Buying fractional tokens of Tesla on Binance Exchange with BUSD tokens is a risky proposition
An innovative product by Binance, CM-Equity AG, and Digital Assets AG?
Binance announced the launch of Zero-Commission, Tradable Stock Tokens
Binance is delighted to announce the official launch of its zero-commission, tradable stock tokens, allowing the users to trade fractional stocks. Stock tokens are denominated, settled, and collateralized in BUSD.
The first Binance Stock Token to be listed is Tesla Inc. (TSLA). Trading for the TSLA/BUSD pair is scheduled to open at 2021-04-12 1:35 PM (UTC). Users will be able to trade fractional Tesla stock on the Binance website.
From the Token Guide
Unlike traditional stocks, users can purchase fractional shares of the listed companies with stock tokens. For instance, for a Tesla share that trades at over $700 per share, stock tokens enable investors to buy a piece of the underlying share (e.g., 0.01) instead of the entire unit.
How do Stock Tokens work?
Stock tokens are denominated, settled, and collateralized in BUSD; this makes the calculation of returns easier and quicker in fiat. Tokens are cash-settled, meaning there will be no physical redemption of underlying shares.
Stock tokens are created on collateral held by a third party. Therefore, each token represents a share in a publicly listed company. This way, the token’s price is pegged to the price of the underlying shares.
Each token is fully backed by shares held by, CM-Equity AG, a licensed and fully regulated asset management firm in Germany. CM-Equity AG entrusts the acquired shares to a third-party brokerage firm for custody. In addition, CM-Equity AG will be monitoring all trading activity for compliance.
Trading Interface
Users will have access to a historical price chart, an order entry panel, and an order/transaction history panel on the trading interface. Please note that RFQ prices are indicative, not guaranteed. There are no volume data or order book widgets. Only K-lines will be available.
Coverage in crypto media has been dominated by the fact that this is an innovative product providing investors outside the US with an opportunity to get exposure to Tesla shares and that too in small fractions of its exorbitant $700 share price that otherwise would not have been available to them.
The purpose of this post to highlight a few risk factors for those who are venturing into this space for the first time. For the crypto pros, these risks are par for the course as they have been navigating the wild west unregulated crypto water for a long time and these risks may seem negligible.
The Token is issued under German law?
Binance is following a path earlier trodden by Basis in the US.
Basis was launched by John Taylor, the economist behind "Taylor Rule" where he was promising that tokens backed by shares or bonds are more stable as per his whitepaper.
It had some big financial backers: Silicon Valley VC heavyweights Andreessen Horowitz and Bain Capital Ventures invested, alongside billionaire hedge fund manager Stanley Druckenmiller, and Kevin Warsh, a former governor of the Federal Reserve. A total of $133m was raised (in late 2017, mid-cryptomania, we should point out). That money is now being given back to investors, however, and Basis is closing down.
He had to close it down as regulatory compliance was bringing in friction. (See screenshot below from homepage)
The key paragraph states
Unfortunately, having to apply US securities regulation to the system had a serious negative impact on our ability to launch Basis.
As regulatory guidance started to trickle out over time, our lawyers came to a consensus that there would be no way to avoid securities status for bond and share tokens (though Basis would likely be free of this characterization).
Due to their status as unregistered securities, bond and share tokens would be subject to transfer restrictions, with Intangible Labs responsible for limiting token ownership to accredited investors in the US for the first year after issuance and for performing eligibility checks on international users.
Enforcing transfer restrictions would require a centralized whitelist, meaning our system would not only lose its censorship resistance, but also that on-chain auctions would have significantly less liquidity.
There is a reason that Binance is launching these Tesla tokens in Germany and/or Switzerland as they would fall afoul of SEC regulations if launched from the US.
BUSD and the reserves backing it
The token can only be purchased through a stable coin BUSD that trades on Binance.
Paxos Trust Company is the USD custodian and issuer of BUSD. Each BUSD the investor holds corresponds to 1 US dollar in the bank account to ensure that one can always buy and redeem the asset anytime with 1:1 pegged US dollars.
Binance claims BUSD is backed 1:1 by Paxos and invites the customer to "Review our auditing firm's monthly attestation reports". The subject reports are not audited reports (if that is the perception Binance was trying to convey by referring to ‘auditing firm’) rather independent accountants report and it says
This is the key assertion that the management is making
There are three problems with the attestations:
Commingling: It is not stated anywhere that the Reserve Accounts are ring-fenced to be strictly used for backing BUSD. For example, see below the attestation of another coin PAX that PAX Trust Company also claims to custody states.
Again it does not mention that the Reserve Account is specifically for PAX. It is possible that there is only one Reserve Account that is backing all the coins issued by Paxos Trust Company. It could also be that these Reserve Accounts also include the operating cash of the company.
If that is the case, then the attestation statement does not provide any comfort.
The impact of outstanding checks/wires, deposits in transit, and other reconciliation items in transit is not contemplated. When issuing auditing reports, it is standard to account for all the known outstanding items such as checks/wires as otherwise, the cash balance appearing in the report will be not reflecting the true picture.
Liabilities: Audited reports of entities usually present the full picture of the company i.e. its assets and liabilities. There is a possibility that PAXOS has achieved the balance in the reserve account by borrowing money.
To summarize, what the attestation statement verifies is that there exists a Reserve Account with sufficient balance to back BUSD 1:1. However, it doesn't confirm if the Reserve Account balance is solely for BUSD, it does not reconcile it with outstanding items and we do not get a true picture of the liabilities if any that have been incurred to achieve that balance.
Trading Service Agreement
The Binance token Trading Service Agreement describes all the risks the client is taking and guarantees none of the service from Binance. From Terms of Service
You are solely responsible and liable for knowing the true status of any position, even if presented incorrectly by Binance at any time;
During Binance system maintenance, you agree that you are solely responsible and liable for managing your stock tokens exposure under risk, including but not limited to, keeping or closing your positions.
Binance.com will use commercially reasonable efforts to ensure that Binance stock tokens service execution system runs stably and effectively. Under the circumstances of network delay, computer system failures, technical problems associated with the use of computers or data feed systems relied upon by Binance or otherwise, failure of hardware, software or communication lines or systems or other force majeure events, which may lead to delay, suspension, interruption of service or deviation of Binance stock tokens trading service execution causing final execution that does not match your expectations, Binance.com does not take any responsibility.
These are boilerplate disclaimers. Under clause 5, while Binance itself does not make any guarantee of minimum service quality, it is expecting the investor to manage the account when she cannot access her account i.e., during maintenance.
CM-Equity
Each token is fully backed by shares held by, CM-Equity AG, a licensed and fully regulated asset management firm in Germany. CM-Equity AG entrusts the acquired shares to a third-party brokerage firm for custody. In addition, CM-Equity AG will be monitoring all trading activity for compliance.
However, there are no details about who is the third party and where is it located. While both Binance and CM-Equity webpages are silent about the third-party broker, one may assume it is Switzerland-based Digital Assets AG but can’t be sure.
Binance, the global blockchain company behind the world's largest digital asset exchange, today announces the launch of zero commission tradable stock tokens to broaden access across traditional capital and cryptocurrency in cooperation with CM-Equity AG, a licensed investment firm in Germany, and Swiss-based Digital Assets AG, an asset tokenization platform. Each digital token represents one share of equity stock and is fully backed by a depository portfolio of underlying securities that represents the outstanding tokens. Users will be able to trade fractional tokens.
Though on the website of Digital Assets there isn't anything about their custody or brokerage capabilities.
Human Resource
It appears that CM-Equity is doing the heavy lifting in terms of tokenizing and trading the Tesla shares. With third-party custody and brokerage services, this requires serious firepower in terms of expertise in compliance and regulatory issues. However, there is no compliance officer as per their website. Most (not all) of the employees are young, newly graduated with little or no experience.
One of the people responsible for Finance and Controlling is on an internship and the other was doing supply chain and project management in the previous internship.
This is par for the course of crypto space as it moves rapidly and it is a place where the young thrive. Those that have spent years in traditional finance are usually handicapped in this fast-paced, "move fast, break things" environment.
However, when one is dealing with such issues as brokerage and custody of traditional regulated assets such as Tesla shares, it behooves the entity to have experienced compliance officers and legal counsel. A strong financial control department is also a prerequisite.
Market maker
If users can buy fractional tokens, it implies that the broker or the custody agent is also acting as a market maker. The customer will be buying say hundredth of a share at $7. The broker will have to buy 1 share for $700 to back it up. This means that the broker will be trading on the margin as it can only put up $7 of the customer's cash and will have to arrange $693 from its own. Any volatility will expose the broker to risks. A strong risk management department is required which unfortunately isn’t there to manage such risk and similar other risks that arise in the market-making role.
Tesla tokens on FTX
CM-Equity also manages TESLA tokens for FTX (a HongKong based exchange). We can get an idea of how CM-Equity manages the Tesla tokens on FTX. However, unlike Binance, CM-Equity is explicitly clear that tokens on FTX are backed by derivatives and not shares.
Product
The Fractional Stocks & Fractional Shares offered here represent derivative contracts whose performance is linked to the price development of a specific stock or exchange traded product ("Underlying"). The respective Underyling is named by the ticker symbol, for example, the ticker symbol “TSLA” represents stocks of Tesla Inc. Fractional Stocks & Fractional Shares are settled exclusively by exchanging crypto assets. CM-E itself provides the purchase and sales prices. There may be a reasonable difference between the purchase and sales price (so-called spread). The Fractional Stocks & Fractional Shares are not freely transferable and can only be sold back to CM-E. Trading on the stock exchange does not take place (so-called OTC derivative). The Fractional Stocks & Fractional Shares exclusively reflect the economic development of the respective underlying instrument, which is composed of the market value and any dividends. This means that purchasers of the Fractional Stocks & Fractional Shares have no claim to delivery of the Underlying asset nor shareholder rights - such as voting rights. The Fractional Stocks & Fractional Shares are perpetual and can be terminated by either party at any time. The Fractional Stocks & Fractional Shares are subject to German law.
CM-E will secure your repayment claim by appropriate hedging transactions. This means that the Underlying or other derivatives of this Underlying asset are purchased and held by CM-E in its own name and for its own account.
Risk
CM-E is holding the assets in its own name for its own account.
The derivatives or underlying assets are not held in custody. If CM-E goes bust, the investors have no claims on underlying.
When you deal with a broker in the US for your Tesla share, a broker may be a member of SIPC (securities investor protection corporation) which is similar to FDIC but for shares. CM-E isn't claiming registration with any shareholding protection agency in the world thus when you deal with CM-E, it is just in good faith.
Granted this is FTX and not Binance but I have yet to see anything substantive from Binance or CM-Equity that the nature of the product or custody of Tesla shares backing the token on Binance exchange will be any different.
Conclusion
Don't let me or this post hold you back from becoming a millionaire or billionaire by investing in Tesla token with Binance and CM-Equity. Those who trade in the crypto market and have made money there do not worry about these risks.