Why we should be wary of exchanges tokenizing assets
These days, it seems like everyone wants a piece of the tokenization pie. And why shouldn’t they? While there’s no telling how long it will take for cryptocurrencies like bitcoin to actually gain widespread adoption, the benefits of moving traditional financial assets onto the blockchain are both clear and compelling, and the market is huge — more or less the tally of all the financial assets in the world.
Exchanges have been no exception. This has been most obvious in the stablecoin boom of the past year and a half. Notable exchange companies like Bitfinex, Gemini and Circle (which owns Poloniex) all launched their own stablecoins, the latter two doing so to great fanfare. Even Paxos, the company behind the rapid-growth Paxos Standard stablecoin, had an exchange (itBit) before it had a stablecoin.
This isn’t surprising. Stablecoins provide a relatively streamlined way for users to trade between fiat-denominated units and speculative cryptocurrencies like bitcoin, saving exchanges some of the hassle of having to deal with banks in order to facilitate fiat-to-crypto trades, and vice versa. And, like we mentioned above, the potential market for asset-backed tokens is enormous, so you can bet that these exchanges are launching the tokens with their top line in mind.
But exchange-issued tokens also come with significant pitfalls. Nowhere has this been more evident that the much-publicized relationship between Bitfinex and Tether. In April, prosecutors in New York claimed that Bitfinex had used $850 million of Tether reserves to cover losses for the exchange. Granted, the Tether-Bitfinex relationship seems to have been fraught with issues nearly from the beginning, and it’s important to note that the two projects have since separated. Still, this doesn’t change the fact that when an exchange — a business model that experiences significant ups and downs based on market conditions — has a huge pile of cash sitting in its stablecoin reserves, the incentives are set up to make this sort of behavior all too tempting.
Exchanges choosing to tokenize assets themselves also creates potential pitfalls in terms of fungibility. For asset-backed tokens to effectively disrupt the financial sector, they need to be as fungible as the underlying assets. This has a lot to do with infrastructure. If Exchange A tokenizes a certain security itself, and refuses to list tokens representing that security from any other issuers for competitive reasons, then it’s easy to see how the infrastructural differences between the two tokens can cause them to have different market prices — making them not perfectly fungible. It’s basically an illiquidity discount — if security-backed tokens are blocked from trading on large exchanges, because the exchanges want to tokenize the securities themselves, then the tokens won’t perfectly track the value of the underlying security. This could potentially make it much harder to tokenized assets to realize their disruptive potential.
Of course, one can make the case that this problem exists even among independent issuers. As multiple companies compete to tokenize the same underlying assets, some of them will build stronger infrastructures and better partnerships than others, which can still lead to price variations among the tokens. This is true, but it still holds that exchanges also acting as issuers will only exacerbate the problem.
As the digital asset industry continues to mature, it’s important that we begin recognizing conflicts of interest, and putting up the appropriate safeguards. It’s also important that we implement this new financial infrastructure in a way that provides the most value for users and token-holders. In order to do this, we need to address the potential pitfalls of exchanges acting as asset-backed token issuers.
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