Zach Fallon: Hello and welcome to the LathamTech podcast, where we survey the latest trends emerging from the world of tech and explore their impacts on your company — both the opportunities and the risks. I’m Zach Fallon, Global Co-Chair of Latham’s Digital Asset and Web3 practice. Joining me today is my fellow Global Co-Chair and Latham partner, Gabe Lakeman. Gabe helps clients navigate the shifting regulatory landscape of digital assets, payment services, and technology. Welcome, Gabe.
Gabe Lakeman: Great to be here, Zach.
Zach Fallon: So, in this episode, Gabe and I are going to explore tokenization and the regulatory and business distinctions across the Atlantic between the US and the UK and the EU. Gabe, there’s been a lot of talk about tokenization lately. How would you describe it? How would you define tokenization? What is it in your mind?
Gabe Lakeman: At its core, I define tokenization as the use of blockchain technology to represent an asset or right. In the context we’re talking about, it’s the use of blockchain technology to represent a financial instrument like a share.
To add a distinction that’s helpful for this conversation, you can distinguish between native and non-native forms of tokenized financial instruments or tokenized shares. In native tokenization, you have a token actually constituting or being the share. In a non-native form of tokenization, you have a token that in some way represents a share without constituting that share itself.
Zach Fallon: Right, almost like perhaps a derivative.
Gabe Lakeman: Yes, various kinds of structures.
Zach Fallon: So, when we’re talking about tokenization, is this new in the EU and the UK? What is the regulatory approach? How are regulators thinking about tokenization as it relates to these types of assets?
Gabe Lakeman: There was a lot of attention on it some time ago in the last four or five years, but not much movement. It’s only now where we are getting to the stage where the opportunity is really starting to present itself. Firms are moving into this space. Regulators have now set out fully defined regulatory regimes that cover traditional financial services and cryptoassets, and make clear where the borders between these regimes lie. We’re now seeing a lot of firms and clients really starting to move into the space.
So far, that’s focusing on non-native forms of tokenized financial instruments. We’ve seen various forms of complex, innovative structures used to have a token that represents typically shares or some other instrument, often held with a custodian or with an SPV, and then layering on some form of derivative or certificate structure to pass through the exposure to that share to token holders.
Zach Fallon: What’s nice is that we’ve moved past the “token is scary, stay away from token” time of the market and are thinking “actually this might be a thing that makes markets more efficient.” Finding a way to tokenize traditional financial assets can be quite exciting, and that’s why folks are dialing in and tuning in on this issue.
Gabe Lakeman: To add to that, you’re also seeing this phase now where lots of different firms have licenses both in TradFi and in the crypto space. We’ve got the development of a mature ecosystem of service providers. People are now familiar with the technology and the types of asset they’re looking to tokenize, and it just becomes a much more realistic prospect.
Zach Fallon: It’s a much more natural evolution of the space — very exciting. In the US, similarly, people have been talking about tokenization for a number of years, but there hasn’t been a lot of adoption. To the extent folks have adopted tokenization of traditional real-world assets — in many ways just, frankly, securities — it’s been a bit of a road to nowhere. There hasn’t really been a place in which you can trade and transact in these assets.
Tokenizing a thing isn’t necessarily novel; it’s just the form the security takes. Maybe 50 years ago it was a paper certificate. So in that sense, it’s nothing necessarily novel other than the technology and the ability for folks to hold these assets in their own self-custodial wallets and potentially interact peer-to-peer, which is quite exciting.
Gabe Lakeman: The interesting thing is some of these structures people are adopting now, like certificate structures, have a lot in common with structures like depositary receipt programs and so on — again, things people have been familiar with for decades. Doing it with a token doesn’t really change anything in the legal characterization of that structure. The more interesting and challenging bit is where people are trying to do native tokenized financial instruments — native tokenized equity. That’s where you start to see more challenges.
Zach Fallon: What would the challenges be?
Gabe Lakeman: In the EU and in the UK there are hard legislative blockers on certain forms of tokenized equity. When a financial instrument is traded on a trading venue in the EU, there are requirements for that instrument to be recorded on the books and records of a central securities depository — a form of TradFi financial markets infrastructure that records securities through some book entry system. That’s inconsistent with the use of a public blockchain to act as a ledger recording everyone’s share interests. Those structures create blockers for firms looking to move into this first thing.
Zach Fallon: So the CSD would be incompatible, you’re saying it would be incompatible with blockchain natively? Is it the way in which they operate or just the fact that it’s two separate systems of accounting?
Gabe Lakeman: It’s really that a user needs to use a private ledger. Not necessarily a private ledger, but it needs to have a certain level of control over the way in which they’re recording those securities, which is challenging if you’re trying to use a public ledger, which is obviously where the promise of a lot of this technology lies.
Zach Fallon: It’s interesting because in the US, certainly, there was uncertainty at the federal level as to whether entities like registered transfer agents could rely on blockchain technology to serve as master security files — security holder files — for their books and records. Earlier this summer, guidance came out from the Division of Trading Markets essentially saying that’s okay. You can use distributed ledger technology to maintain your books and records as a registered transfer agent. And you can have offline information that supplements that, like names and addresses of folks.
In that sense, it seems entirely compatible, and on the US side, it’s just been hesitance to embrace the technology generally in the last handful of years. Those barnacles are being scraped off the boat, so to speak, and we’re going to see a lot of progress in a short period of time.
Gabe Lakeman: Where do you see that coming from? Do you see the US as being the first mover into this new era of fully native tokenized assets?
Zach Fallon: Folks have already issued tokenized equities. We had the first listed Class A common stock a few weeks back made available for sale in tokenized form. Again, that’s not necessarily novel because it’s just the form the security takes. The hard part has been — which is probably not too dissimilar from what you were describing — how intermediaries are going to touch and be able to intermediate these things using traditional rules, using the old rules that don’t necessarily gel or graft too cleanly. There’s a lot of uncertainty that needs guidance. If we’re a first mover, it will only be because we have that guidance.
One thing we do know is that the SEC here in the US has suggested that crypto market structure will be part of the regulatory agenda over the coming years. They’ll be putting out guidance, certainly in the form of proposed rules that people can comment on, and then they can tweak them based on those comments and get eventual rules in place.
Gabe Lakeman: That’s super interesting. In the UK and the EU, regulators are still, to some extent, quite silent on how this will develop as we start seeing more forms of tokenized shares and tokenized financial instruments.
Zach Fallon: How are the EU and UK looking to make tokenization viable? What’s their approach going to be at the end of the day?
Gabe Lakeman: We’ve seen interest from regulators — various regulatory sandboxes and pilot programs to facilitate looking at some of the substantive, hard regulatory blockers to certain forms of trading tokenized equity. So far, those haven’t been that successful, fair to say. We’re still in a phase where it feels like a wait-and-see approach is being taken.
My expectation, building on what you’ve said, is that we will see major US-listed entities issuing tokenized shares. At some stage, there’s then a question of how they get into the hands of people in the UK and the EU. Once that happens, regulatory attention to the space will start to increase.
Zach Fallon: That makes a lot of sense, which is different than the non-native types of tokenization you were talking about before. The irony is those products are being offered — or are starting to come out in certain forms — in the EU that relate to US-based companies. Folks are identifying that as yet another reason why US regulators should act to avoid that outcome.
Gabe Lakeman: One of the really interesting things with this technology is the promise of disintermediation. If you have native tokenized equity, you can hold that in your non-custodial wallet, on an app on your phone, without dealing with a regulated custodian. You can transfer it on a peer-to-peer basis. So, the opportunities to get so much more efficiency in the way markets operate are incredible. But traditionally, when regulators regulate an area, they look at the intermediaries and put regulation on intermediaries. That’s in basic tension with a disintermediated approach.
Zach Fallon: The goal is almost to go find the intermediary even if there isn’t one necessarily. There’s a challenge for regulators to get comfortable with that level of trust in a trustless system.
Gabe Lakeman: How do you think they’re going to come in and do that? Where are they going to focus?
Zach Fallon: We’ve seen in the past — the internet is not regulated, at least not by securities regulators anyway. They’ve gotten comfortable in the face of innovation before, and I think they’ll get there again. It’s a question of at what prompting and prodding it will take to get them there.
The more folks live with and are able to work with these technologies, the more they’ll understand that at their core, the goal — not necessarily always successful — is to be disintermediated, to be passive, automated tools that folks can deploy at their own will. They don’t necessarily need that type of intermediation. If it is intermediation (which I suppose it is in one form), it may not be the kind that should be regulated by the securities regulators; or, if it is, it should be fairly light touch, given the way the technology works.
Gabe Lakeman: We’re seeing it already in regulatory guidance coming out on firms seeking to integrate some of these non-custodial wallet apps, typically within a retail app, and having that boundary between the self-custody, disintermediated service versus the regulated service.
There are a lot of questions about how you can do those within the same or within a similar environment, and what the regulatory expectations are. But at the moment, it does seem like there is a path forward for doing that. I think we will see increasing adoption and use of some of these non-custodial wallet apps. Once tokenized activity flows in, it will be really interesting.
Zach Fallon: For me, the exciting part is the composability of these chains and the technology, the smart contracts, and the ability to take tokenized equities and perhaps find other instruments and then get access to other things. Back to the self-custodial nature of these things, where historically your brokers were out lending your securities, you might be able to do that yourself — and then you build from there. Of course, you can build regulatory frameworks on top of that.
We’re talking about the tail of things; the vast majority of folks will continue to live on TradFi rails, and that’s perfectly fine. We need an approach that facilitates that in a measured way. But we shouldn’t presume that’s the case in every instance, and we should build into it.
Looking ahead, what trends do you foresee as they relate to tokenization? What’s your crystal ball showing you?
Gabe Lakeman: I think we’ll see a wave of adoption and use as some of these structures, particularly in the US, as they get more established and embedded. We’ll start to see more adoption — people holding tokenized equity or other forms of instrument in their self-custodial and non-custodial wallets.
I think we’ll also see firms and service providers continuing to navigate the regulatory perimeter — the area between the regulated TradFi services and some of the new and innovative ways of providing services that don’t chip into those requirements.
Zach Fallon: That’s a very interesting point, because you’re seeing that already — this collision of different asset classes, securities, and commodities. In the US, regulators are finally responding to what has been obvious to everyone for a number of years, providing guidance around whether, for instance, traditional securities intermediaries can interact with spot commodities markets and how those two things interact. They’re stating a reasonable position that it’s not per se prohibited. But we may need guidance as to how that actually works if we want robust adoption.
One thing I foresee is more engagement with regulators on how they can get that right — how they can get it appropriately tailored for purposes of the frameworks. Engagement first with regulators to get the right rules adopted, and then, to your point, off to the races.
One point I’d add, crypto generally, as you know from being in the space for a while, is always pushing the boundaries. Whatever guidance comes out and wherever it lands, other things will be developing on the fringe at any given moment — it’s just the nature of the space. It’s a super exciting time.
Gabe Lakeman: It is fascinating how this area will see product rollout, things getting into the hands of consumers, and then the regulatory regimes following that activity — which isn’t always a bad thing. Good regulation is responsive to issues identified in the market, rather than running ahead and trying to be prescriptive as to how activity should happen. I think that trend will carry on with tokenization.
Zach Fallon: One of the benefits of there not necessarily being a regulatory framework in place right now is that, but for that last handful of years where everything was a problem in the absence of guidance, we can now move to a place where we have guidance with a number of years of experience — which is a better place to ultimately adopt rules when you have experience with the technology. The general approach of common-sense regulation is, as you said, reacting to the issues that come up and not necessarily putting the kibosh on things just because they’re unfamiliar.
Gabe Lakeman: I always say people knew what a share was for about 300 years before we had securities regulation and MiFID. Whereas with crypto, we’ve seen lots of rules coming out somewhat preemptively. Often you end up with better law and better regulation when it follows the activity and reflects what you’ve learned in the meantime.
Zach Fallon: Let’s hope it doesn’t take 300 years, but it has been nice to have some time to season in the space. I think that’s a great place for us to wrap our discussion of tokenization and the approaches on both sides of the Atlantic. Please be sure to join us for our second part in the two-part miniseries, where we talk about stablecoins. Gabe, thank you for joining me. Great to be here. And thank you for tuning in to this episode of LathamTech podcast. We hope you’ll join us next time.
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