In the Ancient Greek tale of Oedipus, travelers were promised great rewards for solving challenging riddles, but a menacing sphinx awaited those who failed. Similarly, in the world of crypto in 2017, blockchain technology held the potential to revolutionize finance and other industries. However, two major obstacles stood in its way: (1) the complexities of securities laws in the context of decentralized systems, and (2) a regulatory environment hostile to digital assets, posing significant risks for those attempting to navigate the first challenge.
Today, the regulatory landscape appears to be shifting, with the SEC’s Crypto Task Force acknowledging past hindrances to innovation and expressing a willingness to collaborate with industry players to develop sensible regulations. While this is a positive step, substantial hurdles remain. U.S. securities laws, a combination of congressional statutes and SEC rules, present significant challenges, with only Congress having the authority to make statutory changes.
Below is an overview of some common challenges faced by developers of tokenized securities.
Regulatory Considerations
Tokenized securities involve the creation of on-chain tokens representing equity in a company or other assets that offer ownership rights. This tokenization can bring about benefits such as instant settlement, share fractionalization, and daily dividend payments, enhancing efficiency and functionality compared to traditional financial instruments.
While the SEC may be more open to tokenized securities concepts, statutory obstacles remain unchanged. Projects in this space will need to address or navigate these challenges presented by existing statutes.
The Investment Company Act
Projects that provide economic exposure to pooled assets through tokens could fall under the purview of the Investment Company Act, which regulates investment companies like mutual funds. Compliance with this act can be challenging for business models involving activities beyond securities trading, with strict restrictions on various operations.
Broker-Dealers Under the Securities Exchange Act
Determining qualification as a broker-dealer involves various factors, and while trading digital assets in this capacity is currently impractical, regulatory clarity could pave the way for such activities with compliance obligations.
Exchanges Under the Securities Exchange Act
Platforms facilitating the trading of tokenized securities may be considered exchanges under certain conditions, with restrictions on account custody and trading activities. Regulatory revisions may offer some relief, but compliance requirements are likely to persist.
Security-Based Swaps Under the Securities Exchange Act
Tokens providing exposure to securities’ economic performance may be categorized as security-based swaps, subject to complex regulatory requirements overseen by the SEC and the Commodity Futures Trading Commission.
AML and KYC
Companies dealing with tokenized securities must adhere to anti-money laundering and know-your-customer laws, necessitating customer information verification.
Addressing the Riddles
Navigating these regulatory challenges is essential for any tokenized securities project. Developers must consider the interplay between economics, technology, and regulatory frameworks from the outset to avoid potential pitfalls. Regulatory compliance should not be an afterthought, as overlooking it can jeopardize the project’s viability and objectives. The current riddles serve as integral components of the blockchain technology puzzle, rather than mere obstacles.
The views expressed in this article are solely those of the author(s) and do not necessarily represent the opinions of Skadden or its clients.