Yesterday a House Financial Services Subcommittee hearing on tokenization laid bare confusion and political differences relating to public blockchains and tokenized securities. More than one Democrat complained that the FIT 21 crypto Bill recently passed by the House would allow securities issuance without the usual safeguards. Those statements needed caveats, making some of them inaccurate. The other bone of contention and confusion was around public blockchains and compliance.
All the witnesses were in agreement on the benefits of tokenization. They said it will create efficiencies in the issuance, servicing and settlement of tokenized securities transactions. Potentially, fractionalization could enable distribution to a broader set of investors.
Public blockchains can support KYC, AML and other controls
The main differences related to public blockchains. Two witnesses suggested public blockchains should be avoided for tokenized traditional securities. Congressman Casten, one of the more thoughtful representatives, has major issues with public blockchains that stem from anonymity.
Several media outlets reported that people sent various crypto tokens to BlackRock’s BUIDL wallet, which Congressman Casten viewed as indicating that activities on a public blockchain are beyond control. Some random person that discovers my bank account number could send me money I didn’t request. That doesn’t mean the banking system lacks controls.
Carlos Domingo, CEO of Securitize noted that the wallet was in fact not the BUIDL wallet. Securitize is responsible for tokenizing BlackRock’s BUIDL fund. He added, “The tokens we issue, they’re only transferable to white listed wallets.” He objected to statements implying it wasn’t possible to have transactions on a public blockchain that comply with KYC and anti money laundering laws. Public blockchain securities issued by Franklin Templeton and WisdomTree are also compliant in a similar manner.
Outside of the U.S., a handful of large institutions have already used public blockchains for securities. In 2019 Societe Generale issued a €100 million bond on the public Ethereum blockchain, followed in 2021 by the European Investment Bank with a bond for the same amount. Bondholders were identified and whitelisted. Several large institutions are experimenting with more complex regulated transactions on public blockchains in Singapore’s Project Guardian.
In Europe, the DLT Pilot Regime supports experimentation with real digital securities transactions. One of the Pilot Regime applicants outlined controls that address the frontrunning aspect of some public blockchains.
As noted by one of the witnesses, blockchains involve layers. The blockchain itself may have anonymous validators, and it’s hard for regulators to control or influence the core infrastructure. However, it’s possible to impose controls at the smart contract level and tokens are often smart contracts.
Does FIT 21 Act allow securities a free pass?
While the FIT 21 crypto Bill was passed with 71 Democrat votes, other Democrats are still licking their wounds. Congressman Sherman, while generally anti-crypto, is usually quite thoughtful. He said, “The FIT 21 Act included an extremely dangerous title dealing with investment contract assets. This would open the door for existing publicly traded companies to avoid regulation by tokenizing their securities and calling them investment contracts.”
With respect, we believe Congressman Sherman’s statement to be false because the situation is far more nuanced. This comment may have been based on the testimony of one of the witnesses who referred to the definition of an investment contract asset.
Here’s the relevant clause in the FIT 21 Act:
The term’ investment contract asset’ means a fungible digital representation of value —
(A) that can be exclusively possessed and transferred, person to person, without necessary reliance on an intermediary, and is recorded on a cryptographically secured public distributed ledger;
(B) sold or otherwise transferred, or intended to be sold or otherwise transferred, pursuant to an investment contract; and
(C) that is not otherwise a security pursuant to the first sentence of paragraph (1).
The FIT 21 Act nuances
The reason for the nuance is the last two words that reference ‘paragraph (1)’ of United States Code 77b(a). That paragraph lists several instruments included in the definition of securities, such as stocks, bonds, treasuries, fractional interests in oil and gas, profit sharing agreements, certificates of deposits, etc. So these would not be classified as an investment contract asset. Hence, if a publicly traded company tokenizes its securities it will not be an investment contract asset.
However, other tokenized assets that today might be regarded as securities could potentially qualify as investment contract assets, such as the tokenization of a piece of art or a fractional NFT.
Meanwhile, a key objective of the hearing was to explore potential legal changes to facilitate the tokenization of real-world assets. This was mainly covered in written testimony from Securitize and the USDF Consortium. We may publish a separate piece summarizing their suggestions.
The author is a not a lawyer and this is not legal advice
