Defining tokens and embracing instant settlement

Panellists at the fourth Crypto Task Force roundtable organised by the US Securities and Exchange Commission (SEC), generally agreed on the potential benefits of tokenisation for capital markets — namely that the technology offers clear ownership of securities and could pave the way for instant settlement. 

Newly installed SEC chair Paul Atkins gave the introductory keynote at the roundtable, Tokenisation: Moving assets on-chain: Where TradFi and DeFi meet. He compared the movement of securities from off-chain to on-chain systems to the transition, decades ago, of audio recordings from analogue vinyl records to cassette tapes to digital software.

“Just as the shift to digital audio revolutionised the music industry, the migration to on-chain securities has the potential to remodel aspects of the securities market by enabling entirely new methods of issuing, trading, owning and using securities,” said Atkins. “For example, on-chain securities can utilise smart contracts to transparently distribute dividends to shareholders on a regular basis.

Commissioner Hester Peirce said tokenisation fits squarely within the SEC’s jurisdiction because it involves formatting traditional financial assets, such as stocks and bonds, as crypto assets (or “tokens”) on a crypto network. 

“Much as earlier internet-based protocols dramatically enhanced our lives by making it easier to communicate and access information, these cryptographic protocols have the potential to improve our lives through enhanced accessibility and efficiency of the markets for traditional financial assets,” said Peirce. 

Crypto networks are “a new type of computing platform” that can “allow you to do more with your assets”, she added. She argued that removing securities from siloed databases and tokenising them on open, composable crypto networks could benefit the securities markets through increased operational efficiency, transactional transparency, liquidity, accessibility, faster settlement and greater investor opportunity.

Picking winners

However, comments by commissioner Caroline Crenshaw, the lone Democratic seat at the SEC, sparked many of the roundtable discussions that followed. 

Crenshaw compared the enthusiasm around tokenisation to the 1989 Kevin Costner film, Field of Dreams, in which a farmer constructs a baseball field in his corn field because a ghostly voice tells him: “If you build it, they will come.”

She warned that regulatory efforts to enable the adoption of blockchain seemed as if the government was “picking winners and losers” before the technology had been proven at scale. 

“Blockchain technology has been around for a long time and, although a number of limited use cases have recently been introduced, it has not been widely adopted for issuance and trading of registered securities,” said Crenshaw. “There is an argument that if we ‘build’ — or, more accurately, rebuild — the financial system to accommodate blockchain, ‘they’ — all manner of market participants — ‘will come’ to embrace tokenised securities.”

The industry should first define tokenisation and determine what exactly it is trying to build, she said. 

“Does tokenisation mean issuing a security directly on a blockchain? Or does it refer to creating a digital representation of a security on a blockchain? This may seem a subtle distinction, but it likely carries significant consequences from a regulatory perspective. 

“Beyond issuance, does or should tokenisation encompass downstream distribution, trading, clearing, and settlement? In other words, would the entire securities lifecycle move on-chain, or only a part of it?” she added.

Same treatment 

According to Robert Mitchnick, managing director at BlackRock, securities should have “the same regulatory treatment, regardless of the form [they take], whether that’s traditional or tokenised”.

Frequently cited benefits of tokenisation include that it can reduce trade settlement from the current state of T+1 to T+0, and make markets more efficient. The argument is that instant settlement can reduce counterparty risks because trades would be pre-funded. 

According to Christian Sabella , managing director and deputy general counsel at the Depository Trust and Clearing Corporation (DTCC), issues around settlement times come down to choice because people “may have different reasons to want a different settlement cycle, a faster settlement cycle”.

That choice means examining enabling “atomic settlement” or instant settlement on chains, and the ability of smart contracts to allow for programmable assets, which has the potential for allowing 24-hour, seven-day-a-week trading, said Sabella.

Sandy Kaul, head of innovation at Franklin Templeton, said tokenisation technology that allows assets to be programmed and represented by smart contracts enables the industry to “rethink” what is common sense. 

“The commonsense approach says that every investor should be able to have as much control over their own assets as possible,” said Kaul. “Today’s account-based system makes this extremely difficult for individual investors, for high-net-worth investors and mass affluent investors.” 

Franklin Templeton has been able to provide more accurate calculations, more efficient reporting, and lower costs on funds by being able to eliminate intermediaries, Kaul said.

This allowed the fund manager to offer “more opportunities to expand the classes of assets” it provides, and diversify the asset pool by being able “to take investments that are investable but difficult to trade and put them into a tokenisation wrapper that will allow them to become part of everyday investor portfolios”.

Benefits for collateral 

The panel also discussed the benefits of tokenisation for collateral. BlackRock’s Mitchnick pointed out tokenisation makes it possible to liquidate various forms of collateral instruments in near real-time. 

It gave an opportunity to enable instant liquidity on a secondary basis, such as stablecoins as digital cash instruments, he said: “That has wide-reaching potential implications across many areas where collateral is a critical part of our financial infrastructure.”

Kaul agreed, suggesting that in the event of a global crash similar to 2008’s, if the underlying securities in a government money market fund were tokenised there would be no uncertainty about how to access that underlying collateral. 

“This tied up some of the lawsuits around Lehman Brothers for two or three years to be able to figure out who owned the underlying collateral,” she added. “If we could immediately move from the tokenised money market fund and into the tokenised assets that sit within that fund, we can immediately get the collateral and begin to find all of the obligations in the marketplace.”

Technology risk 

Hilary Allen, professor of law at the American University Washington College of Law, mentioned some of the risks associated with the technologies underpinning the tokenisation activity. 

“There are limitations on how scalable the blockchains themselves can become, simply because they have to be inefficient or else it’s too easy for the bad guys to take them over,” she said. “You need lots of clean blockchains to try to create liquidity, and that’s usually done by way of APIs (application programming interfaces).”

APIs also introduce operational risks from cybersecurity perspectives and can transmit problems from one chain to another, she added. “That’s another focus of operational risk that I think we need to be very careful about if we are going to put real-world assets on any kind of public, permissionless blockchain.”

The next roundtable, DeFi and the American Spirit, is scheduled for June 6.