By: Mark Hays
Wall Street and crypto are awash in chatter about the industry’s latest financial buzzword, tokenization. In essence, tokenization creates a digital version of other assets — mostly company stock but also potentially real estate or artworks. Like much crypto jargon, this term promises a use case for crypto that will allegedly deploy blockchain’s so-called innovative tech to transform the financial system. In reality, it is another crypto industry attempt to generate massive profits by dodging oversight and accountability for risky and unregulated crypto speculation.
Regulatory arbitrage
Tokenization’s highest value for the crypto industry may be to create a shadow stock market. This would allow crypto exchanges to profit handsomely from crypto and mainstream investors’ trading in new tokenized stocks without having to follow more robust rules designed to protect investors or prevent market manipulation. If you own a share of a company, you have shareholder rights and investor protections, but little or none of that would apply to these tokenized ersatz securities.
The 2008 global financial crisis taught many hard lessons about succumbing to the siren songs of deregulation, speculation, and so-called financial innovation. The 1990s push for financial deregulation was promoted as a way of freeing up financial innovation, but instead spurred speculation in unregulated derivatives (think credit default swaps) that precipitated the financial crisis.
Yet that is precisely what crypto industry leaders are pitching with tokenization. They want tokenized assets to be traded, sold, or listed without the same market and investor protections for these assets that foster confidence and stability. If lawmakers and regulators give lightly regulated tokenization the green light, the results could make the last crisis feel like a prelude to the main event.
Tokenization charm offensive obscures real risks
Tokenization at its most basic level creates a derivative of an existing asset whose value is correlated with and tracks the value of an underlying asset. These tokenized assets are created, recorded, and exchanged on blockchains. The industry claims tokenization can streamline stock trading, reduce costs, and boost investment opportunities.
But most of the time, a tokenized version of some company’s stock would not be a share of stock but instead would be a representation of the value of that stock — in essence, a derivative. Financial derivatives markets already exist where the instrument’s value is derived from the value or change in value of other things (like interest rate swaps).
Crypto industry rhetoric claims creating these tokenized representations is needed to speed up financial market transactions to save time and money. But, even if attainable, the goal of instantaneous and irreversible trading can create harms for investors and the market. A lag between trading and settlement gives brokers or regulators time to correct errors, consolidate capital, reverse fraudulent transactions, or pump the brakes during a financial market run. High-speed trading has already created market crashes even without the blockchain. Faster, round-the-clock tokenized trading without emergency brakes could amplify the fallout of such runs.
Synthetic stocks but real investor harms
Big crypto trading platforms like Coinbase, Robinhood, and others want free reign to list or sell tokenized shadow stocks but without the same level of oversight or responsibility required under existing securities laws. This makes many tokenized assets more like a synthetic stock — an unregulated facsimile of a regulated stock but presented or marketed as something like the existing stock.
Imagine that some crypto company makes a sales pitch to an unsuspecting investor to buy a tokenized share of a privately held company like SpaceX or OpenAI. These companies don’t sell shares to the public, but crypto’s marketing hypes the ability to profit from the perceived value of that company and its business.
This has actually happened. Last year Robinhood offered tokenized versions of OpenAI stock in Europe, even though OpenAI was a privately held company. OpenAI publicly declaimed Robinhood’s effort to tokenize the company and warned people to “please be careful” because the tokenized instrument did not represent any actual equity in the company. Meanwhile, some investors are already getting cajoled into investing in super risky tokenized private funds — a crypto-private equity mashup that combines all the high-risk, high-fee, low-transparency downsides.
But tokenized stocks do not necessarily provide the same rights, disclosures, or protections as traditional stocks. An investor doesn’t own a share of the company, cannot cast a shareholder vote, and doesn’t get the same safeguards from broker self-dealing or for account custody when trading these assets, and the issuers need not provide full disclosures about the underlying value of the tokenized instrument. An investor in these shadow stocks may have little recourse if one collapses, even if it tanks because of a crypto pump-and-dump scam.
Tokenized stocks can harm the market
Lightly regulated or unregulated tokenized stocks would be far more vulnerable to volatility or manipulation that could harm investors and underlying companies as well. Surging or evaporating tokenized stock values could seep over into the real stock market. General Motors could have a banner year, only to face financial fallout when someone shorts its shadow stock, causing investor loss or even harm to GM’s workers.
In a world where more unfettered tokenization is explicitly or tacitly permitted, each crypto exchange or platform can issue their own versions of a tokenized stock of the same company, creating conflicting tokens with different prices that can confuse investors and markets. These problems mean that even though the tokenized stocks are supposed to track the value or movement in value of the underlying stock, sometimes the tokenized values just go off the rails.
Unfettered tokenization would generate a gusher of profits that imperils the economy
The crypto industry is aggressively demanding that Congress and regulators allow virtually unregulated sale of tokenized assets because it would be fabulously profitable. Crypto firms can sell a whole new crop of tokenized assets that would mirror the stock market, suck in new investors, and collect a mountain of fees from investors, traders, and tokenized issuers alike.
The profits would be greater not only because of this influx of new cash, but also because it would allow the crypto industry to save money by dodging the same compliance obligations that exchanges, securities brokers, and traditional stock issuers have to meet to protect investors or the market. To compete, traditional stockbrokers and exchanges could be forced to either play ball with crypto exchanges or join them in offering unregulated tokenized shadow stocks. That isn’t innovation; that’s just ripping off investors through regulatory arbitrage.
And it would pose real risks to the financial system and the real economy. Embracing tokenization wholesale could legitimize the endemic risks in crypto infrastructure, products, and practices. This legitimization — especially through a congressional or regulatory seal of approval — would embed these risks right into the mainstream financial system but with weaker oversight and more risks.
Building a new financial house of cards
We’ve seen this before. Major financial players went big for the largely unregulated trading in exotic financial instruments like credit default swaps and collateralized debt obligations that were sold as financial innovations. The massive speculative bets generated big profits until the market unraveled and pulled down major financial firms. The contagion spread throughout the financial system and caused the Great Recession. Millions of families’ lost their life savings, their homes, their jobs, and their economic security.
Congress is considering crypto legislation crafted by and for the crypto industry that could either endorse lightly regulated or unregulated tokenization or require tokenized assets to have the same investor and market protections as the stock market that have served the economy well for the past century. Much is at stake. Constructing a new unregulated house of cards is a recipe for economic disaster that won’t just swamp the crypto enthusiasts, it could capsize the entire economy.