Navigating the Challenges of Tokenized Securities

Despite a recent easing of regulations surrounding digital assets, the path to properly regulate these assets remains fraught with difficulties. This article offers insights into the major challenges currently facing developers of tokenized securities, highlighted by perspectives from individuals at Skadden.

Key Takeaways

• The SEC’s Crypto Task Force is shifting from a hostile stance to a more constructive approach toward digital asset regulation.
• Developers must navigate complex laws, such as the Investment Company Act and broker-dealer requirements, which complicate tokenized security projects.
• It is essential for developers to incorporate regulatory considerations early in their projects to maintain the economic advantages of blockchain technology.

A Historical Parable

In the myth of Oedipus, those who successfully solved riddles were rewarded, while those who failed faced dire consequences from the Sphinx. In the same way, blockchain technology emerged around 2017 with the promise to disrupt finance, but it faced two significant roadblocks:

1. The existing securities regulatory framework does not easily accommodate decentralized systems.
2. A hostile regulatory environment for digital assets, posing risks for innovators.

Recently, the SEC’s Crypto Task Force has acknowledged this adversarial past and is preparing to work alongside industry participants to develop sensible regulations, but challenges remain. U.S. securities legislation combines statutes created by Congress and regulations established by the SEC. The Task Force’s commitment to revising regulations is promising, yet many obstacles still lie within the statutory framework only amendable by Congress.

Primer on Tokenized Securities

Tokenized securities utilize blockchain technology to create digital tokens representing shares in a company or other asset, granting holders economic rights. This has the potential to enable features such as real-time settlement and fractional ownership, enhancing efficiency.

However, even with a more receptive SEC, statutory constraints continue to pose challenges. Here is a closer look at some intricate issues developers face:

Investment Company Act

If a token grants its holder economic exposure to pooled assets, it may be classified as a mutual fund under the Investment Company Act, placing it under stringent regulations.

Broker-Dealers and the SEC

Broker-dealers face regulatory scrutiny and must navigate complex rules related to their trading activities; finding workable solutions for trading digital assets remains a significant challenge.

Exchanges and Smart Contracts

Platforms utilizing smart contracts to trade tokenized securities may qualify as traditional exchanges, but current regulations restrict these operations.

Security-Based Swaps

Tokens granted holders rights linked to the performance of securities could be considered swaps, which are predominantly overseen by both the SEC and the Commodity Futures Trading Commission.

Compliance with AML and KYC

Entities engaged in trading tokenized securities must uphold anti-money laundering (AML) and know-your-customer (KYC) regulations; compliance varies according to the specific transactional role.

Conclusion

Addressing these riddles is crucial for maximizing the benefits of blockchain technology. Developers must evaluate economics, technology, and regulatory aspects together right from the start. Treating regulatory hurdles as mere obstacles can undermine potential advantages, making them integral aspects of the solution instead.

Note: The opinions expressed in this article do not necessarily reflect those of Skadden or its clients.