Marriage Takes Work: The New Token Paradigm and Traditional Financial Markets

The crypto market is evolving rapidly. The explosion in ICOs over the last 18 months has brought a wave of innovative companies looking to leverage blockchain to change the way they (and their respective sector) does business. These companies are embracing digital tokens as a mechanism to bring liquidity, efficiency, transparency and decentralization to their capital raising and corporate governance activities. The idea of issuing a token, and having that token be immediately fluid and tradable, is an exciting proposition for the issuer. It’s equally, if not more exciting, for investors — especially those (e.g. traditional VCs) who are used to waiting 5-7 years before seeing liquidity for a given investment.

Yet, the reality is that the same characteristics that make tokenizing assets so attractive are also the factors that create heartburn for regulators (and traditional financial institutions who operate in regulated environments). Traditional financial markets have core structures such as custody, transfer agents, and basic rules around regulated transactions and who can participate in them. Regardless of whether a company is issuing a security or cautiously issuing a utility token using a lot of the same parameters as a security (just in case the regulators come calling), the rules that apply to how these tokens are initially sold and subsequently traded in secondary markets, have been established over decades of legislation and regulatory implementation.

Why does this matter? Because if an issuer conducts a token sale that touches the US, a number of regulatory entities, including the SEC, FINRA and FinCEN have jurisdiction. And while the quantity of non-US utility token sales continues to be high, the reality is other countries already have or will eventually institute their own (likely similar) rules for their own citizens. Under US SEC law, issuers have legal obligations in both the primary sale (i.e. the initial sale of tokens) and how those tokens are transacted in the secondary market. For example, if a token is initially sold under Reg D to only accredited investors, and one of the purchasers turns around and sells the token to a non-accredited investor, that can mean big trouble for the issuer. Similarly, an issuer must take reasonable steps to assure itself that both primary and secondary holders of its tokens are not subject to US economic sanctions.

Moreover, it is clear that traditional financial institutions (e.g. large asset management firms, pension funds, etc.) aren’t going to play in this space until these structures are in place. Those entities have too much to lose to dabble in a space with regulatory uncertainty. As of this post, CoinMarketCap lists the combined market capitalization of cryptocurrencies at $290 billion. That’s an impressive number, but it’s peanuts compared to markets where these large entities comfortably deploy their capital. Quite simply, the institutional buy-side needs greater regulatory certainty to embrace the digital asset markets en masse. Ask any compliance officer at one of these firms, and they’ll tell you the nuts and bolts of how transactions work in practice make all the difference between dollars flowing and a “wait and see” approach.

So how do you reconcile these two paradigms? How do you create a framework that allows for regulatory compliance while maintaining the decentralized spirit of tokens and pace of innovation?

The answer is you need to strike a balance — based on technology and a thoughtful approach compliance — that combines respect for the old while embracing the new. Smart players are already starting to do this in areas like custody (e.g. Coinbase and ETC’s recently announced custody solution). Structures like this combine the technology of secure digital control locations with a process that is blessed (or at least not unblessed) by the relevant regulatory bodies. For secondary trading, the token market needs a way to ascribe sustained attributes (i.e. rules) to both the underlying token and the investors who want to transact in them. In order to maintain token and transaction fluidity, these attributes need to be embedded in the token and investor profile from the beginning, and then checked and reconciled in (near) real-time for each transaction. Ultimately, in order to enable the trustless environment of tokens, these attributes need to be maintained and authenticated through smart contracts and the corresponding transactions need to be auditable through an immutable ledger that provides a single source of truth (sound familiar?).

In the beginning, it won’t be a perfect marriage. There is no perfect way to replicate every single structure and process of traditional financial transactions in a token environment — nor should there be. There are plenty of antiquated structures and middle men who live off the inefficiency of the old way to doing things, and fully replicating these inefficient structures would simply be continuing past mistakes. The better path is to be targeted, and focus on areas where blockchain and other technologies can be combined to effectively address regulatory and compliance requirements. In short, it requires balance and cooperation…. and that’s always the recipe for a long and happy marriage.