Tokenized Stock Arbitrage Report: Edition 1 | September 2021

Welcome to Security Token Market’s first-ever tokenized stock report!

Most of you are at least somewhat familiar with security tokens, or digitized assets in equity, fixed income, real estate, investment fund shares, commodities, and structured products traded and held on a blockchain, but not as familiar with tokenized stocks.

They aren’t security tokens. They aren’t traditional stocks.

…So what are they?

WHAT ARE TOKENIZED STOCKS?

A tokenized stock is a digital asset that trades on various licensed exchanges using blockchain technology. In most cases, they are a type of derivative that tracks the performance of an underlying stock, such as Apple (NYSE: AAPL) or Tesla (NASDAQ: TSLA). By buying one share of tokenized stock, you don’t have any ownership in the underlying equity. Instead, you own a derivative collateralized by a share of the underlying stock that tracks its performance.

You may be wondering: Why would someone trade them over traditional stock shares? We’ll get there in a second. But first — where can someone buy this unique asset?

WHERE DO THEY TRADE?

Tokenized stocks trade on several platforms — the most prominent being FTX and Bittrex. To become eligible to purchase tokenized shares of a company on these exchanges, one must pass the regulatory requirements including KYC and AML compliance. At this time, only international investors approved to trade on the respective exchanges can purchase tokenized stocks. Even though the token you purchase is a mirrored asset of the underlying equity, most platforms ensure that investors are entitled to the same dividend payout if the true equity shares pay dividends. While FTX and Bittrex provide the medium to purchase these shares, they do not custody any of the tokenized stock. Brokerage companies like CM-Equity and Digital Assets AG usually tokenize these stocks. Interestingly enough, investors can actually redeem the tokenized stock for the actual underlying stock. With this being said, what stocks are available for purchase?

WHAT TOKENIZED STOCKS ARE TRADEABLE?

Not every stock that is traded on traditional markets is yet available for purchase via a tokenized manner. While it varies based on the exchange, most mega-cap companies such as Apple ($AAPL), Google ($GOOG), Facebook ($FB), and Tesla ($TSLA) are available to invest in via their tokenized stock. You might ask, “if someone can buy tokenized shares of such trusted companies, then this must be regulated, right?”

The answer is not as black and white as you might expect.

ARE THEY REGULATED?

The regulatory status of trading tokenized stocks is not fully clear. Immediately after the crypto craze of 2018, the Securities and Exchange Commission (SEC) cracked down on the industry and classified many coins and offerings that went public via an ICO as securities. This would mean that they should be regulated as such and should be subject to extreme scrutiny. If this were the case, the platform that trades these assets would have to be registered with the SEC as a national securities exchange. However, tokenized stock platforms pushed back on this notion and argued that they were trading derivatives, not stocks, so they shouldn’t be subject to the same scrutiny as platforms that trade actual securities. Such determination remains unresolved.

This regulatory grey area leaves the door open for potential risks for both investors and exchanges. Even still, hundreds of thousands of investors have used tokenized stocks to diversify their investment portfolios.

PROS & CONS

If you understand the potential risks and are approved to trade on an exchange that offers tokenized stocks, what are the pros and cons versus purchasing traditional shares?

PROS:

• 24/7 live and nonstop trading — 3 AM on a Saturday? Yup. Noon on Christmas? Yes, please. 7 PM on New Year’s Day? Why not.
• Fractionalized stock ownership — Investors can buy ½ a share, ¼ share, or even 0.7204825 shares of $TSLA!
• Worldwide Access — International investors can get their hands on assets that may have originally been tough to invest in.
• Instant-settlement — Traditionally, in the public-equity markets, investors have to wait up to two business days (T+2) for settlement to complete — tokenized stocks are virtually instant due to the nature of blockchain technology!

CONS:

• Non-transparent asset collateral — In buying a derivative product, one should expect — and demand — full transparency on the holding of the underlying asset. Unfortunately, this is not the case with the tokenized stocks on the market. There is no private placement documentation, proof of holding, or insight into the settlement process. This certainly poses a risk, as investors cannot be certain that collateral requirements have been met. This has historically been the main cause of regulatory scrutiny by regulators in this asset class. Security Token Market has reached out to CM-Equity for comment, but as of October 14, 2021, nothing has been clarified.
• No voting rights as a shareholder — While you are buying a digital asset that does not have voting rights, the stock providers– like CM-Equity and Digital Assets AG– offer stock redemption opportunities where investors can use their tokenized stocks as a coupon for the true equity.
• Regulatory grey area — Still awaiting certain flags from regulatory agencies worldwide.

ARBITRAGE OPPORTUNITY

Tokenized stocks hold a very special and unique opportunity — an opportunity you won’t find on most public exchanges. Since tokenized stocks are derivatives, that means that their price action will not always mirror its equity share. As we are going to find out shortly, there is the potential for an arbitrage opportunity via cross-platform trading. Readers of this newsletter will be fully equipped to pounce on the opportunity if it presents itself. Let’s get down to business with some of the instances where arbitrage would have made an investor a handsome profit in September 2021.

Even more than that, tokenized stocks kill two birds with one stone. For those that want digital security exposure, they get the benefits of 24/7 trading, efficient markets, zero brokerage fees, trading on blockchain, and portfolio exposure. Much of this is revolutionary to the financial market ecosystem.

While investing in a new product is inherently risky– there is still a lot unknown– and their capital could conceivably be allocated towards more well-known investments, tokenized stocks are different. Investors are able to get all of the benefits of new technology while investing in their favorite big-name stocks. While these are not mirrored shares, nearly all tokenized stocks trading on Bittrex and FTX have a correlation of > 0.70 to their traditional equity shares.

Let’s take a look at a real-life example– Apple.

Both the tokenized stock and traditional equity trade in correlation. In fact, they had a correlation of .71 for September. This measures the strength of the relationship between two variables– Apple’s tokenized stock and NASDAQ’s trading shares in this instance. Investors can conceivably purchase these tokenized shares and watch close price action to the equity.

But there’s more!

If you notice the areas that are circled, there is a noticeable price deviation between the two– this is why the correlation for Apple is not higher. Arbitrage opportunities are instances where one can guarantee a profit on their trade. In today’s markets, this is incredibly rare since high-tech algorithms, market-makers, and Wall Street institutions quickly capitalize and eliminate the chances for “free money” within milliseconds. A prominent example of arbitrage taking place is with Sam Bankman-Fried, founder of Alameda Research and FTX. Noticing a significant disparity between Bitcoin prices in the United States and Asia, he systematically developed a way to purchase in the US, transfer to Asia, and sell the Bitcoin on those markets for a handsome profit.

Something similar might be possible with tokenized stocks. Let’s look at Apple’s chart for reference:

In the first circle, we see that NASDAQ’s $AAPL is more expensive than FTX’s. One could purchase the shares on FTX and sell when it reached the price of NASDAQ’s. This could secure >$1 per share of profit if timed correctly — repeatedly performing this action during the other circled points could help these returns compound over time. If you notice in the chart, FTX and NASDAQ’s prices often revert to the mean for the same stock. This could provide arbitrage opportunities as one can either buy the tokenized stock or short the equity, as the price disparity eventually neutralizes. One can also, theoretically, redeem FTX shares for the actual underlying stock — thereby owning a physical share of any stock desired. As per FTX’s website:

“They [the shares] can be redeemed with CM-Equity for the underlying shares if desired. In the future, there may be other ways to withdraw the tokens from FTX.”

While this is by no means an “infinite money glitch,” knowing that the tokenized stocks have always ended up closing any gap provides a window to capitalize. This is possible because the tokenized shares are not mirrored equity. Rather, it is representing the underlying stock.

In order to provide our readers with some transparency on the arbitrage opportunity, we’ve got to make a few assumptions.

Arbitrage Assumptions:

• (1) Zero transaction & brokerage fees
• (2) Zero slippage & market impact
• (3) Prompt or immediate redemption of FTX token for underlying stock
• (4) Adequate market liquidity available

Current Real-World Limitations

• (1) A trader can redeem an FTX derivative for the underlying share, but cannot redeem the underlying share for an FTX derivative.
• (2) Current market data only allows arbitrage to happen at two points each day — once at 9:30 AM and once at 4 PM close.
• (3) Some slippage may occur due to varying levels of liquidity in the digital securities market.

LET’S SUM IT UP

There’s a very exciting storm brewing on the digital horizon — one that will revolutionize the way we trade traditional equities.

You, as the investor, get to build this tokenized portfolio to gain exposure to all your favorite stock names — $AAPL, $TSLA, $GBTC, $COIN, $AMZN, and over 25 more. All this while enjoying arbitrage opportunities, 24/7 trading, and the security and confidence of a blockchain.

Welcome to the new world of digital securities trading — welcome to tokenized stocks.

Thank you for reading this month’s tokenized stock report! If you have any questions or feedback, please reach out to sam@stomarket.com or aneesh@stomarket.com The security token world is growing at exponential levels. In order to remain in the ‘know’, make sure to utilize our Twitter, website, and podcast!

See you next month! 👋

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Everything in this report is for informational purposes. Nothing in this report should be taken as financial advice or as an inducement to purchase or sell any security. Nothing in this market report should be used as legal advice. Always do your own research before making any decisions regarding financial transactions of securities.

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About Security Token Market

Security Token Market (stomarket.com) is the largest worldwide repository of past, present, and future security token offerings. STM strives to create the most engaged community of security token investors, enthusiasts, and projects to build a thriving ecosystem around this industry. Security Token Market is continuously launching new features to provide users with abilities to connect with new projects, discuss and review the offerings, and help provide the engagement that the industry needs to become self-sustainable.