SEC Crypto Assets Working Group Roundtable: Tokenization of Our Dream Land?

How is the future of tokenization securities? SEC commissioner questions its feasibility.

Written by: Commissioner Caroline A. Crens

Compilation: Vernacular Blockchain

Today's theme is very broad, perhaps the broadest topic discussed in the crypto task force roundtable to date: tokenization. I understand that today's discussion will mainly focus on potential regulatory efforts to promote tokenization.

This topic reminds me of a famous quote from the movie "Field of Dreams" (Field of Dreams) — "If you build it, they will come." You might remember that this movie stars Kevin Costner (Kevin Costner), who plays the farmer Ray Kinsella (Ray Kinsella), inspired by a mysterious voice to plow his cornfield and build a baseball field, firmly believing that great things would happen.

I think this has some similarities with the current enthusiasm for tokenization. Blockchain technology has been around for a long time. Although some limited use cases have been introduced recently, it has not been widely used for the issuance and trading of registered securities. Some believe that if we "build" – or more accurately, "rebuild" the financial system to adapt to blockchain, "they" various market participants will flock to embrace tokenized securities. Investors will benefit from increased participation and choices, and the market will thrive due to the improvements brought by blockchain.

To this, I would like to first ask, what exactly are we trying to build? What is tokenization? Even within the realm of the SEC, this term is difficult to define simply. Is tokenization referring to the direct issuance of securities on the blockchain? Or does it refer to the digital representation of securities created on the blockchain? This seems to be a subtle distinction, but it could have significant implications from a regulatory perspective. Furthermore, should tokenization encompass the distribution, trading, clearing, and settlement after issuance? In other words, will the entire lifecycle of the securities be 'on-chain', or just a part of it?

No matter how we try to answer these defining questions, it is clear that the tokenized financial system is unlike any system we have seen before. It is not as well-known or easily understood as the baseball stadium built by Ray Kinsella. Many envision a fully tokenized system where any security, including highly traded liquidity products such as stocks of Fortune 500 companies, can be issued, traded, cleared, and settled on the blockchain.

Is this technically possible? If we are talking about public permissionless blockchains, at least based on the current state of affairs, the answer seems to be negative. Transaction volume limitations and other scalability issues are well known. The whole concept of public permissionless blockchains—designed to provide trust without government oversight—seems to be an unsuitable tool for complex and heavily regulated areas like the securities market.

If we are discussing private or permissioned blockchains, will it improve the potential for scalability? Even if it can, what is the qualitative difference compared to other database technologies that are already widely used? Does this require any regulatory adjustments?

It seems that no one opposes the SEC maintaining a "technological neutrality" regulatory stance. So, why do we need to evaluate specific forms of blockchain as candidate technologies for industry adoption? Why do we specifically focus on blockchain rather than other types of distributed ledger technologies? The regulatory efforts to promote blockchain – not to mention its specific forms – appear to be the government picking winners and losers. Moreover, it seems we are doing this before the technology has been proven suitable for its intended use.

Aside from the question of what we are trying to build, why are we building it? Supporters believe that tokenization can accelerate transaction settlement and make the market more efficient. The current settlement cycle is T+1 day after the ( trading day, and tokenization may push us towards instant settlement or 'T+0'. There is also a viewpoint that instant settlement can reduce counterparty risk because transactions will be pre-funded. However, while the settlement cycle has been shortened compared to the past, it is a design feature rather than a flaw. The intentional delay between trade execution and settlement supports core market functions and protective mechanisms.

For example, the settlement cycle facilitates netting )netting(. In simple terms, netting allows counterparties to settle a day's trades on a netting basis, rather than on a case-by-case basis. The complexity of multilateral netting in our national clearing and settlement system has dramatically reduced the volume of transactions that require final settlement. On average, 98% of trading obligations are eliminated through netting. This allows the current system to handle huge transaction volumes. This is one of the key reasons why the market has been able to remain stable in the face of consistently record trading volumes recently.

Net settlement also promotes liquidity. Since the vast majority of transactions are settled through "net settlement" without actual settlement, they do not require the exchange of funds. If A sells to B, B sells to C, and C sells to A, these transactions are matched and canceled out. A, B, and C can all retain their funds, whereas in bilateral instant settlement on the blockchain, everyone must at least give up cash for a period of time.

Another important consideration is that instant settlement is often unfavorable for retail investors, many of whom currently rely on the ability to submit payment after placing an order.

We must also remember that key compliance activities will take place during the settlement period. These activities include checks aimed at identifying and preventing fraud and cybercrime. The ability to suspend transactions and conduct investigations when warning signs appear is crucial for protecting investors and for broader issues such as national security and counter-terrorism.

Based on these and other reasons, it is unclear whether shortening the existing settlement cycle is desirable or feasible. Domestic and foreign regulatory agencies and major market participants have raised compelling objections to this.

I believe that, as regulators, it is our statutory duty to remain extremely cautious regarding potential changes of this scale, as such changes in history typically occur only in response to genuine market crises. While there is indeed room for improvement in our markets, I am curious whether the changes discussed today will address any existing specific issues. In "Dreamland," Ray Kinsella's belief in "If you build it, they will come" ultimately brought him good results. However, Ray's choices and risks were limited to his family and farm. The SEC, as the overseer of the U.S. capital markets, must recognize that the systemic changes we are discussing could affect every market participant, from Wall Street to the general public.

Let us ensure that the measures we consider are appropriately limited to the segment participating in the cryptocurrency market - recently estimated to account for less than 5% of American households - and that they do not harm the traditional financial )TradFi( market, on which the majority of Americans rely for their financial well-being.