Tokenized Stock Trading: The Huge Risks In Moving Stocks to Blockchain

The cryptocurrency industry has lately begun to heavily promote tokenized stocks, but what exactly are they? More importantly, what advantages do tokenized stocks offer — especially when investors already have safe, no-cost fractional share trading at many brokers? 

A tokenized stock is a fancy way of saying that ownership of a stock can be transferred via blockchain, the technology behind cryptocurrency. Tokenizing, or digitizing, assets such as stocks, ETFs and other securities allows them to be traded on a specialized digital exchange and potentially directly between investors without the need for an exchange. These tokens are held in a digital wallet, much as crypto coins are, similar to a traditional brokerage account.

“The news cycle for crypto is all about representing traditional financial assets on a blockchain,” says Hilary Allen, professor, American University Washington College of Law. But Allen points out that investors and financial markets will endure major costs for doing so: “There are a lot of protections that are given up by this move.”

In order to establish a tokenized stock, these steps are needed:

• Taking custody of the asset: The asset that will be tokenized needs to be held in custody by a custodian, whose job is to safeguard it on behalf of the token creator.
• Creating the token: A financial institution such as an investment bank or fintech company then creates the digitized token, which corresponds to the asset in custody.
• Setting up smart contracts: Each token is programmed with self-executing smart contracts that give the token’s owner the same rights as stock ownership, including dividend distributions and voting rights, among others.

Once the stock is tokenized, traders can exchange it among themselves on crypto platforms, other decentralized finance platforms or even potentially a traditional stock brokerage. For example, crypto exchange Kraken has created tokenized stocks that it calls xStocks, and now allows trading in 60 major stocks. Meanwhile, brokerage Robinhood launched token trading in the European Union in June, offering access to more than 200 U.S. stock and ETF tokens. 

Asset managers BlackRock and Franklin Templeton already offer tokenized money market funds. Goldman Sachs and BNY are teaming up to launch their own tokenized money market funds, too. More firms are exploring the idea of tokenized stocks.

In short, you could think of a tokenized stock as one that trades via blockchain. So what’s the big deal for individual investors? The cryptocurrency industry is breathlessly hyping this as a huge leap forward – as it has done for crypto coins – but the benefits are modest for individual investors, especially buy-and-hold types, and the risks of tokenized stocks are high. In fact, the best stock brokers already offer many of these same benefits to investors at no cost.

Benefits and risks of tokenized stocks for investors

The crypto industry touts the following benefits of tokenized stock trading, many of which are already features at top brokers or may soon be features.

Benefits of tokenized stocks

• Increased accessibility through fractional shares: Tokenized stocks let investors trade portions of a share, meaning that high-priced stocks are accessible to even those with a little money.
• Lower cost: The crypto industry touts the potentially lower cost of transactions by eliminating intermediaries via blockchain. 
• Transparency: The industry says thatby recording ownership on the blockchain, tokenization ensures that ownership is established. 
• Security: Proponents say that blockchain-enabled trading also increases security because ownership is irrevocably established on the blockchain. 
• 24/7 trading: Because tokenized stocks are held on a blockchain, they can be traded at any hour.
• Immediate settling of trades: Proponents also point to the immediate settling of trades via tokenized stocks, in contrast to next-day settlement in the U.S.
• More direct access between investors and firms: Tokenization may bypass existing financial intermediaries, letting companies raise money more directly from investors. 

Others note the serious risks in tokenizing stocks, particularly in the area of investor protection. 

Risks of tokenized stocks

• Potentially irrevocable transactions: Like cryptocurrency transactions, a tokenized stock transaction may be irrevocable. Once it’s done, it’s done, and it may be all but impossible to undo.
• Uncertain legal protections: The legal treatment of tokenized stocks is way behind where the crypto industry is trying to go, exposing investors to plenty of risks. For example, who is considered the issuer of a tokenized stock: the firm that tokenized it or the stock’s original issuer? What happens if an asset is hacked?
• Inflexible smart contracts: Smart contracts programmed into tokenized stocks will not cover all circumstances, says Allen. “It’s not clear how they’ll operate in unexpected environments.”
• Circumventing investor protections: Private investments are private partially to protect investors, not merely to limit investments to the well-heeled, but tokenizing stocks can allow financial players to get around the rules. “It’s absolutely built as an end run around securities laws,” says Allen. “Crypto is built as an end run around securities laws.” 
• Loss of trust in American financial markets: One of the potential long-term effects of not enforcing existing securities laws is the erosion of trust in American capital markets. If securities laws aren’t enforced or are enforced inconsistently, then markets simply become a place to rip off investors.

Bankrate reached out to Kraken and Robinhood for further comment but has not heard back. 

What’s behind the push for tokenized stocks?

The crypto industry and some traditional financial institutions have talked a big game about tokenization of stocks and some players have moved toward tokenization. But what’s in it for individual investors? Many of tokenization’s supposed benefits touted by the crypto industry are already available for individual investors in the current system. 

• Fractional shares already exist: Individual investors can already access fractional shares — on thousands of stocks and ETFs — at the best brokers for fractional shares. 
• Stock trading is already commission-free: For individual investors, trading stocks is already free at every major online broker, so there’s no added benefit to using tokenized stocks. 
• Transparency and security: Existing brokers already have high levels of security with a proven security process. In fact, it’s the crypto exchanges and other DeFi platforms that have been beset by lax security, fraud and theft.
• After-hours trading: Many brokers already offer after-hours, overnight and pre-market trading on existing stocks. While this is not 24/7 trading, brokers have been expanding access in recent years. Moreover, all-hours access to trading does not benefit long-term investors, who build wealth through the long-term success of the underlying business. Study after study shows that active trading underperforms passive investing.
• “Democratization” of investing: Proponents of tokenization say that it gives access to private investments that are being hoarded by the wealthy. But giving a means to trade a stock — tokenizing it — does not mean that anyone will want to sell it to you. In fact, you should be skeptical when someone wants to sell you what they say is a great investment. (If it’s such a great investment, why are they letting you in on it? It’s not out of the kindness of their heart.)

So, while tokenization may offer a few incremental benefits to individual investors, albeit with significant risks, what’s the real driver of tokenization? Who is actually going to benefit here? It’s the crypto industry trying to make inroads into traditional finance, say experts.

“The crypto industry is waging a multi-pronged battle to get integrated into the financial system,” says Allen. The industry is working to “attract deep pockets” and bring more money into the fold, and tokenized stocks are part of that push, she explains.

So much of the crypto world is about hyping digital currency as “the next big thing.” Part of that process is projecting bombastic price targets for Bitcoin and other cryptocurrencies, ones that are always rising over time. Such hype can make cryptocurrency seem inevitable.

As with cryptocurrency, one of the biggest use-cases for stock tokenization is (illegally) getting around existing laws (in this case, securities laws). So the full-bore adoption of stock tokenization has many potentially destructive effects, including the erosion of investor protections and robust securities laws that protect financial markets. Without these laws, it’s “scammer take all.”

“Investors lose the benefit of the securities laws,” says Allen. She points out that what the crypto industry wants to run roughshod over are the very laws that they claim are roadblocks to their profits. ”We saw what happened in the 1920s and the lack of securities laws.”

Bottom line

Tokenization presents significant risks to individual investors and the financial markets as a whole, while offering few benefits to investors that don’t already exist. Those who try out tokenized stocks should remain wary of their many risks amid an uncertain legal framework.

Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.