Security Tokens Aren’t a Gift to Digital Asset Regulation

Tokenization does not itself create liquidity. Convenience in trading does not always translate into volume. But it is useful to remember what makes tokenized equities convenient: it streamlines multiple points of friction that prevent markets from forming for what otherwise would be (or could be) more liquid assets – like some private securities. Tokenization does this by automating the clearing and settlement functions of a trade.

In the United States, the offer for sale of a security by an issuer requires registration with the SEC (absent an exemption from registration). In order to qualify for an exemption from registration, when an investor purchases a private security (e.g., a limited partnership interest in the BCAP fund) that investor would likely have had to have been an “accredited investor,” a defined legal term. When it comes to secondary market sales, the secondary “offering” also must fall under one of various exemptions to registration as the investor would be selling securities that have not been previously registered. A lawyer can speak to you for hours about these exemptions. In short, resales of private securities are complicated. Such resales traditionally require that each individual transaction has many intermediaries, like lawyers, transfer agents, clearing houses, and central depositories, to verify that the appropriate exemptions apply and that the proper procedures occur to transfer ownership.

The result here is a big bah humbug for liquidity. It usually takes too long and costs too much to transfer private securities – until tokenization. Security tokens allow coding-in of the above requirements in all of their granular detail glory, and on top of that, allow for automated price negotiation (when listed on a compliant secondary trading platform), validation of ownership by the seller and an automated, real-time cap table that is instantaneous and fully auditable. Their potential compliance features come alongside other features that could bring great value to investors.

It’s easy to see how this is an attractive development in the crypto industry. Imagine digitized elves doing the work of securities regulation compliance.

However, all innovative technology presents regulatory friction. After all, the SEC’s most recent actions against AirFox and Paragon called for what seems like a very administratively cumbersome refund and Exchange Act registration (under Form 10) process for the tokens (not the equity of the companies themselves). A compliant security token offering might have resolved much of the SEC’s concerns in those situations.

The key words there are “might have.” Are security tokens truly our guiding star? Well, no. Outside of the narrow purposes they purport to serve, they are actually a distraction from a glaring regulatory problem – a problem that security tokens don’t share because they are fundamentally different from other tokens in the industry. Security tokens are intended to be a tokenized representation of something we all already agree is subject to SEC jurisdiction. Many other tokens, probably most, in the crypto ecosystem do not share that same intent.