SEC Statement on Tokenized Securities: Applicability of Tokenized Securities under Securities Law

Source: SEC Official Website, Compiled by: Jinse Finance

Introduction

To clarify the applicability of federal securities laws to crypto-assets, the U.S. Securities and Exchange Commission (SEC) Division of Corporate Finance, Division of Investment Management, and Division of Trading and Markets issued a statement on the classification of tokenized securities. Tokenized securities are financial instruments as defined in the federal securities law as “security”, which are in the form or representation of crypto-assets, with ownership records held wholly or partially on one or more crypto-networks. Tokenized securities have various models, differing in structure and holder rights. **Tokenized securities are generally classified into two categories: (1) securities tokenized by or on behalf of the securities issuer; and (2) securities tokenized by a third party unrelated to the securities issuer.** This statement is intended to assist market participants in complying with federal securities laws and to prepare them for appropriate action in submitting any necessary registrations, proposals, or requests to the Commission or its staff. We stand by and communicate on any questions. Tokenized Securities Initiated by Securities Issuers **Securities issuers may tokenize securities by issuing them in the form of crypto assets.** To this end, the issuer (or its agent) integrates distributed ledger technology (DLT) into its system for recording the ownership of securities (“Master Security Holder File”), such that a transfer of crypto assets on a crypto network results in a transfer of the corresponding securities in the Master Security Holder File. Therefore, the only difference between securities issued in this manner and those issued in a traditional way is that the issuer (or its agent) does not maintain the master security holder file through a traditional off-chain database record, but rather maintains the file on one or more cryptographic networks that function as an on-chain database record. As part of this recording system, the issuer (or its agent) uses both on-chain and off-chain database records, associating on-chain information (e.g., wallet address, number of securities held, and issuance date) with relevant off-chain information (e.g., security holder name and address). The same type of security can be issued in multiple forms, including tokenized forms. Similarly, issuers can allow security holders to hold securities in different forms and can convert securities from one form to another. The form of issuance or the method of holder recording (e.g., on-chain vs. off-chain) does not affect the applicability of federal securities laws. For example, regardless of the form of the security, the Securities Act requires that every issuance and sale of securities be registered with the Commission unless a registration exemption is granted. Similarly, regardless of the form of the stock, all stocks are classified as "equity securities" under the Securities Act and the Securities Exchange Act. On the other hand, tokenized securities may belong to a different category than securities issued in their traditional form. For example, an issuer may issue one class of common stock in its traditional form and another class of common stock in the form of tokenized securities. However, if the tokenized securities are substantially the same in nature as the securities issued in their traditional form, and the holders of the tokenized securities enjoy substantially the same rights and privileges, then under federal securities laws, for certain purposes, the tokenized securities may be considered to belong to the same category as the securities issued in their traditional form. Alternatively, an issuer (or its agent) may tokenize securities without involving a cryptographic network that constitutes or is part of the master security holder's file. In this model, the issuer issues the securities off-chain and issues cryptographic assets to the security holders. The crypto asset does not transfer any rights, obligations, or benefits of the security, and the crypto asset and its on-chain database record are not directly integrated into the master security holder file of the security. Instead, the crypto asset can be used indirectly to realize the transfer of the security in the master security holder file. In this case, the transfer of the crypto asset (i.e., the security transaction) notifies the issuer (or its agent) to record the transfer of ownership of the security in the master security holder file. Since the off-chain database record constitutes the master security holder file, the issuer (or its agent) will use the on-chain database record to update the off-chain database record to record the transfer of ownership of the security. Tokenized Securities Issued by Third Parties In addition to tokenized securities issued by the security issuer, third parties unrelated to the security issuer can also tokenize the issuer's securities. The models used by third parties for security tokenization vary, and the rights, obligations, and benefits associated with the crypto asset may or may not differ materially from those of the underlying security. Furthermore, crypto assets may or may not represent ownership interests or contractual obligations of the issuer of the underlying securities; therefore, crypto asset holders may or may not enjoy the same rights as holders of the underlying securities. Additionally, crypto asset holders may face risks associated with third parties, such as bankruptcy, while holders of the underlying securities may not necessarily face these risks. We observe two models of third-party tokenization of securities issued by others: **custodial tokenized securities and synthetic tokenized securities**. In the first model, the third party issues crypto assets representing the underlying securities, such as tokenized security interests. The underlying securities are held in custody by the third party, while the crypto asset proves the holder's ownership interest (whether direct or indirect) in the underlying securities held in custody. In the second model, the third party issues crypto assets representing its own securities, which provide synthetic exposure to the underlying securities, such as tokenized associated securities or tokenized security swaps. **Model 1: Custodial Tokenized Securities** A third party can tokenize securities issued by others by creating securities interests that exist in the form of crypto assets. Similar to the issuer-based issuance model discussed above, a third party can achieve this by integrating distributed ledger technology (DLT) into its system for recording interest holders. The transfer of crypto assets results in a transfer of securities interests in the third party's records. In this model, the crypto assets represent the holder's indirect interest in the underlying security through the securities interests. The form of issuance of the securities interests does not affect the applicability of federal securities laws. Alternatively, a third party can tokenize securities interests without relying on a crypto network (or without the crypto network being part of its system for recording interest holders). In this model, crypto assets can still be used to transfer securities interests in the third party's records, similar to the issuer-based issuance model discussed above. Because records are maintained off-chain, third parties will use on-chain database records to update off-chain database records to record the transfer of security interests. The second model: Synthetic Tokenized Securities. Third parties can tokenize securities issued by others by issuing “related securities” in the form of crypto assets. A “related security” is a security issued by the third party itself that provides synthetic exposure to the underlying security but is not an obligation of the issuer of the underlying security, nor does it grant the holder any rights or benefits from the issuer of the underlying security. The return of a related security is linked to the value of the underlying security it references or to events related to the underlying security. Related securities can be debt securities (e.g., structured notes) or equity securities (e.g., exchangeable shares). In certain circumstances (described below), related securities can also be based on a security swap. The crypto assets representing related securities are similar to those discussed in the “Tokenized Securities Issued by Securities Issuers” section above.

Securities-Based Swap Transactions

Third parties can tokenize securities issued by others by issuing security swap contracts in the form of crypto assets. A security swap contract is a security that typically provides synthetic exposure to an underlying security or certain referential events related to the security issuer. Security swap contracts generally do not grant the holder any equity, voting rights, information rights, or other rights related to the underlying security. Unless the crypto asset is registered under the Securities Act and traded on a national stock exchange, a third party may not offer or sell the crypto asset representing a security swap contract to non-eligible contract participants. The crypto asset representing a security swap contract is similar to the crypto assets discussed in the "Tokenized Securities Issued by Security Issuers" section above. The definition of a “security swap” is found in Section 3(a)(68) of the Securities Exchange Act. This definition includes any swap agreement, contract, or transaction that meets the following criteria (the definition of a swap is found in Section 1a of the Commodity Exchange Act): (1) a narrow-based security index, including any interest or value thereof; (2) a single security or loan, including any interest or value thereof; and (3) the occurrence, non-occurrence, or extent of an event relating to the issuer of the single security or a security in a narrow-based security index, provided that such event directly affects the issuer’s financial statements, financial condition, or financial obligations. If a financial instrument existing in the form of a crypto asset is a swap transaction and meets one of the three criteria defined as a “security swap,” then that crypto asset may constitute a security swap. For example, if a crypto asset provides an enforceable exchange of one or more payments based on the value of a security, either fixed or conditional, but does not simultaneously grant the holder current or future direct or indirect ownership of the asset or liability containing the transferred financial risk, then the crypto asset may constitute a security swap. Similarly, if the payments provided by a crypto asset depend on the occurrence, non-occurrence, or extent of an event or contingent event related to potential financial, economic, or commercial consequences, and do not fall under any specific exclusions, and meet any of the three conditions defined above for a security swap, then the crypto asset may constitute a security swap. Security swap transactions and related securities are economically similar, but federal securities laws apply certain additional or different provisions to the regulation of security swap transactions, including transactions with non-eligible contractual participants as described above. Determining whether a financial instrument is a security swap or a related security depends in part on the exclusions of the definition of a “swap.” The definition of a security-related “swap” has several exclusions. If a financial instrument falls under one of these exclusion clauses, it is not a swap transaction and therefore not a security swap. For example, any note, bond, or debt instrument that is a security as defined in section 2(a)(1) of the Securities Act is excluded from the definition of a swap. Similarly, any put, call, straddle, option, or privilege, including any interest in or based on the value of any security, certificate of deposit, or portfolio or index, is not within the definition of a swap, provided it is subject to the Securities Act and the Securities Exchange Act. In assessing whether a financial instrument in the form of a crypto asset meets one of the above exclusion clauses, the factor determining its exclusion is the economic substance of the instrument, not its name.