What Is a Digital Asset Security?
Key Differences Between Digital Assets and Digital Asset Securities
One of the major stories over the past year has been the mainstreaming of digital assets such as stablecoins and non-fungible tokens (NFTs). Now, digital asset securities have taken center stage as multi-billion dollar private equity firms like KKR and Hamilton Lane begin to provide tokenized access to their investments. As more institutions launch new initiatives to provide access to these assets, investors need to understand the ins and outs of digital asset securities and how they compare to digital assets as a whole. What makes digital assets different from digital asset securities, and what are the tradeoffs between them?
Pay Attention to the Word “Security”
“Digital assets” are more commonly known as cryptocurrency, such as bitcoin, NFTs, and stablecoins. Critically, digital assets are not digital asset securities. While the terms may sound similar, there are key regulatory and technological differences between them. Whereas digital asset securities is the term recognized by the Securities and Exchange Commission, these assets are also commonly referred to as “security tokens” or “tokenized securities.” The bottom line is that digital asset securities are asset-backed securities according to the Howey Test, which determines whether an investment is a security or not.
Digital assets are assets that are issued and transferred from one entity to another using a distributed ledger or blockchain technology. Digital asset securities, on the other hand, largely rely upon regulatory exemptions to issue and transfer assets using blockchain technology and to meet compliance requirements. While many digital asset securities rely on exemptions, the ones that do carry similar benefits that traditional exempt securities have, plus the benefits of being on the blockchain. As with all emerging technologies, liquidity, market, and regulatory risks exist, so both digital asset and digital asset securities investors should take note.
Investing with Digital Asset Securities
The most common regulatory exemptions leveraged by digital asset securities are Reg CF, Reg A+, Reg D and Reg S. These exemptions enable both retail and accredited investors (as well as offshore companies) to acquire alternative assets issued on the blockchain and potentially sell them on regulated, blockchain-based secondary markets without all the traditional, costly intermediaries. And this has the potential to democratize access to private markets.
Using blockchain technology makes the entire exempt securities lifecycle more efficient and streamlined than using manual, book-entry methods to issue and transfer ownership records between parties. With digital asset securities, investors are able to truly own their investments with instant settlement and no counterparty risks.
Distinctions that Make a Difference
According to a recent update to 2022 tax forms in the United States, digital assets “are any digital representations of value that are recorded on a cryptographically secured distributed ledger or any similar technology.” This means that the term digital asset now encompasses stablecoins and NFTs, and newer ways of using blockchain technology.
While this definition is now broader than it used to be, it remains distinct from digital asset securities, which follow established securities regulations and do not need new definitions to be created to operate with clarity. This is a key difference that long-term investors should be aware of.
As the ecosystem evolves, regulations will likely adapt to keep up with the pace of innovation. In the meantime, digital asset securities investors have the potential to realize long-term gains without getting caught up in regulatory uncertainty. And this key distinction can make a world of difference.
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