What the heck are tokenized stocks? And are they securities?

Last month, when shares of Coinbase stock began trading on the Nasdaq exchange using the ticker symbol COIN, much of the crypto world was focused on its initial price movements. 

At the same time, a smaller crowd of crypto traders was also focused on a “tokenized” version of COIN listed on crypto exchange FTX.

In fact, COIN is one of many tokenized versions of publicly listed stocks that can be purchased on FTX. Binance, another popular platform that has begun offering these assets, now lists its own tokenized version of Coinbase stock. Last month it listed stock tokens for Tesla, Apple, Microsoft and MicroStrategy — all of which are also listed on FTX.

But the listings by Binance have drawn the attention of regulators. Germany’s Federal Financial Supervisory Authority, or BaFin, issued a statement on April 28 saying it “has reasonable grounds for suspecting” that Binance may be in violation of the country’s security laws. It's not yet clear what that means for Binance, or for tokenized stocks in general.

What are tokenized stocks, anyway? How do they work? And why would regulators be concerned about them?

How they work

Tokenized stocks, also known as stock tokens, are blockchain-based assets that represent the shares of publicly traded companies or organizations. 

FTX and Binance are the two most popular platforms for listing and trading tokenized stocks. Both exchanges work with a third-party, a Germany-based company called CM-Equity, to list these assets. CM-Equity holds the actual stock shares and handles regulatory compliance while the exchanges list digital representations. 

The tokens “are fully backed by a depository portfolio of underlying securities,” according to an explainer from Binance, which adds that all users must satisfy know-your-customer (KYC) and other regulatory requirements. Binance's stock tokens are not available in the U.S., Turkey, and China, according to the guide. 

FTX’s guide on stock tokens reads similarly. “All FTX users who trade tokenized stocks may also have to become customers of CM-Equity, and pass through CM-Equity's KYC and compliance,” it says. “Furthermore, all trading activity may be monitored for compliance by CM-Equity.” The website states that these products are not available in the U.S., Cuba, Crimea and Sevastopol, Iran, Syria, North Korea, and Antigua and Barbuda. 

Unlike FTX, which offers users the option to trade tokenized stocks on a 24/7 basis, Binance follows traditional market hours. 

Binance’s stock tokens are priced in Binance USD (BUSD), a stablecoin pegged to the U.S. dollar and issued by Paxos Trust Company. Eligible users on FTX can trade dollars or bitcoin for stock tokens.

In early April, Binance announced it would roll out a “zero-commission fee system.” FTX charges between two and seven basis points, depending on trading volumes. 

The most popular stock token on FTX in terms of trading volume is German biotechnology company BioNTech, which saw $386.81 in volume in the past 24 hours, according to the exchange's published data. Other popular stock tokens on the platform are Coinbase, Tesla, Nio and Amazon.

On Binance, the most popular stock token in terms of trading volume is Tesla, which saw roughly $486,000 in BUSD-denominated volume in the past 24 hours. Other popular stock tokens are Coinbase, Microsoft, Apple and MicroStrategy. 

Regulatory questions

Like the underlying securities they represent, tokenized stocks entitle holders to economic benefits from things like dividends and stock splits. But holders don’t have legal or voting rights like they would if they held the real stock. They are also not eligible to participate in the company’s annual general meeting (AGM), where the directors of the company present an annual report on the state of the company and its future plans.

So are these tokens securities or not? That's a question that German regulators already seem to be trying to answer in the case of Binance.

On May 5, the German markets regulator, BaFin, rejected Binance’s request to remove a warning that the exchange likely violated securities regulations. BaFin issued the warning to investors late last month, following a Financial Times report that the agency was looking into Binance’s stock tokens.

Under German law, securities and other “investment products” cannot be sold without a formal prospectus, a BaFin-approved document meant to provide investors relevant details about the product, including potential risks. BaFin told the Financial Times that the trading stock tokens on the exchange was enough for the tokens to qualify as securities, which requires a prospectus.

The agency also said the exchange could potentially face a fine of up to 5 million euros or three percent of the total turnover of the last financial year.

Binance has maintained stock tokens are not securities because they are bought and sold through a third-party broker and can’t be transferred to other holders or exchanges, sources familiar with the matter told the Financial Times. The exchange said BaFin’s view is based on a “misunderstanding.”

Binance declined to comment for this article.

Mercedes Tunstall, a partner Loeb & Loeb focused on fintech issues, said BaFin's investigation "seems warranted," specifically because Binance's stock tokens are directly tied to the stock market, and "there are no intervening market forces to determine the stock token's value." Tunstall said the U.S. Securities and Exchange Commission, for instance, would probably view that as a security.

But why is Binance under investigation and not FTX, which uses the same German-regulated third-party entity to list its stock tokens?

“First, it’s not clear whether Binance is in fact getting investigated,” FTX CEO Sam Bankman-Fried told The Block. “Second, FTX makes sure to place appropriate customer notices and information prominently and clearly before users are able to access any markets.”