• Decentralized finance (“DeFi”) models offer a range of new functionalities and opportunities, but also raise foundational questions and create new risks that policymakers need to address – including the extent to which these models are truly decentralized – before determining whether and how these new types of operating models should be permitted to be used for the trading of securities, derivatives and “digital commodities”.
• This is particularly important for markets that trade tokenized equities and other securities, where it is critical that established investor protections and market integrity measures be maintained. Before widespread adoption can occur, there is an important policy discussion that needs to occur among regulators, proponents of DeFi models and well-established traditional securities and commodities market participants to address how these protections would be maintained across all markets to which US investors have access.
• SIFMA strongly cautions against any policy positions, new regulatory definitions or associated exemptions that could allow non-registered entities to facilitate the trading of tokenized equities and other securities in an unregulated or more lightly regulated “DeFi” environment without careful consideration of these issues and consultation with all relevant stakeholders. As we note, there are certain key functions – critical to maintaining market integrity and investor protections – in the securities lifecycle which must be bounded by sensible (if “modernized”) regulation and oversight, even when they occur through the use of a network with decentralized features.
• There are also important questions about how anti-money laundering (AML) and know-your-customer (KYC) obligations will be satisfied in DeFi markets; how decentralized platforms may be integrated into a broader securities market structure in order to avoid disconnects in pricing and liquidity and thus market fragmentation; and how “peer-to-peer” trading models can mitigate risks to investors and markets.

As U.S. legislators, regulators, and policymakers work to integrate digital assets into the broader U.S. capital markets regulatory framework, there are several important questions to be confronted, including how to appropriately regulate activity occurring through ostensibly decentralized models found in the native digital ecosystem.

Broadly termed decentralized finance or “DeFi,” the native digital ecosystem has fostered new operating models based on the concept of open, peer-to-peer markets.  While these DeFi models have largely been unregulated to-date, increasing attention is being paid to the role decentralized models could play in digital asset markets, including in markets for tokenized securities.  In our view, appropriate questions have been raised as to the extent to which these DeFi models are truly “decentralized” (in the sense that they operate without critical reliance on a single, identifiable entity), including the extent to which their reliance on software applications maintained and operated by such centralized entities effectively creates new intermediaries.

While DeFi models offer exciting new functionalities, there are foundational questions and risks that policymakers must address before ostensibly decentralized trading models can be successfully incorporated into the securities and commodities spaces. This includes appropriately distinguishing between pure software-based elements on the one hand, and applications that serve an intermediary function (thus enabling investors to interact with the blockchain or trade with each other) on the other.  This is particularly true when these models are applied to tokenized equities and other securities and derivatives. While there may be new opportunities in these markets arising from the use of these new technologies, failure to consider these issues risks undermining the investor protections and market integrity that have made the U.S. capital markets the largest, deepest, most liquid, and most efficient markets in the world.

What are the challenges of ensuring investor protection and market integrity in decentralized markets?

As SIFMA outlined in our recent comment letters to the SEC’s Crypto Task Force, the current securities regulatory framework addresses the various obligations of broker-dealers, exchanges, custody/clearing firms, and other entities in which market participants place their trust and reliance in order to ensure investor protection and market quality. As we discussed in a recent blog, these statutes and regulations, forged through hard-learned lessons from failures in the past, span market conduct, investor protection, separation of core functions, and maintenance of robust and resilient systems.

In decentralized trading models where traditional broker-dealer and other functions are arguably minimized or eliminated, policymakers must now consider a number of inter-related questions to better understand how investor protection and market quality can be preserved:

• How do you distinguish the role of software developers who support network functions from the applications they develop and maintain, which effectively serve as new forms of intermediaries?
  • For example, are some of the applications which allow investors to access blockchain based markets, or support the functioning of those markets, effectively serving as intermediaries? Is this particularly the case when they do so for some sort of direct or indirect compensation or profit?
• Without a clear understanding of what the term “decentralized” means, how can policymakers and regulators evaluate whether proposed DeFi operating models are, in fact, decentralized (in the sense that regulation and oversight are unnecessary), even if they do include some decentralized features? How should policymakers make these determinations?
• What is the appropriate locus through which regulations to protect investors and preserve market quality should be applied?
  • How and where should investor protection and market quality regulations be applied in a DeFi market i.e., is it at the level of software applications, market participants, or quasi-intermediaries that make up some decentralized markets?

While alternatives to the current regulatory framework have been proposed, so far, they fail to adequately address these questions. For example, some proposed regulatory models envision a greater role for transfer agents, yet do not address how the lack of transfer agents’ obligations to protect investors (e.g., much of which results from the fact that they are not members of the Financial Industry Regulatory Authority (FINRA) or subject to FINRA rules) is consistent with them serving as gatekeepers subject to investor protection and market integrity requirements.

Nor is it convincing that reliance alone on technology features provided by software platforms can replicate the protections offered by regulated intermediaries such as broker-dealers, exchanges, and custodians. While distributed ledger technology has certain features allowing for transparency and “trustlessness,” is it not clear that these technical features alone can replicate the concrete requirements for disclosure and conflict of interest management mandated by entity-based regulation.  Additionally, for many end users, their interaction with the technology platform is not direct but instead occurs via a software application in an intermediary role.

In addition, a pattern of governance challenges in the distributed ledger space over the last decade suggests that even “trustless” systems are reliant on third parties, whose ability to control, change, or operate the systems require similar forms of clear oversight and protections that currently apply to regulated entities.

Do overly broad DeFi definitions and exemptions raise the risk of creating a parallel market and regulatory arbitrage?

Consistently defining “DeFi” is itself a challenge. Many DeFi networks operate on a spectrum, with key functions often performed by actual people in control of software applications that allow investors to interact with the blockchain rather than completely autonomous code or direct investor interactions with the blockchain. Some of these functions involve developing or maintaining the software and technical functions that make DeFi networks operate in a manner that is practical and usable to investors, while others may include governance and control functions that mean they are effectively responsible for the securities trading services that the DeFi network offers its users.

It is critical that policymakers avoid drawing overly broad definitions of DeFi networks or creating associated software developer exemptions that would inadvertently exclude market participants from the benefits of existing investor and market protections, i.e., where functionalities such as software applications effectively end up serving as market intermediaries.  This is particularly important as market participants and policymakers explore decentralized trading of tokenized equity and other securities.

It is also critical to distinguish between an underlying distributed ledger network, which may truly be decentralized, from an application layer built on that network (and the operators of such an application), which effectively performs broker-dealer, exchange, or custody/clearing functions or otherwise facilitates securities market activity. SIFMA strongly cautions against any DeFi definitions or associated exemptions which could allow non-registered entities to facilitate the trading of tokenized securities in an unregulated or less-regulated environment. Doing so would create regulatory arbitrage, as these DeFi entities could intentionally structure products and services to fall outside the scope of existing securities laws, or at least describe their products and services as such. This would create two sets of rules for securities trading for DeFi versus existing market participants, even when trading the same equity or other type of security.

The result would be a bifurcated market and fragmented liquidity. It is uncertain how tokenized equities trading on decentralized blockchain platforms would be interoperable with existing equity exchanges, which can create isolated liquidity pools and reduce depth of order books. This can make it harder to match buyers and sellers efficiently, increasing costs to trade for investors. We explore these challenges in market connectivity in greater detail below.

Further, prices of tokenized equities may diverge from their underlying stocks due to differences in trading practices, such as different market rules and trading hours. This can hinder price discovery, as the price of the tokenized equity – or multiple prices of different tokenized equities – may not accurately reflect the real-time price of the underlying asset, the actual stock. For example, there could be multiple prices for Apple stock in different forms on different markets, confusing investors. These activities could pose significant risks to investors.

How can regulated entities access decentralized markets while still meeting their AML/KYC obligations?

It is uncertain how broker-dealers, who are required to have detailed knowledge of their clients in order to meet robust AML and KYC requirements, would be able to participate in decentralized markets, which have often been characterized by both open access to the network and bilateral trading among participants.

Broker-dealers have extensive regulatory obligations that require them to conduct due diligence on their clients before initiating any trades, requirements which are statutorily mandated by the Bank Secrecy Act (BSA) and the USA PATRIOT Act, among other laws. These requirements are embedded in robust AML and KYC programs that require collecting information on clients as part of their on-boarding process, and to identify and report suspicious activities to regulators and law enforcement. It is not clear how broker-dealers could meet these requirements while participating in a decentralized marketplace given the degree of open access they provide and the prospect of trading with unvetted clients.

If regulated tokenized securities products were to be offered in decentralized markets, but broker dealers and asset managers could not participate in those markets while remaining compliant with illicit finance regulations, it would likely create disconnects in pricing and liquidity between DeFi markets for tokenized securities and the broader markets for those securities, reducing market quality and harming investors.

How can decentralized securities trading models be integrated into broader market structures?

While market structure in U.S. equity and options today features multiple exchanges – and a range of other trading venues in equities, such as alternative trading systems (ATSs) and single dealer platforms – these trading venues are all connected to form an integrated market through regulations and infrastructure providing both pre-trade price transparency and post-trade price reporting.  These features are foundational to integrated, liquid markets and securing best execution on behalf of investors.

However, it is uncertain if and how decentralized trading models for tokenized equity and other securities would be able to be integrated into this broader market structure.  There is currently an absence of any formal requirements for structured pre or post trade price transparency in DeFi networks or for connection to the broader information sharing mechanisms of the U.S. securities markets.  As discussed above, this would likely result in bifurcated markets, price discrepancies, and challenges in ensuring that investors receive the best executions on their orders.

How does DeFi differ from existing approaches to engaging in securities transactions without a broker?

There are several approaches to engaging in securities transactions without a broker. However, these approaches are very limited. These approaches often rely on transfer agents, and transfer agents are poorly positioned to service as intermediaries because they are not subject to the obligations to protect investors that broker-dealers are.

One approach are the Direct Stock Purchase Plans (DSPPs) operated by issuers and their transfer agents, where companies offer DSPPs or dividend reinvestment plans (DRIPs) that allow investors to buy shares directly from the issuer through their transfer agent without a broker. Another is the direct sale of physical stock certificates, which can be sold without a broker by working directly with the company’s transfer agent. However, this requires the seller to individually identify a buyer, to have a physical security, to work with the company’s transfer agent, and to work through the process exchanging the security for cash with the buyer without protections if there is fraud involved.

While these approaches exist today, they are fundamentally different from the large, open-access trading models envisioned by DeFi proponents.  Any hypothetical models which provide exemptions from broker registration for DeFi systems developers in the securities markets would need to either limit their activities to the constraints of these established programs, or limit them to ministerial type roles and functions  in support of markets with regulated intermediaries. These limited approaches that exist today do not provide a precedent for unregulated entities to establish or support broad-based securities markets without the protections offered by FINRA rules, Reg NMS and the broader securities regulatory framework.

Conclusion

While decentralized finance offers innovative models for peer-to-peer trading and potential efficiencies in tokenized securities markets, it also introduces profound regulatory and market integrity challenges. Policymakers must carefully distinguish between genuinely decentralized technologies and applications that effectively serve as intermediaries, ensure investor protection and AML/KYC safeguards are not compromised, and avoid definitions or exemptions that could create regulatory arbitrage and fragmented markets. Without addressing these foundational issues, introduction of DeFi trading models in the securities markets risk undermining the transparency, liquidity, and investor protections that underpin the U.S. capital markets.

Authors

Peter Ryan is a Managing Director and Head of International Capital Markets and Strategic Initiatives at SIFMA.

Charles DeSimone is a Managing Director and Deputy Head of the Technology, Operations, and BCP group at SIFMA.

Related Resources

• Blog

  Modern Markets, Enduring Protections: Protecting Investors in Tokenized Securities

• Podcast

  Tokenized Securities: The Case for Investor Protection