An economic analysis of safe harbor for blockchain applications

Miles Jennings, Scott Walker, and Aiden Slavin
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Bringing traditional securities on-chain is a central focus of this Securities and Exchange Commission (SEC). Recognizing the potential of tokenization, the Commission under Chairman Atkins, launched Project Crypto 9 months ago with the aim of updating American securities rules and regulations. The goal is to enable the nation’s financial markets to move onchain, which allows for instant settlement, 24/7 markets, reduced costs, and more.

But to unleash the full potential of tokenized securities, innovators and investors need clear rules of the road for blockchain applications that allow users to transact in tokenized securities on a peer to peer basis, without intermediaries.

So we and DeFi Education Fund submitted a safe harbor proposal last August to the SEC outlining the criteria for when such blockchain-based applications — the neutral software programs that enable users to interact with public blockchain networks and smart contract protocols — should be excluded from registration requirements under the Securities Exchange Act of 1934. The approach outlines how such applications benefit market participants while advancing the Securities and Exchange Commission’s mission of protecting investors, maintaining fair, orderly, and efficient markets, and facilitating capital formation.

Today, Vanderbilt Professor Craig Lewis — former SEC Chief Economist and Director of the Commission’s Division of Economic and Risk Analysis — just submitted to the SEC his economic analysis of our safe harbor for software proposal. Lewis’ analysis focuses specifically on the proposal, but more broadly conveys the economic costs and benefits of tokenized securities — thus providing valuable insights about the potential of blockchain technology to revolutionize the legacy financial system. While a16z provided financial support for this work, Professor Lewis applied his own rigorous methodology in assessing how to measure the benefits and costs of the proposal.

As part of his analysis, Lewis identifies 5 benefits that the safe harbor could enable qualifying apps to unlock:

  • Atomic settlement — which eliminates the counterparty credit risks associated with delayed settlement windows, and also mitigates the systemic danger of a central counterparty failure cascading throughout the broader market.
  • Onchain transparency — which replaces opaque proprietary ledgers with a more publicly verifiable record of every transaction.
  • Continuous 24/7 trading of tokenized securities — which expands price discovery and liquidity beyond the geographic and temporal limits of traditional exchange hours.
  • Concrete direct cost reductions driven by smart contracts — which automate corporate actions like dividend payments and certain compliance functions. He points out that research from Ripple and BCG, for example, estimates that tokenizing an investment-grade bond could cut operating costs by 40 to 60% relative to traditional issuance.
  • Lower barriers to entry — which could result in new developers exerting competitive pressure on traditional finance institutions, forcing those intermediaries to innovate in a manner that ultimately benefits users.

Lewis also outlines these 4 potential costs of the safe harbor proposal:

  • Eroding investor protections. Lewis performs a side-by-side analysis of traditional broker-dealers and qualifying apps, concluding that the proposal’s narrow scope preserves investor protections by limiting eligibility to software that does not create the risks these regulations are designed to mitigate. However, Lewis flags certain novel risks; for example, while the broker-dealer regulatory framework enables intermediaries to freeze assets and reverse transactions as an investor protection mechanism, eligible apps — by design — do not possess this capacity.
  • Regulatory arbitrage. Traditional broker-dealers could restructure themselves as qualifying apps to escape certain obligations. However, Lewis ultimately avers that the operational machinations required for a traditional intermediary to meet the proposal’s strict criteria would be prohibitive.
  • Tokenized securities. Expanding tokenized securities trading risks fragmenting the market and potential systemic spillovers, with leverage in DeFi protocols potentially transmitting stress to traditional markets. However, Lewis recommends benchmarking this risk against the dark pools and off-exchange venues that already fragment the traditional securities market today, and notes that decentralized market structures have consistently exhibited operational resiliency, even during periods of high volatility.
  • DeFi trading costs for retail. Lewis points out that variable gas fees, price slippage, and smart contract code vulnerabilities are all real risks, but argues that a proper comparison must examine those relative to the embedded costs that already exist in traditional finance. He also notes that DeFi fees are declining sharply. In this regard, Lewis observes that Ethereum’s Dencun upgrade, for example, reduced the cost for L2s to post data to mainnet by over 90%.

Lewis’ analysis was scoped specifically to front-end applications that satisfy the safe harbor proposal’s eligibility criteria, emphasizing that applications meeting the following four criteria are passive software interfaces that, by design, do not create the risks the Exchange Act was built to address. Specifically, that they have:

  • Non-custodial architecture
  • No discretionary trade execution
  • No solicitation or investment recommendations
  • Exclusive integration with genuinely decentralized protocols (with certain allowances for protocols pursuing decentralization in good faith)

Lewis further emphasizes that the relevant comparison is not between those blockchain apps and some idealized market structure, but between them and the existing broker-dealer system, with all its embedded and often invisible costs: DTC fees, clearing and settlement charges, intermediary markups, insurance buffers, and others.

Ultimately, Lewis concludes that: “Should the SEC conduct a formal economic analysis of these costs and benefits, it would likely find that the Safe Harbor would facilitate the realization of the significant economic benefits inherent to tokenized securities.”

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Tokenization “could transform the financial system as we know it”, as Chairman Atkins has observed — and the Commission has supported that vision with Project Crypto, landmark joint staff guidance, and more.

But realizing the full potential of tokenized securities also requires clear and effective rules for the blockchain applications that enable investors to transact in these assets on a peer to peer basis without intermediaries. This is what our safe harbor proposal aims to provide and, as Professor Lewis’ analysis confirms, the overall economic case for adopting it is compelling. There are tradeoffs, but the benefits should outweigh any costs.

Professor Lewis has drawn the map. We encourage the Commission to follow it.

Acknowledgements: Thank you to Amanda Tuminelli, Bill Hinman, Michele Korver, David Sverdlov for their contributions to the original safe harbor proposal, and other helpful feedback.

 

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