It’s time to bring assets onchain

2.4.25

Editor’s note: This op-ed is part of a bigger package of crypto policy views. Find the rest here: “Making the U.S. the crypto capital: What it would take.”

A significant number of projects over the past several years have “tokenized” so-called real world assets, turning more than $20 billion in everything from debt to diamonds and more into tokens. Tokenization may sound like some kind of mysterious alchemy, but the concept is simple: It means “creating a digital representation of” some physical thing — a stock, bond, commodity, or other asset — in a database, usually a blockchain or distributed ledger. The token serves as a financial record.

However, most of these projects either have launched outside the U.S., or have been forced to limit their operations to cut off the world of digital finance from the rest of the financial ecosystem. U.S. regulators have to date mostly failed to appreciate the many benefits of tokenization, and so have enforced artificial and arbitrary distinctions that effectively disallow it in traditional finance. In the past few years the U.S. Securities and Exchange Commission has drawn hard and fast lines between tokens and other assets. It has done this even though its own pre-existing regulatory frameworks around financial recordkeeping would otherwise allow it. The time is now to remove these flawed and untenable restrictions in place of appropriate measures.

Financial records have taken various forms over the years, from written ledgers to tapes to electronic systems. As recently as a few years ago, the U.S. Securities and Exchange Commission (SEC) required brokers to maintain their electronic records “exclusively in a non-rewriteable, non-erasable format” — a permanent record, in other words. Firms were forced to maintain a mirror set of records on obsolete media such as tapes and optical disks for official purposes even as they kept books and records for actual use in modern formats, like cloud storage. It was wasteful and backwards.

To the SEC’s credit, it amended the record keeping rules in January 2023. The change permitted firms to use electronic records as long as the systems provided for a complete audit trail, enabling original records to be recreated even if modified or deleted. There was no specific requirement for the type of database in which these records must be stored, as long as the audit trail requirements were met.

Theoretically, this should have opened the door to using the latest and most sophisticated technologies available — including blockchains and distributed ledgers. The benefits of such systems — advancing liquidity, reducing counterparty risk and trade failures, and creating efficiencies across markets — make them a compelling choice. Through blockchains, outdated systems could be replaced with technologies that streamline the process of execution and clearing of trades. Arcane and completely unnecessary registered entities such as transfer agents could be cut out entirely. Data reconciliation could occur automatically by connecting the systems of various financial intermediaries. And reporting could be automated by including self-regulatory organizations as observers. Indeed, what better audit trail than an indelible blockchain that shows a record of all transactions?

But U.S. regulators haven’t seen it this way. Through informal guidance and statements (rather than formal rulemaking and legislation), they have severely curtailed the adoption of blockchains and distributed ledger technologies across the financial industry. For example, a joint statement issued by the SEC and the Financial Industry Regulatory Authority (FINRA) in 2019 effectively prohibited registered broker-dealers from holding tokenized securities on behalf of customers. Their statement said that it may be impossible for broker-dealers to establish that they have “control” over tokenized securities, making it infeasible to comply with customer protection rules. They cited the risks of fraud and theft as well as information security risks.

This prohibition misses the mark. Financial institutions already all use digital records to evidence possession or control. Paper stock certificates have been obsolete since the paperwork crisis of the 1960s and, since then, various institutions in the chain of custody have represented interests in securities through ledger entries. The concerns about tokenized securities cited by the regulators — potential loss of private keys or misdirected transfers — are technical considerations similar to those associated with the transformation of markets to digital records, and these technical considerations already have many solutions in the marketplace.

The 2019 guidance seems to posit that tokenized securities are different in character from securities whose records are maintained in non-distributed ledgers. No one would think to view these non-distributed records as separate assets from the rights in the shares themselves, or that these records are somehow regulated differently from the shares. Ownership rights in securities can be recorded in written or electronic form, but the ink or computer code does not replace the rights; if a copy of a ledger is made, the owner of an asset listed on the ledger does not suddenly have an entitlement to twice the number of securities that it did before. Just so, it does not appear necessary to regulate the tokenized representation of a security as anything different from the security itself.

If not for U.S. regulators’ somewhat recent artificial and arbitrary restrictions, existing regulatory frameworks would already allow financial industry participants to use blockchains to record transactions in traditional assets — securities in particular — without thinking of digital tokens as separate from the assets they represent. While the SEC has allowed a narrow subset of broker-dealers to maintain blockchain-based records through guidance issued in 2021, this guidance is extremely narrow, limited to broker-dealers who deal only in digital asset securities. Most large broker-dealers deal in many types of securities and have legacy recordkeeping systems that would need to be transitioned to blockchain-based systems over time. The SEC’s current guidance precludes that from happening. It’s unsurprising therefore that pilot projects relating to blockchain-based securities records have taken place in the UK, the EU and Singapore…but not the United States.

While the full realization of the initial dream of blockchains in finance may be years off, there is no reason for the industry to subject itself to additional regulatory impairments when the legal infrastructure already exists to support the recording of asset transactions onchain. Assets are just assets, regardless of their material qualities. How their records are kept should mostly be a matter of housekeeping, with the most advantageous technology prevailing.

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Jenny Cieplak is a partner at Latham & Watkins LLP who advises fintech and financial services clients on the development and deployment of new technologies. Her practice converges at the intersection of industry regulation, emerging technology, and financial services.

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