Tokenization of Equities Part I – the Basics

Brett Redfearn:
Because when people use the term crypto, oftentimes they conflate the idea of crypto products with crypto technology. And quite frankly, it's really different, right? And so it's important to distinguish.
Peter Haynes:
Welcome to episode 76 of Bid Out, a market structure podcast from North of 49. I'm your host, Peter Haynes, and today I'm joined by a very special guest to our podcast, one who needs no introduction to the market structure community. Brett Redfearn returns for the first of a two-part series in which we deep dive into a topic that I believe represents the most profound change to market structure of my career, and that is the move to tokenize securities trading. Brett, thanks for joining us on the pod today.
Brett Redfearn:
It's great to be here, Peter. Thank you for having me.
Peter Haynes:
For those of you that don't know Brett, he is founder and CEO of Panorama Financial Markets Advisory, a firm that focuses on helping clients navigate strategic, regulatory, and operational challenges in the evolving market structure of traditional and digital securities. Prior to founding Panorama, Brett spent four years with the SEC as head of its trading and markets division, and then did a short stint at Coinbase. Prior to the SEC, he spent 14 years as head of market structure at J.P. Morgan across asset classes globally for the corporate investment bank, and he worked at the American Stock Exchange in the early days of his career.
So before we begin, everyone likes to focus on your time at the SEC or your time at J.P. Morgan. I want to know more about what it was like working for the AMEX back in the 1990s, and I'm curious, were you around in 1993 when Nate Most and Steve Blum were in the foxhole launching the SPDRs S&P 500 ETF? And what did you learn from your time at AMEX that helps to shape your thinking about today's equity market structure and landscape?
Brett Redfearn:
Wow, that does seem like a long time ago now, but thanks for that, Peter. So, no, I joined at the end of 1995, so pretty close to that, but I will tell you it was a different world. When I joined the AMEX back in '95, we didn't really distinguish much between a transactions business and a listings business. It was just the exchange business. So that was the time when the primary listing exchanges really had most of the volume. It was before payment for order flow. It was before real competition from electronic markets and certainly before the ETFs even took off. I remember when the SPDR was basically an illiquid product. While there I watched as electronic trading technologies emerged, they challenged the floor-based model. They pulled away a majority of the order flow. They forced several businesses on the specialist floor to either sell or to have the fold.
I saw the ETFs go from an illiquid product to the vast majority trading on the AMEX. The two products, the Qs and the SPDRs became the majority of the volume on the AMEX. And today there's more ETFs, as you know, more ETFs and stocks. Today, the vast majority of order flow trades away from the primary listing venue. Today it's basically almost all electronic, if not all electronic. So I learned a lot. It was a tough way to learn lessons, but one of them was change can come faster than expected. Another one is you can see new technologies can put existing intermediaries out of business and new products or new ways to package existing products can displace other products and unlock new investment opportunities in really interesting ways.
Peter Haynes:
I started my career at the Toronto Stock Exchange and at the time it was a split market where part of it was electronic and part of it was a floor-based, but I always enjoyed being part of the exchange. I thought it was a great place to start my career. Great place to get to know all the different participants in the industry, and I'm sure you benefited from that same opportunity to be able to get to know the different groups and where to shape your career. I think back on my time very fondly, even though I might criticize our local market every once in a while for certain behaviors, I have a big place in my heart for exchanges.
And so let's just think a little bit about the regular listeners at our pod series. You will know that over the last few weeks we've been dropping various episodes that represented panels from our recent 26th annual portfolio management market structure conference, which was held in early November in Toronto. Brett, you too were a speaker that day at our conference. And your topic was also tokenization, which is today's focus for the pod. And while I really enjoyed the discussion that you and I had at the conference, I think we both agreed that taking off the handcuffs of the time limit we were under will allow us to dig a little deeper into some of the more important aspects of the move to tokenization of equities. And based on the feedback I received at that conference, I'm sure there's going to be a lot of interest in this podcast. There seems to be a thirst for information on the topic from all ends of the equity trading landscape.
So let's start with a couple of the basics here. We hear about crypto technology, we hear about the generic term crypto. Can you tell us the difference between crypto the product and crypto the technology?
Brett Redfearn:
First of all, it was a great event, Peter, so thank you for having me to that. And yeah, I think this is a really good question because oftentimes people understand that I'm focused on this space and they'll come up and they'll be like, "Oh, so you're into crypto now?" And it's not always clear what that question needs, right? Because when people use the term crypto, oftentimes they conflate the idea of crypto products with crypto technology, and quite frankly, it's really different, and so it's important to distinguish. The products are really a mixed bag. They fall into several categories. You've got cryptocurrencies, obviously there's Bitcoin and there's Ethereum and there's NFTs, there's collectibles and there's security. There's a lot of different types of products. Some of those products have real utility, some of them create the chains upon which other things can be built. Some of them are pretty scammy and have been associated with pump and dump schemes and run pools and things like that.
So even in the product set, it's quite a diversity and it's important to separate what is what and which ones have meaning for you because it's very hard to just generalize and say, "Yeah, I'm into crypto." On the underlying technology, crypto technology period, it's really a combination of three things. So you have cryptography, distributed ledgers, and then consensus mechanism. Cryptography is basically the mass that secures the data and improves ownership. Distributed ledgers are the shared record that everyone can see and verify. So that's where people just talk about it just being a better ledger and consensus mechanisms are the rules for how everyone agrees on what is true.
So these three things together, I think this is sort of the fundamental aspects of the technology and the reality is that crypto technology itself, we've seen a lot of the applications for these various crypto products, but the technology itself has substantial applications for traditional financial products. It can bring new efficiencies, additional utility, and I think that's why it's become really interesting when we start talking about tokenized securities.
Peter Haynes:
And yeah, we're going to work through a couple of the terms that people hear and maybe don't understand. I throw in there the word blockchain as one we hear a lot, but I want to move to what I consider I think the second most common term we hear after crypto, and that is the word stable coin. What is a stable coin and why is this considered a better infrastructure for the go forward securities trading?
Brett Redfearn:
So when people think about the real use cases for crypto, I think the first and obvious one is stable coins. And so the term stable coin, it's based upon a product that has a stable value. So it's cryptocurrencies designed to maintain a stable value. This is basically means that the peg to a currency like the dollar, the biggest ones are the dollar based products like Tether and USTC and now a whole slew of others. But unlike Fiat, Peter, there's different utility that you can get from this. And so let's ask then, okay, if you go on-chain and you become a stable coin, then what are the utilities that are added to that? Well, the first one is 24/7 global instant settlement transaction fees are low. If you compare moving money to Western Union or something like that, it's very cheap. Fractionalization is very easy out to multiple decimal points, importantly to hold them you don't need a bank, you just need a phone or a computer.
So there's a lot of people around the world, they might not have banking account, but they have phones, and so now they can be holding dollar-based currency on their phone. I think that's pretty important. And what really makes them interesting, and this is more relevant when we get into tokenization, is they're programmable. So there's ways in which... because you have smart contracts here, you can have scheduled payments, you can have conditional payments. So if this happens, then I pay that, get an automated tax withholding. So this is programmable money. All of these things add additional utility to an underlying dollar-based currency.
Peter Haynes:
Okay, so you mentioned tokenization. That's the next term I want to go through. What do people mean when they say, "I want to trade IBM stock in token form and how can this be done?"
Brett Redfearn:
One of the things that we talked about initially was when we think about tokenization and we think about the on-chain world and the off-chain world, and I don't know if you were going right to that, Peter, but tokenization is, in this particular case, when we differentiate between the on-chain world and the off-chain world, we have to make very clear distinctions here. Because When you're talking about something that's on-chain, you're talking about things that are occurring directly on blockchain networks and things that are using smart contracts. And when you go on-chain, it includes activities like staking, looping, lending on DeFi protocols. So there's a lot of really interesting things that happen if you tokenize something in the on-chain environment. But these can also be rewarding.
However, to own crypto and to benefit from something that's in a tokenized form. You don't have to be an expert or a savant in DeFi protocols and all these things that are happening in the on-chain market. There's also sort of an off-chain world. Trades are not executed on blockchains. They're executed in matching engines or with wholesalers that in ways look very much like traditional markets. So like a hundred percent of the trades that are happening on Coinbase exchange happen off-chain.
And the same is basically true with other centralized exchanges, even Robinhood who uses third-party liquidity providers. And these users are really, like investors, they're sort of crypto curious, but not really the crypto native crowd. And I think this is really important for understanding how tokenized securities can work because in my view, it's pretty likely that the majority of trading of tokenized securities may be off-chain as is the case with crypto exchanges. So I wanted to make sure that we were clear about sort of the on-chain and off-chain distinctions there before getting into the tokenization thing. And I don't know if you want I can get into specifically what are some of the different models of tokenization.
Peter Haynes:
I want you to go there now and then I'm going to follow up with a couple of questions just related to the reason and some of the use cases, but I do want you to go through those different models that people are using when they talk about tokenizing trading in IBM.
Brett Redfearn:
There's a lot of people who are talking about tokenization. When we talk about tokenization, it's again, like I said before, when people use the term crypto, are they really talking about different things? I think the same is true when people talk about tokenization because we're seeing a lot of different models of tokenization that have come out. So the best way to understand this is to sort of break it out into what are the basic models that are out there. And quite frankly, while there's more than three, I think it's sort of the high level breakdown into three makes the most sense for this discussion.
I think the first one is you should think about securities that are being tokenized essentially like derivative products or synthetics. So these are cases where you can provide exposure to an underlying stock like a security-based swap construct. But in this case, tokens are really created from special purpose vehicles where securities are purchased and put in special purpose vehicles. Tokens are essentially minted out of that. In that situation, an investor can participate in the upside of the downside price movement of the security, but they don't have direct ownership. So this means no dividends, no voting, no additional, and then it also comes with some additional counterparty risk. Because of the nature of this construct.
There's a lot of these sorts of things that have been launched offshore. So in many cases what we're looking at out there does kind of fall into this kind of a construct. And quite frankly, without getting into this aspect of it, Peter, a lot of these raise fundamental questions about AML KYC. Because some of the ways this has been done is in a way where they're transferable in a permissionless manner, meaning that there are no smart contracts that are governing transfer restrictions. And so they're moving around in ways where the other person on the other side might not be KYC. And we can talk about this when we get into US investors or who's able to purchase some of these things. That's the first one. So there's sort of like this derivative thing. I don't think that this is the best form and I don't think the SEC actually loves this one either.
The second one is considered tokenized receipts. So these are much more like depository receipts where the token receipt is actually on-chain, but the underlying security is still held in book entry in DTCC. So you essentially have a security, it's being held in custody, you've created like a depository receipt. The underlying product is still being held in a DTCC framework. And you'll see this also is something where in my view there are some benefits that do come from this, but I don't think that this unlocks all of the potential utility that tokenization promises doesn't, for example, unlock underlying faster settlement.
It kind of adds another layer and there's still the settlement process that happens to happen at the DTCC layer. Securities are still anchored in DTCC, and I think this category is also oftentimes referring to unsponsored depository receipts, which means that the issuers are not necessarily involved. So when we talk about tokenization, there is a big question, I know we'll get to it later, which is like what is the issuer's role in this? Should the issuer have a say? How do they get involved? Should they also know who these investors are?
So the third category, what is called issuer sponsored or native tokenized securities, this is where the issuer is involved and is part of the decision to take part of the float and turn it into a tokenized security. In this case, Peter, tokenized security is really is equivalent to a traditional security. So the token is the security, the tokenized process, tokenization process means moving shares out of DTCC, back on register, a transfer agent, and then converting them into a tokenized form that is simply captured on a blockchain-based master security file of the transfer agent. The cool thing about this is the tokenized security confers the same ownership rights as the traditional security. It includes voting rights, dividend rights, other corporate actions, and the model is one where you have them put on smart contracts where investors are always KYC and the wallets are always white-listed.
So this is a world where they can't just go anywhere. There still is a way of tracking back to the initial owners. And I also believe that this unlocks a lot of utility. It's a harder approach because if you have to go issuer to issuer, it's going to take longer to roll this out in a broader way. But once it is launched, I think these products are more transferable globally. I don't think you need depository receipts in each jurisdiction around the world to have them move around. And I think that it also unlocks the ability to sort of unlock other utility like transforming the settlement and the proxy distribution process for issuers.
Peter Haynes:
You mentioned that most of the activity, if not all of it at say a Coinbase is trading off-chain on their matching engine and if not 99% of the activity. So that leads to this question that we all know the markets work pretty well right now at the NYSE and NASDAQ with their matching engines. It comes to that question of why are we doing this? You mentioned some of the benefits 24/7 being able to hold your security in your wallet, but what are the main use cases outside of the ones that people talk about that you see for both the investor community and the issuer community?
Brett Redfearn:
The number one use case should not be, this is a way of avoiding regulation. And so I think in the conversation you will see that sometimes participants come forward and they're like, "Yeah, we want to tokenize securities, but we don't want to do all the registrations. We don't want all the rules and dah, dah, dah. I think it's really important that as we think through this, we need to think through the regulatory structure in a way where it's not a big regulatory arbitrage. I think we're getting that strong messaging out of this commission where they're saying we want innovation without arbitrage. And when I hear that term, I'm thinking without regulatory arbitrage. So I think that that's really important.
So let's just say I think that's a very important first point, but when we break up the utility, I feel like there's almost too much of the conversation has been focused on the secondary market environment. The secondary market, it's quite important. But quite frankly, I believe that there will be a substantial amount of the secondary market trading that happens off-chain just like as the case in a Coinbase exchange or any other exchange. And so secondary market trading in many cases may look exactly the same. I'm not saying that there's not this sort of DeFi utility, but that will exist as well. And that was the point I was trying to make a moment ago.
But if we say, "What are the things outside of trading specifically?" So the first thing is issuance. Let's go to the issuer level, and if you were an issuer, why would you want to actually have your stock tokens? So discussions are now being had where it's sort of like, okay, in today's world when a retail investor buys a security broker dealer typically will default them as an objecting beneficial owner. So they won't necessarily know who the investor is. And then when they're an objecting beneficial owner, then there's a lot of downstream effects that happens from that in the proxy distribution process.
I won't get into all the details, but I think for issuers, if they can know the owner and the owner, if there's token holders, then they actually establish a nexus with that particular investor. They can give them discounts, they can give them benefits. I can say, "Oh, you own my AMC, Peter, so you have my token on your wallet. You can walk in anytime you go to a movie, now you get free popcorn." Or, "I own TV securities and I just got over, I'm now invested my first $10,000 and I'm getting airdropped a token of TV securities, you're now an investor in my company." Anything, when you think about airline miles or hotel points or free popcorn, there are ways in which it unlocks a connectivity between the issuer. And what I would say is this category, the investor/customer, I think that's really interesting, and in a lot of retail applications you'll see some cool stuff being done.
For investors, one of the things is collateral. So if I have a tokenized security, I can now use that as collateral. If I want to buy a house, I want to buy a boat, I can have it in tokenized form, I have smart contracts, I can pledge that with a smart contract and that is now a form of collateral. So I think it unlocks securities as a form of collateral. I think that's an important use case for investors.
Stock loan. If you think about the stock loan business, there are some cases where broker dealers will pass through some of the revenue that come from the stock loan business, especially for hard to borrow names. I think that we're going to someday be seeing clearinghouses that are going to be competing to give investors greater advantages and greater economics associated with offering certain tokenized securities for loan out to folks that need to find locates.
Easy to transfer. So for an investor, I own some tokenized securities. Peter, if you had a white-listed wallet, I could basically just transfer that to you.
Peter Haynes:
What does a white-listed wallet mean?
Brett Redfearn:
In the crypto ecosystem, you have this concept of self-hosted wallets with the ability for an individual to custody something themselves. This gets back to the point I made with stable coins where if you don't have a bank... You actually don't need a bank. So you can actually have on your wallet be holding securities where you are actually custodying them in your own wallet. They're very protected. There's multiple layers in which these things have to be protected, but you can have a self-hosted wallet, and if you have that, I can actually transfer something to you.
If you think about in today's world, if somebody's trying to move even from one broker to another, it's actually a pretty slow, long paperwork-intensive process. I think in this case, if you took one of these sort of issuer sponsored native tokenized securities, you put it on a wallet, being able to move from one broker to another broker just got a lot easier. Being able to send a security to somebody else just got a lot easier. Conceivably, I could even do a trade and you want to give me something and I'll be like, you know what? I don't have a lot of cash right now, but I'm going to give you 10 shares of XYZ. That also becomes something that's kind of a lock.
So that's easy. And look, there's also in the DeFi stuff I talked to you about before, so for the more crypto native people, there's going to be other things that can be done in crypto. If you look at the way that people pledge a security to a DeFi pool, I could take certain securities, I could post them there and I could get stable coins back and I could do something else with those stable coins, maybe even make another investment. There's leverage that is very commonplace in the crypto world. Without getting into the whole array of use cases in DeFi, I think those things start to find different applications for traditional securities. So that's investors.
And then there's one more, and the last one to answer your question is when we think about settlement. So many times people will talk about instant settlement or atomic settlement. And I think that that is interesting because you do have the ability for a stable coin and a digital asset security or tokenized security to essentially have an atomic swap where instantly the cash or the stable coin is transferred for the security. That ownership can happen atomically at that point in time. You're not waiting for a clear, you're not waiting for a potential decay. It happened, it's done. It's irreversible, right? Presumably. And so that can unlock, but that's more in the on-chain space. I think that even in the off-chain space, there's other ways of doing settlement more faster and more efficient.
So you're seeing certain entities pop up right now who are looking at rolling settlement cycles throughout the day or settlement at the end of the day. So even if you have a off-chain trading world with a different sort of custody infrastructure, there is going to be an unlock for settlement to be happening in shorter cycles. And the beauty of unlocking that sort of more efficient settlement is it frees up capital. You don't have that situation where you're waiting for the full day or what we saw during March of 2020 when a few of the brokers got a little bit in trouble because they were waiting for everything to settle and there was a capital problem and, "You better not be buying anymore." So I think on settlement, there's a lot going on there. There's a lot of work being done to try to figure out how to make that most efficient.
And the last thing is proxy distribution. So to me, when issuers start to know who the investors are and when things potentially start, even if it could be NDTCC, it could be out of DTCC, but there could be another way where you have more non-objecting beneficial owners. Information that's not sort of much more concentrated and therefore you're not sort of stuck with one proxy distribution model. That competition and other alternatives start to come into that space that can bring real efficiencies to a portion of the marketplace, which I would argue is not arguably subject to adequate market forces today.
Peter Haynes:
So Brett, I want to pick up on one of those perceived benefits for the issuer community, and that is this notion of knowing exactly who your shareholders are in real-time. That might work for retail investors who are buying and selling a stock and buying a hundred shares or less than what's offered. But when we move into the institutional community, I don't think the institutional community is going to like the idea that an issuer knows exactly what they're doing in real time. One, because of the potential leakage on large ADV orders and two, because if say I'm an owner of a stock and I'm lightening up and the company knows that, they might say, I'm not going to meet with that company why they're selling our stock. So if I'm a large investor, I'm not sure I like that type of transparency. Are there things that can be done to potentially mask that activity?
Brett Redfearn:
A hundred percent. It's a great question. Transparency is obviously a double-edged sword. In crypto you hear a lot of people talking about its full transparency. Everybody can see what everybody else is doing on the chain. That's great, but when it's an institution, they're making trades or other activity, they don't want everybody to know that and that that's information leakage and that could be problematic. So it's a very different use case that has to be figured up. So yes, there are ways in which this can be handled. Right now I would say we're getting into a more esoteric part of all this, but one of them is sort of ZK proofs. So zero-knowledge proofs is one way in which this is being done to help mask that. A second one is there are something called layer-two privacy rollups.
I won't get into all of that. One of the things when I think about institutions, the easiest way for me to think about it is that the ownership for an institution is still going to, it still can be held in a custodial wallet. So I can either self-custody it, I can either have it in my own wallet, in my own name. But when we think again about the on-chain trading world, it can be held in an omnibus custodial wallet. So my broker could still be holding these tokens under its name, and so you're going to see a wallet, but it's going to be a big broker who's executing trades conceivably alongside of a number of other participants, just like you have today, when we see broker give-offs going out there.
So there's more wood to chop on this, but I think that the use case is there and if the benefits are there, it's very conceivable that this problem can be solved. I do think that there is a sort of an institutional use case where two institutions could conceivably move a block of trade on-
Peter Haynes:
No disintermediation of brokers here. Okay, come on, come on.
Brett Redfearn:
All right, so we'll skip that for now.
Peter Haynes:
No, I'm kidding.
Brett Redfearn:
We will be talking about disintermediation soon, because that is part of the tokenization narrative.
Peter Haynes:
I get that. And I am laughing because I think about a story I heard about an emerging market, where there was IDs and a particular account was trading a name, and there was someone who was the brother of an executive of the company that this firm was selling and he worked in the area that had access to this information. He calls his brother up and tells him, "Hey, this XYZ company from US is selling your stock." And this is the type of leakage that you just think we can get out of the business here in 2025. But I'm glad to hear that things will be worked on in your world or in the crypto world as we move in this direction.
So one thing during your time when you're at the SEC and following during the Gensler SEC was whether or not this whole definition of whether a cryptocurrency was a security or not, and there's this red line definition called the Howie test. Can you tell us what the Howie test is for defining what a security is and where did the regulator land on what is in fact deemed to be a security?
Brett Redfearn:
It's a really important question. I think that we're moving past some of this now with the Atkins administration in the SEC, but I mean look, so the first obvious statement is securities are security. Some of them are just simply obvious. So this question really does come down to a lot of the crypto products that were perceived to meet the conditions of the Howie test. And so sort of like, "Well, here's an initial coin offering or here's a crypto product, and really it's different, but it looks a lot like the security." So how do we know if it is or not and how do we know if they're just simply trying to get around the rules? So the Howie test has been very important in that it's a little bit unfortunate. We're using a standard that was determined by a court decision in 1946 about orange groves that talked about investment contracts making something a security.
So look, the Howie test and the analysis that's used to determine if something is a security or an investment contract is really four things. It's one, it involves an investment of money. Two, in a common enterprise. Three, with the expectation of profits. Point four, derived solely from the efforts of others. So they look at that set of things, they say, "Okay, well he's invested money. It's a common enterprise." They're expecting profits from this, and guess what? Those profits are being done because of the efforts of others. So that's the Howie test. That's a legal standard. Those things have been applied many times over nowt.
Keep in mind this, right? So the Howie test, same language, during the Gensler era, Chair Gensler believed most products, most of the crypto products were securities, including using that analysis. Chair Atkins, interestingly, he says most of these products are not securities, and he recently gave a speech where he sort of elaborated on a need for a more clear taxonomy to help provide clarity for people on that.
And I think it's worth noting when you ask about the status of this, this is a live topic in the US Congress right now. As you know, there is a bill that has passed the house called the Clarity Act. Obviously the name Clarity is because during the last five years, the crypto community and others have continued to say, we need clarity. So we have the Clarity Act. It's passed in the house, it still hasn't passed the Senate. So we don't have a final final on this. But I would say this, that Atkins in his last speech on Project Crypto, he really got us closer to that because he did sort of talk about a taxonomy and get into some of the other aspects of this.
By the way, one of the reasons why it's really important Congress acts is because we don't want a situation where this SEC sort of has one interpretation and then we have the ability for the next one who knows, could come in and say, "No, actually we're going back to the old definition." So it's important that Congress acts here.
Peter Haynes:
You talked about taxonomy in the speech you're referring to that Atkins gave recently, I think it was the Philly Fed speech. He talked about how something can be a security and then not a security. It starts out as a security and then it's not afterwards. I think it relates to the initial coin offerings, but can you explain that for our listeners?
Brett Redfearn:
Let me try to get to this, right, and you'll see this in one of the court decisions that's out there, but the idea is that something could actually reflect the characteristics of the security at the time of issuance, but that as it is released into the world and as it becomes more decentralized, it may no longer have reflect all of the characteristics of the security. And you've seen this with some of the products that are out there. Like an interesting precursor to this is the speech that Bill Hinman gave on Ethereum where he talked about when Gary met Howie Plastics, and these are two different lawsuits, but the basis of the analysis was that at the beginning there was a group who had created a product, Ethereum, and they ended up putting it out into the world, but then at some point in time it became adequately decentralized, and so therefore it no longer was a security.
So for example, you could have a product where somebody releases a crypto token, they offer it out in some kind of an offering that's a securities transaction, but over time it becomes a decentralized product. It's no longer controlled by a specific entity. It doesn't give you any rights into the equity of any particular company. And so there's a lot more to this, but I think that kind of gets it at the gist of how something could start out as an investment contract and then no longer be considered a security over time. It's a little tricky, but I think that it is important to understand because this is likely going to be baked into the final legislation that we see.
Peter Haynes:
And obviously we're in an evolving space. No one knows the exact answers, and I appreciate you're giving us the best lens into this of anyone.
So recently, regulators held a joint CFTC SEC roundtable in part to discuss streamlining regulation of crypto-based technology. Where is this debate at currently, and is there still uncertainty over who regulates what products in the US?
Brett Redfearn:
I think that we're making progress. I do believe that this is heading in the right direction. I think this roundtable was great. It's wonderful to see the CFTC and the SEC getting together and trying to figure things out in one room. But yeah, there still is some uncertainty here. I think until Congress acts on this and sort of articulates some specific jurisdictional issues, I think there will be some questions. I think hopefully there's... I think a very constructive dialogue going on between the SEC and CFTC. I think with Selig's nomination to run the CFTC, he worked closely with Paul Atkins. So I think that relationship is going to really help them work together. And I think that relationship at the high level of these two agencies is going to be important for getting on the same page because quite frankly, it's challenging when you have two separate regulatory entities that have to get on the same page who at the same time oftentimes are fighting for jurisdictional authority.
So because of that, they don't always look at products and markets through the same lens, and institutionally they can have different interests in terms of who controls and who oversees what. So that creates a bit of a tension. It's very hard to solve because as you know, also the CFTC is overseen by the Agriculture Committee and the SEC is more House Financial Services and Senate Banking. So like I said, I think for this reason it's important congress does a good job. I think they need to be as clear as they can. The Clarity Act should be very helpful.
But one of the tricky things I think that it's worth noting is that if you think about it, so for a lot of these products that are being deemed crypto commodities or commodities, there's an interesting dynamic. If you think commodities like, okay, well that must be the CFTC, but keep in mind the existing mandate for the CFTC does not include some of the things that were involved here. So ETH markets are spot markets, ETH investors are retail investors. The CFTC does not regulate spot markets, and the CFTC generally does not regulate retail investors. So there has to be an expansion to the roles and responsibilities in the jurisdiction of the CFTC.
And spot markets, the SEC is very familiar with that. So think about it, CFTC is professional markets derivatives, it's different professional investors. As they move into this space of regulating spot markets and retail investors, there is going to need to be a lot of conversation back and forth. I think the SEC has a lot of the expertise there, and like I said, the CFTC has been limited to for retail markets, it's mainly over fraud and manipulation, but not the broader regulatory authority.
Peter Haynes:
It's such a difficult space right now when you think about the types of products that are now traded on exchanges in what we think of as stock exchanges, yet you have triple leverage ETFs on single names or on sectors that are derivative-like. And it just seems to be very difficult to draw the line between what's considered a derivative. Obviously the SEC has options under their purview as well. So I find that a complexity. I'm glad to hear that you think there's going to be good cooperation and that assuming that this new nominee is approved, he'll have a good working relationship with Chair Atkins.
So I want to come back to taxonomy, which you mentioned a second ago in that recent speech from Chair Atkins. And I want to pick up on one aspect of that speech, which I found kind of interesting, and I'm going to read a quote to you and then get your perspective. And this was what Atkins had said.
"While capital formation should continue to be overseen by the SEC, we should not hamstring innovation and investor choice by requiring that the underlying assets to trade in one regulated market versus another." So when I read that and read it over again, it sounded to me like the commission wanted to focus on, when we think of 33 and 34, the 33 act governs primary offering. Sounds to me that seems to be where the commission is focusing and less on secondary activity, which is governed by the 34 Act. Am I reading too much into that or do you think that he's going to lighten the oversight of secondary market activity as we expand into the DeFi world?
Brett Redfearn:
I got to say, I think that you're spot on and picking one of the more interesting tidbits of this speech, and I think it's worth having this discussion. I'm not sure if I know exactly where he is headed in here, but I'm happy to share some thoughts.
Let me just say first of all, in that speech, kudos to Chair Atkins for really moving the discussion along and helping to provide the taxonomy. One of the things that he did was he took a number of these products and he made it very clear that they're not securities. So when he talk about digital commodities and collectibles and tools and things like that, that was important because there's a lot of builders out there who were trying to do things and he's sort of given them comfort that they can continue with their projects and not have to worry about getting that call from enforcement or that Wells notice. So I think that's really great.
On this one, it's interesting. So in the Project Crypto speeches and the last one in particular, he talked about sort of super apps and other things being able to happen. And one thing I think that connects into what you're saying here. What he said crossed my mind. So it feels to me like they may be looking to enable securities to, in certain cases, trade peer to peer on unregulated venues. And so when you think about super apps like today, there are DeFi platforms where it's really software that's enabling an individual to transfer a security to somebody else where there's no broker dealer involved, there's no eight registered ATS, there's no exchange involved. So in a libertarian worldview, if you had a stock certificate, Peter, you could give me the stock certificate. So in the technological world that we're in today with tokens, could that potentially be feasible?
So I don't know, this sort of gets me to the speculation about what is going to be in this innovation exception. Are they looking to unlock the ability for peer-to-peer transfers in unregulated venues to try something out to see how that world goes? I know that there are some crypto companies who are very interested in doing that without being broker dealers, without having ATSs. But remember when I say this, when I say peer to peer, I'm not talking about broker-facilitated transactions. It's like in a DeFi pool I can meet you there. Or I think there's also the possibility that liquidity providers could be in there as well, right? Because they wouldn't be registered dealers, but they'd be offering up securities.
Like I told you before, not on this pod, but elsewhere, I've gone in and bought some of these things. And I think that there are liquidity providers on the other end that aren't registered dealers. My view is that this is looking towards freeing up an exemption for individuals to be able to freely do things that they can't do today in a world without all the regulated [inaudible 00:40:13].
Peter Haynes:
What happens if I'm an insider when you transfer that to me, and/or Al Qaeda? I'm just curious. This is where I think the market is going to put a red flag up and say, "Let's be a little bit careful here." Do you think there's a way for this to work to allow those libertarians to achieve their goals while also protecting investors and markets?
Brett Redfearn:
In this evolving space, there are different kind of normative perspectives on how far the concept of economic freedom goes and how far some of these sort of deregulatory positions land. My personal view is that smart contracts should be deployed for registered tokenized securities to ensure lawful transfers. So even if I don't necessarily have a broker dealer at play, I could send you something, but this goes back to the concept I used before about a white-listed wallet. So Peter, if you had a white-listed wallet, it would mean that your wallet has now been certified.
Peter Haynes:
Right. It's like my brokerage account.
Brett Redfearn:
This is Peter Haynes, your name isn't on the wallet, but it says this is somebody who's been AML KYC. This is a Canadian citizen in my case, in some cases for these white-listed wallets, I've tried things where I live in New York and somebody might not be licensed New York or New York DFS and told to block me by a smart contract.
For private market securities white-listed wallets will say, "Are you an accredited investor?" Or, "Are you a qualified participant?" All of these things are attached to the wallet and the smart contract will know when you do that transfer that this is okay. So it is my hope that there is the ability to unlock some greater economic behavior, but where smart contracts facilitate lawful transactions. I know that today, and I don't know if you want to get into this, but there's a lot of this happening with permissionless transactions.
So a lot of what we will talk about Europe, but a lot of, I think what is happening offshore are happening in permissionless ways where it is wholly feasible for the first person might need to be KYC, but after the first person, if you don't have permissioning in smart contracts, it could go from that guy to Al-Qaeda to Hamas to a Russian oligarch and then back to somebody who's KYC who can then essentially redeem the token. And that is a different world, and I think that we really need to think that through. And my view is that hopefully that lands in the right space for the purposes of OFAC, et cetera.
Peter Haynes:
I know I shouldn't joke about these things, but I've laughed a couple of times in thinking about 13F pages where they list all the shareholders and we're going to see Al-Qaeda listed on some company's shareholding list and wonder how. But at any rate-
Brett Redfearn:
In some cases, transparency is important.
Peter Haynes:
Yeah, that's exactly right. And I do understand this is something that the regulators are going to take very seriously. Just before we finish up here, in part one where we've been doing a lot more of the background, and that is I want to talk about an announcement that NASDAQ made recently, that it was partnering with the clearing entity DTCC to offer digital alternatives to stock trading on its platform. Can you explain the significance of that announcement?
Brett Redfearn:
Right. So without getting into the details of the proposal and what they're trying to do, I'd say first and foremost, it is important because it's a signal that major financial intermediaries are taking tokenization of securities extremely seriously. I think there was a time when people were sort of like, "Eh, we don't really need to deal with this. This is just those crazy crypto people." And I think now you're seeing much more serious financial intermediaries realizing they need to do something, they need to come up with a plan.
I know that investors who were in NASDAQ, owned it, and they've been asking these questions. So I think that it's important to show that there's an action that's been taken, and I think you're going to see that more and more. I'm not a hundred percent sure about the compelling nature of this current proposal because I think it has some limitations. So for example, this remains in a world where everything is still locked in DTCC. It puts DTCC in the position as the sole minter of tokens. And I think there's a lot of other people who can do things. So I think there's other models that could emerge for issuer-sponsored, native tokenized securities that unlock more things. But in the meantime, I think that what they've done is an important first step, and it shows that the time has come to take the tokenization of security seriously.
Peter Haynes:
Well, Brett, that's been a great introduction here, and that's the end of part one of our two-part podcast special on tokenization. Be sure to tune in for part two, which will be coming soon. Thank you.