For years, tokenization has been discussed as a future possibility for equity markets. Last month, the New York Stock Exchange outlined plans to develop a regulated platform that could enable 24/7 trading of tokenized stocks and ETFs. For market participants, questions around how tokenized equities function, how they differ from traditional stocks and cryptocurrencies, and what they mean for best execution, investor protection and market integrity are becoming increasingly urgent.
In an interview with Traders Magazine, Reid Noch, Vice President of U.S. Equity Market Structure at TD Securities, discusses how tokenized equities work, what trading them would look like in practice for both retail and institutional participants, and the key structural and regulatory challenges that would need to be resolved before this model can scale in U.S. markets.
What exactly is a tokenized equity?
A tokenized equity is a digital token on a blockchain that provides exposure to a stock. Depending on how it’s structured, that token may be fully fungible with traditional equity, or it may represent a synthetic derivative that provides exposure to the underlying stock.
How would trading a tokenized stock actually feel different? From a trader’s point of view, what changes compared with buying and selling a stock on an exchange today?
The experience would be different for institutional and retail traders, beyond the availability of 24/7 trading.
For retail traders, there may not be much difference on the surface during regular market hours – the larger difference is around pricing. The price a retail trader receives may fall outside the National Best Bid and Offer (NBBO), and even if it’s within, traditional best-execution rules may not apply. As a result, retail traders may receive a worse price than they would in traditional equity markets. This disconnect could be larger when trading in size, particularly given lower liquidity. In addition, the leverage available on these trades may be materially higher than what is typical in traditional markets.
For institutional traders, instant settlement presents a major issue. It would require trades to be pre-funded, which can leak important information to the street ahead of time. Beyond prefunding, the other issue is priority. Most public blockchains don’t follow the same price-time model used in traditional markets, meaning execution rules and price can vary by platform. In some cases, transactional ordering mechanisms – such as those based on gas fees – can allow orders to be front-run. And of course, trading may also fall outside of the NBBO – although institutions will be more aware of what that means.
What does 24/7 trading change for markets and investors? What happens to liquidity outside normal market hours?
24/7 trading materially changes liquidity profiles and the way traders think about volume curves and Volume-Weighted Average Price (VWAP). More than 20% of the U.S. equity market is retail, and that share continues to grow – particularly with international retail participation. As a result, even if institutions don’t want 24/7 trading, liquidity may still move there. In those cases, institutional traders will follow the liquidity.
We would expect other major global markets to match the U.S. hours to avoid losing business. Many companies are foreign issuers that list in the U.S. to gain exposure, and local markets are unlikely to stop trading those names. In addition, many of these companies are global in nature. As a result, mega- and large-cap companies trade more like FX, following the sun, while small- and medium-cap companies’ liquidity continues to consolidate in their domestic markets around the close.
In the early stages of tokenized equity trading, what are the biggest pitfalls traders should watch for?
Liquidity is the first thing to watch. Next, it’s important to make sure the platform is reputable and that what you’re buying is what you expect. You may think you’re buying a tokenized stock, but it can turn out to be a swap. If the platform fails, you may lose all of your money with nothing in return.
What issues around investor protection, best execution, and market integrity would regulators need to resolve before tokenized equities can scale in U.S. markets?
Most U.S. investor protection rules are built around intermediaries. Today, there are very limited investor protection, best-execution and market integrity rules for blockchain venues. In many tokenized equity proposals, these intermediaries go away.
As a result, there will be significant debate between traditional finance and decentralized finance around what protections or rules and requirements are needed. From a traditional finance perspective, it’s important to avoid regulatory arbitrage, and from a decentralized finance perspective, it can look like traditional finance is slowing down the regulatory process as firms catch up and build their own platforms.
Beyond that, there are questions around how mechanisms like Limit Up/Limit Down (LULD) bands would function in a 24/7 market and how markets would handle corporate actions.
