Turning stocks and bonds into crypto-style trades won't be happening soon. Here's why.

By Frances Yue

'A widespread shift from the current trading system to an exclusive blockchain-based system would be a real paradigm shift,' one lawyer notes

SEC Chair Paul Atkins last month announced a new crypto agenda aimed at updating securities rules and regulations "to enable America's financial markets to move on-chain."

There's been growing buzz this summer about a bold idea to change how Wall Street works.

The idea? Move all stocks and bonds onto a blockchain, or create digital versions of them that can be traded, transferred and tracked using the same technology powering cryptocurrencies.

Supporters say this approach could make markets more efficient by speeding up transactions, lowering costs and expanding access for investors around the world. But turning that vision into reality may still be a long way off.

"A widespread shift from the current trading system to an exclusive blockchain-based system would be a real paradigm shift that would require changes up and down issuers, intermediaries, investors, throughout the whole securities-trading ecosystem - and I think that would take a lot of time to develop the right systems and to put into place," said Marc Rotter, capital-markets counsel at law firm Ropes & Gray.

Still, optimism is growing - fueled in part by Paul Atkins, chair of the U.S. Securities and Exchange Commission, who last month announced a new crypto agenda aimed at "moderniz[ing] the securities rules and regulations to enable America's financial markets to move on-chain," he said in remarks

That vision has some crypto bulls convinced the shift could happen sooner than many expect. "I would say definitely within the next five years -probably sooner, closer to two - I think large financial players will end up tokenizing [stocks and bonds]," said Thomas Cowan, head of tokenization at crypto financial-services firm Galaxy.

Others are more cautious. Trish O'Donnell, a partner at law firm Reed Smith, said she thinks tokenization could be the future, but called it "a generational switch." It could take decades for market participants who are used to the traditional financial system to move fully to one built on blockchain, she noted.

While companies including Robinhood (HOOD), Kraken and Bybit have launched stock tokens this year targeting investors outside the U.S., these are not actual stocks. Instead, they're "wrapped" versions, analysts said. In practice, that means the exchange buys the real shares from a broker-dealer when an investor purchases a stock token, and sells those shares when they dispose of the token.

These products may face issues like low liquidity during off-market hours, no shareholder rights and the risk of depegging, according to Rob Hadick, general partner at crypto venture-capital firm Dragonfly.

Read: Soon you'll be able to trade shares of OpenAI and SpaceX like crypto - but should you?

Meanwhile, although Wall Street heavyweights such as BlackRock (BLK), Apollo Global Management (APO) and Franklin Templeton (BEN) have launched tokenized funds focused on U.S. Treasurys, money markets and credit, they face far fewer hurdles than they would with tokenizing public equities and corporate bonds, noted Justin Browder, partner at law firm Simpson Thacher.

Investors in such funds are also concentrated in digital-asset firms, which are not the traditional investor base for these assets, noted Louis LaValle, chief executive and co-founder at crypto investment manager Frontier Investments. Most firms buying tokenized money-market funds are using them as collateral, but the majority of traditional brokerage firms don't accept them because they lack the necessary digital infrastructure, LaValle said in a phone interview.

Here are the changes experts say are needed for true tokenization, whereby stocks and bonds primarily operate on a blockchain, to become a reality.

Regulatory changes

To start with, there need to be a wide range of regulatory updates, Browder said.

"A number of SEC rules, in particular, don't contemplate transactions on a blockchain. They assume the existing market structure, which is an intermediated system where transactions flow through a central clearinghouse," Browder noted.

One example is Reg NMS, or the Regulation National Market System, a set of SEC rules adopted in 2005 aiming to ensure fair pricing and transparency across different trading venues. The rules are built for the existing market structure, whereby investors trade through a broker-dealer while a clearinghouse handles settlement. A broker-dealer is a firm or individual licensed to buy and sell securities either for clients or for its own account, while a clearinghouse ensures that trades between buyers and sellers are settled accurately and on time.

The rules work well for today's stock market because it relies on middlemen to route trades, collect data and publish prices to ensure all market participants can understand what's a good value for a particular security, noted Browder. But in a peer-to-peer setup like blockchain-based trading, where people can deal directly without intermediaries, there's no central source for tracking and sharing prices. That makes it unclear how Reg NMS's rules on fairness and transparency would still work, Browder said.

What's more, if a company wants to record its issued shares on a blockchain today, its transfer agent still has to keep the official records off-chain, while also maintaining a duplicate ledger on the blockchain, said Seoyoung Kim, a finance professor at Santa Clara University with expertise in cryptocurrencies. Transfer agents are the official recordkeepers for a company's stocks or bonds, tracking who owns them and logging any changes in ownership.

That is because the blockchain record is not yet legally recognized as the official source of truth, said Kim.

"In the longer term, what we really hope to have happen is the blockchain itself become that source of truth," said Galaxy's Cowan. In that scenario, the stock or bond tokens people hold would be the actual asset, rather than a digital placeholder for something that primarily operates off-chain, Cowan said in a phone interview.

Still, Michael Sonnenshein, president of tokenization startup Securitize, said he thinks there is already a clear, regulated path for issuing tokenized securities. The firm has partnered with Apollo to launch a tokenized credit fund; teamed with BlackRock to launch a tokenized money-market fund; and has helped crypto software company Exodus tokenize its shares.

It comes down to firms applying for the proper licenses from the SEC, Sonnenshein said, adding that Securitize is one of the "select few" registered as a transfer agent, a broker-dealer and an alternative trading system authorized to engage with tokenized securities. (An alternative trading system is a regulated trading platform that matches buyers and sellers of securities outside of traditional stock exchanges.)

Digital rails

In addition to regulations, existing clearinghouses would also need to be upgraded to operate on the blockchain to encourage more issuance of tokenized securities, according to LaValle.

"You have to have on-chain clearing and settlement if you want to have tokenized securities. Otherwise it's like having a brand new wrapper on old rails - it just doesn't work," LaValle said.

At the moment, even when assets are tokenized, the actual clearing and settlement still happen off the blockchain. In most cases, that means the blockchain record is essentially just a duplicate of the real transaction, which is finalized through the old systems, LaValle noted.

Only by innovating clearing and settlement can the benefits of the blockchain truly be realized, according to LaValle. For most stock and bond trades, settlement happens one business day after the trade date. By contrast, blockchains could enable near-instant settlement, cutting down on counterparty risk and freeing up capital much faster, LaValle said.

Exchanges would also have to upgrade their infrastructure to handle the trading of tokenized securities, he added.

More adoption

To reach a point where the entire financial system operates on the blockchain, every issuer of stocks and bonds would have to agree to not have their securities in physical form and move them entirely onto a blockchain, said Simpson Thacher's Browder.

"It's not necessarily the case that every one of the over 4,000 publicly listed companies out there today [in the U.S.] are going to have an interest in having their securities represented in tokenized form. Those are issues we have to confront if we want to move the whole market on-chain," Browder noted.

Even if that hurdle is cleared, there must also be enough liquidity in the secondary market to ensure trading remains efficient, said Frontier's LaValle. Without active trading, tokenized assets risk becoming illiquid, making them less attractive to investors.

That's why interest from market participants is essential, and why tokenization firms must demonstrate clear, tangible advantages over the traditional system, added Julian Sawyer, CEO at digital-asset platform Zodia Custody.

"I think where we are at the moment is that a lot of the tokenization projects have not yet really articulated why they are different from the traditional securities," said Sawyer.

Ultimately, changes in regulation and technology, and participation from broker-dealers and exchanges, will all have to happen in tandem for full-scale tokenization to take hold, LaValle said.

"If you have the tech without the regulation, there are no rails. If you have the regulation without the tech, or if we don't have enough market participants or liquidity, it's not going to happen," he noted.

-Frances Yue

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