The SEC will mandate Security Tokens

The US Securities and Exchange Commission (SEC) mission is to “to protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation. The SEC strives to promote a market environment that is worthy of the public’s trust.”

In order to fulfill this mission, the regulatory organization has, on occasion in the last 25 years, mandated the use of technology. Here are two examples:

  1. The SEC states, “In early 1993, the Commission began to mandate electronic filings through its Electronic Data Gathering, Analysis, and Retrieval system, (EDGAR). This system is intended to benefit electronic filers, enhance the speed and efficiency of SEC processing, and make corporate and financial information available to investors, the financial community and others in a matter of minutes. Electronic dissemination generates more informed investor participation and more informed securities markets.”
  2. As early as 2006, the SEC adopted XML technology because “the data becomes “computer readable,” or interactive, so analysts, investors and regulators can easily compare one set of financial data to another.”

So why do regulators historically mandate or drive adoption of technology?

An article titled “Disruptive Technology and Securities Regulation” was published in the Fordham Law Review in 2015 and stated “new technologies can connect financial market participants in ways that bypass institutions that have been required by law or market forces to screen investors, bridge information asymmetries, or ensure market integrity. Yet other innovations may have appeal or be popular precisely because of their ability to engage, undermine, or elide existing regulatory and market systems. In either case, technology can create opportunities for market participants to do things that they were never able to do before, or to do things better (or faster) than before, and in the process, challenge or arbitrage established regulatory architectures.”

Essentially, technology mandates or forced adoption is a regulators response to new technology that (1) side-steps current regulations, (2) enhances the data accuracy & transparency for market participants, or (3) creates a more efficient & compliant system.

This framework leads me to believe that the SEC will eventually mandate the adoption of tokenized securities.

A tokenized security is where an asset has its ownership structure managed by a blockchain, including units of ownership represented as digital shares/tokens (instead of paper share certificates). Most of the hype around tokenizing securities comes from the perspective of investors or issuers, which includes advantages like increased liquidity, global investor base, 24/7 market, and breaking of capital controls.

While I agree that those advantages will drive market participation, I want to present the idea that the most important advantage tokenized securities create is from the regulators perspective.

When you move asset ownership onto a blockchain, you are able to build a more regulatory compliant system. Yes, tokenized securities actually create more compliance, rather than less.

Today’s regulators are reactive by nature. They spend a ridiculous amount of time, energy, and resources to monitor the securities market. (The SEC’s 2017 budget was $1.6 Billion.) Once the organization identifies that someone has broken the rules, the SEC spends up to two years & millions of dollars to build a case and prosecute the culprits. It would be an understatement to say the current process is costly, time-consuming, and less than desirable.

This reactive approach will go by the wayside once assets are tokenized however. Regulators will be able to ensure that current laws are accurately written into the underlying protocols, which then govern all securities activity. By adopting this technology, regulators become proactive and save time & money.

So how does a regulatory-compliant protocol governance system work?

If I am an accredited investor in the US, I can purchase a Reg D security offering but am not allowed to trade it within 12 months of purchase. The new tokenized system, specifically the protocol, knows who I am (my wallet is KYC/AML verified), what security I hold (all properties such as regulation exemption status, jurisdiction & date of issuance, etc is written into the token), and anyone that I am trying to transact with (their wallet is KYC/AML verified).
If I attempted to trade my Reg D security within 12 months or with an unaccredited investor, the protocol would instantaneously identify the trade fails compliance criteria and the trade would be rejected. The security would be returned to my wallet, along with information on why the trade was rejected.

In this example, a regulatory-compliant protocol governance system actually prevents me from doing something that breaks the law. It no longer requires a centralized third-party to reactively monitor and enforce compliance.

It will be difficult for regulators to ignore the benefits of tokenized securities once the technology & impact is better understood. The idea of regulation becoming proactive, while also increasing compliance and data accuracy/transparency, is quite compelling. Not to mention, the hundreds of millions of dollars and thousands of man hours that can be saved.

Simply, a tokenized securities market is an improved securities market.

The idea of moving securities to a blockchain is new. Many people don’t understand it and some people even think it isn’t possible. Eventually though, adoption will be driven by asset owners, investors, and regulators. The reward is a perfect alignment of win-win-win for all market participants.

The irony of the steady state will be that tokenized equity, a radical idea today, will be boringly referred to as “equity.” I can’t wait.

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