Tokenization is moving faster than Washington

Tokenization is moving faster than Washington

Regulatory clarity is not simply a legal or political issue, argues former New York Governor Andrew Cuomo. It is an economic one.

Three months ago, bringing U.S. equities onto blockchain-based markets still looked more like a vision for the future than an immediate question of market structure. On Sept. 17, that changed. The Securities and Exchange Commission created a temporary framework for limited trading of tokenized U.S. stocks on qualified onchain venues — moving tokenization another significant step from the financial frontier toward the regulated mainstream. I have had a close view of that transition as co-chair of a joint venture between Intercontinental Exchange, the parent company of the New York Stock Exchange, and OKX that is building infrastructure for tokenized and digitally native financial products.

The SEC issued what it calls an “Innovation Exemption,” creating a temporary, conditional framework under which qualified venues, using automated market makers and liquidity pools, can trade certain tokenized stocks listed on American exchanges without registering with the SEC. The exemption lasts five years and permits experimentation with blockchain-based trading while imposing restrictions intended to protect investors.

That is a significant development. But its greater significance may be what it tells us about the pace of technological change.

The debate is no longer whether blockchain technology might someday reach traditional capital markets. The question is how existing markets will incorporate it and what rules will govern that transition.

Andrew Cuomo is the former Governor of New York, and a board member of OKX.

Tokenization does not eliminate financial risk, nor does it make the basic responsibilities of regulators obsolete. Quite the opposite. Markets ultimately function on trust, and new technology succeeds only when investors have confidence that ownership is real, transactions are reliable, markets are fair and bad actors will be held accountable.

I learned that lesson from the other direction.

As New York attorney general during the financial crisis, I saw what can happen when innovation and financial engineering move more quickly than oversight and risk management. Subprime lending and increasingly complex mortgage securities were promoted as innovations that expanded access to credit and distributed risk. Instead, bad underwriting and inadequate safeguards helped transmit risk throughout the financial system.

The lesson wasn't that financial innovation should stop. It was that innovation and regulation have to develop together.

That appears to be the approach the SEC is taking now.

Its exemption isn't a free-for-all. All trading venue participants must be permissioned. Tokenized shares traded under the exemption must provide investors the same rights and privileges as the traditional shares of an equivalent class. Trading venues face limits on the number and volume of tokenized securities they can trade. Issuers can object to the trading of their shares when tokenized by unaffiliated third parties. Smart contracts must be auditable and deployed on public blockchains, and trading in a tokenized security must stop when trading in the underlying security is halted.

This is regulation being used as a laboratory: permit innovation within defined guardrails, observe how the technology performs and use that experience to inform the rules that follow.

SEC Chairman Paul Atkins described the exemption as a “bridge toward durable rulemaking.” That description matters because the Innovation Exemption is, by definition, not a permanent regulatory architecture.

The limits of the current system became especially apparent two days before the SEC acted.

On Sept. 15, the Senate failed to advance the Digital Asset Market Clarity Act. The cloture motion received 49 votes, short of the three-fifths threshold required to proceed. The legislation would have established a comprehensive statutory framework governing digital assets and clarified the responsibilities of the SEC and Commodity Futures Trading Commission.

There were substantive disagreements over the bill, including questions involving consumer protection, banking, ethics, illicit finance and the respective powers of federal regulators. Those debates aren't trivial.

But the underlying technology and the markets developing around it will continue to advance regardless of the legislative calendar.

I have been reminded of that repeatedly over the past two weeks while meeting with regulators and financial-market participants in Europe. European policymakers face many of the same questions the U.S. does: How do you encourage innovation without compromising market integrity? How do rules designed for traditional intermediaries apply to decentralized technology? And how quickly can regulators adapt without creating instability?

Europe hasn't figured everything out. Its own experiment with distributed-ledger market infrastructure has experienced growing pains. But the European Union has established common regulatory frameworks and is learning from their implementation.

That matters because capital and technology are mobile.

Financial institutions making long-term investments in infrastructure care about the substance of regulation, but they also care deeply about its predictability. Firms deciding where to invest, build trading systems, develop products and deploy capital need to understand the rules under which they will operate. A stringent rule that is clear can be planned around. Persistent uncertainty is much harder to price.

This is why regulatory clarity is not simply a legal or political issue. It is an economic one.

Jurisdictions that establish credible and predictable frameworks are better positioned to attract investment, talent and financial infrastructure. Those that remain uncertain risk allowing standards — and ultimately markets — to develop elsewhere.

The SEC's action addresses part of that uncertainty in the U.S., and it does so in a thoughtful way. But it also illustrates an institutional reality: Agencies operate under authority Congress has already granted them. Exemptions expire. Regulations can be amended by future commissions and challenged in court. Statutes, on the other hand, provide a higher degree of permanence and define the boundaries within which agencies operate.

That distinction will become more consequential as tokenization continues to expand.

The potential applications are substantial. Distributed-ledger technology could change how securities are issued, transferred, traded, settled and recorded. It could reduce certain transaction costs, increase transparency and expand liquidity, particularly in markets where assets historically have been difficult to trade.

None of those benefits is guaranteed. Technology has to prove itself, and investor protection has to remain paramount.

But financial history suggests that when technology can make a process faster, cheaper, more transparent or more accessible, markets will test it. Electronic trading transformed Wall Street. Mobile technology transformed banking. Tokenization may prove to be another such transition.

The SEC has now opened the door to finding out.

What happens next — in markets, at regulatory agencies and in Congress — will determine more than the rules governing a new class of financial technology. It will influence where firms invest, where new infrastructure is built and which jurisdictions establish the standards for the next generation of capital markets.

The technology is moving quickly. The question now is whether the United States can create a regulatory framework durable enough to move with it.

Note: The views expressed in this column are those of the author and do not necessarily reflect those of CoinDesk, Inc. or its owners and affiliates.

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