Unlocking the Secrets of Tokenized Securities: What You Need to Know

What to know:

In the timeless Greek story of Oedipus, brave travelers were promised rich rewards for solving complex riddles. However, a formidable sphinx presented the puzzles and consumed anyone who couldn’t find the answers. Likewise, in the early days of cryptocurrency around 2017, blockchain technology showed promise to transform various sectors, particularly finance. Yet, there were two obstacles that hindered its full potential: (1) traditional securities laws struggled to apply to decentralized systems, and (2) a regulatory body skeptical towards digital assets often posed significant risks for those attempting to navigate the first hurdle.

Today, the enigmatic sphinx has decided to offer more assistance, yet the riddles persist. The Securities and Exchange Commission’s (SEC) Crypto Task Force has expressed that their previous regime fostered an unfriendly atmosphere for innovation. They have pledged to collaborate with industry partners in creating practical regulations. However, substantial hurdles remain. U.S. securities laws are a combination of legislation passed by Congress and rules established by the SEC. The Task Force indicates the SEC’s readiness to streamline these rules via new guidelines and exemptions. Nevertheless, it is primarily the statutes that pose challenges, as only Congress, not the SEC, has the power to amend them.

Below is a primer on the more common riddles currently facing developers of tokenized securities.

Regulatory Considerations

Developers generate on-chain tokens, each symbolizing a piece of ownership in a company or other financial asset, such as a stock share or cash flow rights. This process of tokenization enables features like immediate transaction settlement, fractional ownership, and daily dividend distributions, making the digital product more streamlined and versatile compared to its traditional finance equivalents.

Although the Securities and Exchange Commission (SEC) might be open to suggestions regarding tokenized securities, it lacks the power to amend laws. Consequently, any tokenized securities projects must tackle or circumvent the challenges posed by the existing legislations.

The Investment Company Act

If a token allows its owner to financially connect with assets compiled by the creator, this token-based venture may fall under the purview of an investment company subject to the Investment Company Act. This legislation applies to organizations, such as mutual funds, which invest in securities and provide investors with exposure to these investments through shares they distribute.

This enigma predates cryptocurrency, and many chose to bypass being labeled as an investment firm initially due to the Investment Company Act’s regulations not aligning well with businesses that involve activities beyond just trading securities. These regulations impose stringent limitations on fundraising through debt and equity, borrowing, and transactions with related parties. Those who couldn’t evade these restrictions might find suitable exceptions available for their situation.

Broker-Dealers Under the Securities Exchange Act

A person who trades securities on behalf of others or intends to do so for their own account might be classified as a broker or dealer. There’s no strict definition that separates a broker-dealer from others, but factors such as providing market liquidity, charging a fee tied to the trade price, actively seeking investors, or managing customer funds or securities can all suggest that one is functioning as a broker-dealer. The SEC and courts use these indicators when determining this status.

Although it’s not feasible at present for broker-dealers to trade digital assets directly, the Securities and Exchange Commission (SEC) has the power to establish a viable roadmap for such transactions. This process might be lengthy and would involve certain regulatory requirements.

Exchanges Under the Securities Exchange Act

A platform that utilizes smart contracts to combine orders for digital securities from various buyers and sellers, facilitating matches and transactions, might be classified as a securities exchange if its design complies with certain requirements.

As a crypto investor, I find myself constrained by the current system where only broker-dealers are authorized to execute trades on exchanges. These same exchanges are barred from holding my accounts or safeguarding my securities. If the Securities and Exchange Commission (SEC) manages to revise these regulations, there’s no doubt that certain conditions will remain in place.

Security-Based Swaps Under the Securities Exchange Act

If a digital asset represents a portion of multiple securities’ performance, it might now fall under the complex realm of security-based derivatives. Typically, assets that allow for future payments tied to a security’s value (or related events) without granting ownership rights are often considered derivatives. Security-based derivatives are regulated by both the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC). These types of investments have numerous regulations, with key restrictions such as limiting retail investors from purchasing them.

AML and KYC

Companies dealing with tokenized securities trade or transfer should be mindful of the relevance of anti-money laundering regulations and know-your-customer (KYC) procedures. The specific compliance measures may vary depending on the transaction role, but they often involve gathering and verifying customer details such as name, date of birth, and address.

The Riddles Must Be Worked Through, Not Around

When tackling these riddles isn’t just about reaching a final goal. In any tokenized securities project development, developers take into account economics, technology, and regulatory aspects. These elements are interwoven as the technology can facilitate the economics and determine a project’s regulatory placement. Since these factors are deeply connected, it’s crucial for developers to approach them comprehensively from the start. Delaying regulatory analysis until later stages can lead to a Jenga-like situation where problematic parts are eliminated, only to potentially undermine the benefits and objectives of both economics and technology. Instead, these riddles serve as essential pieces in understanding blockchain technology’s advantages rather than mere hurdles.

This article represents the personal views of the authors, which may not align with the perspectives of Skadden or its associated parties.

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2025-04-10 18:54