Crypto race to tokenize stocks raises investor protection flags

(Reuters) - A race by crypto companies to sell tokens pegged to stocks is raising alarm bells among traditional financial firms and regulatory experts who warn that the fast-growing novel products pose risks to investors and market stability.

Buoyed by President Donald Trump's pro-crypto stance and his administration's push for friendly regulations, the crypto industry is rushing to capitalize on a global surge in enthusiasm for the sector.

Robinhood (HOOD.O),Gemini (GEMI.O) and Kraken among others have launched tokenized stocks in Europe, while Coinbase (COIN.O), Robinhood and startup Dinari are seeking approval to launch similar products in the United States. Nasdaq, meanwhile, last month became the first major exchange to propose offering tokenized shares.

The industry says tokenized shares — blockchain-based instruments that track traditional equities — could revolutionize stock markets by allowing shares to be traded 24/7 and settled instantly, boosting liquidity and reducing transaction costs. The combined value of tokenized public stocks geared toward retail investors as of September grew to $412 million, compared with just a few million dollars 12 months ago, according to tokenization tracker RWA.xyz.

Although many products are marketed like stocks, they rarely offer the same rights, disclosures and protections as traditional equities. Instead, they more closely resemble riskier derivatives, according to a Reuters review of several products and interviews with a dozen industry executives and legal experts. That increases the hazards for investors, while tokenization more broadly could undermine market integrity and fragment liquidity if left unsupervised, critics say.

"You're buying exposures to those shares through creating some sort of synthetic instrument," said Diego Ballon Ossio, a partner at law firm Clifford Chance in London. "A lot of the burden gets shifted on you to understand what exactly it is that you're buying."

A few companies have issued their own experimental stock tokens on the blockchain - software that acts as a shared digital ledger - but most tokenized shares are pegged to public companies and issued by third parties like Ondo Global Markets and Dinari. Some tokens are backed 1:1 by underlying stocks, while others provide economic exposure through derivatives.

The industry is divided over which regulations apply to stock tokens, and investor rights and protections vary. Often, the products provide no ownership, voting rights or traditional dividends, while creating counterparty risk exposure to the token issuer.

For example, there are multiple tokens pegged to Nvidia (NVDA.O) and Tesla (TSLA.O) with a range of structures and terms and conditions.

"The fact that different tokenized offerings have different rights and different disclosures ... that's a real big worry," said Gabriel Otte, CEO of Dinari, which offers 1:1 collateralization.

Robinhood in June launched trading in tokens pegged to public companies and said it plans to offer tokenized stocks of private companies. To promote the launch, it gave away tokens pegged to OpenAI. Those tokens are derivative contracts backed by Robinhood's ownership of fund units in a special-purpose vehicle that holds OpenAI convertible notes, according to its terms and conditions. The announcement drew pushback from OpenAI, which said it had not blessed the offering. It also prompted scrutiny from Robinhood's European regulator.

Johann Kerbrat, general manager of Robinhood Crypto, said the company clearly flags that its tokens are derivatives.

"It's just one step forward to be able to have the benefits of no longer having multiple days to settle," he added.

While Robinhood is issuing public company tokens on the blockchain, it is not yet settling the trades on the blockchain, a spokesperson said.

Gemini declined to comment.

CORE INVESTOR PROTECTIONS

In Europe, Robinhood, Kraken and others operate under the "MiFID" derivatives rules but some legal experts say that law is insufficient to oversee the novel products. Trump's crypto-friendly chair of the U.S. Securities and Exchange Commission, Paul Atkins, has indicated the agency plans to grant would-be issuers exemptions from securities rules.

That plan is facing opposition from powerful Wall Street players including Citadel Securities and the Securities Industry and Financial Markets Association, which say such major structural changes should go through a formal rulemaking process.

"Just because a security is represented on blockchain, that doesn't change the core investor protections and other provisions that apply to securities," said Peter Ryan, head of international capital markets at SIFMA.

In a July letter to the SEC, Citadel Securities raised concerns that tokenization would siphon liquidity away from public markets.

Spokespeople for the SEC declined to comment, while Citadel Securities did not provide comment beyond the letter.

A spokesperson for the European Securities and Markets Authority, which helps oversee MiFID, said it was aware of the potential risks of tokenization and was monitoring developments.

The World Federation of Exchanges recently urged regulators to crack down on tokenization, citing insufficient investor protections and liquidity fragmentation, although the group told Reuters it supports Nasdaq's proposal because it would treat tokens like traditional stocks.

Coinbase is also in talks with the SEC about launching tokenized securities that would similarly grant investors the full legal rights and benefits associated with conventional stocks, according to a source familiar with the matter.

Other issuers said they hew closely to traditional securities, anti-money laundering, bankruptcy protections and other rules.

Mark Greenberg, Kraken's global head of consumer, said the company offered the "gold standard" including 1:1 collateralization and investor disclosures, while dismissing derivative offerings as "IOUs."

"Done right, tokenization enhances investor protections, rather than eroding them," said Ian De Bode, chief strategy officer at Ondo Finance.

Reporting by Hannah Lang in New York and Elizabeth Howcroft in Paris; Editing by Michelle Price and Matthew Lewis

Reuters report

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