The established stock market is potentially facing major changes. The cryptocurrency world has long suggested that blockchain technology could revolutionize trading, making it faster, more available, and operational 24/7. Now, entities such as Robinhood Markets Inc. and Coinbase Global Inc. are actively seeking a “quick regulatory route” to test this idea, according to reports. But what are the potential risks?
Traditional financial powerhouses, like Ken Griffin’s Citadel Securities, a leading market maker in the US, are strongly against this concept. Regardless of who prevails in this initial clash, anticipate numerous future battles as the financial system of the 20th century grapples with the innovations of the 21st century.
The vision of crypto advocates is a world where the lines between investors, customers, suppliers, and employees are blurred – distinctions that are critical to current financial regulations and the business models of traditional players – replaced by dynamic, collaborative, cryptographic algorithms that utilize game theory to incentivize participation.
This is just the beginning of what could be a long conflict. Nobody is suggesting we’ll immediately transition to a distributed ledger as the primary record of stock ownership – effectively turning stocks into cryptocurrency tokens. That might never happen, and certainly not soon.
The proposals from Robinhood and Coinbase are more akin to exchange-traded funds (ETFs). One idea involves creating special entities – sponsored by these companies and others – to purchase stock within the existing system and then sell ownership interests in those stocks to individuals, allowing these interests to be traded on a blockchain. Legal proof of stock ownership would remain within the present, complex system.
Essentially, this is similar to an ETF, but the tokenized stock would trade on a crypto-based exchange rather than conventional exchanges. While other structures are possible, they all revolve around individual investors trading tokens on a blockchain that represent indirect ownership in underlying stocks.
One area of concern is the security of the link between the traded interests and the actual underlying stocks. This includes questions about whether the tokenized asset exposes investors to the credit risk of the product’s creator; how dividends, voting rights, and other corporate actions will be managed; and how the price of the tokenized stock will align with traditional market prices. These are well-defined issues with existing solutions used for ETFs, mutual funds, stock futures, and other forms of indirect stock ownership.
A more significant concern involves the crypto trading process itself. Much of financial regulation occurs at the exchange level. In a traditional exchange, buyers and sellers submit orders, and the exchange matches them. Each party trades with a clearinghouse, not directly with each other. Blockchains, however, are peer-to-peer, making it hard to define or enforce current exchange and broker regulations.
For instance, brokers and asset managers are required to achieve “best execution” for their clients. However, blockchains only show transactions – ownership of stock interests moving from one wallet to another – not the prices paid. It’s possible for one party to transfer stock to another for any privately agreed-upon amount. Even if the token sponsor requires an official price on the blockchain, there’s no way to verify its accuracy.
This opens the door to abuses like tax avoidance, insider trading, and money laundering. If the reported prices for the crypto tokens aren’t accurate, tax authorities can’t verify gains and losses, regulators can’t prove insider trading, and funds can be moved for illegal activities like bribes, terrorist funding, or concealing criminal proceeds.
Another worry is the potential for market fragmentation. If tokenized stock can’t be easily converted back to direct ownership, and if different stock blockchains don’t interact, the result will be multiple, separate markets instead of one unified market. This can lead to wider bid-ask spreads for investors and lower trading volumes, making these securities less attractive.
Regulators can’t prevent the offering of tokenized shares in US companies, and this practice is becoming more common in Europe. However, they can set rules for US-registered brokers and dealers and take action against foreign entities dealing with US citizens. If well-known companies like Robinhood and Coinbase are permitted to offer SEC-approved stock tokens, many within the financial sector believe these will quickly gain a substantial portion of US retail trading.
The core conflict is the age-old debate of “everything not explicitly forbidden is allowed” versus “everything not explicitly allowed is forbidden.”
Because crypto tokens aren’t specifically prohibited, Robinhood and Coinbase are urging regulators to approve their plans without creating new regulations – a lengthy and complex process. Others, like Citadel, point out that crypto tokens aren’t specifically allowed and make existing rules unclear or unenforceable. They would rather prohibit tokenized stocks until a comprehensive regulatory framework is in place.
In essence, Robinhood and Coinbase want to launch their operations, address problems as they arise, and allow the financial system to evolve. Citadel prefers a slower, more planned approach, designing the future system beforehand to avoid the dangers of unchecked experimentation.
Regardless of which path regulators choose, this is only a single skirmish in a larger, ongoing battle. Once tokenized stock becomes mainstream, as it likely will, some company will want to issue it directly, bypassing the traditional financial system altogether. Some financial players will want to create their own virtual versions, and others will seek to repackage them, similar to mortgage securities before 2008. And some exchange will likely want to connect these perhaps-securities/perhaps-derivatives with other crypto networks.
If regulators attempt to control these changes too tightly, they risk losing control of the financial markets. If they rely too much on trial-and-error, there will be many errors and unhappy participants. Regulators must decide how firmly to manage this dynamic situation.
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This analysis reflects the individual opinions of the writer and may not represent the views of the editorial staff or Bloomberg LP and its owners.
Aaron Brown is a former head of financial market research at AQR Capital Management. He is also involved in crypto investing and has advisory roles with crypto businesses.
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