Digital asset exchanges that use blockchain technology are looking at regulation as the next step to market growth. There are a number of exchanges that are developing their technologies to enable traditional assets such as bonds, venture capital, real estate and art to be tokenized and traded in a way that is compliant with local securities regulations.
Exchanges–no longer the wild west of crypto
We have come a long way from when the first exchange was founded in early 2010 to match buyers and sellers of Bitcoin. There are currently just under 230 cryptocurrency exchanges according to CoinMarketCap, and with millions of dollars traded daily, they play a crucial role by providing secondary market liquidity in the cryptocurrency economy.
A number of exchanges are focusing on the regulated securities token market, and we are beginning to see traditional broker-dealers working with technology providers to deliver regulated exchanges that build in systems to deliver the required security procedures, investor protection and internal controls in order to satisfy regulatory requirements.
Regulation good for business
Regulatory compliance is a positive development in the crypto economy and is particularly relevant for the process of tokenization of assets in order to create a pathway to liquidity. The surge in popularity of initial coin offerings (ICOs) that we saw in 2017 and 2018 raised the question of exactly whether tokens constituted securities.
As a result, the SEC took a number of steps to provide clarity as to what constituted a utility token and a security token and continues to provide guidance to the marketplace. In the U.S., tokens that could be considered securities (most likely by way of application of the Howey Test) need to be issued in the U.S. as a registered securities offering or may take advantage of one of the exemptions from registration, such as those provided under Regulation D, Regulation S or Regulation A of the Securities Act 1933.
As securities token offerings (or STOs) involve the issue of securities, they may only be traded on regulated exchanges. The existing exchanges, such as Nasdaq and other alternative trading platforms (such as https://www.otcmarkets.com) do not (yet) have the required technology to deal with the tokenized securities trading. Because of this, and in anticipation of the demand from security token offerings for a primary and secondary marketplace, a number of regulated broker-dealers are applying for Alternative Trading Systems (ATS) licenses that will enable them to operate regulated securities token exchanges in the U.S.
By focusing on regulatory compliance (customer asset protection, improved transparency, increased market surveillance and stringent IT security), digital asset exchanges will become the springboard for market participants to access new pools of national and international capital. By adopting regulated best practices, these crypto exchanges are expected, over time, to attract interest from the institutional investment community as well as from retail investors.
Innovation because of, not despite, regulation
Global regulators receive an unending stream of applications for market authorization, with some of the crypto-related products at the leading edge of innovation. As trading crypto assets evolve, so the traditional exchanges are also adapting. Conventional financial market players are realizing that there is value in trading crypto assets.
The Swiss Stock Exchange, in July 2018, announced that it is developing a fully integrated blockchain-based platform to tokenize existing securities and non-bankable assets. In the U.S., the Commodity Futures Trading Commission (CFTC), which regulates Bitcoin, has approved two crypto futures products: one from the Chicago Board Options Exchange and another by the Chicago Mercantile Exchange.
And in early 2019, the Nasdaq, partnering with Van Eck is planning to launch cryptocurrency products.
Infrastructure supports secondary trading
Digital assets are here to stay, and security tokens and tokenization of assets will add an important layer to the existing capital markets. With full compliance within a regulatory framework that protects issuers and investors, a new breed of tokenized exchanges will encourage more product innovation, providing much-needed access to new sources of capital with the attractiveness of a fast-path to liquidity.
STO issuances and securities token exchanges have the potential to quickly provide a sizeable, parallel financial services ecosystem that will be a valuable addition to the existing capital markets systems.