Tokenized Securities — What Corporations Should Know
The U.S. system for issuing, trading, clearing, and holding securities rests on a book entry framework developed more than half a century ago. Familiar, time tested, and generally reliable, that framework also entails settlement delays, limited trading hours, layers of intermediaries and records, and substantial reconciliation work. Some market participants are now testing whether a different recordkeeping technology can reduce those frictions and modernize this infrastructure through tokenization, which is the representation of securities on a blockchain.
Proponents contend that tokenization could enable near instant settlement; 24/7 trading; fewer intermediaries; a potential fix for the tangled recordkeeping that complicates shareholder voting; and greater transparency on public blockchains, where activity is visible to anyone, though participants are pseudonymous. Securities in a programmable environment could also enable further efficiencies. These prospects have attracted institutions at the center of traditional securities trading, including the Depository Trust & Clearing Corporation (DTCC), which launched a tokenization service for financial institutions last week; NYSE and Nasdaq, which are developing tokenization platforms; and BlackRock, which offers an institutional on chain money market fund.
Tokenization has become an immediate issue for public companies following the SEC’s September “Innovation Exemption,” effective for five years and accompanied by a request for comment. It permits trading of tokenized National Market System stock through an “automated market maker” (open source software that prices and executes trades against pooled liquidity rather than by matching buyers and sellers) while exempting its operator (a “Tokenized Securities Venue” or “TSV”) from registration as a national securities exchange. An issuer may tokenize its own shares, or a third party may tokenize them, subject to advance notice to the issuer, which then has 30 days to opt out. One TSV, OKXICE, has given notice of its intent to tokenize the shares of more than 60 major corporations. Most have already opted out, perhaps reluctant to be the first to cross a newly built bridge, but all public companies should prepare for the possibility of receiving a TSV notice. Key considerations for navigating this evolving landscape include the following.
1. There is more than one model for tokenization, and the differences matter.
Tokenization models differ in what tokens represent, what rights tokenholders enjoy, how tokens trade, and the role of the issuer. In brief, the models are as follows.
- Third party custodial model. Under OKXICE’s model for unaffiliated third party tokenization, the tokenizer acts through a registered broker dealer to buy and hold the shares, issuing one token per share held in custody. The venue must verify that tokenholders receive the same economic and voting rights as shareholders, and tokens are redeemable for the underlying shares. OKXICE’s notice describes each token as a security entitlement (the legal interest a brokerage customer holds in securities credited to its account) to one underlying share; how voting and corporate action mechanics function in practice remains to be seen. Some other share backed tokens trade offshore, outside the Innovation Exemption, and may differ materially, since one for one backing does not necessarily confer voting rights or a legal claim to the underlying shares.
- DTCC model. Here, intermediaries are preserved. A token represents a book entry security entitlement to a security already held at DTCC’s depository subsidiary, DTC, and is held and used only by DTC participants, which perform their traditional brokerage, clearing, and custodial functions. The model does not replace traditional order matching and initially runs on private or quasi private blockchains at DTC participants’ initiative. For issuers, it is a back end change to DTC’s infrastructure.
- Issuer sponsored tokens as actual shares. Here, tokens do not represent a claim on shares; they are shares, with a blockchain position functioning as a form of direct registration (holding shares directly on the company’s books rather than by a broker). Because state corporate law and other legal requirements do not permit “bearer” shares, transfers must be reflected in the corporation’s stock ledger (which Delaware law has since 2017 permitted to be blockchain based). Securitize Corp. (NYSE ticker SECZ), for example, has issued its own shares in tokenized form on public blockchains.
- Synthetic model. Here, a token tracks a security’s price but confers no ownership of shares, and no shareholder rights. Generally regulated in the U.S. as a security based swap or security future, this model is highly popular outside the U.S., particularly as perpetual futures (which never expire).
2. Tokenization is likely to grow. Securities tokenization remains in its infancy. TSVs are not yet operative, domestic trading volume in tokenized U.S. equities is negligible, and effort is focused on launching models and venues. But the SEC’s focus on innovation; initiatives by DTCC and major stock exchanges; vast 24/7 offshore markets for tokenized equity; and the maturation of blockchain technology all suggest adoption will grow, including by issuers.
3. Blockchain programmability expands the “art of the possible.” To issuers, 24/7 trading on unfamiliar infrastructure may at first seem to offer little more than liability or reputational exposure from tokens they did not sponsor, while also demanding attention to how round the clock trading interacts with investor relations, disclosure timing, insider trading policies, repurchase programs, and beneficial ownership reporting. But if legal frameworks evolve (for example, state law fixing record date windows), tokenization could offer benefits. These include greater visibility into trading and the shareholder base (particularly under direct registration, which would strip away the nominee layers that can obscure beneficial ownership); streamlined corporate actions, such as eliminating dividend ex dates (the record date could be the payment date) and the gap between voting record and meeting dates; transfer restrictions and antidilution adjustments administered in code; and even a code based poison pill, whose rights separate and become exercisable automatically (subject, of course, to a board’s fiduciary discretion to amend or redeem).
4. Experimentation must precede wider adoption. For all tokenization’s touted benefits, it bears acknowledging that existing “traditional” systems generally work rather well, and their reliability is critical to American prosperity. It would be imprudent for more disruptive forms of securities tokenization to become systemically important without a careful, incremental approach. A recent cyberattack on a leading cryptoasset exchange, for instance, reportedly involved roughly $6.3 billion. Some smart contracts have shown severe security vulnerabilities, and even well functioning crypto markets have seen “flash crashes” evoking the program trading debacle of 1987’s “Black Monday.” And issuers and markets will need time and thoughtful rulemaking to absorb 24/7 trading at scale, surveil pseudonymous blockchain markets, balance transparency with privacy, and develop best practices for incident prevention and response.
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Public companies may not be interested in tokenization, but tokenization is interested in them. They should prepare accordingly, including by assigning responsibility for monitoring TSV notices and market developments and by evaluating whether particular tokenization arrangements serve their interests.
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