With the emergence of crypto and blockchain technology over the past decade, individuals the world over seem to be fast gaining exposure to a variety of new ways through which their investments and assets can be issued, managed, and transacted.
In fact, through the use of decentralized ledgers, it’s possible for assets to be broken down into infinitely smaller fractions while making ownership extremely easy — be it in relation to digital art, real estate, or even equity.
In essence, any asset (be it digital or physical) can be tokenized, however, this then begs the question, ‘What exactly does tokenization entail?’
In its most basic sense, asset tokenization refers to the process by which it becomes possible to issue digital tokens using a distributed ledger (a.k.a. blockchain) system. These tokens are linked to their underlying assets directly, and thanks to the use of blockchain, their ownership can be verified with the touch of a button.
So what exactly are tokenized stocks?
Simply put, tokenized stocks can be thought of as synthetic derivatives of real equities, giving investors the option of buying fractional portions of shares. However, what separates these novel offerings from their traditional stock counterparts is that they are easily accessible, allowing investors who cannot easily purchase equity of companies like Apple, Tesla, etc due to certain trade restrictions and limitations, to gain access to such mainstream offerings.
Additionally, thanks to the power of tokenization, it is possible for individuals to invest in the entire S&P 500 as well as dabble in other stock/crypto bundles. And since tokenized assets are sold via cryptocurrency exchanges, they can be traded 24 hours a day, unlike the US stock market, where trading is only allowed between 9:30 am – 4:00 pm everyday.
How does tokenization work?
On a technical front, one can see that in order to help facilitate the entire tokenization process, most exchanges have to work hand-in-hand with an intermediary that can help them buy company stock and subsequently designate these assets for digitization. For example, Bittrex has hired the services of Swiss fintech firm Digital Assets AG, enabling them to buy shares of company stocks that are custodied by a licensed bank.
Once the acquisition is done, Bittrex issues digital tokens in a ratio of 1:1 for each share, representing a collateralized derivative contract. Investors purchase these contracts digitally, allowing them to gain indirect exposure to the stock of various companies effortlessly.
That said, while Bittrex and Terra Labs’ Mirror Protocol offer clients the option to buy/sell synthetic stocks that have their values pegged to actual equities, companies like Binance provide investors similar offerings but back their values using a depository portfolio of underlying securities managed by a third party investment firm.
Why do we need tokenized stocks?
Greater trade flexibility
The process of tokenization helps make traditionally illiquid and exotic assets highly liquid by allowing investors to buy small portions of certain shares that are otherwise quite expensive, thereby allowing for more money to flow into this space. Not only that, they also help reduce lock-up periods — time windows during which investors are not allowed to sell their holdings — enabling investors to gain greater flexibility in their investments.
One of the most unique aspects of tokenized stocks is that they provide investors with a high level of transparency — primarily in terms of asset pricing — thus allowing them to make better, more calculated market decisions.
Tokenized properties will be freely traded at exchanges, which will improve liquidity and ensure transparency of pricing. Buyers and sellers will be able to make transactions in tokens without causing major changes to prices of the assets.
Eliminates geographical limitations
More often than not, it is impossible for individuals living outside America to purchase and gain direct exposure to U.S.-based companies such as Apple, Tesla, and Amazon due to trade restrictions enforced by regulatory agencies.
However, this problem is largely mitigated through tokenized stocks. Investors are purchasing a derivative while the actual stock is purchased by an eligible entity, allowing them to participate in Security Tokenization Offerings (STO) in a legally compliant manner.
The challenges facing tokenized stocks
One of the biggest hurdles facing the tokenized stock market is ‘unclear regulation’. This is because security tokens can potentially fall under the purview of various government bodies, whose rules and regulatory protocols tend to differ quite substantially from jurisdiction to jurisdiction.
For example, a lot of experts believe that tokenized stocks can and should be classified as securities. In this regard, a number of regulators across the globe have already raised red flags across different countries and regions in regard to how tokenized stocks can potentially violate various securities laws.
As a result, some of the core benefits afforded by this technology can be greatly undermined, especially if regulations prevent investors from freely exchanging these assets internationally. That said, with each passing month, traditional markets are fast adapting to the idea of a tokenized economy, and thus it stands to reason that it is only a matter of time before fractionated stocks become a part of the mainstream.
In a recent interview, Sam Bank-Friedman, co-founder of data analytics firm Alameda Research and cryptocurrency exchange FTX, stated that he is fairly confident that in the near term, a lot of tokenized stock options will go public with the help of regulators.
“U.S. regulators will eventually allow these products,” he said. “Nothing operates 9:30 a.m. to 4 p.m., five days a week. There’s actually a lot of room to innovate in stock exchanges.”
Similarly, another concern that looms large on the horizon in relation to tokenized stocks is that these offerings offer ‘little to no investor guarantees’. What this means is that in case of an exit scam or hack it is entirely possible that individuals may end up losing all of their hard earned money irrevocably.
Lastly, as this niche market continues to grow, problems related to scaling — especially in issuance/trading large fractionalized shares — may also continue to rise quite rapidly, thereby adding another level of complexity that has not yet been witnessed within this nascent space.
As we move into an increasingly digital future, it appears as though the concept of tokenization is fast being adopted across a wide range of markets, including real estate, commodities, precious metals etc. This is because the blockchain technology on which tokenization is built is fast gaining traction among a growing list of mainstream players including banks, media houses, tech firms, IT players, and many others.
Not only that, with a large part of the global economy already digitized — most transactions taking place today are done via the help of centralized systems — a tokenized framework would help take things to the next level.
With the power that blockchain and crypto tech possesses, the core idea underlying tokenization stands to transform a large number of markets globally. However, despite all of this amazing potential, there are still certain scalability related issues that need to be ironed out before the tokenized economy can go mainstream.
For example, if the concept garners a lot of mainstream traction and fractionalized shares start to be adopted across the globe, it might become increasingly more difficult for exchange owners to scale up their operations and issue these offerings while providing a high degree of accountability.
Chyna Qu, co-founder and COO at DeFiner, a non-custodial crypto asset DeFi platform and peer-to-peer network for savings, lending, and borrowing, is a passionate leader in the DeFi space, and a strong advocate for women’s leadership and entrepreneurship.