Podcast: Using Security Tokens to Facilitate Capital Formation

Emerging technologies such as distributed ledger technology (DLT) and digital assets like security tokens offer new and cost-efficient methods of capital formation.

In this podcast, SIFMA president and CEO Kenneth E. Bentsen, Jr. and managing director Tom Price discuss SIFMA’s new white paper on security tokens. The paper, entitled Current Regulatory and Operational Considerations for Broker-Dealers and a Look Towards the Future and co-authored by SIFMA and PricewaterhouseCoopers LLP, provides a foundational understanding of how distributed ledger technology and digital assets such as security tokens interplay with the current securities market. It also describes the key operational challenges faced by U.S. broker-dealers hoping to adopt this technology and recommends where regulatory clarity would be helpful in addressing these challenges.

Edited for clarity

[Ken Bentsen] Thank you for joining us for this episode in SIFMA’s Podcast Series. I’m Ken Bentsen, SIFMA’s President and CEO. I’m joined today by my colleague, Tom Price, Managing Director and Head of SIFMA’s Operations, Technology and Business Continuity Planning Team, to talk about the securities token white paper coauthored by SIFMA and PricewaterhouseCoopers, LLP.  So with that, let’s get started. Tom, thanks for joining me today

[Tom Price] Thanks, Ken. Glad to be here.

[Ken] So as a jumping off point, can you define security tokens?

[Tom] Yes, Ken. A security token is a digital form of a security that satisfies the applicable regulatory definition of a security. For example, it could represent an investor’s interest in common stock ownership. In effect, it’s a digital representation of a security that relies on a blockchain. In the case of a common stock, security tokens would represent an investor’s ownership stake in a company, and that ownership interest would be preserved on a blockchain.

Further to that point, a blockchain is a type of Distributed Ledger Technology, also knows as DLT, that recalls all transaction in the network that is theoretically unchangeable. And its digitally recorded data package is called flux. Each block contains a batch of records of transactions, including a timestamp and a reference to the previous block, linking the blocks together in a chain.

Ken, while we’re at the 30,000-foot level, do you want to talk a bit about the paper and what it covers and why it was developed?

[Ken] Sure. So we’ll start from the premise, of course, that the United States has the deepest and most liquid capital markets in the world, facilitating growth and innovation across all industry sectors. And throughout the years, the U.S. capital markets have continued to innovate as technology has allowed for rapid and significant advances. And so over the last few years, as DLT has rapidly gained interest in the securities industry, including to SIFMA, and many of us are members, this is something that we increasingly wanted to take a look at.

And so in response to these efforts and the industry’s desire to support innovation, we had developed the white paper for really two principal reasons: one, to provide an understanding of how DLT and digital assets such as security tokens interplay with the current securities market; and two, to provide the key — to describe, rather, what the key challenges faced by U.S. broker dealers are, hoping to facilitate the security’s life cycle using this technology and to recommend where regulatory clarity or amendment would be helpful in addressing these challenges.

Tom, you’ve been having conversations with members about DLT. What are some of the ways that it’s being used today, and how do the regulators view DLT?

[Tom] Important question, Ken. First, regulatory — regulated financial institutions, market infrastructure providers, and market participants in general are looking to explore how the technology could help advance the development of capital formation, improve the transference and value across parties.

By and large, the U.S. securities industry is exploring the potential benefits of using DLT, including and not limited to using the technology to create efficiencies and issuance; leverage the blockchain to create efficiencies in clearing and settlements; the possibility of creating efficiencies; creating efficiencies in automating regulatory compliance, which is an important point; also to integrate programmability into an asset via smart contract; leverage data immutability; and improve trade efficiencies.

And then to build on your previous points, in the paper we looked at the life cycle of a security and the characteristics of a security token life cycle. These are truly exciting times with the development of new technologies that will continue to create efficiencies in our complex financial markets’ infrastructure. Think about the possibilities of trading, clearing and settling and custodying a security in a more efficient way.

The goal is to embrace innovation that creates efficient market structures, while still providing the same investor protections that we have built up over decades. Regulators have been engaged in the dialogue around these issues through public statements such as the SEC and FINRA 2019 joint statement on security tokens, and by engaging market participants directly.

To date, we’ve seen global regulatory authorities issue licensed entity servicing digital securities. A few have approved Regulation A security token offerings. One public company sought to issue a completely digital dividend that evolved into a courtesy copy being available through a digital format. In addition, we have a proposed trading facility for the listing and trading of a new type of tokenized equity security.

And lastly, even the first ever effectiveness of a public offering of a security native to DLT in the U.S. Truly, we’re at the early stages of evolution, in my view. Ken, you mentioned the challenges faced by U.S. broker dealers hoping to facilitate the securities life cycle using security tokens. Can you expand on that?

[Ken] Sure. Well, first, the white paper covers each phase of the security’s life cycle applicable to the security token. You talked a little bit about that. And these include the finding of security, issuance, trading, clearing and settlement, and custody and consumer protection, and impact on retail investors. As we think about securities token — security tokens, rather, there are a number of issues across the life cycle of a security to work through.

However, our member working group identified three priority areas stakeholders and regulators will need to address in order for the market to fully develop. Number one, whether DLT would be sufficiently robust to act as the registrar or to satisfy books and records requirements. Number two, how to meet possession or control requirements such as SEC Rule 15C33, the customer protection rule, when using DLT-based systems.

And number three, whether certain parties involved in the clearing and settlement of a transaction require registration as a clearing agency.

[Tom] Those are good points, Ken. I think those are some of the issues that we still need to work through as an industry, working with regulators – the books and record requirements, possession or control requirements, as well as the whole issue on clearing agency. As we work through these questions, we can think about where DLT goes from here. What is your view of the future?

[Ken] Well, DLT is still in its early stages, but it’s exciting to think about how this is going to develop. As security tokens and their underlying technologies mature, securities markets may rely on DLT platform for a broader range of market functions. And if that happens, we’d expect to see regulations evolve to cover new technology, as it has in the past.

I’d also like to highlight that in order to preserve the integrity of the markets, there are key safeguards that have been put in place over the past hundred years or so that must be maintained. These are protections built around rules for custody and safekeeping of assets, trading, and customer protections and other important areas designed to maintain an expansive, stable, liquid, and equitable market structure.

SIFMA and its members fully support these protections, as well as the robust and competitive marketplace that has evolved from it. In parallel, we also acknowledge that some of the requirements in place may need to be interpreted or amended to allow for the industry to take full advantage of this new technology.

So Tom, any last takeaways from the white paper you’d like to highlight?

[Tom] As with any new technology, Ken, it’s vital to determine which factors will be key building blocks or, conversely, stumbling blocks to growth. And the paper was written with that in mind. We believe that it offers broker dealers wanting to transact in security tokens key issues to consider, to ensure they can meet their regulatory, operational, and investor protection obligations under the SEC and FINRA rules and regulations.

As the industry moves forward with a broader adoption of these types of assets and their supporting technologies, we hope the points raised in this paper will encourage further dialogue between the industry participants and their regulators.

[Ken] Well, Tom, thank you for being with us today to talk about this important piece of work, and congratulations to you and your team and our colleagues at PricewaterhouseCoopers for preparing the security tokens white paper. To learn more about SIFMA and this white paper and our work to promote effective and resilient capital markets, please visit us at www.sifma.org, and thank you.

Kenneth E. Bentsen, Jr. is president and CEO of SIFMA, the voice of the nation’s securities industry. He is also chief executive officer of the Global Financial Markets Association (GFMA). Tom Price is a managing director and head of technology, operations and business continuity for SIFMA.