The crypto industry has consistently highlighted the promise of blockchain technology to enhance trading efficiency, increase liquidity, and operate around the clock. Currently, companies are advocating for “a speedy regulatory pathway” to initiate that experiment. But at what cost? Traditional financial firms, including Ken Griffin’s Citadel Securities, one of the leading market makers in the US, are expressing significant resistance to the idea. Whoever emerges victorious in this round should brace for numerous turf wars ahead, as the 20th-century financial system grapples with the challenges of co-existing alongside 21st-century technology. The vision for cryptocurrency is to eliminate the divisions among investors, customers, suppliers, and employees — distinctions that are essential to financial regulation and traditional business models — and to substitute them with dynamic, multilateral, peer-to-peer cryptographic algorithms that incorporate game theory incentives.
This is merely the initial clash in that ongoing battle. The conversation around transitioning to a distributed public ledger as the definitive source of stock ownership — effectively transforming stocks into cryptocurrency tokens — remains largely absent. That might not occur at all, and regardless, it certainly won’t be happening anytime soon. A proposal has emerged for special-purpose entities, backed by these companies and others, to acquire stock in the existing system. These entities would then sell interests in those shares to individuals and facilitate trading of those interests on a blockchain. The legal proof of stock ownership would continue to reside within the intricate framework currently in place. This resembles an ETF, but the tokenized stock would be traded on a cryptographically managed exchange instead of traditional exchanges. Alternative structures exist, yet each one entails individual investors engaging in trading on a blockchain for tokens that signify indirect ownership stakes in the underlying stocks.
One set of concerns revolves around the secure linkage of traded interests to the underlying stocks. This encompasses considerations regarding the extent to which the tokenized asset will subject investors to the creditworthiness of the product’s sponsor; the management of dividends, corporate voting, and other related issues; as well as the mechanisms in place to ensure that the prices of the tokenized stock align with conventional trading practices. These are clear-cut issues with practical solutions that have been implemented for ETFs, mutual funds, stock futures, and other indirect forms of stock ownership. More explosive are worries surrounding the crypto trading landscape itself. Much of the financial regulation occurs at the exchange level. In a traditional exchange, participants on both sides of a transaction submit their orders, and the exchange is responsible for determining which orders to match. Each party engages in transactions through a clearinghouse, rather than directly with one another. Blockchains operate on a peer-to-peer basis, which complicates the definition and enforcement of certain existing exchange and broker regulations. Brokers and asset managers must pursue “best execution” on behalf of their clients. However, blockchains solely display transactions — the transfer of stock interests from one wallet to another — without indicating prices. One party can indeed transfer stock to another for any consideration that has been mutually agreed upon in private discussions. Despite the token sponsor’s request for an official price to be recorded on the blockchain, the accuracy of that price remains uncertain.
This creates opportunities for potential abuses, including tax evasion, insider trading, and money laundering. Inaccurate price reporting for crypto tokens poses significant challenges. The Internal Revenue Service faces difficulties in validating gains and losses, while the Securities and Exchange Commission struggles to demonstrate that individuals with insider information profited. Additionally, such discrepancies can facilitate the transfer of funds for bribes, terrorist financing, or the concealment of 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, we will see fragmented markets instead of a single market for all buyers and sellers. The result is an increase in bid/ask spreads for investors and a decline in trading volumes, rendering securities less appealing to hold. The SEC is unable to prevent individuals from providing tokenized stock in US companies, and this trend is gaining traction in Europe. However, it has the authority to establish regulations for brokers and dealers registered in the US, and it can take action against foreign entities that engage in transactions with US citizens. If prominent companies receive the green light to offer SEC-approved stock tokens, a substantial portion of the finance community believes these will swiftly capture a notable share of US retail trading.
The current conflict revolves around the age-old debate of, “everything not explicitly forbidden is allowed,” in contrast to, “everything not explicitly allowed is forbidden.” With crypto tokens not explicitly banned, companies are pushing the SEC to greenlight their proposals without the need for new regulations — a lengthy process that could span years. Citadel and others highlight that crypto tokens lack explicit approval, rendering current regulations ambiguous and difficult to enforce. They are in favor of prohibiting tokenized stocks until a comprehensive regulatory framework is established. In other terms, companies aim to establish their operations, tackle challenges as they arise, and allow the financial system to progress towards an improved condition. Citadel aims to take a measured approach, focusing on crafting a superior state while avoiding the risks associated with reckless experimentation. Regardless of whether the SEC chooses a rapid or gradual approach, this represents merely a minor skirmish in what promises to be a lengthy conflict. As tokenized stock approaches mainstream adoption, it is highly probable that a company will seek to issue it directly, circumventing the conventional financial system. Some financial players are poised to issue their own virtual versions, while others may look to slice, dice, and repackage assets reminiscent of mortgage securities prior to 2008. Some exchanges may seek to connect these potential securities or derivatives with various crypto chains.
If the SEC attempts to impose stringent regulations on these changes, it risks losing its grip on the financial markets. Relying on trial-and-error could lead to significant mistakes, resulting in a considerable number of dissatisfied individuals. The regulator faces a wild ride ahead and must quickly decide how firmly to grip the reins. This column represents the author’s individual perspective and may not align with the views of the editorial board. Aaron Brown previously served as the head of financial market research at AQR Capital Management. He is also an active participant in the crypto investment space, holding venture capital investments and advisory connections with various crypto firms.