Mirror, mirror on the wall, whose Street fakes are best of all

For years, the powers that be on Wall Street have toyed with whether it would be feasible to move the stock market onto a blockchain, the underlying technology behind cryptocurrencies.

The innovators in the fast-moving world of decentralised finance — or DeFi — are not waiting about to see how those discussions unfold. Instead, they have built synthetic versions of equities that track some of the world’s biggest companies. In essence, the anti-establishment ethos of the crypto world is being applied to a rough facsimile of the stock market.

Fake versions of Tesla, Apple, Amazon.com  and other big stocks, as well as a few popular exchange traded funds (ETFs), have been created by the projects Mirror Protocol and Synthetix over the past year. The tokens, and the programming that allows them to trade, are engineered to reflect the prices of the securities they track without any actual purchases or sales of the real stocks and ETFs involved. So far, volumes are just a tiny fraction of those on regulated exchanges. But for crypto enthusiasts, the potential upside is huge.

The synthetic shares join a strange new world of assets such as digital artwork and highlights of US basketball games now trading on blockchains. Yet, unlike the modern art and dunks of the nonfungible token universe, these instruments raise questions about fitting into a global stock market and brokerage industry governed by thousands of pages of rules from dozens of countries.

At the moment, it is a case of innovation that is way ahead of regulation.

Which is exactly how Do Kwon likes it. The co-founder and CEO of Terraform Labs, the South Korean company that created the Mirror Protocol on its Terra blockchain, Kwon fancies himself as a sort of modern-day Robin Hood of finance — in the mode of no-fee broker Vlad Tenev or venture capitalist Chamath Palihapitiya. DeFi “is so powerful in unlocking financial services for disenfranchised people about the world”, he said via e-mail, that “it’s better to move fast and break things. Waiting for fragmented regulatory frameworks to crystallise before innovating is counterintuitive.”

Synthetic assets

For Kwon and other proponents of these new synthetic assets, avoiding the various rules and barriers of the financial world is a feature, not a bug. It opens up opportunities for wealth creation now only available to a fortunate few, he said. Users can trade the tokens anonymously 24 hours a day, seven days a week, from anywhere, unhindered by capital controls, “know your client” rules imposed on broker-dealers, and other frictions of the traditional financial system.

Kwon said Terraform Labs does not generate any revenue from fees charged on the Mirror Protocol. Those go to users as an incentive to provide liquidity. Rather, the firm profits via a cryptocurrency it created that tends to increase in value as projects such as Mirror grow in popularity.

So how exactly do these synthetic equities work? Well, it’s complicated. But to oversimplify, under the Mirror Protocol, the idea is to keep prices of the synthetic — or “mirrored” — equities in the ball park of the real thing by offering incentives for traders to arbitrage price discrepancies and manage the actual supply of tokens. Users can create, or “mint”, new tokens when prices are too high by posting collateral, and destroy, or “burn”, tokens when prices are too low, driving the price up or down.

Through these incentives, the “synths closely track the price of the real-world asset”, Kwon said. “But they’re still only tokens on a blockchain providing explicit price exposure.”

Trojan Horse

The tokens trade on decentralised, automated markets such as Uniswap and Terraswap, which allow users to buy and sell the assets directly on the blockchain — a different model than centralised crypto exchanges run by the likes of Coinbase Global or Binance.

So far, trading volumes are unlikely to be high enough to cause executives at Nasdaq or the New York Stock Exchange to lose much sleep. Mirrored Apple tokens, for example, have a market capitalisation of about $34m, according to Coinmarketcap.com. That compares with about $2.3-trillion for the real stock, and is about a thousandth the size of the novelty cryptocurrency Dogecoin.

A comparison of prices between various mirrored equities and the real securities at various times over the past week shows that the difference between the two can range from a penny to several dollars. For example, in afternoon trading on June 30, the price of Mirrored Tesla on CoinMarketCap.com was almost $6 higher than the $684 level the real shares were trading for on the stock market.

Yet, the projects bear watching by traditional finance institutions, given some of the ambitions in the DeFi space. As digital-asset management firm Arrington XRP Capital put it in a report analysing and describing its support for Mirror, the goal of DeFi is not to simply improve a user’s experience with the banking system, but rather to dismantle it entirely. These new synthetic equities, the firm wrote, “are one of DeFi’s most obvious Trojan Horses into legacy markets”.

A spokesperson for the US Securities and Exchange Commission (SEC) and representatives for Nasdaq, the listing exchange for most of the equities being copied by synthetics, declined to comment.

“Since these synthetic products are not regulated and not traded on a national securities exchange, I would think that the SEC would take issue with them,” said Joseph Saluzzi, the co-head of equity trading at Themis Trading who has provided testimony to the US Congress on market issues. “According to the SEC, their mission is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation. This sounds like an investor protection issue to me.”

Binance, the world’s biggest cryptocurrency exchange, has already drawn the attention of Germany’s financial regulator BaFin by offering tokens that are tied to the performance of popular US stocks but backed by the actual equities. Binance may have violated securities rules when it issued the tokenised shares of Tesla, MicroStrategy and Coinbase, BaFin said in April.

Regulators could also start looking more closely at the DeFi space after some spectacular blow-ups in stablecoins — digital currencies designed to closely track the value of national currencies (and which Mirror traders use as collateral to mint new tokens). Dallas Mavericks owner Mark Cuban, an enthusiastic and influential investor in DeFi, recently called for regulations to deal with the cryptocurrencies after losing money when one crashed in value to zero.

Billionaire crypto investor Mike Novogratz, founder and CEO of Galaxy Digital, recently tweeted that players in DeFi markets may regret it if they do not start abiding by so-called know-your-client and anti-money-laundering rules.

“Invest in a compliance layer now or pay the piper later,” he wrote. “If we want this ecosystem to grow we need to recognise we need to operate within the rules society sets.”

Kwon said Terraform Labs has not yet had any conversations with regulators in the US or elsewhere about mirrored equities. Nor has the company communicated with exchanges such as Nasdaq, or the firms that manage the ETFs that have been mirrored.

But to stop mirrored stocks and other synthetic assets from trading, you would have to shut down the underlying open-source software code that makes up the blockchain and is used by a global user base that includes many anonymous players, he added.

“As long as there are ardent believers in the greater picture of what’s possible with the technology, shutting down crypto, DeFi, or synths is a Sisyphean task,” he said.

Bloomberg News. More stories like this are available on bloomberg.com