The ancient Greek tales of Oedipus awaited travelers who could solve difficult riddles, but the powerful sphinx brought riddles and devoured those who could not solve them. Similarly, during the ancient crypto era around 2017, blockchain technology was a revolution in finance and other fields. However, two challenges prevented us from enjoying the technology to the fullest. (1) securities laws that cannot be easily mapped to decentralized systems, and (2) securities regulators hostile to digital assets often pose serious risks to those who tried to solve their first challenges.
Today, the Sphinx is determined to be more useful, but the mystery remains. The Securities and Exchange Commission (“SEC”) Cryptody Task Force has said that the agency’s previous regime “created an environment that was hostile to innovation,” and has pledged to work with industry participants to create sensible regulations. Promisingly, there are still important challenges. The US Securities Act is a combination of laws passed by Congress and rules adopted by the SEC. The task force demonstrates the SEC’s willingness to make the latter more viable through new rules and exemptions. However, the statute presents most challenges and only the Congress, not the SEC, can change them.
Below is an introduction to the more common mystery facing developers of tokenized securities today.
Regulatory Considerations
For tokenized securities, the developer creates a chain token each representing the share of the stock in the company or other security, or another asset that provides cash flow rights. This tokenization opens up the possibilities for instantaneous payments, turning into a fork, and paying daily dividends. This can be more efficient or functionally diverse than product responses.
The SEC may be more open to the idea of tokenized securities, but it is not authorized to change the law. Therefore, tokenized securities projects must resolve or avoid the mystery in which these laws exist.
Investment Company Law
If a token provides the owner’s economic exposure to assets pooled by the developer, the token project could become an investment company subject to the Investment Companies Act, which regulates companies such as mutual funds and allows investors to be exposed to those investments through the stocks they issue.
This mystery existed well before the code, and most people chose to navigate it by avoiding being classified as an investment company in the first place. This is because the requirements imposed by the Investment Companies Act do not work well in business models that include more than buying and selling securities. There are considerable limitations on debt and stock raises, borrowing, and even business with affiliate marketing. For those who can’t avoid triggering these requirements, there are exemptions available.
Broker Dealer under the Stock Exchange Act
Anyone who buys and sells securities for others, or is ready to buy and sell securities for their accounts, could be a broker or dealer. There are no bright line rules to qualify as a broker-dealer, but the SEC and courts consider clear line rules that show whether they provide liquidity, charge fees related to trade prices, or actively find investors and play a role in holding customer funds or securities.
Currently, there is no practical way to trade digital assets as broker-dealers, but the SEC can use existing authority to diagrammatically traverse the realistic path to do so. In the best case, it takes time and still has some compliance obligations.
Exchanges under the Stock Exchange Act
While it may not look like a traditional stock exchange, smart contracts can be used to bring a platform to match and execute orders from multiple buyers and multiple sellers.
Currently, only broker-dealers can trade on the exchange, and the exchange cannot hold customer accounts or custody customer securities. Even if the SEC could remake these rules, some requirements would definitely last.
Security-based swaps based on the Stock Exchange Act
Tokenized security could have crossed the complex world of security-based swaps when exposed to the economic performance of one or more securities. In general, a token that offers future exchanges of payments based on the value of security (or events related to that security) without configuring ownership can be a swap. Security-based swaps are under the joint jurisdiction of the SEC and the Commodity Futures Trading Commission. Those requirements are numerous, and the most notable rule is the rule that prohibits retail investors from purchasing swaps.
AML and KYC
Companies involved in trading or transferring tokenized securities should consider the applicability of anti-money laundering and knowledgeable laws. Compliance requirements depend on the role played in the transaction, but can include collection and validation of the customer’s name, date of birth, and address.
The mystery needs to go through, not around
Solving these riddles is not the end in itself. When designing tokenized securities projects, developers make choices based on economic, technical and regulatory frameworks. These areas are intertwined as technology allows economics and allows projects to determine where within the regulatory framework. However, these considerations are interrelated, so developers need to analyze them comprehensively from the start. Leave regulatory considerations for the end could turn into a game of Jenga where the problematic parts are removed just to defeat the advantages and objectives of economics and technology. The riddles that posed today are not just obstacles to the many benefits of blockchain technology, but are also an important part of the answer.
The opinions expressed in this article are those of the author and do not necessarily reflect the opinions of Skadden or its clients.
