How To Address Regulatory Compliance When Tokenizing Real-World Assets

Decentralized finance (DeFi) broke onto the scene a few years ago aiming to revolutionize the way investing, lending, trading, custody and other financial activities are conducted. Despite the successes and notable innovation in the space, these DeFi activities have generally been operating outside of the traditional financial ecosystem. At the same time, traditional financial institutions have mostly steered clear of crypto and DeFi out of compliance concerns and fear of drawing the attention of skeptical regulators.

The tokenization of real-world assets (RWA), however, is the one theme that can unite the DeFi and TradFi factions.  Leading web3 companies Coinbase, Circle and Aave recently formed the Tokenized Asset Coalition aims to bring the “next trillion dollars of assets” on-chain[1], while major investment banks such as JP Morgan, Société Générale, Goldman Sachs and Citi are actively working on projects leveraging blockchain to tokenize securities and real world assets. The latter has described tokenization as the “killer use case” and forecast $4 - $5 trillion of tokenized assets by 2030[2]. A recent study by Texture Capital found that 86% of market participants felt that RWA tokenization would increase over the next 24 months[3].

Merging these two worlds will not be straightforward, however. Practitioners will need to consider the following factors when tokenizing RWA:

Regulatory Structure  – This is the #1 factor to consider as most real-world assets will either be securities, commodities, or a banking product. Of these the largest category will be securities as this includes stocks, bonds, fund interests, and most real estate investments. In addition, commodities such as gold and oil, and banking products such as loans are often securitized.

Jurisdiction – Different countries have their own securities regulations. So while a cryptocurrency can be easily transferred across borders, the same is not true for securities. Issuers of RWA will need to ensure their offering can be legally sold in the desired jurisdictions.

Primary Issuance – depending on the asset type, an issuer of tokenized RWA will need to comply with the appropriate regulations. Under US securities regulations, in order to sell an investment to the public a company will either need to file an S1 and go through a full registration process leading to an IPO or utilize a Regulation A or Regulation CF exemption. Reg A allows issuers to raise up to $75mm per year (it is sometime called a ‘mini-IPO’.) Reg CF allows smaller emerging growth companies to utilize crowdfunding up to $5mm. For more information on Reg A and Reg CF, take a look at our recent blog. Alternatively, an RWA issuer could utilize the Reg D exemption, but would be limited to selling to accredited investors only and there would be a 12-month lock-up on secondary trading.

Broker Dealer – Although not necessarily a requirement, issuers will usually need to work with a broker dealer to distribute the RWA to investors. When selecting a broker dealer, it is important to work with one who has specific expertise and licenses for digital asset securities such as Texture Capital.

Offering Memorandum – An offering memorandum will be required to sell securities. This includes a description of the offering, the company, business plan, financials and a discussion of potential risk factors. A white paper is not sufficient!

KYC, AML & Due Diligence – To help ensure investor protections, broker dealers are required to conduct due diligence on all issuers. This involves background checks on the control persons, and analysis of the issuing entity to ensure risks are appropriately disclosed and marketing materials are fair and balanced. In addition, all investors will be subject to Know-Your-Customer rules and Anti Money Laundering screening. Recent distributed identity innovations in web3, can help streamline this process. A Decentralized Identity token (DID)in an investor’s wallet can verify their identity and KYC/AML status seamlessly without them having to go through a full onboarding process.

Transfer Agent – a transfer agent (TA) is required when issuing and trading digital securities including RWA. The TA’s role is to maintain the official cap table for an issuer and sign off on any secondary transfers. Traditionally TAs have been legacy entities using proprietary centralized databases, but newer entrants are embracing blockchain to fulfill their record-keeping obligations[4].

Blockchain – When tokenizing assets, it’s important to select a blockchain that supports smart contracts and token issuance, with low transaction fees. Another important consideration is whether it should be public, a permissioned subnet, or fully permissioned. Generally speaking, financial institutions prefer some level of permissioned access to enhance compliance and transaction confidentiality. Large investment banks will typically choose a fully permissioned network such as Canton or Corda, whereas other issuers will choose permissioned subnets of public chains such as Ethereum or Avalanche. 

Trading – For RWAs that are securities, trading can only occur on platforms that are registered with the SEC such as a national stock exchange or alternative trading system. At this time no national stock exchanges support trading of digital securities[5], and only a handful of ATSs – including the Texture ATS – can support trading of digital securities[6]. Decentralized exchanges (DEx’s), which are popular in DeFi are typically not licensed to trade security tokens in the US.

We are still very much in the early innings of RWA tokenization, but the entrepreneurs building in the space are helping create a new market structure that will improve access, transparency and liquidity[7]. Texture Capital is proud to be working with leaders in RWA tokenization such as DigiShares, KoreConX, Plural Energy, Polymesh, Provenance, RE Tokens, Roji, T-Rize, Vertalo, and Vesta Equity.

As BlackRock CEO, Larry Fink recently said, “The next generation of markets is tokenization of securities[8]”, and we expect it is only a matter of time before the disparate camps of DeFi and TradFi become fully integrated.

[1] https://www.coindesk.com/business/2023/09/07/tokenization-advocacy-group-wants-to-bring-the-next-trillion-of-assets-to-blockchain/

[2] https://www.citigroup.com/global/insights/citigps/money-tokens-and-games

[3] https://www.texture.capital/insights/tokenization-of-real-world-assets

[4] See for example: https://transferagentprotocol.xyz/

[5] Note: the Boston Security Token Exchange utilizes blockchain but only for certain order and post trade data.

[6] https://www.finra.org/media-center/blog/inside-look-finras-crypto-asset-work

[7] Blockchain is a new technology and unproven in financial markets. There is no guarantee that tokenization will enable any secondary market liquidity.

[8] https://blockworks.co/news/blackrock-ceo-us-lagging-innovation-tokenization