One of the latest buzzwords in finance is “tokenization.” Although the concept has been around for years — Securitize, the digital securities platform backed by BlackRock and Hamilton Lane, was founded in 2017 — the practice of turning financial assets into crypto assets is having its moment in the sun this summer.
According to proponents, tokenization can bring faster settlement and fractional ownership to more investors, while offering a potential means of building a liquid secondary market for traditionally locked up assets like growth-stage private equity or cross-border small-cap stocks.
Players ranging from cryptocurrency exchanges to traditional financial institutions have already launched tokenized equity products, including Robinhood, Kraken, JPMorgan, and Franklin Templeton. Others, such as Coinbase, have signaled their intention to join the space.
But despite these large companies rushing to claim market share, there are hurdles to wide-scale adoption of tokenization, including unanswered questions over ownership rights, exchange registration, custody standards, and taxation that have kept many potential players from entering the fray.
And there are reports that institutional investor attention remains disappointing. An August 6 JPMorgan research report seen by II from global market strategist Nikolaos Panigirtzoglou indicated that much of the activity in the space continues to come from retail and crypto native investors and is being largely ignored by more sophisticated counterparts. Instead, these players “continue to be reluctant to participate as they face significant hurdles and risks such as lack of harmonized cross-border regulations, lack of legal clarity on on-chain investments, and lack of assurances on smart contract enforceability or protocol security and reliability.”
The report added that despite the hype the actual amount of tokenized assets is hovering around $25 billion, a number that is deemed “rather insignificant”, despite the potential benefits in liquidity and capital efficiency it could offer if the regulatory and legal hurdles it faces can be overcome. Around $15 billion of this number is in the private credit market, but because this is concentrated to a few players and lacks a secondary market JPMorgan believes this to be exaggerated in importance.
Liat Shetret, VP of global policy and regulation at blockchain analytics firm Elliptic, said that the industry has largely ignored compliance and risk management frameworks as it pushes ahead with tokenization. She expressed concerns about the pace at which the technology is progressing, recalling how she attended a tokenization roundtable task force at the SEC in May where industry experts openly discussed concerns and ideas, but little action was taken.
“All of these different models are coming to bear to the market and the regulatory expectations we come back to are not yet clear,,” she said. “And that mismatch is what concerns me the most.”
Shetret pointed to the commotion between Robinhood and OpenAI earlier this month, when the ChatGPT owner called out the exchange for its stock tokens. OpenAI said that the tokens did not represent equity in the company and that any transfer of equity requires their approval — which it did not grant in this instance. Robinhood’s CEO Vlad Tenev acknowledged that the tokens are not actually equity but are “enabled by Robinhood’s ownership stake in a special purpose vehicle.”
“These two giants were essentially rushing to market with a particular perspective, but a lot of questions were left unanswered,” added Shetret. “My concern is that when we go into this at scale in the market, we’re going to come across many more of these instances where there’s a mismatch. For now, it is just on the U.S. side, but if you start going global, then you will have a mismatch of not just securities laws and regulatory perspectives, but criminal and justice prosecution systems too.”
The SEC continues to investigate tokenization, and it is expected that the agency will compile opinions to provide clarifications on how tokenized assets will be treated. But in the meantime, Shetret said, “the market is moving.”
Perhaps the biggest structural issue with tokenized equities is that investors do not actually own the underlying asset — only the token that represents it. This structure raises ownership questions and creates liquidity concerns. If a token holder wants to sell, there must be a willing buyer on the same platform where they acquired it. A run on the platform, for example, may result in investors being unable to exit tokenized assets. Then, if the issuing company were to fail, questions could remain over who actually owns the equity.
The broad definition of a national securities exchange does not help matters, according to Lewis Cohen, partner at Cahill Gordon. He pointed to automated market makers which allow people to find each other to make trades.
“There’s a huge question about whether that sort of activity is regulated or non-regulated activity,” he said.
As technology advances and interest grows in tokenized securities, more questions will emerge. SEC Commissioner Hester Peirce came out in July and said that tokens are indeed securities, which helped to clarify one issue, but more questions remain unanswered.
There are also significant variances within the industry itself. Crypto exchange Kraken has launched xStocks, which can be traded 24 hours a day Monday to Friday. Mark Greenberg, Kraken’s global head of consumer, said that a lot of other products are not really tokenized and function more like derivatives.
“Users are being told they can do all these things with them, but they actually can’t in reality,” he said. “They are just derivatives backed by a single company, and they typically aren’t backed one to one. Just like high risk random instruments, they are basically an IOU from the broker.” He added that Kraken’s offering is built to function like securities and abide by European regulations.
“We believe very heavily in changing the way equities work, at the same time working very closely within the rules of every individual market,” he said.
