NFTs for Equities

At the time of writing Trump has said that the USA and Iran are “very close” to a negotiated agreement. Bloomberg’s sub-headline for their lead article said “Of Course, Trump Lies All the Time", There’s No Agreement!”…hahaha, just kidding, Bloomberg reported it all verbatim, and threw in Rubio’s useless comment that he “sees good news coming.” Why do they continue to do this?

Anyway, the topic for this blog post is the unstoppable stumble to the rollout of a so-called innovation called tokenized stocks or tokenized equities. A very short version of the post could read: “No one wants these, they are useless, and the SEC has been corrupted", but what am I doing here if not to educate the people who read this blog (Hi Mom!).

Tokenization allows anyone to sell a “token” which will then track the performance of an individual stock, like MSFT or APPL. The holder of the token could then take advantage of any increase in value of the token and sell it anytime in a decentralized trading platform. This is the principal advantage that supporters of tokenization push: that it increases liquidity, and enables 24×7 trading.

Before I point out the downsides of this tokenization proposal, I should note that the SEC announced on Friday May 22 that they are postponing the approval of an exemption for the trading of tokens as unregulated securities, which is a good thing.

The biggest risk point with tokens is that they can be issued by anyone, and have no contractual rights that a normal equity has. Despite some assurances from an SEC commissioner that these would be maintained, this seems structurally impossible, as the tokens would be traded anonymously on decentralized platforms, so tracking ownership will be decidedly difficult. Third-party issuers of the tokens have no obligation to secure shareholder rights, nor do the token holders have any rights to dividends. So the token holder’s only hope is for the stock price to go up, and for there to be a buyer on the other side if they want to sell their tokens. Meanwhile, just as we have seen in the crypto space, there is risk that issuers can be hacked, or do a rug-pull, leaving the token holders with a bag of dirt.

It was less than five years ago that there was a craze for Non-Fungible Tokens or “NFTs” which were digital pieces of paper linked to the value of basically anything, such as art (hence the proliferation of the “Bored Ape” images), or Jack Dorsey’s first tweet. It all ended with NFTs being worthless, and we don’t see a lot of Bored Ape images clogging our feeds. Tokenization is the same garbage but a different pile: the only difference is that instead of linking to esoteric “assets”, the tokens are linked to recognizable assets like Microsoft or Apple equities. So brokers will try to sell them to gullible retail investors, who will think that they’re now Apple shareholders. But as I mentioned, they aren’t Apple shareholders: they can’t vote, they don’t received dividends, or participate in stock splits, and if the issuer closes up shop, you’re out of luck.

And if the SEC actually tries to enforce shareholder rights for token holders (a huge if!), then it will lead to other complications: are corporations, who had nothing to do with the tokenization, obligated to issue voting rights and dividends to these token holders? If the SEC can untie that knot, what if enough tokens are issued to dilute existing majority shareholders? That won’t stand. Another observer pointed out the use case of tokens being owned by North Korea or Iran: does Apple then have to violate US law by sending money to those countries?

Among the sidebar topics to this is the role of SEC Commissioner Hester Peirce (“Crypto Mom”) in pushing this innovation exception. On May 19, it was announced that she will be leaving the SEC in time to join the faculty of law at Regent University, the university started by Pat Robertson. So she will be gone, leaving this regulatory escher staircase for someone else to figure out.

Securities regulation is critical for the functioning of public capital markets, the foundation of capital formation and the driver of a lot of the wealth creation in the world over the past fifty years. Destroying the credibility of the SEC, and making equity investing opaque will reduce confidence in the investor world, reducing the amount of retail investors, and pushing more power in the hands of institutions, who as we have seen in 2008 can secure bailouts for themselves, and avoid regulatory scrutiny.

I’ll close with this quote from the Bloomberg article about the SEC delay: “Joe Saluzzi, a partner at Themis Trading, a Chatham, New Jersey, brokerage firm, said he has asked a number of clients about their interest in trading in the 24/7 markets that tokenized securities can provide. None were. “Nobody is asking for this,” he said.”

I’m indebted to John Reed Stark for his writing on this topic in LinkedIn. Mr. Stark is a former Head of Internet Enforcement at the SEC, and spent 18 years in the Office of Enforcement.