For most U.S. investors the need for tokenizing stocks like Apple AAPL or Amazon AMZN , whose shares are already tradeable in fractional amounts at most brokerage firms, seems puzzling. However, outside of the United States, it is a different story. In many countries, investors don’t have easy access to U.S. securities markets or, if they do, it is a costly proposition. I spoke to FTX CEO Sam Bankman-Fried, who described tokenization as a growing trend. “Accessing equities markets is spotty country by country,” he says. “You don’t see 24/7 access to most stock markets but FTX’s markets are always open.”

It gets technical very quickly, however, and a key point is to understand not all tokenized stocks are created equal.

One of the most important points is that, depending on the exchange, tokenized stocks may or may not have collateral behind it. The tokenized stock without collateral is a synthetic security that the crypto exchange or intermediary writes into existence on a blockchain somewhere. This matters because if that ‘somewhere’ is in Minsk, Ukraine or some remote tiny island, investors may not have much recourse if the service provider hurts investors. Crypto exchanges offering tokenized stocks without collateral include Currency.com.

Today, we dig deeper into the offering of crypto exchanges with collateralized stock tokens, such as: FTX, Binance, and Bittrex Global.   

There are other important nuances for would-be investors, such as whether or not owning a tokenized stock gives you ownership rights to get paid stock dividends and be able to vote as a shareholder. For example, Binance states on its website that “holding stock tokens does not transfer any shareholder rights to you” whereas FTX and Bittrex report being committed on a ‘best-efforts’ basis to see tokenized stock holders receive stock dividends. 

So, what exactly does one own when clicking ‘buy’ for these novel tokenized stocks? 

The short answer is you own a collateralized digital derivative product that can be traded much like the spot instrument, i.e. the share or ‘real thing’. A derivative security references its value from a separate security that trades in the cash market. Both the derivative and spot instrument can generate profits and losses in lockstep in someone’s trading account.

The Demise of CFDs?

One way to understand the significance of collateralized asset issuance is to compare it to what it might be replacing. One of the potentially disruptive qualities of tokenized securities is that they could steamroll the large retail FX and Contract for Difference (CFD) industry, which is well established and generally offers tradable instruments that are not saved to a blockchain. Broadly speaking, CFD brokers also lag crypto exchanges in terms of crypto sophistication and product depth. For example, CFD’s – which are not available in the United States – have long let users trade a synthetic instrument mimicking Apple or Microsoft MSFT stock prices, but are, at heart, IOUs issued by a retail broker, not traded on exchange, and non-transferable. The adaptability of well capitalized CFD retail brokerage firms such as IG, CMC Markets, and Plus500 should not be underestimated, however.

Tokenized Stocks Trading Conditions 

The price of a tokenized stock is not necessarily the same price seen for the actual stock in a regulated exchange. It is higher or lower depending on a number of factors, such as whether or not the stock market is open.  Another factor is latency, which exists due to potential internet communication delays depending where the trader is located, or the actual liquidity at the crypto exchange for that security.  

While on the surface a tokenized Apple stock is traded in multiple exchanges, you should know that any tokenized stocks can only be traded in one crypto exchange. For example, AAPL/USD is the ticker name in the FTX platform, while Binance uses the AAPL/BUSD ticker, and Currency.com the AAPL.cx ticker. Try to transfer your AAPL/BUSD or AAPL.cx securities to FTX and you will be informed that the stock token is not portable to other crypto exchanges or to your local brokerage firm where you have your securities portfolio. “It would be really powerful to be able to freely move tokenized stocks on the blockchain, but as of now FTX and [German financial services firm] CM-Equity do not support that. They remain on FTX, a tied agent to CM-Equity,” indicated FTX’s Bankman-Fried.   

Best case scenario, investors trade with ease the tokenized stock at any time without a glitch. Worst case scenario, the value of the investment resides digitally at a firm that may not offer the service tomorrow or could be at risk if the other intermediary firms went out of business. In the U.S. stock owners are protected from the risk that a brokerage firm is put out of business by the Securities Investor Protection Corporation (SIPC), a non-profit run by U.S.-based registered broker-dealers. To our knowledge, no such protection exists in the world of tokenized stocks, in part because this type of security is so new. 

The number of crypto exchanges offering tokenized stocks is relatively small still, but appears to be growing rapidly now that they have been adopted by select market leaders. FTX offers 36 tokenized stocks plus tokenized indices and futures contracts, and Binance, the largest crypto exchange by trading volume and Web visitors, just launched its service last month with simply four tokenized stocks: Apple, Coinbase, Microstrategy MSTR , and Microsoft. Currency.com offers hundreds of non-collateralized tokenized stocks. Publicly-listed crypto exchange Coinbase does not offer tokenized stocks but, ironically, its peer FTX offers a tokenized stock of Coinbase (ticker: COIN/USD).

Collateralization 101: A Tokenized Stock Is Born

The collateralized tokenized stocks hitting the market are mainly originating from two European firms working together in different capacities to serve various crypto exchanges. CM-Equity AG  describes itself as a “fully-licensed capital markets infrastructure platform” and acts as brokers to the crypto exchanges. A separate company in this financial engineering, Swiss-based Digital Assets AG describes itself as a “boutique firm focused on the issuance of tokenized financial products.”

To give an example of how this works, when an FTX customer wants to invest in Coinbase he or she buys a one COIN/USD token, this sets off instructions – steps 1 through 7 – until the newly created token appears in the client’s exchange account.

                           FTX TOKENIZED STOCK GENERATION PROCESS

The client owns the COIN token issued by Digital Assets AG and custodied by FTX. FTX specifies in its website that, at the users’ discretion, CM-Equity can honor a redemption of the spot token for the actual share of stock. By contrast, Binance, states that stock tokens are “generally redeemable from the issuer” and that a special redemption fee may apply and that the redemption is “generally settled in stablecoin”. 

What is Counterparty Risk in Owning This Type of Security?

Counterparty risk is the non-compliance risk in a transaction, such as between an investor and the brokerage firm or exchange holding a security on behalf of the investor. It doesn’t occur often, but at times brokerage firms and crypto exchanges may cease doing business. The tokenized stocks a client may hold could be unreachable or unusable outside of the issuing party, even if written to a blockchain. The fail point from a cash stockholder perspective is limited to the non-invested cash a brokerage firm holds. In the United States there are transfer agents that keep track of who owns what, and there are central securities depositories that custody shares for investors.

For the tokenized stock, there are some separation of duties by the exchange, the holder of the shares, and the company minting the new token. Investors should also evaluate which crypto exchanges have a better track record keeping servers up and client money intact. Uptrends.com and Dotcom-monitor.com are two sites offering free trials to measure uptime and reliability of websites, including those of crypto exchanges.

Last week, German regulator BaFin served Binance a warning that its German unit Binance Germany risked being fined for offering its digital tokens without publishing an investor prospectus. A Binance spokesperson indicated that the firm is “committed to following local regulator requirements wherever we operate,” and is currently working with regulators to address their questions. When Forbes asked FTX about its experience with German regulators, its CEO Sam Bankman-Fried stated that “we’ve never received a reprimand from global regulators.”

One of the reasons why prospectuses filed with regulatory authorities like the SEC play an important role for investors has a lot to do with risks – especially for new investment vehicles  like tokenized stocks.  There are numerous risks associated with stock tokens, including not being able to redeem the digital token, significant adverse price slippage for trading during illiquid hours, or not being able to receive a fair treatment related to corporate actions. 

There’s several ways to keep inexperienced traders from owning tokenized stocks. For example, having exchanges enforce a suitability test or raising the minimum investable amount for riskier products. FTX and its brokerage partner CM-Equity currently require any interested client to complete a full identity verification, a review of relevant terminology, and a suitability questionnaire that gauges a person’s proficiency with this type of financial products.

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