Developments in the Tokenization of Securities in Canada

As the pace of innovation accelerates the use of blockchain technology to improve and disrupt financial markets, traditional financial institutions are moving quickly to keep up. In the United States, the shift over the last year to a more engaged regulatory environment has coincided with a seemingly continuous stream of announcements of new crypto-enabled service offerings and experiments by major market participants, such as The Depository Trust Company, Nasdaq and the New York Stock Exchange, as they explore how digital assets can help them improve existing services and keep ahead of disruption. While stablecoin technology has captured attention for its promise in disrupting payments, money transmission and other applications by “tokenizing” money, developments in the tokenization of other assets — and securities in particular — are raising the prospect of fundamental changes to traditional investment markets.

Tokenization of Securities

Tokenization is the process of creating a digital representation of a tangible or intangible asset using a distributed ledger technology network such as blockchain. A range of assets can be tokenized, including physical assets (such as commodities and real estate), financial assets (stocks and bonds) and intangible assets (such as digital artworks).

A tokenized security generally refers to a financial instrument or arrangement that meets the definition of “security” under existing securities legislation and that is formatted as or represented by a crypto asset, where the record of ownership is maintained in whole or in part on or through one or more crypto networks. Prominent examples trading in global markets today include tokenized money market funds, bonds and structured products linked to large-cap equities.

Proponents of tokenization suggest that potential benefits of a tokenized securities marketplace over existing financial market structures include 24/7 trading, instant settlement, fractional ownership, increased investor access to currently private markets, increased transparency in recordkeeping, increased efficiency and decreased reliance on intermediaries, such as through “programmability” (the use of smart contracts to enable automated execution of transactions). In a recent media appearance, Chairman Paul Atkins of the U.S. Securities and Exchange Commission (SEC) stated that tokenization could bring “huge benefits,” particularly noting that shortened settlement times could help reduce market risk and that tokenization would make markets “much more transparent” by making it easier for investors to own or hold securities directly, thereby giving companies more visibility as to their securityholder base.

Others argue that some of the touted benefits of tokenization could be (or have already been) realized using existing financial market infrastructure (such as fractional ownership or wider trading windows) or may run contrary to existing rules and public policy relating to investor protection (such as low-liquidity and market-abuse concerns respecting 24/7 trading). Institutions such as the Financial Stability Board have issued warnings about systemic risks unique to tokenized markets.

Taxonomy of Tokenized Securities

It is important to keep in mind when discussing “tokenized securities” that this is not a uniform category, nor one that fits neatly into a single regulatory framework in Canada. Tokenized securities encompass a wide range of instruments and investment products, each of which may raise specific considerations under securities and derivatives regulation and potentially other regulatory frameworks (including the developing regulation of stablecoins pursuant to Canada’s new Stablecoin Act). Instruments referred to in the market as tokenized securities range from issuer-sponsored, digitally-native securities (e.g., shares of a company issued using a digital ledger in place of an off-chain traditional share register) to products issued by third parties that may more closely resemble a custodial investment product or structured note.

In this context, a recent Statement on Tokenized Securities (SEC Staff Statement) published by Staff of the SEC offered a useful taxonomy of tokenized securities, described below.

Issuer-Sponsored Tokenized Securities

Where tokenization is undertaken by the issuer of the security, SEC Staff described two broad structures:

• An integrated model where the issuer (or its agent) integrates distributed ledger technology into the systems that it uses to record owners of the security, such that a transfer of the crypto asset on the crypto network results in a transfer of the security on the master securityholder register.
• A notification model where the issuer issues the security in the traditional manner (off-chain) and issues a related crypto asset to securityholders. The master securityholder register remains off-chain, and the token does not carry any rights with respect to the security. However, the token is used indirectly to effect transfers of the security — more specifically, transferring the crypto asset to someone else will notify the issuer (or its agent) to record the transfer of ownership of the security on the off-chain master securityholder register.

Issuers can choose to issue a single class of securities in multiple formats (such as a tokenized form of the security and an off-chain form, which could be made convertible into one another) or to issue such class only in one format.

Third-Party-Sponsored Tokenized Securities

Where a third party tokenizes securities issued by another unaffiliated person, the SEC Staff Statement describes two possible structures:

• Custodial tokenized securities: In this model, the underlying security is held in custody, and the third party issues a crypto asset representing the underlying security. The crypto asset evidences the holder’s ownership interest (whether direct or indirect) in the underlying security being held in custody.
• Synthetic tokenized securities: Here, the third party issues a crypto asset representing its own security that provides synthetic exposure to the underlying security. The return on the tokenized security is linked to the value of the security it references or events relating to the referenced security, but the tokenized security is not an obligation of the issuer of the referenced security. An example of this would be a tokenized structured note that represents a debt obligation of the third-party issuer with a payout linked to the performance of the referenced security.

Tokenized securities sponsored by third parties raise specific regulatory concerns in particular. The rights of investors to the underlying security, and the linkages between the tokens and the securities, can be subject to wide variations depending on the tokenization structure. As highlighted in a recent report on tokenization of financial assets published by International Organization of Securities Commissions (IOSCO), purely synthetic tokens may simply represent a promise by the token issuer to make payments linked to fluctuations in the price or valuation of the underlying asset, adding an element of counterparty risk exposure to the token issuer (in addition to the risks of fluctuations in the value of the underlying security), while custodial tokenized securities may add custody risks such as the use of non-bankruptcy-remote structures. These and other risks raise important disclosure considerations for token issuers.

Tokenization of Securities in Canada: Looking Ahead

The approach of Canadian securities regulators to the crypto industry thus far has generally been predicated on the view that existing securities legislation applies to crypto market participants, and the tailoring needed to adapt regulation under securities laws largely developed in the last century to this new technology has largely been done via regulatory guidance and exemptive relief. Staff of Canadian securities regulators have consistently taken a risk-focused approach in guidance notices regarding the application of securities laws to the crypto industry, such as Staff Notice 21-329 Guidance for Crypto-Asset Trading Platforms: Compliance with Regulatory Requirements. For now, Canadian securities regulators have published little guidance respecting tokenized securities specifically but are watching the space closely (the Ontario Securities Commission included monitoring tokenization use cases and impact among its proposed key priorities for the upcoming fiscal year).

Consistent with the “technology-neutral” approach to technological developments in securities markets espoused by IOSCO (which counts a number of Canadian securities regulators as members), Canadian securities regulators can be expected to take the view that offering and trading in securities, regardless of the format and whether tokenized or not, is subject to securities legislation, including existing prospectus and registration requirements. In addition, market participants will need to navigate other regulatory considerations, depending on the economic substance of a particular offering, which may include considerations relating to the application of securities laws to specific offerings like structured notes and investment funds, existing regulatory guidance applicable to “value-reference crypto assets,” existing regulatory frameworks in respect of non-tokenized custodial investment products, derivatives regulation, and the developing landscape of stablecoin regulation in Canada.

Tokenization of securities presents exciting opportunities to incumbent and new-entrant issuers and intermediaries alike. However, it is essential to bear in mind key risk considerations and focus on the economic substance of a given offering in design and offering phases. Our legal team at Blakes has deep expertise in the digital assets industry and traditional investment product offerings, and we stand ready to assist financial institutions and FinTech businesses in navigating the complex regulatory environment in Canada for tokenized securities.

For more information, please contact the authors or any other member of our Investment Products & Asset Management group.