SEC Cautions That Tokenization Doesn't Bypass Securities Requirements

Tokenization modifies the format of a financial instrument but does not change its legal identity.

Key Takeaways

Tokenization modifies financial instruments but does not alter their legal status.
SEC regulations apply to both issuer-sponsored and third-party tokenization models.
Tokenized securities are still subject to federal securities laws.
The statement serves as a compliance framework, urging firms to consult with regulators.

Tokenization

This is the main takeaway from recent comments by US securities regulators, who assert that tokenized versions of established financial products still fall under federal securities laws, independent of the technology employed.

In a staff statement released on Wednesday, the SEC’s Division of Corporation Finance, Division of Investment Management, and Division of Trading and Markets aimed to provide clearer guidelines to market participants as tokenization transitions from experimental phases to actual products.

The statement describes tokenized securities as financial instruments that meet the legal definition of a security and are presented as a crypto asset, with ownership either fully or partially recorded on crypto networks.

Understanding the Risks of Tokenization

SEC Highlights Different Tokenization Models

The SEC staff categorized the tokenization landscape into two main types: issuer-sponsored tokenization and third-party tokenization. In the issuer-led model, a company or its representative connects on-chain transfers to its official shareholder records, effectively substituting a conventional database with an on-chain record-keeping system while maintaining the same legal obligations concerning offering, sales, and reporting.

They also described instances where the token does not inherently convey underlying rights but serves as a mechanism to prompt an update to official ownership records off the blockchain. In this framework, while the blockchain assists in coordinating transfers, the security and its legal standing remain tied to the issuer’s off-chain records.

The Complexity of Third-Party Tokenization

Third-party tokenization is the more intricate category, where an entity not associated with the issuer produces a crypto asset linked to someone else’s security. The SEC staff indicated that these models can vary significantly and may introduce extra risks, such as vulnerability to the third party’s financial stability, including potential bankruptcy, an issue that holders of the underlying securities might not directly encounter.

Regulatory Concerns with Swap-Like Token Structures

The statement pointed out that regulators have identified two prevalent third-party tokenization approaches. One method is custodial tokenization, where the underlying security is held in custody while the token represents an indirect interest.

The second is synthetic tokenization, where the token represents the third party’s own instrument that aligns with an underlying security, such as a linked security or a security-based swap, which comes with its own regulatory implications.

Regarding security-based swaps, the staff highlighted that offerings made to individuals who are not eligible contract participants may trigger additional requirements, including registration and exchange-trading conditions. The key point remains that simply wrapping an exposure in a token doesn’t exempt it from established market regulations.

Compliance and Future Developments

This guidance coincides with significant industry players exploring how tokenized securities could function under regulatory measures. Just last week, F/m Investments submitted a request to the SEC to approve recording ownership of tokenized shares of its Treasury bill ETF on a permissioned blockchain, as asset managers and exchanges strive for quicker settlements and around-the-clock functions without compromising existing investor protections.

The SEC staff framed their statement as a roadmap for compliance rather than a sign of approval, encouraging firms to collaborate with the agency as they navigate registrations, proposals, or requests for action.