Binance stock tokens
German financial regulator BaFin has firmly signalled its intent to crack down on the issuance of stock tokens by crypto exchange Binance. The exchange claims that the tokens offer the benefits of stock ownership to holders of crypto assets. Likely BaFin will prevail and Binance's venture will be shut down. But there are systemic issues at play that will not simply vanish.
Binance's product works, for the moment, as follows. Prospective investors acquire Binance's stablecoin BUSD, which—the company asserts—is backed one-for-one by USD. Users can then initiate a purchase of stock tokens on Binance's platform. They redeem their BUSD, freeing up USD to purchase shares in regular equity markets. A company called CM-Equity AG apparently holds the shares and issues stock tokens one-for-one to the Binance customer. Buy and sell prices for the tokens differ by a spread, providing a source of profit to Binance and CM-Equity.
In T accounts, the transaction looks something like this:
Why? The arrangement meets a pressing need for holders of crypto assets. The Binance stablecoin BUSD can be purchased using Bitcoin, Ethereum and other cryptocurrencies. So stock tokens provide a way for crypto investors to get exposure to equity markets, a standard asset class.
Binance and CM-Equity tell customers that their funds are being used to purchase shares one-for-one. But if they are just like shares, the regulator BaFin says, then Binance should be providing more documentation. At the same time, the companies describe the tokens as over-the-counter swaps that don't require such disclosures. So there is plenty of room for unexpected risks to slip in.
What could possibly go wrong?
The tokens must be something like a total return swap, which was one of the instruments that brought down family fund Archegos just weeks ago. Archegos entered its swaps in a highly leveraged way that obligated the fund to put up additional collateral when the value of its position fell. When eventually Archegos failed to do so, its prime brokers (Nomura, Credit Suisse, UBS) rushed to sell the shares they had held as a hedge. The sales came at a huge loss to the banks.
If Binance's swaps are in fact one-to-one as claimed, then they are fully collateralized by the initial purchase; so Binance is not going to run into the same troubles as Archegos. Instead Binance and CM-Equity, or other companies who try similar schemes, will find themselves sitting on a large pile of shares. The temptation to lend the shares out, post them as collateral or otherwise encumber them will only grow.
Holders of the swap tokens probably don't appreciate that they are exposed to CM-Equity. If the issuer fails to pay, investors could lose their principal. In this way it is similar to Coinbase's Bitcoin deposits, and even to stablecoins. In all three cases, one-to-one backing is standing in for actual pricing of credit risk. Regulations, like those BaFin is trying to enforce, do exist for a reason.
More systemically, Binance's stock tokens are a providing a channel to connect the high valuations of crypto assets to the high valuations of equities. This is a kind of economizing on reserves that makes sense during a boom. Unfortunately it can be revealed as a house of cards quite suddenly. Liquidity kills you quick. Only when the tide goes out do you discover who's been swimming naked. But as long as the music is playing, you've got to get up and dance.