(Bloomberg Opinion) — The stock market as we know it is on the brink of a transformation. The crypto industry has long touted the potential for the underlying blockchain technology to make trading more efficient, more liquid and 24X7. Now, firms including Robinhood Markets Inc. and Coinbase Global Inc. are pushing for “a speedy regulatory pathway” to begin that experiment, according to The Information. But at what cost?
There’s strong opposition to the idea from traditional financial firms such as Ken Griffin’s Citadel Securities, one of the top US market makers. Whoever wins this round, expect many more turf wars as the 20th-century financial system struggles to co-exist with 21st-century technology.
The crypto dream is to erase the boundaries between investors, customers, suppliers and employees — distinctions that are fundamental to financial regulation and incumbents’ business models — replacing them with fluid, multilateral, peer-to-peer cryptographic algorithms, embedding game theory incentives.
This is only an opening skirmish in that war. No one is talking about a transition to a distributed public ledger as the authoritative source of stock ownership — making stocks into cryptocurrency tokens. That may never happen, and in any case, it will not happen soon.
What Robinhood and Coinbase are suggesting is more like an exchange-traded fund. One proposal is for special-purpose entities — sponsored by these companies and others — to buy the stock in the current system and sell interests in those shares to individuals, and trade those interests on a blockchain. The legal proof of stock ownership would remain with the complex existing system.
This is similar to an ETF, except that the tokenized stock would trade on a cryptographically managed exchange rather than on existing exchanges. There are other potential structures but all of them involve individual investors trading on a blockchain for tokens that represent indirect ownership interests in the underlying stocks.
One set of concerns is whether the traded interests will be securely linked to the underlying stocks. This includes whether the tokenized asset will expose investors to the credit of the product’s sponsor; how dividends, corporate voting and other matters will be handled; and how prices of the tokenized stock will be kept in line with traditional trading. These are straightforward issues with workable solutions that have been used for ETFs, mutual funds, stock futures and other indirect forms of stock ownership.
More explosive are concerns about the crypto trading itself. A lot of financial regulation happens at the exchange level. With a traditional exchange, both sides to a transaction submit orders, and the exchange chooses which ones to match. Each side trades with a clearinghouse, not with each other. Blockchains are peer to peer, making some existing exchange and broker rules difficult to define or enforce.
For example, brokers and asset managers are required to seek “best execution” for their clients. But blockchains only show transactions — stock interests moving from one wallet to another — not prices. It’s possible for one party to transfer stock to another for any consideration agreed to privately. Even if the token sponsor demands an official price be included in the blockchain record, there’s no way to know if it is accurate.
This opens the door for abuses such as tax evasion, insider trading and money laundering. If the prices reported for the crypto tokens are not accurate, the Internal Revenue Service cannot validate gains and losses, the Securities and Exchange Commission cannot prove people with inside information made profits, and money can be transferred for bribes, terrorist funding or disguising criminal profits.
Another concern is the fragmentation of liquidity. If tokenized stock cannot be seamlessly converted to direct ownership and vice versa, and if the stock blockchains don’t interact with other blockchains, instead of a single market for all buyers and sellers, there will be fragmented markets. That leads to higher bid/ask spreads for investors and lower trading volumes, making securities less attractive to hold.
The SEC can’t stop people from offering tokenized stock in US companies, and the practice is becoming common in Europe. But it can set rules for US-registered brokers and dealers, and it can act against foreign entities that transact with US citizens. If Robinhood, Coinbase and other well-known companies are allowed to offer SEC-approved stock tokens, many in the finance community think these will quickly absorb a significant share of US retail trading.
The immediate tension is the ancient one of, “everything not explicitly forbidden is allowed,” versus, “everything not explicitly allowed is forbidden.”
Since crypto tokens are not explicitly forbidden, Robinhood and Coinbase are urging the SEC to approve their plans without writing new rules — a laborious process that can take years. Citadel and others note that crypto tokens are not explicitly allowed, and they make existing rules ambiguous or unenforceable. They prefer forbidding tokenized stocks until a full regulatory regime is installed.
Put another way, Robinhood and Coinbase want to set up operations, deal with problems as they come, and let the financial system evolve into a better state. Citadel wants to slow down and design the better state, without the dangers of headlong experimentation.
Whether the SEC opts to go fast or slow, this is just one small battle in what will be a protracted war. Once tokenized stock goes mainstream, and it very likely will, some company will want to issue it directly, bypassing the traditional financial system. Some financial players will want to issue their own virtual versions, and others will want to slice and dice and repackage like mortgage securities before 2008. And some exchange will want to link these maybe-securities/maybe-derivatives with other crypto chains.
If the SEC tries to regulate these changes too tightly, it could lose control of financial markets. If it trusts to trial-and-error, there will be a lot of error, and a lot of unhappy people. The regulator has a bucking bronco to ride and must choose soon how hard to pull on the reins.
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This column reflects the personal views of the author and does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Aaron Brown is a former head of financial market research at AQR Capital Management. He is also an active crypto investor, and has venture capital investments and advisory ties with crypto firms.
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