Tokenized stocks and ETFs are digital slices of existing investments. This article explains what tokenization is, how it works, which benefits and risks come with it and how the rules in Europe broadly fit together. It is an explainer, not investment advice.
What are tokenized stocks and ETFs?
Tokenization means that a right to an existing product is recorded digitally in a token. A token is a digital proof of ownership stored on a blockchain. A blockchain is a shared digital ledger in which transactions are recorded.
A tokenized stock is therefore a token that tracks the value of a share. A tokenized ETF (an index fund traded on an exchange) works the same way, but for a basket of investments. Other things can be tokenized too, such as real estate, commodities or bonds.
Note that the token is not always the same as the share itself. What exactly you own depends on the issuer’s terms. Sometimes you hold a right to the price movement, sometimes also to dividends or voting rights, and sometimes only a claim on the issuer.
How does it work?
- An issuer, often a financial institution, holds the underlying shares or ETF units with a custodian.
- The issuer creates tokens linked to these investments, usually using smart contracts. These are computer programs on the blockchain that carry out fixed agreements automatically.
- Investors buy and sell the tokens through a platform that offers them.
- The token’s value is meant to follow the price of the underlying product. This does not always match exactly.
Fractional investing
With tokens you can often buy part of a share. If a share costs €900, for example, you can buy a tenth of it for €90. It works the same way for an ETF. This is called fractional investing. Some regular brokers offer it without a blockchain, so tokenization is not always needed for this.
Benefits
- Lower entry threshold: you can start with a smaller amount.
- Possibly faster settlement: a transaction may complete sooner than in traditional trading, where settlement sometimes takes one or two business days.
- Possibly lower costs: fewer intermediaries can mean lower costs. This depends heavily on the platform and the issuer.
- Transparency: transactions on a blockchain can often be traced and are hard to change afterwards.
- Access outside exchange hours: some platforms allow trading outside regular exchange opening times.
Risks
- Counterparty risk: you depend on the issuer and the custodian of the underlying shares. If one of them fails, it can be hard to exercise your right.
- Custody: tokens are kept in a digital wallet or with a platform. If you lose access or a platform is hacked, you can lose your tokens.
- Liquidity: liquidity is how easily you can buy or sell without moving the price much. Many tokens trade thinly, so selling can be hard or at a poor price.
- Price gap: the token’s price can differ from the price of the underlying share or ETF.
- Legal uncertainty: it is not always clear which rights you have, for example in an insolvency.
- Technical risks: a bug in a smart contract or a network outage can cause losses.
- Investment risk: as with any share or ETF, the value can fall. You can lose your investment.
Regulation in Europe
The rules depend on how the product is set up. This is a general overview, not legal advice.
- MiFID II: a European law for investment services. If a token counts as a financial instrument, such as a share, the provider and the service generally fall under these rules.
- MiCA: the European regulation for crypto-assets. It applies to crypto-assets that are not already covered by existing financial rules. Whether a given token falls under MiFID II or MiCA depends on its design.
- Supervision: in the Netherlands the AFM supervises investment services, among others. At European level, supervisors such as ESMA work on a consistent interpretation.
Not every platform that offers tokens is licensed for investment services. Check the supervisor’s register to see which licence a provider holds and which supervision the product falls under.
What to look at
- Read the terms: what exactly do you own, and what happens if the issuer fails?
- Check who holds the underlying shares.
- Check the costs, how easily the token can be traded and the price gap with the underlying product.
- Check the provider’s licence.
- Only invest money you can afford to lose and spread your investments. See also our explanation of diversification.
Conclusion
Tokenized stocks and ETFs are a different way of recording and trading investments. They can lower the entry threshold, but they bring their own risks, such as counterparty risk, custody and thin trading. Make sure you know what you are buying and from whom.
Investing involves risk. You can lose some or all of your investment. This article is for information only and is not investment advice. You can find more explainers on Daytraders.nl.