The Road Ahead For Digital Assets Looks Promising

Originally published on Law360

The financial services industry is increasingly looking to blockchain technology to modernize financial markets.

Using blockchain technology to tokenize a security or other asset — or digitally representing that security or other asset as a token on a distributed ledger — has the potential to reshape financial markets, in both significant and less significant ways.

Potential benefits include shortened settlement periods, the mobilization of dematerialized securities (potentially enhancing collateral mobility and liquidity), fewer geographical or time restrictions on trading and tradability, and the automation of more routine compliance functions (potentially streamlining identity verification).

In his annual letter to investors released earlier this year, BlackRock Chairman and CEO Larry Fink highlighted the potentially revolutionary impact of tokenization:

Every stock, every bond, every fund — every asset — can be tokenized. If they are, it will revolutionize investing. Markets wouldn't need to close. Transactions that currently take days would clear in seconds. And billions of dollars currently immobilized by settlement delays could be reinvested immediately back into the economy, generating more growth.¹

U.S. Legislative and Regulatory Developments

In the U.S., the Genius Act — signed into law in July — creates a federal regulatory framework for the issuance of so-called payment stablecoins. It also clarifies their status as neither securities nor commodities,² and is expected to accelerate the adoption of blockchain-based payment systems.

The U.S. House of Representatives also recently passed the Clarity Act, which would create a federal regulatory framework and address the market structure for digital assets.³ Although the Clarity Act will likely evolve as it makes its way through the legislative process, the final legislation, if passed, would fundamentally change how digital assets and related market participants are regulated in the U.S., and would likely accelerate the convergence of traditional finance and decentralized finance.

Against this legislative backdrop, the U.S. Securities and Exchange Commission has taken a markedly more permissive approach to digital assets and blockchain technology. This represents a significant shift from the prior administration.

For example, at the SEC's Crypto Task Force's May roundtable on tokenization,⁴ SEC Chairman Paul Atkins compared the movement of securities from "traditional (or 'off-chain') databases to blockchain-based (or 'on-chain') ledger systems" to the evolution of how we consume music: from vinyl records, to cassette tapes, to digital music files.⁵

He also noted that "[b]lockchain technology holds the promise to allow for a broad swath of novel use cases for securities, fostering new kinds of market activities that many of the [SEC's] legacy rules and regulations do not contemplate today."⁶

Shortly thereafter, the SEC's Division of Trading and Markets and the Financial Industry Regulatory Authority withdrew a controversial 2019 joint statement on broker-dealer custody that had imposed major obstacles to SEC-registered broker-dealers taking custody of digital assets, including digital asset securities.⁷

The SEC staff subsequently issued more accommodative guidance in the form of a series of FAQs addressing certain blockchain- and digital asset-related activities of SEC-registered broker-dealers and transfer agents. These FAQs included clarifications that transfer agents can use blockchain technology to maintain their official master securityholder file and that brokers can hold digital asset securities in uncertificated form in good control locations.⁸

Equally important is the SEC's recent willingness to consider changes to the National Market System, which sources quotations from across the national securities exchanges to generate a national best bid or offer. SEC Commissioner Hester Peirce, in particular, has publicly considered the issuance of a conditional exemptive order to allow firms to use blockchain technologies to issue, trade and settle securities. That exemptive order may be subject to conditions around:

• Market integrity measures to prevent fraud and manipulation;
• The availability of disclosures to users about a platform's products, services, operations, conflicts of interest and risks, including smart contract risks;
• Compliance with recordkeeping and reporting requirements;
• Monitoring and examination by SEC staff; and
• Maintaining adequate financial resources for operations.⁹

This more accommodative regulatory posture extends beyond the SEC.

U.S. federal banking regulators issued a joint statement in July for banking organizations that provide, or are considering providing, digital asset safekeeping for their customers.¹⁰ Although the joint statement does not create any new supervisory obligations, it highlights the issues and risks that banking regulators expect banking organizations holding digital assets for their customers to mitigate.

The joint statement appears to normalize risk management for digital assets in a manner generally consistent with other types of assets, which is consistent with the current administration's broader efforts to treat digital assets like other assets classes. Together with recent actions by the SEC and its staff, the joint statement seems likely to encourage more traditional banking organizations to offer digital asset safekeeping, thereby offering asset managers more options for qualified custodians to custody digital assets for their clients.

The Road Ahead

As blockchain technology continues to mature and demonstrate resiliency, as institutional adoption continues to progress, and as the regulatory framework continues to develop, the road ahead looks promising.¹¹ But hurdles, although not insurmountable, remain for full-scale adoption.¹²

To address these remaining hurdles, the thoughtful, constructive dialogue that is currently taking place among legislators, regulators, the industry, the securities and banking bars, and other interested parties must continue. These ongoing dialogues, while sometimes glacial in pace, are necessary to address the unique challenges and opportunities raised by blockchain technology, and to keep the U.S. financial system competitive and the destination for capital formation over the long run.

So, while the journey continues and remains uncertain, the end destination appears closer than ever.