenisation — provides fractional access and administrative efficiency, without representing that the token is more liquid than the asset it represents.

• Honest listing — acknowledges that the exchange provides a venue, not a guarantee of depth, and sizes liquidity risk disclosures accordingly.

The standard for disclosure should be simple: can an investor, reading the product documentation, understand exactly what they would face if they needed to exit in size, in adverse conditions, within a short timeframe? If the answer is not clearly yes, the wrapper is doing concealment work, not investment work.

— The Asset Is the Asset

Markets punish wrapper thinking reliably, if not immediately. The punishment is delayed — which is precisely what makes the fallacy so durable and so dangerous. Capital flows toward structures that appear to offer liquidity without the underlying asset earning it, until a moment of generalised stress causes the market to look inside the box. At that point, the box is irrelevant.

A private loan extended to a marginal borrower is still that loan whether it sits on a balance sheet, inside a CLO tranche, or represented as a token on a blockchain. An office building in a market with uncertain demand is still that building whether it is owned directly, through a listed REIT, or through a fractional digital title. The asset is the asset. The box is the box.

The question worth asking — always, of every new structure — is not whether the technology is real, or whether the legal mechanism functions, or whether the exchange listing has been obtained. The question is whether, and under what conditions, you can actually get your money back. That question is answered by the asset. The wrapper is decoration.

Sources

1. Gorton, G. & Metrick, A., Securitization, National Bureau of Economic Research, 2012.

2. Financial Crisis Inquiry Commission, The Financial Crisis Inquiry Report, U.S. Government, 2011.

3. BIS, DeFi risks and the decentralisation illusion, BIS Quarterly Review, December 2021.

4. IOSCO, Decentralized Finance Report, International Organization of Securities Commissions, March 2022.

5. Brunnermeier, M. & Pedersen, L., Market Liquidity and Funding Liquidity, Review of Financial Studies, 2009.

Every asset that cannot be sold instantly carries a cost that standard pricing models either ignore or absorb into a residual. This article examines illiquidity as a first-order determinant of asset value: where the concept originates, how the premium is derived and measured, what drives it, and what the historical record reveals about its behaviour across market cycles.

The theoretical foundations run from Amihud and Mendelson’s bid-ask spread model through Kyle’s lambda and on to Acharya and Pedersen’s liquidity-adjusted CAPM — each formalising what practitioners have long known informally: investors demand compensation for being locked in. The derivation of the illiquidity discount is tractable in theory but treacherous in practice, collapsing under circular valuation logic, peer-group contamination, and the absence of observable transaction prices for the very assets being valued.

Accounting treatment compounds the danger. IFRS 13 and ASC 820 both require fair value measurement of illiquid positions, but leave the determination of illiquidity adjustments to management discretion within a three-tier hierarchy. Level 3 assets — valued entirely on unobservable inputs — sat at roughly 6–10% of major bank balance sheets entering the 2008 crisis, and again accumulated in private credit portfolios through the 2020s. The smoothed mark creates a false stability that flatters NAV, suppresses reported volatility, and defers loss recognition until the moment of forced sale.

The historical record is consistent: illiquidity premia compress in benign conditions, appear to vanish in bull markets, and are collected violently and involuntarily in crises. The 2008 structured credit collapse, the 2020 March dislocation, and the 2022 UK gilt crisis all exhibited the same dynamic — liquidity withdrawn faster than prices could adjust, with mark-to-model valuations sustaining the fiction of stability until they could not. The outlook into the late 2020s is structurally elevated illiquidity risk, driven by the scale of private market expansion, the thinness of secondary markets, and the duration mismatch embedded in open-ended vehicles holding closed-ended assets.

The illiquidity premium is not compensation for bearing risk — it is the cost of having overstated an asset’s value from the moment it was acquired.

#finance#markets#assetpricing#privateMarkets#riskManagement

01 — Origins: Why Liquidity Has a Price

The formal study of liquidity as a priced characteristic of assets is relatively recent. Classical finance, from Markowitz through the CAPM, treated markets as frictionless. Assets were assumed to convert to cash at their fair value without cost or delay. The spread between bid and ask, the depth of the order book, the time required to find a counterparty — none of these entered the model. Return was compensation for systematic risk. Everything else was noise.

The breakdown of that assumption became evident not through theory but through practice. Institutional investors operating in thin markets — small-cap equities, municipal bonds, emerging market debt — observed systematically higher returns than CAPM predicted. The excess could not be explained by beta. Something else was being priced. Amihud and Mendelson were the first to formalise it rigorously, demonstrating in 1986 that expected return increases with the bid-ask spread, that clientele effects emerge (long-horizon investors hold less liquid assets), and that the relationship is concave — the marginal premium per unit of illiquidity diminishes as illiquidity rises (Amihud & Mendelson, 1986).

The intuition behind the premium is not complicated. An investor who holds an asset she cannot sell without incurring material cost or delay bears a risk that does not appear in a single-period return: the risk of needing liquidity at the wrong moment. This is not credit risk or duration risk. It is exit risk — the possibility that the price at which she can actually transact diverges materially from the price at which the asset is marked. In a crisis, that divergence is not marginal. It is the entire trade.

Kyle’s 1985 model of informed trading introduced a complementary mechanism. In Kyle’s framework, liquidity — defined as the ability to trade without moving the price — depends on the information structure of the market. Where informed traders are present, market makers widen spreads to protect themselves against adverse selection. Illiquidity is not just a transaction cost; it is a signal of information asymmetry (Kyle, 1985). Assets with thin trading are thin precisely because few people are confident in their valuation. That uncertainty is itself a cost to the uninformed buyer.

These two strands — transaction cost and information asymmetry — together explain why illiquidity commands a premium. The investor is compensated for (i) higher round-trip transaction costs, (ii) a reduced ability to rebalance in response to changing information, and (iii) exposure to the possibility that, at the moment she needs to sell, the market for her asset has effectively ceased to function.

02 — Deriving the Illiquidity Premium: Models and Mechanics

The most tractable derivation of the illiquidity premium begins with the bid-ask spread as a proxy for transaction costs. If an investor pays the ask and must sell at the bid, the round-trip cost reduces the net return of the trade. For a buy-and-hold investor with horizon T, the cost is amortised over the holding period. A shorter horizon means a higher annualised drag; a longer horizon means a lower one. This is why illiquid assets migrate to long-horizon holders — they are the rational owners.

The Amihud Illiquidity Ratio

The most widely used empirical proxy for illiquidity is the ratio of a day’s absolute return to its dollar trading volume: ILLIQ = |r| / Volume. A high ratio indicates that a small amount of trading moves the price substantially — the asset’s price is sensitive to order flow. This can be aggregated across days and stocks to produce a market-level illiquidity measure, which exhibits strong counter-cyclical properties: it spikes during crises and compresses in bull markets.

Acharya and Pedersen extended the CAPM to incorporate liquidity risk directly, producing the liquidity-adjusted CAPM (LCAPM) (Acharya & Pedersen, 2005). Their model yields an expected return that has four components: the standard market beta premium; a premium for the covariance of the asset’s illiquidity with market illiquidity (assets that become illiquid precisely when the market does are most dangerous); a premium for the covariance of the asset’s return with market illiquidity (assets that fall in value when liquidity dries up); and a discount for assets whose illiquidity covaries negatively with market returns (rare; these are natural hedges). The model’s central insight is that not all illiquidity is equivalent. An asset that is merely hard to trade in normal times is different from one that becomes untradeable in a crisis. The latter commands a much higher premium — or should.

For private assets — unlisted equity, real estate, private credit, infrastructure — the derivation of an illiquidity discount takes a different form. The premium and the discount are the same phenomenon viewed from opposite sides of the transaction: the discount is the lower price paid at acquisition; the premium is the higher return earned over the holding period as a consequence. One is the cause, the other the effect — and in a well-functioning market, they should be equivalent in present value terms. The standard approach to measuring this is the restricted stock discount: studies of transactions in which identical equity was sold both freely tradeable and subject to a lock-up consistently show a discount of 20–35% on the restricted shares (Silber, 1991). The discount reflects the expected cost of illiquidity over the lock-up period, capitalised into the initial price.

More sophisticated models derive the illiquidity discount from option theory. Longstaff’s 1995 model treats the liquidity constraint as forgoing the option to sell at the optimal time (Longstaff, 1995). The value of that option is bounded by the value of a lookback option on the asset — since the optimal exit point is, in retrospect, the peak. For a volatile asset with a long lock-up, this bound is not trivial. Even for moderate asset volatility of 25% and a one-year lock-up, the upper bound on the illiquidity discount exceeds 15%.

The determinants of the illiquidity premium, drawn from both empirical and theoretical work, can be organised as follows:

• Asset-level: bid-ask spread — the baseline transaction cost; the primary driver in Amihud-Mendelson

• Asset-level: trading volume and depth — thinner markets imply greater price impact per unit traded

• Asset-level: price volatility — higher volatility increases the option value of timing, thus the cost of losing it

• Asset-level: lock-up duration — longer constraints compound the discount non-linearly

• Market-level: systemic liquidity — Amihud’s market ILLIQ; conditions under which all assets become hard to sell simultaneously

• Investor-level: horizon — shorter-horizon investors require higher compensation; the premium is partly an endogenous clientele effect

• Investor-level: funding liquidity — investors who may face redemptions or margin calls cannot tolerate illiquidity; their required premium is higher

The interaction of the last two factors deserves emphasis. The 2008 crisis was, among other things, a demonstration that funding liquidity and market liquidity are endogenous to each other. When investors face forced redemptions, they sell what they can — typically their liquid holdings — which concentrates the illiquid residual, raises its effective weight in the portfolio, and increases the urgency of exit precisely as the market for those assets disappears. Brunnermeier and Pedersen formalised this spiral in 2009, showing that margin requirements tighten as prices fall, forcing further deleveraging, which further depresses prices (Brunnermeier & Pedersen, 2009).

03 — Accounting Treatment: The Architecture of Optimism

The accounting framework governing illiquid assets is structurally disposed toward overvaluation. This is not a design flaw. It is an unavoidable consequence of requiring entities to report fair values for assets that have no observable market price. The result is a set of rules that delegate the most consequential measurement decisions to the entity whose interests are served by a higher number.

Both IFRS 13 and US GAAP ASC 820 require fair value measurement and organise inputs into a three-level hierarchy (IASB, IFRS 13, 2011) (FASB, ASC 820, 2011):

• Level 1 — quoted prices in active markets for identical assets; no adjustment permitted

• Level 2 — observable inputs other than Level 1; includes quoted prices for similar assets, or identical assets in inactive markets

• Level 3 — unobservable inputs; valuation based on the entity’s own assumptions about what market participants would use

Level 3 is the problem. It captures precisely the assets whose fair value is most uncertain and most subject to managerial discretion. Private equity NAVs, illiquid structured credit, direct real estate, infrastructure assets, and private credit positions all commonly sit at Level 3. The reporting entity determines the discount rate, the comparable transaction set, the exit multiple, and whether — and by how much — to apply an illiquidity discount. External auditors review the model and the inputs; they do not independently derive the value.

The smoothed mark is not a measurement of value. It is a record of what management believed the value to be, at a point in time, using assumptions that no transaction has tested.

Three specific accounting dangers follow from this architecture.

Stale pricing and volatility suppression

Private asset valuations are typically updated quarterly, or upon a triggering event. In the interim, the carrying value does not move. This creates the well-documented phenomenon of return smoothing: private equity and real estate funds report returns that appear to have lower volatility and lower correlation with public markets than is economically real. Getmansky, Lo, and Makarov demonstrated in 2004 that observed serial correlation in hedge fund returns is largely an artefact of stale pricing rather than genuine persistence (Getmansky, Lo & Makarov, 2004). The same mechanism operates in private equity. A fund’s reported Sharpe ratio is flattering not because the underlying assets are genuinely less risky, but because the measurement frequency artificially compresses the denominator.

The institutional consequence is that allocation models that include private assets will systematically understate portfolio risk and overstate diversification benefit. Mean-variance optimisers will over-allocate to the smoothed series. This is not a theoretical concern — it is a documented feature of the modern endowment model and of retail multi-asset funds with illiquid sleeves.

NAV inflation and deferred loss recognition

Because the illiquidity discount is management’s to apply, the incentive structure runs toward minimisation. A lower discount produces a higher NAV, which supports fundraising, reduces the appearance of impairment, and delays the recognition of losses. This is not fraud in the normal case — it is the exercise of discretion within a permitted range. But it means that carrying values for illiquid portfolios systematically overstate realisable value in a forced-sale scenario.

The gap between carrying value and realisable value is not a rounding error in stress conditions. During the 2008 crisis, AAA-rated tranches of residential mortgage-backed securities carried at par — or close to it — by major banks sold at 20–40 cents on the dollar when forced transactions occurred. The accounting hierarchy had permitted a fiction that the market ended abruptly.

Duration mismatch in open-ended structures

Perhaps the most structurally dangerous configuration is the open-ended fund holding Level 3 assets. The fund offers daily or weekly liquidity to investors — a Level 1 or Level 2 obligation — while holding assets that require months or years to liquidate without material price concession. The fund’s NAV is stated at the mark; redemptions are met at that mark. As long as the fund is in net inflow, the mismatch is invisible. Once net redemptions begin, the fund must sell liquid assets first, concentrating the illiquid residual, which raises its weight in the portfolio and accelerates the divergence between NAV and realisable value. The gating decisions imposed by Woodford Investment Management in 2019 and by several real estate funds in 2022–23 were the mechanical consequence of exactly this structure (FCA, 2020).

IFRS 13 requires disclosure of the sensitivity of Level 3 valuations to changes in unobservable inputs. In practice, these disclosures are of limited utility — they describe what happens if a particular input changes by a specified amount, but do not address the scenario in which the market for the asset ceases to function entirely, which is the risk that actually matters.

04 — Historical Analysis: When the Premium Is Collected

The illiquidity premium has a distinctive temporal profile: it is promised in normal conditions, appears to be earned in bull markets, and is collected — involuntarily and violently — in crises. The historical record across asset classes is consistent on this point.

The long-run evidence

Amihud’s 2002 empirical study of US equities demonstrated a robust positive relationship between stock-level illiquidity (measured by his ILLIQ ratio) and subsequent excess returns, controlling for size, beta, and prior returns (Amihud, 2002). The premium is economically significant: moving from the most liquid to the most illiquid quintile of stocks yielded an annualised return differential of roughly 4–8% over the 1964–1997 sample. Subsequent replications in international markets confirmed the pattern, with the premium tending to be larger in markets with weaker investor protections and less developed secondary trading infrastructure.

In fixed income, the liquidity premium shows up most clearly in the spread between on-the-run and off-the-run US Treasury securities — bonds with identical credit risk and near-identical duration that trade at a persistent yield differential solely because the on-the-run issue is more actively traded. This spread, typically 5–15 basis points in normal conditions, widened to over 50 basis points during the 2008 crisis — a stark illustration of how fast the premium can reprice (Krishnamurthy, 2002).

2008: the structured credit collapse

The 2007–2009 crisis was, in its financial mechanics, a liquidity crisis as much as a credit crisis. Structured products — CDOs, CLOs, RMBS tranches — had been priced on the assumption of continuous market function. When interbank funding markets froze in August 2007 and then catastrophically in September 2008, the secondary market for these instruments did not just widen; it ceased to exist for extended periods. Dealer balance sheets, already leveraged, could not absorb the inventory. The absence of price discovery meant that Level 3 marks sustained values that any informed participant knew were fictional.

The crisis revealed a second dimension: liquidity risk is correlated across asset classes precisely at the moment diversification is most needed. Equities, credit spreads, commodity prices, and currency pairs all moved together in the September–October 2008 period. The liquidity-adjusted CAPM’s prediction — that assets which become illiquid when the market does deserve a higher premium — was validated in the worst possible way.

2020: the COVID dislocation

March 2020 produced a shorter but in some respects sharper liquidity dislocation. Even the US Treasury market — the deepest, most liquid market in the world — experienced severe dysfunction, with bid-ask spreads widening to multiples of their normal levels and the Federal Reserve ultimately intervening to purchase Treasuries directly. Corporate bond ETFs traded at discounts to their stated NAV of 5–7%, revealing the gap between the price at which the underlying bonds could theoretically be valued and the price at which they could actually be sold (O’Hara & Zhou, 2021).

The episode was instructive because it demonstrated that illiquidity is not confined to genuinely illiquid assets. Given sufficient selling pressure and balance sheet constraints, liquidity can evaporate from instruments that institutional investors treat as effectively cash. The illiquidity premium, in that sense, is latent in every asset and becomes manifest when the aggregate demand for liquidity exceeds the aggregate supply of it.

2022: the UK gilt crisis

The UK gilt market disruption of September–October 2022 illustrated the specific danger of duration mismatch in institutional structures. Defined benefit pension schemes, operating under liability-driven investment strategies, held leveraged gilt positions as duration hedges. When gilt yields spiked sharply following the Truss government’s fiscal announcement, the collateral calls on those positions exceeded the liquid assets available to meet them. The funds were forced to sell gilts into a falling market, which depressed prices further, which triggered further collateral calls. The Bank of England’s intervention in the long-end gilt market on 28 September was not a policy choice — it was a financial stability necessity (Bank of England, 2022).

The LDI crisis is a pure expression of the liquidity spiral described by Brunnermeier and Pedersen. The pension schemes held assets they believed they could sell; under stress, the selling itself destroyed the market. The illiquidity premium they had not explicitly priced was collected in full over two weeks.

05 — Outlook: Structural Elevation in the Late 2020s

The conditions entering the late 2020s are structurally more illiquid than any prior period in the institutional investment era. Three forces account for this.

First, the scale of private market allocation. Assets under management in private equity, private credit, and real assets exceeded $13 trillion globally by 2024, having roughly tripled over the preceding decade (McKinsey Global Private Markets Review, 2024). Institutional portfolios that held 5–10% in alternatives in 2010 routinely carry 20–30% today. This is not inherently dangerous — long-horizon capital should hold illiquid assets. But the speed of the expansion has outrun the development of secondary markets, which remain thin, information-asymmetric, and accessible primarily to the largest participants.

Second, the democratisation of private assets. Retail-accessible structures — European Long-Term Investment Funds (ELTIFs), interval funds, perpetual NAV vehicles — have extended private market access to investors who have neither the liquidity reserves nor the horizon patience that the underlying assets require. The structural mismatch is identical to Woodford and the 2022 real estate funds, simply at greater scale. When redemption pressure arrives — and it will — the absence of a deep secondary market will translate directly into forced discounts or imposed gates.

Third, the interest rate reset. The 2022–2024 rate cycle significantly altered the economics of private credit and real estate. Assets underwritten at low yields now carry both a mark-to-market impairment and reduced debt serviceability. The slow repricing of private portfolios — which Level 3 accounting permits to occur gradually rather than immediately — has masked the extent of the adjustment. The gap between carrying values and transaction values in secondary private equity markets has been material and persistent, with secondary buyers typically pricing portfolios at 85–92 cents on the dollar of stated NAV.

The secondary market gap as a real-time illiquidity signal

Secondary private equity transaction prices provide the most direct observable measure of the illiquidity discount embedded in private portfolios. When well-managed institutional funds with diversified portfolios transact at 88 cents on the dollar of NAV, that eight-to-twelve point discount is the market’s estimate of the combined cost of illiquidity, information asymmetry, and uncertainty about the accuracy of the mark itself. It is not a distressed signal. It is the normal price of private market participation.

The macro environment adds a further dimension. Central bank balance sheet normalisation has withdrawn a significant source of liquidity from fixed income markets. Dealer balance sheets — constrained by post-2010 regulation — have not expanded to fill the gap. The ratio of corporate bond outstanding to dealer inventory has risen sharply, meaning that the market can absorb less selling pressure before prices dislocate. The next credit cycle downturn will encounter this thinner market structure.

The mitigant — partial and imperfect — is the growing institutionalisation of secondary markets and continuation vehicles in private equity. GP-led secondaries, NAV lending, and tender offer structures have created more exit optionality than existed in 2008. But volume in these markets remains a fraction of the stock of illiquid assets that would need to transact in a genuine stress scenario. They provide exit for the prepared seller; they do not provide liquidity for the system.

— The Premium That Prices Itself

The illiquidity premium is unusual among risk premia in that it compounds its own danger. An investor who earns the premium does so by accepting reduced optionality — fewer rights to exit, fewer mechanisms to respond to new information. This is tolerable when the investment performs as expected. When it does not, the illiquidity that was supposed to be compensated becomes the binding constraint.

The accounting framework, rather than disciplining this dynamic, accommodates it. Level 3 valuation permits the carrying value of an impaired illiquid asset to remain close to its acquisition price until a transaction forces otherwise. The reported premium appears to be earned — consistently, smoothly, with low volatility — right up until the exit. At that point, the premium is either confirmed or consumed.

What the historical record suggests, and what the current structural configuration implies, is that the premium has been systematically underpriced across the private markets expansion of the 2010s and 2020s. The gap between NAV and secondary transaction prices is not noise. It is the market’s estimate of what the illiquidity cost actually is, stated plainly in the only currency that matters: money changing hands.

Investors who hold illiquid assets without an explicit, independently derived illiquidity premium — priced at the portfolio level, not borrowed from public market analogues — are not earning a premium. They are deferring a reckoning.

Sources

1. Amihud, Y. & Mendelson, H., Asset Pricing and the Bid-Ask Spread, Journal of Financial Economics, 1986.

2. Amihud, Y., Illiquidity and Stock Returns: Cross-Section and Time-Series Effects, Journal of Financial Markets, 2002.

3. Kyle, A.S., Continuous Auctions and Insider Trading, Econometrica, 1985.

4. Acharya, V. & Pedersen, L.H., Asset Pricing with Liquidity Risk, Journal of Financial Economics, 2005.

5. Silber, W.L., Discounts on Restricted Stock: The Impact of Illiquidity on Stock Prices, Financial Analysts Journal, 1991.

6. Longstaff, F.A., How Much Can Marketability Affect Security Values?, Journal of Finance, 1995.

7. Brunnermeier, M.K. & Pedersen, L.H., Market Liquidity and Funding Liquidity, Review of Financial Studies, 2009.8. Getmansky, M., Lo, A.W. & Makarov, I., An Econometric Model of Serial Correlation and Illiquidity in Hedge Fund Returns, Journal of Financial Economics, 2004.

9. Krishnamurthy, A., The Bond/Old-Bond Spread, Journal of Financial Economics, 2002.

10. O’Hara, M. & Zhou, X.A., Anatomy of a Liquidity Crisis: Corporate Bonds in the COVID-19 Crisis, Journal of Financial Economics, 2021.

11. Bank of England, Financial Stability Report, November 2022. bankofengland.co.uk

12. IASB, IFRS 13 Fair Value Measurement, 2011. ifrs.org

13. FASB, ASC 820 Fair Value Measurement, 2011. fasb.org

14. FCA, Illiquid Assets and Open-Ended Funds: Feedback Statement, February 2020. fca.org.uk

15. McKinsey & Company, Global Private Markets Review, 2024.

Benjamin Graham gave investors Mr. Market — a moody, irrational counterparty who shows up daily with a price and invites you to trade. The parable is psychologically precise but structurally incomplete. It tells you how Mr. Market behaves; it does not tell you what kind of entity he is, or how many faces he wears. This paper addresses both questions in two movements.

Part I approaches the market through economic sociology and institutional theory. Markets are not mechanisms that float free of society — they are social institutions, embedded in culture, power, and convention, constituted by the identities and relationships of their participants. The livestock fair, the weekly periodic market, the local souk, and the global derivatives exchange are all markets, but they operate by different logics, enforce trust through different mechanisms, and distribute power very differently. Understanding this is not background knowledge — it is the foundation of any serious analysis of price formation.

Part II maps Mr. Market’s structural faces through ten typologies, each framed as an opposition: sales market versus source market, spot versus futures, bilateral versus exchange-based, regulated versus informal, auction versus posted-price, thin versus deep, platform versus pipeline, B2B versus B2C, primary versus secondary, in-person versus e-commerce. The opposition format is deliberate — each pole implies a different competitive logic, a different distribution of information and power, and a different basis on which price forms. A closing synthesis surveys five further typologies in brief and draws the argument together.

Graham told us Mr. Market is irrational. What he left unsaid is that Mr. Market is also plural — and misreading which market you are actually in may be the more costly error of the two.

#markets#finance#economics#marketstructure#politicaleconomy

Benjamin Graham’s Mr. Market is one of the most enduring metaphors in the investment canon (Graham, 1949). Imagine, Graham wrote, that you own a share in a private business alongside a partner called Mr. Market. Every day he appears and names a price at which he will either buy your share or sell you his. Sometimes his price is euphoric, sometimes despairing, always driven by sentiment rather than reason. Your advantage lies in knowing that you are not obliged to trade — you can simply wait until his mood produces a price worth acting on.

The parable is psychologically exact. But it leaves a prior question unanswered: what kind of entity is Mr. Market? What are the rules of the arena in which he operates? What social and institutional forces produce his prices — and his moods? Graham assumed a single, generic market. In reality, every market has a structure, and that structure shapes behaviour as powerfully as psychology does. Before you can profit from Mr. Market’s irrationality, you need to know which Mr. Market you are dealing with.

This paper answers that question in two movements. Part I establishes the market as a social institution — a creature of culture, power, and convention, not a free-floating price mechanism. Part II maps Mr. Market’s structural faces through ten typologies, each framed as an opposition between two poles. Together they form a single argument: that the most dangerous assumption in markets is that “the market” is a unified entity with a single logic, and that the practitioner who sees its structural variety clearly holds an advantage that no amount of valuation skill alone can replicate.

Part I

What Kind of Entity Is He? The Market as Social Institution

01 — Two Theories of the Market

Classical economics treated the market as the natural meeting point of self-interested rational agents. In this framing, price is the market’s language: it aggregates dispersed individual knowledge and transmits it as a coordination signal without any central authority. Hayek elevated this into a near-mystical claim — that the price system accomplishes feats of information processing that no planned economy could replicate (Hayek, 1945). Mr. Market, in this account, is a mechanism. He is impersonal, indifferent, and ultimately efficient.

Economic sociology offered a corrective. Markets, argued Polanyi, Weber, and more recently Granovetter, are embedded in social structures — they do not float free of culture, power, trust, and convention (Granovetter, 1985). A transaction between two strangers in a Saharan souk is governed not only by supply and demand but by norms of hospitality, reputational networks, and customary price ranges that no formal model captures. Mr. Market, in this account, is not a mechanism but a community of practice — constituted by the concrete identities of his participants and the historical conditions in which they meet.

The market does not precede society. It is society in one of its most concentrated and revealing expressions.

Both accounts are needed. The neoclassical account explains price formation under idealised conditions and gives us the benchmark against which real markets can be measured. The sociological account explains why real markets so often depart from that benchmark — and why the departures are not random noise but structured by identifiable social forces. Mr. Market’s moods, in this light, are not simply psychological aberrations. They are the expression of the social relations, power structures, and institutional conventions that constitute the market in which he operates.

02 — Mr. Market at the Cattle Fair

To see what the sociological account adds, consider Mr. Market in his oldest form: the livestock fair. The weekly cattle fair, the horse market, the sheep sale — these are not merely economic mechanisms. They are dense social occasions in which the market’s institutional character is most legible, precisely because abstraction has not yet obscured it.

In the traditional livestock market, valuation is inseparable from embodied knowledge. The buyer circles the animal, examines its teeth, assesses its gait, reads the condition of its coat. Price emerges from the encounter of expert judgements, not from an order book. This is what Akerlof formalised in his analysis of the market for lemons — markets in which quality is difficult to observe are plagued by adverse selection, as sellers with superior information exploit buyers with inferior information (Akerlof, 1970). The livestock market evolved elaborate social mechanisms to address precisely this problem: the reputation of the drover, the word of the dealer, the custom of the third-party witness. These are not inefficiencies layered on top of the market. They are the market’s infrastructure.

The periodic or weekly market extends this logic into the temporal dimension. Its fixed rhythm — assembling on the same day, at the same place, week after week — is not an inefficiency to be engineered away. It is constitutive of the market’s social function. The regularity of the cycle allows trust to accumulate. The same traders return to the same positions, and reputation has time to build and be tested. Braudel identified the periodic market as the primary institution through which pre-industrial economies integrated local production with wider circuits of exchange (Braudel, 1979). Anthropologically, both the fair and the weekly market exemplify what Mauss theorised as the total social fact — an institution that simultaneously encompasses economic, legal, moral, and aesthetic dimensions (Mauss, 1925). The deal struck in a cattle ring is not merely a transfer of title. It is an affirmation of the social order, a performance of identities, a ritual confirmation of belonging. Strip this away and you have not a purer market, but a thinner one.

03 — Local, Global, and the Scalar Question

Mr. Market operates at a scale, and scale is not a neutral variable. It shapes the nature of competition, the role of information, the possibilities for trust and regulation, and the distribution of power between participants.

The local market is defined by spatial proximity and social density. Its participants are typically known to one another or to common intermediaries. Price competition is moderated by ongoing relationships, the threat of social sanction, and the asymmetric costs of exit from a community where reputation matters. Economic anthropology — from Malinowski’s study of Kula ring exchange to Geertz’s analysis of the Moroccan souk — has documented the ways in which local exchange is structured by thick webs of personal obligation and collective identity. The local Mr. Market possesses rich, tacit knowledge of his counterparties and of the specific qualities of goods. But he may also be captured by local monopolies and the arbitrary exercise of power by dominant actors.

The global Mr. Market operates at a scale that dissolves personal knowledge into standardised information. Prices are set by the interaction of millions of participants who will never meet. This anonymity is, in one sense, a triumph — global markets realise gains from specialisation at a scale unimaginable to any earlier epoch. Yet they generate their own pathologies. The 2008 financial crisis illustrated what can occur when global markets in complex instruments are constituted by participants who neither know their counterparties nor understand their own positions. As Wallerstein and global value chain theorists emphasise, the global market is not flat or frictionless — it is structured by power: the power of standard-setting bodies, dominant currencies, and the states whose legal systems backstop international contract enforcement (Wallerstein, 1974). The global Mr. Market appears impersonal, but his arena was built by someone, and it was not built neutrally.

04 — Mr. Market Is Always Constituted by Rules

No market exists in the absence of rules. Even the most apparently free and informal market rests on a substratum of social norms, legal conventions, and institutional arrangements that define property rights, enforce contracts, and adjudicate disputes. The notion of an unregulated market is, in the strictest sense, a contradiction in terms. Mr. Market does not precede his rules — he is made by them.

Regulation serves multiple functions simultaneously. It addresses market failures — the negative externalities that unregulated exchange imposes on non-participants, the information asymmetries that enable fraud and exploitation, the systemic risks that individually rational behaviour can collectively generate. But regulation is also a site of contestation. Stigler’s theory of regulatory capture proposed that regulated industries tend over time to bend the rules to their own advantage (Stigler, 1971). The regulated market is therefore neither a simple instrument of the public interest nor a mere mask for private power — it is a field of ongoing political struggle over the terms on which Mr. Market is allowed to operate.

The most sophisticated financial markets in existence are regulatory achievements — brought into being by collective political decision and sustained by continuous institutional maintenance. A listed equity exchange, a cleared derivatives market, a carbon trading scheme: none emerged spontaneously. Each was built, and each can be rebuilt differently.

This matters for the practitioner because regulatory change is among the most systematically underpriced variables in any sector analysis. And because it matters who wrote the rules: the capture-status of the regulator — whether oversight serves public interest or incumbent protection — is a structural input to any investment thesis in a regulated industry. Mr. Market’s behaviour in a given sector cannot be fully understood without asking whose rules he is playing by, and why those rules exist in their current form.

Part II

His Ten Faces — A Structural Typology

Part I established that Mr. Market is a social institution: embedded, rule-constituted, shaped by power and history. Part II turns to his structural variety. The ten typologies that follow are each framed as an opposition between two poles. The opposition is the point — each pole implies a different competitive logic, a different distribution of information and power, and a different basis on which price forms. Read them as a diagnostic overlay: applied simultaneously to any market, they reveal which Mr. Market you are actually dealing with.

05 — Sales Market ↔ Source Market

Sales MarketvsSource Market

Max Weber’s distinction between the sales market and the source market is the most useful single cut in market typology, and the most underappreciated (Weber, 1922). A sales market is one in which sellers compete for buyers — the logic of disposal governs. A source market is one in which buyers compete for supply — the logic of procurement governs. The error most analysts make is treating “the market” as a unified entity when it is always simultaneously both, depending on whose position you occupy.

Consider the crude oil market. For the national oil company bringing barrels to market, it is a sales market — they compete against other producers for the best clearing price. For the airline treasury desk hedging jet fuel exposure, it is a source market — they compete against other buyers for supply certainty. The price that clears between them is the same number, but the strategic logic on each side is entirely different. In a sales market, differentiation and brand protect margin. In a source market, relationships, information, and procurement discipline protect margin. Confuse the two and your competitive strategy will be systematically misdirected. Mr. Market is not the same entity depending on which side of the transaction you sit.

06 — Spot Market ↔ Futures Market

SpotvsFutures

The spot market prices the world as it is right now. The futures market prices the world as participants collectively expect it to be at a specified future date. The spread between these two numbers is one of the most information-dense signals in finance — and it is where Mr. Market’s psychology becomes most legible, because it encodes not just current supply and demand but the entire structure of expectations, risk premia, and carrying costs.

When futures prices trade above spot — contango — the market is expressing that the cost of carrying inventory must be compensated, or that it expects higher prices ahead. When futures trade below spot — backwardation — the market is expressing either that current demand is exceptionally acute, or that a convenience yield accrues to those who hold the physical commodity today. In commodity markets, persistent backwardation is often a signal of genuine physical tightness. In financial markets, the shape of the futures curve encodes the entire architecture of interest rate expectations, credit risk, and liquidity preference. The futures Mr. Market does not predict the future — he prices the risk of the future. These are different things, and the gap between them is where informed practitioners earn their edge.

07 — Bilateral Exchange ↔ Exchange-Based Market

BilateralvsExchange-Based

Strip away every layer of market infrastructure and what remains is bilateral exchange — two counterparties, one transaction, a price negotiated between them. This is the logical atom from which all other market structures are built. Price is not discovered; it is negotiated. The outcome depends on each party’s outside option, information asymmetry, time pressure, and threat point. Nash bargaining theory formalises this: the surplus of exchange is divided in proportion to each party’s power relative to what they receive absent a deal (Nash, 1950). Improve your outside option, close information gaps, reduce your urgency — and you shift the price. This is the bilateral Mr. Market, and he is more common than the exchange-based variety: the OTC derivatives market — notionally the largest financial market in existence — is almost entirely bilateral, governed by ISDA master agreements that constitute a private legal infrastructure for dyadic commerce at scale.

The exchange-based market sits at the opposite pole: a centralised venue in which standardised instruments trade continuously against a visible order book, with prices publicly disseminated in real time. Here price is discovered rather than negotiated, and the counterparty is anonymous. The same directional view, expressed in an OTC bilateral swap versus a listed future, implies radically different counterparty risk, price transparency, and exit conditions. Knowing which Mr. Market you are in determines which variables actually matter.

08 — Regulated Market ↔ Informal Market

RegulatedvsInformal

As Part I established, all markets are rule-governed. The opposition here is between markets whose rules are statutory and formally enforced, and markets whose rules are customary and enforced through social sanction, reputation, and the persistent threat of coercion. The regulated Mr. Market — the licensed stock exchange, the cleared derivatives market, the supervised banking system — is constituted by his regulatory architecture as much as by his participants. The informal Mr. Market — the hawala network, the black market in foreign exchange under a fixed peg, the grey market in controlled goods — is governed by his own internal logic: trust networks, repeated dealing, and enforcement mechanisms that operate entirely outside the state.

The practical implication runs in both directions. In formal markets, regulatory change is among the most systematically underpriced variables in any sector analysis — a rule change can be more consequential than a decade of organic earnings growth. In informal markets, the relevant analytical question is not what the rules say but who enforces the norms, and at what cost. The capture-status of the regulator in formal markets, and the enforcer-identity in informal ones, are structural inputs to any serious thesis.

09 — Auction Market ↔ Posted-Price Market

AuctionvsPosted-Price

In a posted-price market, the seller sets a price and the buyer either accepts or walks away. Price is not discovered through competition — it is administered. Most retail commerce operates this way: the supermarket shelf, the SaaS subscription page, the petrol station forecourt. The seller bears the risk of mispricing; the buyer bears no negotiating burden. Power sits with the price-setter, and margins are protected by brand, switching costs, or information asymmetry.

In an auction market, price is discovered through competitive bidding under a structured set of rules — and different formats produce systematically different prices for identical assets. The English auction (ascending open bid), the Dutch auction (descending price clock), the first-price sealed bid, and the Vickrey second-price auction all diverge in the real world of correlated values and strategic behaviour (Milgrom & Weber, 1982). The winner’s curse is the central pathology: the winning bidder in a common-value auction systematically overpays, because their winning bid is selected precisely because it was the most optimistic. Discipline in auction markets means shading your bid below your own estimate of value by enough to account for this selection effect. In financial markets, auction dynamics appear in Treasury issuance, IPO bookbuilding, M&A competitive bid processes, and distressed asset sales — and the practitioner who understands the specific format in play holds a structural advantage over those who simply bid their estimate of intrinsic value.

10 — Thin Market ↔ Deep Market

ThinvsDeep

A deep market is one in which large positions can be transacted without meaningfully moving the price. Bid-ask spreads are tight, market impact is low, and exit is cheap. Mr. Market here is liquid and relatively indifferent to the size of individual transactions. A thin market is the opposite: few participants relative to the size of positions that need to be transacted. A single motivated seller can move prices by percentages rather than basis points. This is where Mr. Market’s manic-depressive character is most extreme — not because participants are more irrational, but because the structural conditions amplify any given sentiment into large price movements.

Illiquidity is not simply a transaction cost — it is a risk that compounds with all other risks. In a thin market, the act of exiting may itself move the price adversely, creating a feedback loop in which an orderly reassessment becomes a forced liquidation (Amihud & Mendelson, 1986). The liquidity premium earned in ordinary times is a payment for bearing catastrophic risk in stressed ones. The full cost of illiquidity includes market impact, the option value of liquidity foregone, and the correlation of illiquidity with adverse conditions — when you most need to exit, the market is thinnest. Thin market positions must be sized to survive the worst plausible scenario, not the average one. Patient capital that can provide liquidity to a motivated seller in a thin market earns a structural premium that liquid-mandate investors cannot access.

11 — Platform Market ↔ Pipeline Market

Two-Sided PlatformvsLinear Pipeline

A pipeline market is the classical linear structure: a firm acquires inputs, transforms them, and sells outputs to customers. Value flows in one direction along the chain. Most industrial and consumer goods markets are pipeline markets. Competition occurs at each stage of the chain, and margin accrues to whoever controls the most defensible step in the sequence.

A two-sided platform market connects two distinct user groups whose participation is mutually dependent (Rochet & Tirole, 2003). The value to each side depends on the size of the other — more Uber drivers means more value for riders, more riders means more income for drivers. This interdependence creates a winner-take-all dynamic at scale: the platform that achieves critical mass on both sides compounds a structural advantage that late entrants cannot easily overcome. Platform businesses price asymmetrically, subsidising one side to attract the other. Google charges advertisers and gives search to users for free; stock exchanges charge issuers and subsidise market makers. This Mr. Market requires a different valuation framework entirely — conventional DCF struggles to capture network effects because the marginal value of an additional user is non-linear and path-dependent. The relevant questions are: how strong are the network effects, how defensible is the incumbent against multi-homing, and what is the platform’s ability to shift pricing between sides over time without triggering defection?

12 — B2B ↔ B2C

Business to BusinessvsBusiness to Consumer

B2B markets are characterised by informed buyers, complex purchasing decisions, long sales cycles, and value propositions built around ROI and total cost of ownership. The buyer is a professional whose career depends on making sound procurement decisions. They respond not to advertising in the conventional sense but to reputation, track record, reference customers, and the quality of the ongoing relationship with the vendor. Margins tend to be protected by switching costs and entrenched relationships rather than by brand imagery. B2C markets are characterised by emotionally driven buyers, short decision cycles, brand sensitivity, and price elasticity that varies sharply across segments. The consumer responds to packaging, social proof, and the full apparatus of behavioural influence. Margins are protected by brand equity, distribution control, and the management of consumer attention and habit.

The B2B/B2C distinction maps almost perfectly onto moat type, and therefore onto the durability of competitive advantage. B2B compounders are built on relationships, switching costs, and recurring revenue. B2C compounders are built on brand, habit, and distribution. Conflate them and you misidentify the moat — and therefore how long the return can sustain. The emergence of C2B and C2C peer exchange has complicated the taxonomy without undermining it: a platform operating on B2C logic typically sits between individual counterparties, extracting rent from the volume of peer exchange. The strategic question is always who captures the surplus, and on what structural basis.

13 — Primary Market ↔ Secondary Market

PrimaryvsSecondary

The primary market is where new securities are born — the IPO, the bond issuance, the private placement. Capital flows from investors to the issuer. Price is set rather than discovered: the issuer and its advisers assess demand, run a bookbuild, and set the clearing price. This is a sales market operation for the issuer, governed by the logic of disposal and subject to the full force of securities regulation, disclosure requirements, and liability for material misstatement.

The secondary market is where existing securities change hands. No capital flows to the issuer — only ownership changes. Price is discovered continuously through the interaction of buyers and sellers whose motivations — liquidity needs, rebalancing, conviction changes, forced selling — are entirely unrelated to the issuer’s capital needs. Secondary market prices are the primary market’s memory and its forward signal simultaneously: they tell the issuer what future capital will cost, and they tell secondary investors what the primary market’s original pricing implied about subsequent performance. The gap between IPO price and secondary market price in the weeks following issuance is one of the most reliable indicators of the power dynamics between issuers and underwriters — and of how Mr. Market’s mood at the moment of issuance diverged from his considered view thereafter.

14 — In-Person Market ↔ E-Commerce

In-PersonvsE-Commerce

The in-person market is defined by physical co-presence: the buyer can touch, smell, try, and assess the good before committing. Information asymmetry is reduced by direct sensory access. The seller can read the buyer’s reactions, adjust the pitch in real time, and deploy the full apparatus of social persuasion. Geographic price discrimination is structurally possible — prices in a tourist district and a residential neighbourhood can diverge because search costs are high and comparison is effortful. Trust is established through the physical environment, the appearance of the vendor, and the social norms of the setting. This is the Mr. Market of the souk, the antique fair, the private bank meeting room — a market saturated with social information, in which relationships and embodied knowledge shape price as powerfully as supply and demand.

E-commerce inverts many of these dynamics. Search costs collapse: a consumer can compare prices across dozens of vendors in seconds, compressing margins and accelerating commoditisation for undifferentiated goods. Geographic price discrimination becomes harder to sustain publicly, though personalised dynamic pricing attempts to replicate it at the individual level using behavioural data. The inability to physically assess goods before purchase reinstates information asymmetry in a new form — one that ratings systems, return policies, and brand reputation are designed to address, imperfectly. E-commerce advantages go to whoever controls the aggregation layer: the platform that indexes supply and captures demand extracts rent from both sides without holding inventory. The in-person advantage survives where embodied experience, immediacy, or trust cannot be replicated digitally — a reality that explains the persistent premium of physical presence in luxury goods, perishable food, professional services, and any market where the relationship is, itself, the product.

— Five Further Typologies in Brief

The ten oppositions above form the primary diagnostic framework. Five further typologies deserve acknowledgement without requiring full treatment, because each captures a structural dimension that the ten do not fully cover.

Centralised versus decentralised markets. A centralised market routes all transactions through a single venue, producing a unified reference price. A decentralised or OTC market produces a distribution of prices across bilateral relationships, with no single clearing point. Cryptocurrency markets have introduced a third structural form — decentralised exchanges operating via automated market-making algorithms rather than human counterparties — whose long-run implications for price discovery remain contested but are structurally significant.

Transparent versus opaque markets. Pre- and post-trade transparency determine how much information participants can observe about current bids, offers, and completed transactions. Dark pools — off-exchange venues that conceal order flow — allow large institutional trades without telegraphing intent to the market. The trade-off is genuine: transparency improves price discovery and reduces information asymmetry for smaller participants, but it can disadvantage large participants by exposing their positions to front-running and adverse selection. Regulators across jurisdictions have spent two decades calibrating this balance, with no settled answer.

Continuous versus batch auction markets. Most equity exchanges operate as continuous markets — trades can occur at any moment during trading hours. Embedded within them are batch mechanisms: the opening and closing auctions, in which orders accumulate and clear simultaneously at a single price. Batch auctions eliminate the speed advantage of high-frequency traders, since submitting an order one millisecond earlier confers no benefit if the auction clears at a fixed time. This has prompted serious academic and regulatory debate about whether continuous equity markets should be converted into frequent batch auctions — a structural reform with significant implications for market microstructure and the economics of speed.

Monopoly versus competitive markets. The classic structural spectrum remains the most important single variable in sector analysis. A monopoly market offers unconstrained pricing power; a competitive market tends toward marginal cost pricing over time, with returns competed away to the cost of capital. The practitioner’s task is to identify where any given market sits on this spectrum, and whether the forces moving it are structural or cyclical. Most real markets inhabit the contested middle — oligopolies in which a small number of participants compete on dimensions other than price, and in which the stability of the structure depends on regulatory tolerance and the credibility of tacit coordination.

Domestic versus cross-border markets. The moment a market crosses a jurisdictional boundary it acquires new dimensions: currency risk, regulatory arbitrage, jurisdictional fragmentation of enforcement, and the possibility of divergent accounting and disclosure regimes. Cross-border markets also create structural opportunities that purely domestic markets cannot: access to deeper pools of capital, talent, or demand; the ability to arbitrage regulatory differences. The cost is the permanent overhead of operating across multiple legal, linguistic, and institutional systems — and the political risk of a regulatory environment that is, by definition, beyond the control of any single participant.

— Mr. Market Has Ten Faces

Graham told us that Mr. Market is irrational — that his daily prices are driven by sentiment rather than reason, and that the disciplined investor’s advantage lies in patience and independent judgement. This remains true. But it is incomplete. Before you can exploit Mr. Market’s irrationality, you need to know which Mr. Market you are dealing with: which competitive logic governs his behaviour, how his prices are discovered, whose rules he is playing by, how liquid his arena is, and what kind of counterparty he actually is.

Ten Typologies — The Diagnostic Overlay

• Sales ↔ Source — Which competitive logic governs your seat at the table?

• Spot ↔ Futures — What does the curve say that the price does not?

• Bilateral ↔ Exchange-Based — Is price negotiated or discovered, and who sets the reference?

• Regulated ↔ Informal — Who wrote the rules, and whose interests do they serve?

• Auction ↔ Posted-Price — Is price set by competition or by administration?

• Thin ↔ Deep — What does liquidity actually cost, and in which scenario?

• Platform ↔ Pipeline — Where are the network effects, and who captures the surplus?

• B2B ↔ B2C — What is the moat made of, and how durable is it?

• Primary ↔ Secondary — Is capital being raised or reallocated, and who has the pricing power?

• In-Person ↔ E-Commerce — What happens to information asymmetry when search costs collapse?

Mr. Market is not one entity. He is ten simultaneously — and any given market is characterised by all ten dimensions at once. The practitioners who consistently find edge are not those with the best models of intrinsic value. They are those with the clearest understanding of the structural environment in which value is being priced. Graham gave us the right temperament. These typologies give us the map.

Sources

• 1. Graham, Benjamin. The Intelligent Investor, 1949. Harper & Brothers.

• 2. Hayek, Friedrich. “The Use of Knowledge in Society.” American Economic Review 35(4), 1945.

• 3. Granovetter, Mark. “Economic Action and Social Structure: The Problem of Embeddedness.” American Journal of Sociology 91(3), 1985.

• 4. Akerlof, George. “The Market for Lemons: Quality Uncertainty and the Market Mechanism.” Quarterly Journal of Economics 84(3), 1970.

• 5. Braudel, Fernand. Civilisation and Capitalism, 15th–18th Century, Vol. 2, 1979. Harper & Row, 1982.

• 6. Mauss, Marcel. Essai sur le Don, 1925. English edition: The Gift, Routledge, 1990.

• 7. Wallerstein, Immanuel. The Modern World-System I, 1974. Academic Press.

• 8. Stigler, George. “The Theory of Economic Regulation.” Bell Journal of Economics and Management Science 2(1), 1971.

• 9. Weber, Max. Economy and Society, 1922. Bedminster Press, 1968 (English translation).

• 10. Nash, John. “The Bargaining Problem.” Econometrica 18(2), 1950.

• 11. Milgrom, Paul and Robert Weber. “A Theory of Auctions and Competitive Bidding.” Econometrica 50(5), 1982.

• 12. Amihud, Yakov and Haim Mendelson. “Asset Pricing and the Bid-Ask Spread.” Journal of Financial Economics 17(2), 1986.

• 13. Rochet, Jean-Charles and Jean Tirole. “Platform Competition in Two-Sided Markets.” Journal of the European Economic Association 1(4), 2003.

• 14. Polanyi, Karl. The Great Transformation, 1944. Beacon Press.

This article examines how the mechanisms of price formation in equity markets have migrated away from the exchange order book — the venue that regulation, education, and most market participants still treat as the locus of price discovery.

The first generation of algorithmic trading colonised the order book and then abandoned it. Resting orders became signals to be front-run; the rational response was to hide. An entire parallel infrastructure — dark pools, internalised retail flow, and bilateral execution — now accounts for 35–45% of US equity volume, with no pre-trade quotes feeding the public tape.

For many of the most economically significant assets, price discovery has migrated off the cash market entirely. Equity index futures set the overnight signal; the cash market adjusts at the open. Options dealer hedging — amplified by the explosion of zero-days-to-expiry contracts, which now account for over 57% of SPX options volume — drives mechanical intraday equity flows that have nothing to do with fundamental supply and demand. ETF creation and redemption adds a further layer of portfolio-level flow untethered from individual security order books.

The central finding is that the order book is now a strategic prop — a venue, a signal, and a trap — rather than the engine of price discovery it was designed to be. The canonical microstructure models built on order flow informativeness describe a market that no longer exists in its original form. Practitioners, researchers, and regulators all need to update their frameworks accordingly.

The order book is not where price is formed anymore — it is where professionals play games with each other using information the rest of the market can see.

#finance#markets#market-structure#algorithmic-trading#price-discovery

There is a fiction that persists in financial education, in regulatory frameworks, and in the mental models of many market participants: that price is formed on exchanges, in the order book, through the continuous collision of buy and sell interest. That the lit, visible, centralised venue is where the market lives. In the age of algorithmic trading, this is no longer meaningfully true — and understanding why matters enormously for anyone trying to understand what prices actually represent.

Market structure at a glance

• 60–80% — share of US equity volume attributable to algorithmic and high-frequency strategies (Bloomberg / SelectUSA, 2023)

• ~45% — share of US equity trades executed off-exchange, via dark pools and internalisation (HeyGoTrade, 2024)

• ~57% — share of daily SPX options volume now accounted for by zero-days-to-expiry contracts (Cboe, Q3 2025)

01 — What the Order Book Was Supposed to Be

The exchange order book is elegant in theory. Buyers post bids; sellers post offers; when they overlap, a trade prints; the price of that trade becomes the market’s signal. The limit order book is a continuous double auction, and for most of modern financial history it was the primary mechanism by which supply and demand discovered a clearing price in real time. The specialist system on the NYSE, the market makers on NASDAQ — these were mechanisms to ensure the book stayed liquid, but the central idea held: price was formed in a public, transparent, centralised venue.

Regulation drove this model. Consolidated tape, best execution obligations, and the fragmentation reforms of the early 2000s — Reg NMS in the United States (SEC, 2005), MiFID in Europe — were built on the assumption that competition between lit venues would sharpen price discovery. More exchanges, more competition, tighter spreads, better prices. The order book was the temple. Regulation built the pews.

Then the algorithms arrived. And they did not worship there.

02 — How Algorithms Colonised, Then Abandoned, the Book

The first generation of algorithmic trading did engage with the order book directly — indeed, the whole point was to pick it apart. Statistical arbitrage strategies searched for cross-asset mispricings. Market-making algorithms replaced human specialists, posting quotes in milliseconds, harvesting the spread. Execution algorithms — VWAP, TWAP, implementation shortfall — broke large orders into fragments and fed them into the book in a way that minimised market impact.

But as algorithms multiplied and competed, the order book itself became a hostile environment for genuine price discovery. The book is observable. Everything posted to a lit exchange is visible to any market participant with co-location access and a fast enough data feed. This created an adversarial dynamic: any resting order in the book became information that other algorithms could trade against. A large buy order posted to the book is, in effect, a signal that demand exists — and sophisticated high-frequency strategies could detect and front-run that signal before the order was filled.

The order book became a strategic environment — not a neutral marketplace. Price formation migrated to wherever it was hardest to detect and exploit.

The rational response, for any large order, was to hide. And an entire infrastructure was built to accommodate exactly that.

03 — Where Price Is Actually Formed Now

Dark Pools and Alternative Trading Systems

Dark pools — Alternative Trading Systems (ATS) in US regulatory parlance — are private matching venues that execute trades without pre-trade transparency. There is no visible order book. Orders are posted and matched internally, with prices typically referenced to the prevailing National Best Bid and Offer (NBBO) from the lit market. The irony is profound: dark pool prices are derived from the lit market’s order book, yet the dark pool has become, by volume, a major share of all activity. By 2012, dark pools and internalizers already accounted for some 40% of US equity volume (Wikipedia — Dark pool, 2024); recent estimates put total off-exchange execution — dark pools combined with internalised retail flow — at roughly 35–45% of shares traded. (HeyGoTrade, 2024) The parasite has come to rival the host.

Internalisation and the Wholesaler Model

For retail order flow, the mechanics are even more removed from the traditional order book. Payment for order flow (PFOF) directs retail orders from brokers to market makers — wholesalers such as Citadel Securities, Virtu, or Jane Street — who execute those orders off-exchange, internalising them at prices marginally better than the NBBO. (SEC — Gensler, 2024) The exchange sees none of this flow. The trades print on the tape, but they never interact with the order book.

This has profound implications. Retail order flow — historically understood to be relatively uninformed, providing liquidity to the market — is now siphoned away from exchanges entirely. What remains on the lit book is increasingly the province of professional algorithmic strategies trading against each other: HFT firms, arbitrageurs, institutional algorithms. The composition of exchange volume has shifted dramatically toward sophisticated, fast, and information-rich participants. The book is a sparring ring for professionals, not a price-discovery venue for the market at large.

Derivatives and the Tail Wagging the Dog

For many of the most economically significant assets, price discovery has migrated not just off-exchange but off the cash market entirely. Equity index futures — S&P 500 futures on the CME, for instance — trade nearly around the clock and with vastly more leverage per dollar than the underlying stocks. When macro news breaks at 3am, the S&P futures move first. The cash equity market, when it opens, adjusts to that signal. The tail is wagging the dog.

Options markets present a similar dynamic. The notional size of the options market on major US equities and indices now dwarfs the cash market on any given day. Because options dealers must dynamically hedge their books, their hedging activity — the buying and selling of underlying equities to remain delta-neutral — transmits options market structure directly into equity prices.

The 0DTE effect. Zero-days-to-expiry options on the S&P 500 accounted for 57% of all SPX options volume in Q3 2025, according to Cboe data. (Cboe, Q3 2025) Because these options expire the same day, their gamma — the rate of change of delta — is enormous near the strike price. Options dealers who have sold these contracts are forced to hedge aggressively as the underlying moves, amplifying price swings rather than dampening them. This is a feedback loop with no historical precedent in equity microstructure. Price formation in this environment is not supply and demand meeting in a book. It is a mechanical, model-driven consequence of dealer positioning — a structural artifact of derivatives market architecture rather than any expression of fundamental value.

ETF Arbitrage and the Creation/Redemption Mechanism

The explosive growth of exchange-traded funds introduces yet another layer of price formation complexity. ETFs trade on exchanges like stocks, but their prices are kept roughly in line with their net asset values through an arbitrage mechanism involving authorised participants (APs). When an ETF trades at a premium, APs create new shares by delivering the underlying basket; when it trades at a discount, they redeem shares for the underlying. This continuous arbitrage links ETF prices to basket prices, and basket prices to individual component prices.

The consequence is that large ETF flows generate mechanical buying and selling of constituent securities — not driven by any view on those securities’ individual merits, but by the arithmetic of the creation/redemption basket. In a market where passive ETF assets rival or exceed active ones, this mechanical flow is substantial. Price formation in individual equities is increasingly contaminated by these portfolio-level flows, which have nothing to do with the order book dynamics of those individual names.

04 — Algorithmic Trading as Price Formation Infrastructure

It would be a mistake to conclude from all of this that price discovery has collapsed or that prices have become arbitrary. Algorithms are, in many contexts, extraordinarily good at processing information and incorporating it into prices rapidly. The question is not whether prices are informationally efficient — they may well be more efficient, in some narrow technical sense, than they have ever been — but rather what the mechanism of price formation actually looks like, and what it means.

The dominant algorithmic strategies operating across these venues can be classified roughly into three categories with respect to price formation.

• Market-making algorithms provide continuous two-sided quotes and are the primary mechanism by which liquidity is maintained in fragmented markets. HFT market makers now contribute more than half of displayed depth on leading equity venues. (Mordor Intelligence, 2026)

• Arbitrage algorithms — statistical arbitrage, ETF arbitrage, cross-asset — continuously enforce relationships between related instruments, transmitting price signals across markets at near-zero latency.

• Directional algorithms, including trend-following and momentum strategies, trade on signals derived from price itself, creating the potential for feedback loops and momentum cascades.

What these strategies share is that their behaviour is determined by models, parameters, and market conditions — not by fundamental views on intrinsic value. Price formation in heavily algorithmic markets is increasingly the output of a complex adaptive system of interacting models, each responding to the outputs of the others. The order book is one input among many, and often not the most important one.

05 — The Implication No One Wants to Confront

If price formation has migrated away from the exchange order book, then the entire regulatory and conceptual apparatus built around the order book is addressing the wrong thing. Best execution obligations calibrated to the NBBO are measuring a derived, reference price — not the price at which most actual economic interest is transacted. Transparency requirements for lit markets are providing visibility into a venue that represents a shrinking fraction of genuine price discovery. Systemic risk monitoring focused on exchange activity may be missing where the real leverage, interconnection, and fragility actually lives.

Regulators built cathedrals to centralised price discovery. The congregation moved to the basement, the alley, and the derivatives market — and no one told them.

There is also a deeper epistemological problem. The canonical model of market microstructure — the Glosten-Milgrom model of bid-ask spreads under adverse selection (Glosten & Milgrom, 1985) and Kyle’s model of sequential auctions with an informed insider (Kyle, 1985) — assumes that price formation is a process by which informed traders gradually reveal private information through their order flow, and market makers update their quotes accordingly. This model made sense when humans with fundamental views were the primary participants. In a market dominated by algorithmic strategies that have no fundamental view — that are trading on signals derived from price, volatility, positioning, and flow — the information content of order flow is radically different. The price formed may be technically efficient without being economically meaningful in the way the theoretical framework assumes.

06 — The Order Book as Echo Chamber

What remains in the lit order book of major exchanges is, in many ways, an echo of a market that has largely moved elsewhere. HFT market makers post quotes as obligations of their strategy, not as expressions of genuine value opinion. Institutional execution algorithms post and cancel orders as part of a tactical game of information concealment. The visible order book is, simultaneously, a venue, a signal, and a trap — and every sophisticated participant treats it as all three.

The spread quoted in the book is narrow. The depth is often illusory — available in microseconds, vanishing the moment a real order appears. The price printed on the tape may be the NBBO at the instant of execution, but that NBBO is itself a construction of algorithmic market-making models across fragmented venues, not an organic clearing of supply and demand.

This does not mean markets are broken. Liquidity in major instruments is, by most measures, abundant. Transaction costs have fallen dramatically over the past two decades. Information is incorporated into prices quickly. But the mechanism by which all this happens bears almost no resemblance to the order book model that still dominates how markets are taught, regulated, and discussed.

— Where Does This Leave Us?

Understanding price formation in contemporary markets requires abandoning the order book as the organising metaphor and replacing it with something more honest: a distributed, multi-venue, multi-asset, algorithmic system in which price is the emergent output of interacting models operating across lit markets, dark pools, derivatives markets, and bilateral trades, at timescales ranging from microseconds to days.

For practitioners, this means that the order book is an input, not a destination — and for large orders, it is often the last place you want to be. Understanding dealer positioning in options markets, ETF creation/redemption flows, futures-cash basis dynamics, and the inventory constraints of major market-making firms is at least as important as reading the equity order book. The information that matters is no longer centrally located or publicly visible.

For market structure researchers, the challenge is to develop models of price formation that accurately describe the system as it actually operates — multi-agent, multi-venue, feedback-driven — rather than optimising theories built for a world that no longer exists.

For regulators, the challenge is frankest of all: the rules were written for a market where the order book was the locus of price discovery. In a market where more than a third of equity volume never touches an exchange order book (HeyGoTrade, 2024), where derivatives dwarf the cash market in notional terms, and where the primary liquidity providers are high-frequency algorithms with no long-term view, the rules need to catch up to the reality. The order book is not the market anymore. The sooner that is acknowledged, the sooner the right questions can be asked.

Sources

• 1. Bloomberg / SelectUSA: algorithmic trading accounts for 60–75% of overall US equity volume; upper-bound estimates reach 80%. QuantifiedStrategies.com

• 2. Off-exchange (dark pools + internalisation) estimated at 35–45% of US equity volume. HeyGoTrade, Dark Pools Overview

• 3. Cboe Global Markets, State of the Options Industry: Q3 2025. 57% of SPX options ADV comprised of 0DTE contracts.

• 4. SEC, Regulation NMS, effective August 29, 2005.

• 5. Wikipedia / TABB Group: by 2012, dark pools and internalizers accounted for roughly 40% of US equity volume. Dark pool — Wikipedia

• 6. SEC / Gary Gensler: PFOF routes retail orders to wholesalers who execute off-exchange against the NBBO. SEC Office Hours: Dark Pools, PFOF & Market Structure

• 7. HFT market makers furnish 30–40% of displayed depth on major venues. Mordor Intelligence, Algorithmic Trading Market Report 2026

• 8. Glosten, L.R. & Milgrom, P.R. (1985). Bid, ask and transaction prices in a specialist market with heterogeneously informed traders. Journal of Financial Economics, 14(1), 71–100. ScienceDirect

• 9. Kyle, A.S. (1985). Continuous auctions and insider trading. Econometrica, 53(6), 1315–1336. Econometric Society

  Share

Most people use the words “price” and “value” interchangeably. In everyday conversation, that’s fine. In investing and trading, confusing the two can be costly.

Julian Gretzinger

Price is what you pay. Value is what you get.

That simple distinction, famously attributed to Warren Buffett, is the foundation of one of the most enduring ideas in finance.

01 — Price is objective

Price is a fact. It’s the number on the screen, the figure on the receipt, the last traded print. It’s determined by supply and demand in the market at any given moment — shaped by sentiment, momentum, liquidity, news, and sometimes pure emotion. Price doesn’t care about fundamentals. It just reflects what buyers and sellers agreed on right now.

1.1 — How price is derived

At its core, price is set by the intersection of supply and demand. In an exchange, this happens through an order book — buyers post bids, sellers post offers, and a transaction occurs when the two sides meet. Several forces push and pull that meeting point:

• Sentiment and momentum — fear, greed, and trend-following behaviour drive prices away from fundamentals, sometimes for extended periods

• Liquidity — thin markets move price more violently; deep markets absorb orders with less impact

• News and catalysts — earnings releases, macro data, geopolitical events can reprice an asset instantly

• Market microstructure — order flow, large block trades, and algorithmic activity all influence where price prints moment to moment

Price is ultimately a social phenomenon. It is what a crowd of participants, with different motivations and timeframes, collectively agrees on right now.

02 — How price forms: from two parties to a crowd

Price doesn’t always form the same way. Depending on the market, the asset, and the circumstances, price formation can range from a simple conversation between two people to a complex, real-time collective process involving thousands of participants.

2.1 — Bilateral exchange — the purest form

The simplest form of price formation is a direct negotiation between two parties. A buyer and a seller meet, each with their own sense of value, and they haggle until they agree on a number — or walk away. This happens every day in real estate, private business sales, art auctions, and over-the-counter derivatives. There is no central market, no published price feed. The price is whatever these two parties decide, shaped by:

• Relative bargaining power — who needs the deal more

• Information asymmetry — one party often knows more than the other

• Alternatives available — the more options each side has, the stronger their negotiating position

• Urgency — a motivated seller in a distressed situation will accept a lower price; a patient buyer can afford to wait

In bilateral markets, price is private, negotiated, and often opaque. The same asset could trade at very different prices on the same day depending on who is at the table.

2.2 — Dealer markets — price set by the seller

In many markets, a dealer or market maker sets the price. Rather than negotiating, the buyer simply accepts or rejects what’s on offer. Think of a currency exchange desk at an airport, a bond dealer quoting a bid-ask spread, or a car manufacturer’s list price. Here, the seller holds pricing power. They set the ask, manage their inventory risk, and adjust quotes based on their own exposure and market conditions. This model is common in fixed income and credit markets, foreign exchange, and certain physical commodity markets.

The flip side also exists. In distressed or illiquid markets, the buyer sets the price. Pawnshops, liquidation buyers, and private equity firms acquiring distressed assets often dictate terms — price formation driven by necessity and leverage, not by fair market equilibrium.

2.3 — Auction mechanisms — competitive price discovery

Auctions introduce competition on one or both sides of the trade, pushing price toward a more “true” market level. There are several variants:

• English auction (ascending) — bidders compete openly, price rises until only one buyer remains. Price reflects the most any buyer is willing to pay

• Dutch auction (descending) — price starts high and falls until a buyer accepts. Used in IPOs and some government securities auctions

• Sealed-bid auction — all bids are submitted simultaneously without knowledge of others. Encourages bidders to reveal their true valuation

Auctions are particularly powerful for price discovery in markets where the “correct” price is genuinely unknown — a rare painting, a newly issued bond, or a spectrum licence.

2.4 — The order book — collective pricing at scale

The most sophisticated form of price formation is the continuous double auction, the mechanism behind most modern financial exchanges. Here, price is not set by any single party — it emerges from the collective interaction of all market participants simultaneously. An order book aggregates limit orders (resting bids and offers at specified prices) and market orders (immediate buy or sell orders that execute against the best available resting price). The best bid and best ask define the current market.

• Depth — the volume available at each price level; deep books are harder to move

• Imbalance — when significantly more volume sits on one side, price tends to move toward the thinner side

• Spoofing and layering — manipulative practices where large fake orders are placed and cancelled to create a false impression of supply or demand

• Price impact — large orders consume liquidity and move price, which is why institutional traders break up orders to minimise footprint

By tracking which side is initiating trades — buyers hitting the ask or sellers hitting the bid — CVD gives a window into the aggression behind price movement, something the order book alone doesn’t reveal.

2.5 — Administered and reference prices — price set by authority

In some cases, price is not discovered through any market mechanism at all. It is simply set or fixed by an authority:

• Central banks — set benchmark interest rates, anchoring the price of money across the entire economy

• Regulated utilities — have prices determined by government bodies

• LIBOR, SOFR, and similar benchmarks — calculated from panel submissions or transaction data and used as reference rates across trillions of dollars of contracts

• Transfer pricing — within multinational corporations sets internal prices for goods and services traded between subsidiaries

These administered prices can distort market signals when set incorrectly — as the LIBOR manipulation scandal demonstrated — but serve important functions in markets where pure price discovery would be impractical or destabilising.

03 — Value is subjective

Value is an estimate. It is your independent assessment of what an asset is intrinsically worth — grounded in fundamentals rather than anchored to what others are currently paying. Two analysts can look at the same company and arrive at very different valuations. That is not a flaw. That is the whole point.

3.1 — How value is derived — and what actually qualifies

Not every method that goes by the name “valuation” is genuinely an attempt to estimate intrinsic worth. Aswath Damodaran, widely regarded as the foremost authority on valuation, draws a sharp and important line here. True valuation, in his framework, has one legitimate form: Discounted Cash Flow (DCF) — projecting a company’s future free cash flows and discounting them back to the present using a required rate of return that reflects the riskiness of those cash flows. This is the only method that derives value entirely from the asset’s own economic fundamentals — its growth, profitability, and risk — without any reference to what the market is currently paying for similar assets.

Everything else, Damodaran argues, is better understood as pricing — not valuation.

3.2 — Multiples and comparable company analysis

P/E, EV/EBITDA, Price-to-Book, EV/Sales — these are the dominant tools of equity research and M&A advisory. But despite the language of “valuation” that surrounds them, they are fundamentally pricing exercises. A multiple is a standardised price: it tells you what the market is currently paying per unit of earnings, cash flow, or book value for a peer group of companies.

When you apply that multiple to your target company, you are not estimating what it is worth in any independent sense — you are anchoring to the crowd’s current judgement and asking whether your company is cheap or expensive relative to that benchmark.

The deeper problem with multiples is not that they reference market prices — it is that their assumptions are hidden. Every multiple implicitly embeds views on growth, risk, and returns on capital, but those assumptions are invisible rather than explicit. A DCF forces you to defend your forecast. A multiple lets you smuggle in the same assumptions without ever stating them.

3.3 — Asset-based approaches

Asset-based approaches sit on a spectrum. Liquidation value — estimating what a business’s assets would fetch if sold piecemeal — is essentially a pricing exercise, since it relies on market comparables for each asset class. Sum-of-the-parts analysis, where divisions are each assigned a multiple and the results aggregated as NAV, is pricing with an extra layer of arithmetic. Only where each individual asset is valued on its own projected cash flows does asset-based analysis genuinely cross into valuation territory.

3.4 — The exit multiple method — pricing in disguise

The exit multiple method — a common DCF variant where terminal value is calculated by applying a multiple to final-year earnings — deserves special scrutiny. It looks like valuation. It uses a discount rate, it projects cash flows, it has all the apparatus of a DCF. But the terminal multiple at the end smuggles pricing back in through the back door.

The terminal value in these models often accounts for 60–80% of the total result, which means the entire exercise is largely anchored to whatever multiple the market happens to be assigning today. Damodaran calls this a pseudo-DCF — a pricing tool wearing the clothes of intrinsic valuation.

3.5 — The honest taxonomy

• DCF with fundamental terminal value — true valuation

• Multiples / comparable company analysis — pricing

• Precedent transaction analysis — pricing

• Liquidation / asset-based (market comparables) — pricing

• Asset-based (DCF per asset) — true valuation

• Exit multiple DCF — pricing dressed as valuation

None of this makes pricing illegitimate. Pricing is widely used, often efficient, and practically indispensable in fast-moving markets. The problem is one of honesty — claiming to value a business when you are actually pricing it. If you have no independent anchor in intrinsic value, you have no basis for disagreeing with the market when it is wrong. You will simply be carried along with the crowd, in both directions.

04 — The gap between them is where opportunity lives

When price and value diverge, something interesting happens. If a stock trades below its intrinsic value, a value investor sees a margin of safety — a chance to buy a dollar for fifty cents. If it trades far above value, a disciplined investor steps aside, no matter how compelling the story sounds.

Traders think about this differently. A momentum trader may not care about intrinsic value at all — they’re trading price, not value. But even then, understanding value helps define context: is this breakout happening in an already-overvalued asset, or is there room to run?

05 — Why it matters

Markets are often efficient, but not always. Prices can overshoot and undershoot. Sentiment swings. Narratives take over. In those moments, anchoring to value gives you a framework to act rationally when others aren’t.

The investor who confuses a rising price with rising value is the one who buys at the top. The one who understands the difference knows that price is just the market’s current opinion — and opinions change.

Price is a fact. Value is a judgement. And knowing which one you’re actually working with — however it’s labelled — is the beginning of financial honesty.

The section on valuation versus pricing draws substantially on the work of Aswath Damodaran, Professor of Finance at NYU Stern School of Business. Key ideas are sourced from his blog Musings on Markets, his NYU Stern course materials, Quartr Insights, and The Acquirer’s Multiple.

Julian Gretzinger

Julian Gretzinger writes on markets, valuation, and monetary economics.

Leave a comment

The European Commission’s MiCA draft is a necessary step toward harmonising crypto-asset treatment across the EU. But several provisions contain ambiguities that — if left unresolved — will undermine the very legal certainty MiCA sets out to create.

Felix Saible & Julian Gretzinger · 2 November 2020 · Bank Frick

Based on broad public consultations and the Digital Finance Outreach, the European Commission adopted a digital finance package on 24 September 2020 — including a digital finance strategy and legislative proposals on crypto-assets and digital resilience — with the aim of giving consumers access to innovative financial products while ensuring consumer protection and financial stability.

At first glance, the package can be deemed a large and mostly smart step toward integrating distributed ledger technology into the existing EU legal framework. However, the devil is in the detail. Below we have identified a number of provisions in MiCA which need further clarification to allow for uniform applicability throughout the Capital Markets Union.

Our critical remarks are aimed primarily at industry experts and professionals as well as relevant stakeholders involved in the legislative process of MiCA.

01 — Definition and scope of “advice on crypto-assets”

Article 3(1), point 9(h) & Article 3(1), point 17

“Providing advice on crypto-assets means offering, giving or agreeing to give personalised or specific recommendations to a third party, either at the third party’s request or on the initiative of the crypto-asset service provider, concerning the acquisition or the sale of one or more crypto-assets, or the use of crypto-asset services.”

Questions arising

• What is the exact scope of “advising on the use of crypto-asset services”?

• The regulation of “advice” seems mainly rooted in consumer protection. However, given the vague definition, consulting services to prospective crypto-asset service providers could likely be deemed a crypto-asset service itself.

• Article 73 does not appear to explain “use of crypto-asset services” in more detail, which further raises the question of scope.

• MiFID II does not regulate “advising on the use of investment services” — hence why should the mere advice on the use of crypto-asset services be regulated?

Possible solutions

• Delete the provision “or the use of crypto-asset services”.

• Alternatively, specify the scope in Article 73 such that “advising on the use of crypto-asset services” applies primarily to retail clients on a professional basis — meaning against compensation.

02 — Definition of “asset-referenced token”

Article 3(1), point 3

“’Asset-referenced token’ means a type of crypto-asset that purports to maintain a stable value by referring to the value of several fiat currencies, one or several commodities, or one or several crypto-assets, or a combination of such assets.”

Questions arising

• How is “purports to maintain a stable value” to be measured?

• When differentiating from a collective investment scheme token or derivative token — neither falling under MiCA — the criterion “purports to maintain a stable value” will likely be the main deterministic provision, requiring detailed judicial precedence or formal test criteria.

• The purpose of maintaining a stable value could be non-static and might change during the token lifecycle. How should a changing purpose be treated from a regulatory perspective?

• “Stable value” always needs to be measured in certain accounting units — by varying the unit the concept of stability changes as well.

Possible solutions

• Clarify that the “stable value” concept refers to a stable value in fiat money terms.

• Clarify how to measure or test the “stable value” concept.

• Clarify how to deal with a changing nature of a token during its lifetime.

03 — Definition and scope of “issuer of crypto-assets”

Article 3(1), point 6

“’Issuer of crypto-assets’ means a legal person who offers to the public any type of crypto-assets or seeks the admission of such crypto-assets to a trading platform.”

Questions arising

• Are natural persons excluded? Are private individuals prohibited from issuing crypto-assets, or merely not subject to MiCA?

• MiCA appears to centre the definition on “offering to the public” and “seeking admission to a trading platform” — but issuing, offering and seeking admission are different activities that should not be combined for regulatory purposes.

Possible solutions

• Modified wording: ‘Issuer of crypto-assets’ means a legal person who issues any type of crypto-assets or seeks the admission of such crypto-assets to a trading platform.

04 — Definition and scope of “placing of crypto-assets”

Article 3(1), point 15

“’Placing of crypto-assets’ means the marketing of newly-issued crypto-assets or of crypto-assets already issued but not admitted to trading, to specified purchasers, and which does not involve an offer to the public or an offer to existing holders of the issuer’s crypto-assets.“

Questions arising

• Does the element of “marketing” alone already trigger the service of “placing crypto-assets”?

• The differentiation between issuance (to the public) and placement (excluding an offer to the public) diverges significantly from the corresponding definitions in MiFID II and the Prospectus Regulation, and is not 100% clear to an ordinary market participant.

05 — Applicability of MiCA vs. other financial market regulations

Article 2(2), Article 7(3), Article 16(2)(d)

“This Regulation does not apply to crypto-assets that qualify as: (a) financial instruments as defined in Directive 2014/65/EU; (b) electronic money as defined in Directive 2009/110/EC; (c) deposits as defined in Directive 2014/49/EU; (d) structured deposits as defined in Directive 2014/65/EU; (e) securitisation as defined in Regulation (EU) 2017/2402.”

Questions arising

• A legal opinion as the foundation for qualifying whether a regulation applies should be avoided by all means — the purpose and applicability of law should be kept as clear as possible as a matter of rule of law.

• Definitions of non-equity financial instruments and their distinction from collective investment schemes are not harmonised across EU Member States, contributing to increased difficulty when assessing whether one is dealing with a financial instrument or a crypto-asset.

Recommended testing cascade

• Is the crypto-asset a structured deposit?

• Is the crypto-asset a deposit?

• Is the crypto-asset electronic money?

• Is the crypto-asset a financial instrument?

• If NO to all of the above — it is a crypto-asset subject to MiCA.

Possible solutions

• Clear definition of the various forms of financial instruments in one juridical act, taking into account the provisions of RTS 2, preferably as a directive to achieve true harmonisation.

• Clarification that MiCA applies only if the crypto-asset cannot be qualified as one of the exempted forms in Article 2(2).

06 — Requirement for crypto-asset issuers to be a legal entity

Article 4(1)

“No issuer of crypto-assets, other than asset-referenced tokens or e-money tokens, shall, in the Union, offer such crypto-assets to the public, or seek an admission to trading, unless that issuer: (a) is a legal entity.“

Questions arising

• If there is no issuer in the form of a legal entity — e.g. Bitcoin — issuance appears prohibited under MiCA. However, the rules governing “placing” remain applicable. How can “issuing” be prohibited while “placement” remains feasible?

Possible solutions

• Modified wording focusing on “issue” rather than “offer”, with “offering” regulated separately and possible in the Union even where the issuer is outside the EEA, is not a legal entity, or where there is no issuer at all.

07 — Consequences of excluding deposits from the scope of MiCA

Article 2(2)(c)

Questions arising

• Tokenising deposits appears possible without triggering MiCA. But could a bank voluntarily treat crypto-assets as “deposits”, removing them from MiCA’s scope?

• If certain crypto-assets were eligible to be treated as deposits, which regulatory capital requirements would apply — for trading book purposes, long-term investment, crypto-asset deposits, or granting loans in crypto-assets?

Possible solutions

• Clarify whether crypto-assets can be treated as deposits.

• Clarify which regulatory capital requirements apply if a credit institution reflects crypto-assets on-balance-sheet.

08 — Interest prohibition

Article 36

“Issuers of asset-referenced tokens or crypto-asset service providers shall not provide for interest or any other benefit related to the length of time during which a holder of asset-referenced tokens holds asset-referenced assets.”

Questions arising

• Does this provision also capture benefits generated from lending activities, or does a lending fee not qualify as “interest” within the meaning of Article 36?

• A holder of an asset-referenced token will generally only hold the token — not the underlying assets — making the phrase “holds asset-referenced assets” unclear.

Possible solutions

• Modified wording: “...shall not provide for interest or any other benefit related to the length of time during which a holder of asset-referenced tokens holds such tokens.”

— Conclusion

MiCA is a large and necessary step toward harmonising the treatment of crypto-assets throughout the Union. However, given the need to differentiate crypto-assets from existing financial instruments and banking regulation, there is room for better definitions and targeted amendments to sharpen the regulatory profile of MiCA.

We are excited to follow the further fine-tuning of MiCA and its incorporation into European law. We hope this article contributes constructively to the process. Despite not being directly part of MiCA, a coherent list of the various financial instruments and their distinctions under European law could significantly contribute to a resilient Capital Markets Union.

Felix Saible

Senior Marketing Manager at Bank Frick. Joint-Degree Master’s from the Universities of Zurich, Basel and Lucerne.

Julian Gretzinger

Head Capital Markets at Bank Frick. Master’s in Banking & Finance, University of St. Gallen; LL.M. in International Business Law, University of Zurich.

Originally published at bankfrick.li · 2 November 2020

The ICO market broke volume records in 2018 even as prices collapsed and regulators moved in. The response from issuers and investors is a decisive shift toward regulated security token offerings — but success depends on process discipline from the very start.

Julian Gretzinger & Felix Saible · 25 February 2019 · Bank Frick

While more funds were collected with initial coin offerings (ICOs) in 2018 than ever before, the still relatively young market remained exposed to considerable influences. Following significant price losses and regularly occurring cases of fraud, regulators around the world are increasingly devoting their attentions to the risks and opportunities of this new asset class — and this is especially true of the U.S. Securities and Exchange Commission (SEC).

Issuers and investors are welcoming the emerging legal certainty, as there is no real interest in a Wild West environment. Their focus is therefore shifting toward the regulated version of an ICO — the security token offering (STO). A successful process needs to be planned, however.

Despite significant price losses suffered by established tokens such as Bitcoin and Ethereum, ICOs steadily grew in popularity in 2018, primarily reflected in their volume. Based on CoinDesk data, more than three times as many funds were collected in 2018 than in the preceding year. The average ICO volume also rose from USD 8 million in 2017 to USD 10 million in 2018 — making ICOs an increasingly interesting alternative to venture capital financing.

01 — Changing terminology — legal questions persist

Empirical analysis confirms the trend toward this innovative and, in many cases, more efficient form of project and corporate financing. In practice, however, there is still no international consensus with respect to declination, which is why a precise definition would be desirable for the future.

The terms coin and cryptocurrency likely originated from Bitcoin, the alternative payment system presented in 2009 in the whitepaper of Satoshi Nakamoto. Subsequently, meta-terms became established for all new projects set up with the help of blockchain technology. The ICO also originates from this time — similar to a classic initial public offering (IPO), it involves the first-time public offering of coins.

Since February 2018, FINMA has differentiated between payment tokens, utility tokens and security tokens, although mixed forms can also occur. This differentiation has also been partially adopted by other regulators. The SEC has correctly stated that the classification of a token can change during its life cycle. A survey of ESMA has also revealed that, in certain cases, tokens do not have a clear functional character.

At an international level, the meta-terms token and crypto assets appear to be winning through. Token is used as a meta-term throughout this article.

02 — Classification as securities

Although there is still no common international consensus on when a token falls under applicable securities law, the US has already taken an initial step — it opines that almost all tokens qualify as securities. This stance was triggered in no small part by the SEC statement on the issuing and trading of digital assets published in November 2018.

In June 2018, William Hinman stated that a digital asset itself is simply code — but the way it is sold: as part of an investment, to non-users, by promoters developing the enterprise — can be, and in that context most often is, a security. Classification as securities and increased reporting obligations were the consequence.

A trend toward regulated security token offerings — so-called STOs — has been clearly observed since the second half of 2018. While ICOs were still a standalone term on popular industry platforms at the start of that year, explanations of STOs were already becoming far more frequent by late summer. They gradually emerged as the next level, often accompanied by the positive undertone that STOs would not only advance the market, but also significantly contribute to rebuilding trust through their regulatory framework.

Based on the concepts of the classic securities segment, it is logical to talk about token offerings, public token offerings, token private placements or an IPO in the form of tokens. These terms are known to market participants and leave fewer questions unanswered.

03 — Process planning as the number one priority

An efficient and successful process chiefly requires the observance of and compliance with applicable law. The involved players need to precisely define target markets and clients at the outset in order to involve the respective jurisdiction in the structuring of the marketing strategy.

Existing knowledge with respect to launching public offerings for securities still primarily lies with investment banks. However, these institutions are continuing to proceed very cautiously on the market for token offerings, meaning that knowledge transfer is only taking place very hesitantly, if at all. This is a further reason to break up the existing arcane knowledge and place a focus on planning — primarily with a view to sustainable business success and later efficiency gains.

The issuer or organiser must generally adhere to the legal provisions of their domicile or the state from which the token offering is being conducted. The provisions of all states in which investors are being addressed must also be observed. Any failure to observe the applicable security laws within this jungle of legislation could — depending on the structure of the token offering and its marketing communication — very quickly lead to a possibly unintentional infringement of applicable foreign law.

The term public offer is very broadly formulated in many jurisdictions: a simple roadshow or advertising video on YouTube without geo-blocking can exhibit all the features of a public offering, subjecting it to registration and prospectus obligations.

04 — Marketing and compliance go hand in hand

To proactively mitigate this considerable risk, it is advisable to establish a marketing and communication plan as a central element during the planning phase of the token offering. In cooperation with the supporting law firm and other project partners, the intended strategy can be reviewed at an early stage with respect to its feasibility, objectives and effectiveness.

The primary objective of the issuer is to achieve a public offering in as many jurisdictions as possible, thus allowing it to address an optimally broad investor base. Like classic IPOs, the balance between costs and effectiveness needs to be decided upon for each new token offering. One solution is to combine public offerings in primary target markets with private placements for professional investors in secondary target markets.

05 — Practical design of publicity guidelines

It is advisable to define publicity guidelines — which have always been part of contracts for classic IPOs. These set the permitted framework for everyone involved in the project team with respect to who communicates the details of the token offering, what is communicated, when and where, and how.

Publicity guidelines prevent unnecessary conflicts and provide an efficient tool for a targeted marketing and communication strategy, ensuring the legitimacy and professionalism of the token offering. The guidelines generally apply from the time of approval at the beginning of the planning process to a few weeks after the commencement of trading.

Structure of publicity guidelines — own illustration

1. Communication restrictions

   • Definition of publicity and information concept

   • Permitted publicity

   • Regulations for dealing with the press

   • Regulations for dealing with analysts (where applicable)

   • Regulations for working on the internet

   • Offering marketing

   • Research reports (where available)

   • Participation in conferences, etc.

2. Legal requirements

   • Local law of the issuer / provider

   • US law

   • Local law of the envisaged target markets

   • Guidelines regarding publicity on the internet

3. Compliance

   • Internal procedures for ensuring compliance with the guidelines

   • Compliance test

The compliance section includes the designation of an individual responsible for monitoring all communication and specifies the forwarding of the guidelines to the Management Board and involved parties such as PR agencies. Both sections can be adopted for further projects.

06 — Positive development

The triumphant march of token offerings will continue further due to their legal structure and they may possibly replace ICOs — in the classic sense — in the not too distant future. The basis for this development is primarily formed by viable, transparent and successful investment cases.

Their regulatory classification as securities serves as both a seal and a protective shield: on the one hand asserting a claim to quality in light of the massive number of fraud cases that emerged for ICOs in 2018; on the other hand providing an escape from the crackdown by regulators who are no longer simply watching on.

At present, the distribution focus for a token offering still needs to be placed on the monitoring of target jurisdictions, as tokens — and especially security tokens — unlike classic securities remain subject to regulatory dynamics. Although the classification as securities initiated by the SEC is an important step, this is by no means the last word, as new laws can be passed quickly elsewhere.

The Law on Transaction Systems Based on Trustworthy Technologies (TT Act; VTG) planned by Liechtenstein — which not only addresses individual applications, but the token economy as a whole — is a good example of an elegant and efficient legal solution that could potentially act as a precedent at an international level.

Thanks to their technical characteristics, tokens provide the opportunity to bring together local financial markets — which in some cases are largely closed off at present — to form a common, global capital market. How national supervisory authorities will deal with the consequences of greater international cooperation and the associated loss of autonomy and sovereignty with respect to intervention remains to be seen.

Julian Gretzinger

Head Capital Markets at Bank Frick. Master’s in Banking & Finance, University of St. Gallen; LL.M. in International Business Law, University of Zurich.

Felix Saible

Senior Marketing Manager at Bank Frick. Joint-Degree Master’s from the Universities of Zurich, Basel and Lucerne; Executive MBA candidate.

Originally published at bankfrick.li · 25 February 2019