Tokenized Securities: The Case for Investor Protection

In this episode of the SIFMA Podcast, Kenneth E. Bentsen Jr., President and CEO of SIFMA, joins Charles DeSimone and Peter Ryan to discuss the critical importance of investor protections in markets for tokenized securities.

Transcript

Edited for clarity

Kenneth E. Bentsen Jr.: I am Ken Bentsen, SIFMA president and CEO. Welcome to our latest episode of The SIFMA Podcast. I'm joined today by my SIFMA colleagues, Peter Ryan, managing director and head of International Capital Markets and Strategic Initiatives, and Charles DeSimone, managing director and deputy head of Technology Operations at BCP, to talk about digital assets, and more specifically, the importance of protecting investors in tokenized securities. There's a lot to discuss in this topic, so let's jump right in.

So Peter and Charles, thank you for spending some time with us today. We have said, many times, that in order to ensure there's long-term viability, it's critical that tokenized securities markets incorporate the robust investor protections that have helped make the US securities markets the largest, deepest, most liquid, and most efficient in the world. We'll dive into specifics in our conversation today, but maybe as a starting point, what does that mean from a broad perspective?

Peter Ryan: Well, as you noted, Ken, the strength of the US securities market has really grounded and invested its confidence in the efficiency, resiliency, and integrity of the markets, which, in turn, derives from the well-established set of protections that both retail and institutional investors enjoy under US security laws and regulations. That's why it's so important that the investor and market integrity protections underpin the traditional securities markets also be reflected in markets and platforms that facilitate the issuance or trading of tokenized securities. Without these protections, it will be difficult to build long-term investor confidence in many digital asset innovations and blockchain-based operating models, undermining the potential benefits that they could offer to investors, issuers, and other market participants.

In a recent letter that we sent to the SEC's Crypto Task Force, we discussed the important benefits and protections that current securities regulation market structures provide for investors and other market participants. Those protections are based on several key principles, including the principles that venues trading the same asset class should be linked in order to reduce marketing liquidity fragmentation, and that there should be fair access to market services, such as listing and trading, for all eligible participants, that there is transparency for investors about the prices of securities and available to trade, as well as transparency around other elements of the trading experience, such as order routing. More generally, that issuers and intermediaries must disclose accurate, timely, and material information to investors to allow them to make informed investing decisions. Similarly, platforms permitting proprietary trading by entities that either owns or is affiliated with should disclose key details about their trading activity and have procedures in place to prevent trading ahead of investor orders.

Another key principle is investors should be afforded best execution, meaning they should be able to obtain the most favorable overall terms, reasonably available for orders that they place with brokers or platforms. Investors should be, furthermore, protected from market manipulation, misconduct, and financial criminals through market surveillance mechanisms, robust books and records and auditing requirements, and anti-fraud and AML.KYC rules.

We'll talk more about this shortly, but it's also particularly important that investors are protected from conflicts of interest that can harm them. That means a separation of core functions, such as custodial and brokerage functions, as well as ensuring there are limits on vertical integration between different types of entities, such as exchanges and brokers. Related to this, investors should also be able to choose how and where their orders are handled and executed without being steered into a single broker venue or to type custody or clearing arrangements, what's described as customer optionality.

And finally, customer assets need to be protected through the segregation of assets and financial activities from those of a custodian, and such assets should be subject to proper safekeeping controls. Customer assets should be further protected through financial responsibility and prudential controls, such as capital and liquidity requirements, as well as measures designed to mitigate clearing and settlement risk.

So as we've consistently said, modernization of the securities markets and rule books to accommodate blockchain technology and tokenization should reinforce all of these core investor market integrity principles, not remove them. While blockchain networks only lead to new models of securities issues in trading, and while tailoring of many existing requirements will clearly be needed to reflect these new operating models, it should not come at the cost of failing to protect investors or creating fragmented markets, which would, in turn, undermine the long-term viability of markets for tokenized securities. It's therefore in the interest of all digital asset market participants, including both new and existing market participants, that tokenized securities markets incorporate the core protections I just described, again, with some tailoring as necessary to reflect the unique features of blockchain technology.

Bentsen: So that all seems inherently logical, but there is a school of thought among some that broker-dealers and similar intermediaries in the traditional securities world are maybe not necessary or applicable in a decentralized operating model that you often find in the natively-issued digital markets. What are the flaws in that point of view?

Charles DeSimone: Sure. I like to describe broker-dealer regulation as what we call a load-bearing element of the broader investor protection and market quality regulatory framework. What this means is that the protections Peter discussed before originate in large part from the regulatory responsibilities which broker-dealers are required to undertake. You see this across the scope of the capital markets, broker-dealer regulations covering how investors and issuers interact with the markets, standards for trading and managing conflicts of interest, managing what happens after the trade, securing client assets, and ensuring critical systems are robust and resilient.

For example, broker-dealers are responsible for ensuring best execution and appropriate disclosures to clients about investor risks and conflicts of interests. This gives customers enough information to confidently make choices about how to direct their investments, typically at the touch of a button and with very little, if any, transaction fees. Broker-dealers are also bound by customer protection safekeeping rules that ensure that the assets they hold on behalf of clients are secure. They also meet other requirements that deter bad actors and financial criminals from exploiting investors in disrupting markets. When companies want to raise capital, broker-dealers and their function as underwriters also provide important protections to issuers. These protections arise from having to meet due diligence and offering conduct standards, underwriting and distribution responsibilities, responsibilities for supporting orderly trading in the secondary market, and conflict management to ensure fair treatment for individual issuers and investors. More broadly, the participation of issuers in the capital markets is supported by a range of requirements governing their ongoing disclosures to investors.

There are those who suggest that broker-dealers alongside other types of intermediaries are unnecessary for the types of decentralized or distributed operating models that have often been found in markets for natively issued digital assets. We'll speak in more detail later on about some of the key open questions about applying those decentralized models to the securities markets, but fundamentally, these critiques fail to establish how the investor protections associated with broker-dealers would be replicated in these markets, particularly since those protections have facilitated decades of successful economic growth, market performance, and widespread investor protection in the US securities markets. It's crucial that policymakers consider these implications before providing any exemptions from current broker-dealer registration requirements or shifting broker-deal responsibilities to other actors in the market with more limited capacities such as transfer agents, a subject we discuss at greater length than our recent letter to the SEC.

Bentsen: So safekeeping of customer assets is a really core investor protection function for broker-dealers. How has that evolved with new technologies and how will it work with tokenized securities?

Ryan: Well, custodial services offered by banks and other qualified institutions have been critical to the success of modern capital markets for over 80 years, helping manage conflicts of interest, ensure high levels of investor protection, and promoting the efficiency and stability of the markets. As we've commented on many occasions over the past number of years, creating certainty around custody protections will similarly be foundational to development of safe and mature tokenized securities markets, and indeed digital asset markets, more generally.

The custody function is firm on three key principles. The first is segregation of client assets, meaning that client assets other than cash must be segregated from the custodians' proprietary assets and the assets of other clients. The second is the separation of financial activities, meaning the safekeeping function must be separately maintained and operated from trading asset management and other similar market-facing activities. And the third is proper control, which requires that the custodian have control over the assets of its clients at all times and the ability to transfer assets held for its clients based on the receipt of proper instructions.

It's important to note that these principles are technology-agnostic, meaning that the manner in which safekeeping is provided will continue to evolve with new technologies as it has done over the past several decades. They also do not preclude new entrants or new business models from offering new services, nor does it prevent clients from holding their own assets and keys in a self-custody scenario. But custody solutions that do not incorporate these three principles are unlikely to ensure the proper protection of clients' assets. It's therefore critical that any entity offering digital assets safekeeping services adheres these principles in order to protect investors and prevent customer losses.

Bentsen: So some find that one-stop shopping is appealing. We're all core market functions are vertically integrated, and in fact, as I think both, Peter, you and Charles discussed earlier, there is vertical integration in the system today with limits for good reason. Why is it important for investor protection and market quality to continue to separate or put limits on core functions?

DeSimone: That's a great question. I think, in our perspective, separation of core functions is another cornerstone of investor protection and market quality. By assigning distinct roles and responsibilities to broker-dealers, exchanges, custodians, and clearinghouses, today's regulatory framework disperses financial, operational, and default risks among those entities and manages potential conflicts through a system of checks, balances, and disclosures. While there are, as you noted, some limited use cases in which broker-dealer and trading venue functions operate within adjacent structures within the same entity, for example, in broker-dealer affiliated ATSs. In those cases, protections for investors are achieved through procedures, controls, and obligations that address key questions like investor suitability, manage conflicts and operational risks, and ensure that there are robust disclosures.

By contrast, if you were to permit broad vertical integration that combines all these market functions in a single one-stop shop, we're concerned that would strip away the protections that are currently through separation, effectively reintroducing major risks and undermining investor trust. It's worth remembering that the separation of functions was introduced in the US during the financial reforms of the 1930s to combat the abuses we saw in prior decades, where close connections between exchanges, brokers, and custodians allowed for a range of problems. We see this dynamic playing out in the unregulated crypto sector as well, where integrated models have sometimes given rise to conflicts of interest and market manipulation, most notably in the case of FTX.

A better approach, in our view, would be to expand existing programs and requirements for the trading and issuance of tokenized securities to allow market participants to take advantage of the efficiencies that these new technologies offer, while preserving the protections for investors that are offered by the existing separation of functions model.

Bentsen: So a critical point that's come up and is the source of a lot of debate is, when is a token of security or not a security? And investors obviously need to know what they're buying, and by virtue of that, what protections that they have and what obligations they're owed. How are you thinking about this issue?

DeSimone: We think this is one of the key issues which needs to be resolved to build investor confidence in digital asset markets. We've already talked about the protections of the securities regulatory framework, but from the investor's perspective, one of the key features of the market is clarity about what exactly they're buying. We discussed that in the context of issuer disclosures, but at a fundamental level it means understanding the economic rights and entitlements that come with the purchase of an asset. Are you entitled to dividend payments? Voting rights? Coupon payments? Do you have an underlying stake in the ownership of the issuer themselves or a claim in bankruptcy? These questions are all clear for established capital markets products.

When we start to look at some parts of the tokenized assets market, however, things start to become more murky. There needs to be a path to create tokenized equities, bonds, and other financial assets that have the same rights and entitlements as their traditional analogs. We're very supportive of regulatory modernization to make sure that tokenization can create products which are legally and economically equivalent, and we're encouraged by the work underway at the SEC and Congress to provide this clarity.

On the other hand, some approaches to tokenization can create products which are advertised as tokenized securities but don't have the fundamental economic and legal rights as traditional securities, and that's concerning to us. For example, you could structure a tokenized product which is not a direct conversion of an existing equity or bond, but is instead some sort of derivative like a securities based swap or a mirror token reflecting the value of that related asset. Marketing this type of asset under the name of a tokenized security is misleading to investors, as it doesn't convey the same economic rights. Indeed, something which is structured as a security-based swap is generally not eligible to be sold to retail investors, whether in traditional or digital form.

We were encouraged to see SEC Commissioner Peirce clearly state the summer that it must be clear to investors when they're purchasing a tokenized security with legal and beneficial ownership and not some sort of other token without those legal and economic rights.

We think the path is clear to help resolve this question. On one side, creating a career regulatory path to create tokenized securities with the same underlying economic rights, and on the other side, for policymakers to adopt a standard industry taxonomy that clearly and consistently classifies digital assets according to their underlying economic characteristics so the correct regulatory treatment can be applied to those assets and investors can have clarity on what they're buying.

Bentsen: Yeah, I think it's really important. And I would add to that, the difference between marketing a product through a broker-dealer or an investment advisor, as opposed to not, and the obligations that are owed to the investor when you go through that regulated channel. Let's switch gears a bit. At one point we've raised, with the Securities Exchange Commission, the importance of establishing a carefully-designed innovation exemption, or so-called regulatory sandbox. What benefits would that offer? And what would be the essential elements of such an exemption?

Ryan: Well, as you know, Ken, we have discussed the idea of an innovation exemption and the analogous concept of a regulatory sandbox with the SEC on a few occasions recently. We also know that similar concepts are being discussed as part of the market structure bills working their way through Congress at present.

SIFMA's view is that a properly designed innovation exemption framework would allow firms and other innovators the opportunity to test novel digital asset products and business models in a flexible, yet controlled, environment, and would give the SEC real-time visibility into these products and services. These insights could then be used to better design tailored regulatory regimes that foster innovation while maintaining the core investor protections and market integrity principles we have been speaking about today. However, it's critical that any innovation exemption or regulatory sandbox framework act as a supplement to afford a policymaking process and not backdoor mechanism for rewriting key elements of the existing market structure regime.

As we've said on several occasions, major structural changes to markets or core investor protections should be addressed through a normal notice-and-comment rulemaking process, not through the granting of exemptive no-action or safe-harbor relief from existing rules or indeed through an innovation exemption framework.

Beyond this, we agree with Commissioner Peirce that any framework should be open to all market participants. That is, it should not result in any single institution or group of firms gaining effective monopolies over a specific innovation. We also think it's critically important that any innovation exemption or regulatory sandbox framework operate within clear guardrails to avoid potential harm to investors or disruptions to the markets. Absent clear guardrails and innovation exemption could become a way to issue and trade tokenized securities outside of the core protections of the federal securities laws, increasing exposure to fraud, manipulation, and conflicts of interest, especially if issuance, trading, and settlement functions were to be vertically integrated within a single intermediary. Operating tokenized markets on platforms decoupled from the existing regime, but also fragment liquidity, degrade price transparency and impair execution quality would knock on negative impacts on overall market liquidity and investor outcomes.

To ensure that the appropriate guardrails are put in place, the innovation exemption itself should, first, be subject to a transparent notice-and-comment process that allows for public input and engagement on its design and operation. In addition, significant project applications approved under this framework should also be subject to minimum disclosures and some form of public input prior to being approved. Allowing public input on both the design and the innovation exemption framework itself, as well as specific project applications, will lead to better policy outcomes that balance the need for innovation with the importance of protecting investors and market integrity.

In terms of specific guardrails, there are three types of parameters common in other jurisdictions with regulatory sandbox-style regimes, such as the UK, and that should be applied to projects temporarily operating outside of the normal securities regulatory regime. First, there should be some limits on the pool of investors that may participate in an innovation project, with an initial focus on more sophisticated institutional and accredited investors. This will help limit any potential adverse consequences, particularly for retail investors. Second, there should be caps on the size and volume of transactions and the number of customers that can participate to mitigate against any possibility of regulatory arbitrage and market fragmentation. And third, there should be duration limits, which are essential to avoiding firms operating outside the normal securities law framework for indefinite periods.

Now, the exact parameters of these guardrails will vary according to which part of the securities' life cycle a project is focused on. So a project focused on post-trade or settlement may be less disruptive to markets than projects involving the trading of already-issued tokenized securities. The guardrails should also be adjusted as projects demonstrate resilience over time. So for example, projects may be expanded in scope and extended in duration by the SEC. But there must be some outer limits on lease guardrails and clear guidelines for making these adjustments.

Finally, it's also crucial that there be a smooth exit ramp into a permanent regulatory environment, though only once a project proves it can meet the full suite of investor protection and market operations requirements. That means that projects should not be transitioned from an innovation exemption framework into a light-of-touch regulatory regime, that being one subject to exemptive relief or no action measures.

Bentsen: There's been a lot of discussion of decentralized finance, also known as DeFi, and how that model can be included in the new digital assets regulatory framework. Do you have any thoughts on that, Charles?

DeSimone: It's a great question and one where we're still working through how these proposed decentralized models would actually operate and how they would connect with the securities regulatory framework. To start with, there's a couple of key questions we think people need to bear in mind when looking at potential DeFi models in the capital markets.

The first is the question of how decentralized these models really are. Without getting too technical, while market structures and applications can be built on top of a decentralized blockchain network, they can still have centralized features in that software layer where trading and client interactions occur. If that's the case, we would argue those functions likely need to be regulated like their analogous activities in the traditional markets are. Layering a trading platform or a client brokerage platform on top of a decentralized network should not exempt it from regulation. There needs to be a locus where regulation can be applied to ensure that any securities trading that occurs in more decentralized models is subject to the same standards of investor protection and market integrity that other markets are. We also need to consider how regulated entities will be able to interact with these markets while still meeting KYC and AML requirements.

Second, decentralized trading models exist today which allow peer-to-peer securities transactions, largely under the 144A framework. However, these peer-to-peer models are highly constrained by federal and state regulations limiting the types of investors that can take part in the volumes of securities traded. These restrictions were put in place to deal with historical patterns of fraud and insider abuses. We need to be very careful that any expansion of peer-to-peer models through DeFi operating models on the blockchain does not reintroduce these risks to the securities markets.

Bentsen: So digital assets' policymaking is clearly a major focus for the administration, the regulatory agencies, the SEC and the CFTC, and Congress, with legislation working its way through the Senate having worked its way through the House, and with both the SEC and CFTC conducting robust review of potential future rulemaking. What are the next steps for SIFMA in this space?

Ryan: Ken, as you said, there's a lot going on right now and we are working on a lot of fronts. We're engaging with Congress on the pending market structure legislation where we continue to emphasize the importance of protecting investors and markets anywhere that tokenized securities are being traded. As Charles alluded to, we're also working on another response to the SEC on a variety of tokenized securities issues, particularly how requirements should be applied to new trading models with various levels of decentralization. We're also providing inputs into the CFTC as part of the Crypto Sprint that Chairman Pham had launched recently. And we will be engaging with the Treasury, the SEC, and the prudential regularies on a range of other topics, including the implementation of the GENIUS Act on payment stablecoins, the permissibility of bank engagement with digital activities and the capital treatment of different types of digital assets at the broker-dealer and bank holding company levels. So a lot more to come from us over the coming weeks and months.

Bentsen: Well, that's great. And with that, I think we've covered this topic well for today. Peter and Charles, thank you for the discussion, and thanks also to all our listeners for joining us. We hope you found these conversations as valuable as I did. Comments and questions are welcome. Listeners can reach us via email at [email protected]. More information on SIFMA's views and work on digital assets and other matters involving the capital markets is available on our website at https://www.sifma.org. And thank you, again, for listening today.

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Related Resources

• SIFMA and SIFMA AMG Letter

  Request for Comment on Statement by Commissioner Hester M. Peirce Re: Crypto RFI

• Blog

  Modern Markets, Enduring Protections: Protecting Investors in Tokenized Securities