The CEO of the Securities Industry and Financial Markets Association (SIFMA) has written to the Securities and Exchange Commission (SEC) expressing concerns relating to tokenized securities. SIFMA members have read press reports implying that digital asset firms might receive SEC no action letters or exemptive orders for trading tokenized traditional securities on digital asset platforms. In other words, the digital asset firms won’t have to comply with the same securities rules that SIFMA members adhere to.
Given this could have far reaching consequences for capital markets, SIFMA would prefer to see the process follow the SEC rulemaking process “which allows for public notice and comment, oversight, and broad industry engagement.” SIFMA raised similar issues in a longer letter last month responding to SEC requests for information.
An example given by SIFMA was Coinbase looking to trade tokenized securities in the United States. In the past week there has been a flurry of activity on this front, mainly US digital asset brands launching tokenized securities in Europe. This includes Robinhood, Kraken and Gemini. Last week crowdfunding platform Republic announced US-based “mirror tokens”. The company plans to acquire INX, a licensed alternative trading system (ATS) to support trading. While Coinbase owns a FINRA registered broker-dealer, it does not own an ATS. Yet. Coinbase’s moves appear to align with thinking at the SEC.
SEC Commissioner Peirce mulled exemptive orders
During a May speech SEC Commissioner Peirce said the SEC was considering a “potential exemptive order that would allow firms to use DLT to issue, trade, and settle securities.” Her rationale was that the tokenized securities market faces a circular challenge: firms may be reluctant to bear the costs of registering as broker-dealers, exchanges, or clearing agencies given the currently limited market size. However, this market constraint perpetuates itself, as issuers are deterred by the insufficient secondary trading infrastructure.
Commissioner Peirce’s proposed exemptive order would potentially address this bottleneck by allowing digital asset platforms to bypass traditional market structure requirements.
At issue is a desire by digital asset firms to apply the efficiencies they achieve in crypto trading to the securities markets. That means merging exchanges, brokers, clearing systems, and probably custody into one platform. Their logic is if a trade is agreed between the consumer and the exchange and immediately settled atomically, why do you need a broker or a separate clearing platform? There’s some logic to that, but making that change overnight would be more than a little disruptive to capital markets.
However, the consolidation of multiple market functions raises operational and risk management concerns. The collapse of FTX, which had argued for similar platform unification including custody, serves as a cautionary example. By contrast, the EDX institutional digital asset trading platform founded by incumbents uses a single third party custodian and segregated clearing.
Given these risks, the stakes for regulatory decisions are particularly high. If Coinbase gets a no-action letter, Robinhood and others will expect one as well. These two platforms alone account for roughly 10 million and 12 million monthly active users respectively.
Coinbase digital securities proposals
The potential ripple effects become clear when examining Coinbase’s proposals, which represent very substantial changes to market structure, although they expect that parts may be implemented via rulemaking. Beyond collapsing segregated functions, it wants to be able to operate 24/7 trading without intermediaries. Coinbase would also like to see exceptions from National Market System (NMS) rules which would apply to a digital asset platform that hosts the trading of a listed stock, such as a tokenized TSLA stock.
One potentially controversial example is the best execution rule requiring that a broker shouldn’t execute an order when there’s a better price displayed on another venue. Coinbase argues that this only accounts for price rather than the size of the order or the ability to meet demand at that price. It claims that bitcoin and ether have “better market quality measures” than the vast majority of stocks.
“To this end, the Commission should give markets an opportunity to operate without the cumbersome artifice of legacy order routing requirements until and unless markets do not develop in a way that demonstrates they cannot or chose not to provide high execution quality,” Coinbase argued in its digital securities recommendations submitted in March.
This is just the opening flurry of what will be a lively discussion between startups and incumbents. Significant market structure changes are starting to look likely. The art will be to balance innovation and market stability in determining the timescale.
