SEC Grants Temporary ‘Innovation Exemption’ for Trading Tokenized NMS Stocks on Distributed Ledger Venues

The US Securities and Exchange Commission has issued an exemptive order that opens the door to trading tokenized public company stock using blockchain technology through the creation of a temporary framework to trade tokenized National Market System (NMS) securities on so-called Tokenized Securities Venues (TSVs) by certain automated market makers (AMMs) and liquidity pools (together, AMM Liquidity Pools).

The US Security and Exchange Commission’s (SEC’s) “Innovation Exemption” (the Order)[1] is designed to facilitate the trading of “Tokenized NMS Stock”[2] on TSVs through AMMs and AMM Liquidity Pools by providing a five-year, conditional exemption from: (i) the definition of “exchange” under Section 3(a)(1) of the Securities Exchange Act of 1934 (the Exchange Act) for TSVs that sponsor such trading (the TSV Exemption); and (ii) the definition of “dealer” under Section 3(a)(5) of the Exchange Act for certain firms that provide liquidity for such AMM Liquidity Pools (the Covered Firm Exemption).

The SEC, using its statutory exemptive authority, has established a limited pathway for permissioned secondary-market trading of Tokenized NMS Stocks using public, permissionless blockchain infrastructure. In the accompanying press release, SEC Chair Paul Atkins indicated that the experience gained under the temporary relief, together with public comment, can inform possible future rulemaking or action.

While the Order removes some significant obstacles of the existing exchange, alternative trading system (ATS), Regulation NMS, and dealer frameworks for such covered activities, it is subject to detailed limits on eligible securities and trading volumes, and also includes disclosure, transaction-transparency, technology, recordkeeping, trading halt, and other investor protection conditions that may remain challenging barriers to entry for some market participants.[3]

BACKGROUND

The existing regulatory framework presents a number of challenges for trading Tokenized NMS Stocks through AMM Liquidity Pools. Unlike a conventional order-book market, AMM Liquidity Pools typically use programmed rules and algorithms to determine prices based on the relative quantities of assets committed to a pool. Among other issues, the SEC noted that this model can be difficult to reconcile with Regulation NMS requirements governing trade-throughs, quotation dissemination, and minimum pricing increments.

For example, because an AMM may determine price by reference to assets in a liquidity pool rather than external market quotations, compliance with Rule 611’s trade-through requirements would likely require material changes to the AMM model. The SEC similarly noted that blockchain-based pricing may operate at finer increments than Rule 612 permits, and that rounding those prices to satisfy existing tick-size rules could affect arbitrage.[4]

SCOPE OF THE ORDER

The Order defines a TSV as an organization, association, or group of persons that brings together buyers and sellers of Tokenized NMS Stock by providing one or more AMM Liquidity Pools through which permissioned participants interact and agree to the terms of trades and by establishing standards governing access to those pools.[5] A TSV operating in compliance with the Order is exempt from the Exchange Act definition of an “exchange.”

As a result, it is not required, for covered activities, to register as a national securities exchange or operate pursuant to the ATS exemption from exchange registration. The TSV also will not be treated as a trading center or market center under Regulation NMS and therefore will not be subject to such applicable Regulation NMS provisions.[6] The exemption does not extend to securities activity outside the TSV or alter the regulatory status of TSV participants.

The exemption is limited to Tokenized NMS stock that is either tokenized by or on behalf of the issuer of the underlying NMS stock or tokenized by an unaffiliated third party. The definition does not extend to a third party’s own security that provides synthetic exposure to an underlying security, such as a tokenized linked security or tokenized security-based swap.

While the relief in the Order would apply to the trading of exchange-traded fund (ETF) shares that are NMS stock,[7] the Order does not provide exemptive relief from any provisions of the Investment Company Act of 1940 (1940 Act). In a footnote addressing the scope of eligible securities, the SEC observes that activities involving tokenized investment companies may raise issues under, among other provisions, Section 18, Section 22(d), and Rule 22c-1 of the 1940 Act.[8]

Accordingly, the Order could provide a trading venue for tokenized ETF shares while leaving fund sponsors, intermediaries, and others to address separately the 1940 Act and related requirements implicated by the particular tokenization structure. The specific 1940 Act concerns that are triggered by tokenized investment companies may not, however, be applicable to commodity-based exchange traded products (ETPs), such as spot commodity, commodity index tracking and other commodity derivative ETPs that are not registered investment companies.

Under the Order, Tokenized NMS Stock must be paired for trading with another Tokenized NMS Stock, a non-security crypto asset, including, for example, a qualifying payment stablecoin, or a tokenized money market fund. Importantly, a non-security crypto asset or tokenized money market fund may not be traded on a TSV unless it is directly paired with Tokenized NMS Stock.[9]

The relief is limited to secondary-market activity and provides that no primary issuance or initial offering of securities is permitted on a TSV pursuant to the exemption.[10]

PERMISSIONED TRADING ON PUBLIC BLOCKCHAIN INFRASTRUCTURE

An important feature of the Order is the distinction between accessibility of the blockchain and accessibility of the market. A TSV must establish standards allowing only permissioned participants to access trading. The Order contemplates, among other mechanisms, allowlisting or whitelisting wallet addresses or encoding eligibility criteria into the tokenized security itself.[11]

At the same time, the distributed ledger applications used by a TSV must be auditable and public and must be deployed on a public, permissionless distributed ledger. The SEC states that this requirement is intended to enhance transparency and market integrity and to permit participants and third parties to audit applications and identify vulnerabilities.[12]

ISSUER NOTICE, OPT-OUT RIGHTS, AND TOKENIZED STOCKHOLDER RIGHTS

Public Company and Other NMS Stock Issuers’ Rights

The Order establishes certain rights for public companies and other NMS stock issuers, dividing them into two categories: (i) issuers who have tokenized their own shares or engaged a third party to do so on their behalf; and (ii) issuers who have not tokenized their own shares or authorized any third party to do so on their behalf.

Issuers in the former category may have their tokenized shares picked up for trading by a TSV and do not have a right to receive notice or opt out of having any TSV make such tokenized securities available for trading on the TSV. Issuers falling into the latter category are entitled to advance notice from the TSV and a 30-day period to opt out of having any unaffiliated third-party tokenized shares made available for trading on a TSV.

The Order requires a TSV to provide an issuer with advance written notice of the TSV’s intent to make available for trading any unaffiliated third-party tokenized shares (the Issuer Notice). The issuer then has 30 calendar days from receipt of the Issuer Notice to send the TSV a written notice of objection (the Notice of Issuer Objection). If a TSV receives a timely Notice of Issuer Objection, the TSV is prohibited from making such tokenized shares available for trading and must update its public notice within five business days to reflect receipt of the objection.

The Order anticipates potential scenarios as to why public company issuers may wish to opt out, including concerns in maintaining control of its shareholder register and potential price dislocation from, or adverse effects on, the price of the issuer’s traditional NMS stock.[13]

Importantly, the Order provides that TSVs must send any Issuer Notice to “the physical or email address for the issuer’s principal executive offices listed on the cover page of the issuer’s Exchange Act reports”[14] and must include accurate contact information to which the issuer can return any Notice of Issuer Objection.[15]

If the issuer delivers a timely Notice of Issuer Objection, the TSV cannot make the unaffiliated third-party Tokenized NMS Stock available for trading; if the TSV does not deliver a required Issuer Notice or observe a timely Notice of Issuer Objection and the TSV permits such unaffiliated third-party tokenized shares to trade, the TSV will not meet the conditions of the TSV Exemption with respect to trading such Tokenized NMS Stock.

The Order appears to contemplate that this notice/opt-out process be undertaken on a TSV-by-TSV basis, such that an issuer could receive notices from (and deliver notice of objection to) multiple TSVs.

TOKENIZED STOCKHOLDER RIGHTS

The Order establishes protections for holders of Tokenized NMS Stock. Each TSV must ensure that any Tokenized NMS Stock made available for trading on its venue provides holders the same rights and privileges as traditional NMS stock of an equivalent class. The SEC identifies, among other attributes, owning the same interest in the company that holders of non-tokenized shares have, equivalent rights to dividends and voting, and rights to residual assets upon liquidation.

For stock tokenized by an unaffiliated third party, the third party must also distribute or otherwise make available related proxy materials and issuer communications without cost to the issuer or shareholders.[16]

TRADING VOLUME AND SYMBOL LIMITS

The SEC has limited the scale at which TSV trading can develop during the exemption period. The Order borrows the Tier 1 and Tier 2 classifications from the LULD Plan. Tier 1 generally includes NMS stocks in the S&P 500 and Russell 1000 and certain eligible ETPs, while Tier 2 generally comprises other eligible NMS stocks.

A TSV may make securities from both tiers available for trading, subject to separate limits: up to 75 Tier 1 symbols, with trading in each security limited to 0.25% of the underlying stock’s prior-month average daily share volume, and up to 250 Tier 2 symbols, with trading in each security limited to 2.5% of prior-month average daily share volume.

Affiliated TSVs must aggregate their trading volume and number of symbols for purposes of applying these limits, with the average daily share volume of the tokenized security traded on the TSV as the numerator, and the average daily share volume of the relevant NMS stock as reported by an effective transaction reporting plan as the denominator.[17]

The Order includes a stepped approach for violations of the volume thresholds. The first breach of a volume threshold for a particular Tokenized NMS Stock generally does not require a trading suspension; subsequent breaches require the TSV (and affiliated TSVs) to pause trading in that security for three months. The stepped approach does not apply to violations of the symbol limits.[18] These limits are intended, in part, to reduce potential adverse effects on the broader market while participants experiment with TSV trading.

PRICE DISLOCATIONS AND POTENTIAL ARBITRAGE BETWEEN TOKENIZED AND TRADITIONAL MARKETS

The coexistence of TSVs and traditional securities exchanges could create new channels for cross-market price discovery and arbitrage. Because AMM pricing generally reflects the relative quantities of assets in a liquidity pool rather than protected quotations in the traditional market, the SEC recognizes that a Tokenized NMS Stock may trade at a price that diverges from the corresponding conventionally traded security.

Where participants can convert between tokenized and traditional shares or otherwise establish offsetting positions, those differences could create arbitrage opportunities. The mechanics and effectiveness of that arbitrage would depend on the relevant tokenization structure, liquidity, settlement arrangements, transaction costs, and access restrictions; the Order itself does not prescribe a particular arbitrage mechanism.

The potential interaction may be particularly significant outside conventional exchange hours because TSVs may operate on a 24/7 basis. Tokenized markets therefore could contribute to overnight price discovery and generate repricing or arbitrage activity when the traditional market opens or reopens. The SEC expressly requests comment on the effects of overnight trading and the 10-minute transaction reporting requirement on market quality and exchange opening, reopening, and closing processes.

A TSV must also halt trading concurrently with a halt or suspension of the underlying NMS stock on its primary listing exchange, a condition intended to limit material price dislocations during formal trading stoppages.

PUBLIC TRANSPARENCY AND OPERATIONAL DISCLOSURE

Rather than subjecting TSVs to the full exchange and ATS disclosure and reporting frameworks, the Order imposes a bespoke transparency regime. At least 30 calendar days before commencing operations, a TSV must publish a detailed notice on its public website and notify the SEC within one business day.

The notice must address, among other matters, the TSV’s governance and ownership; participant eligibility and permissioning; eligible assets and tokenization arrangements; affiliate activities and conflicts; trading and AMM mechanics; fees and market data; systems safeguards and material risks; clearing and settlement; and trading surveillance and halt procedures. The notice also must make clear that the TSV is not registered with the SEC for activities conducted under the exemption and is not subject to Regulation NMS or the fair-access requirements applicable to certain ATSs.[19]

Separately, a TSV must make specified US dollar–denominated transaction data freely and publicly available in machine-readable format for transactions during the preceding 30 days. The data must be updated within 10 minutes after a transaction and must include specified price, size, time, direction, asset-pairing, and liquidity pool information.[20]

CONDITIONAL DEALER RELIEF FOR LIQUIDITY PROVIDERS

The Order separately addresses the regulatory status of certain liquidity providers. Notably, the SEC states that liquidity provision alone does not ordinarily constitute dealer activity and anticipates that, absent other indicia of dealing, AMM liquidity providers typically would be traders rather than dealers. Dealer status questions may arise, however, where a liquidity provider also engages in conduct such as quoting prices to customers or committing capital pursuant to liquidity arrangements.

The Order therefore exempts a liquidity provider that supplies Tokenized NMS Stock using proprietary capital and may engage in such additional indicia of dealing (Covered Firm) from the dealer definition for specified proprietary liquidity-provision activities in AMM Liquidity Pools operating under the TSV Exemption. A Covered Firm must conduct the covered trading solely for its own account and may not hold or custody customer assets.

It must also maintain specified records, make certain public disclosures, and notify the SEC concerning its business model, risk controls, liquidity-provision arrangements, compensation, and other matters.[21] The SEC states that reliance on the Covered Firm Exemption does not create a presumption that a person otherwise is a dealer.[22]

WHAT THE ORDER DOES NOT EXEMPT

The Innovation Exemption is consequential but limited. The Order does not provide relief from other applicable federal securities laws, including the antifraud and antimanipulation provisions of the federal securities laws, such as Exchange Act Section 10(b) and Rule 10b-5. It also does not relieve a TSV or TSV participant from federal anti-money laundering requirements or applicable Securities Act registration requirements related to transactions in Tokenized NMS Stock.[23]

With respect to the Securities Act, it is possible that many transactions on TSVs may be exempt from registration under Section 4(a)(1) of the Securities Act (the “ordinary trading” exemption); however, the applicability of the ordinary trading exemption, or any exemption from registration, will depend on the facts and circumstances at such time.[24] The TSV Exemption also does not determine the regulatory or registration status of TSV participants.

Depending on their activities, participants may remain subject to SEC and self-regulatory organization (SRO) registration requirements, federal securities laws, applicable SRO rules, and anti-money laundering requirements.

REQUEST FOR COMMENT

The exemptions are effective through September 17, 2031, although the SEC may modify their duration or other terms under Section 36 of the Exchange Act. The SEC is seeking comments on all aspects of the exemptions, including whether the TSV and Covered Firm exemptions should be modified or made permanent.

Among other subjects, the SEC particularly seeks input regarding potential effects of TSV trading on liquidity, pricing, and trading in underlying NMS stocks; overnight trading and the 10-minute transaction reporting standard; whether securities beyond Tokenized NMS Stock should become eligible; whether restrictions should apply to assets paired with tokenized stock; whether the Tier 1 and Tier 2 symbol and volume limits are appropriately calibrated; whether regulated entities face barriers to becoming TSV participants; and whether broker-dealer participants require Regulation NMS relief.[25]

PRACTICAL CONSIDERATIONS FOR MARKET PARTICIPANTS AND PUBLIC COMPANIES

Market participants interested in relying on the Innovation Exemption should consider the conditions as an integrated framework rather than focus solely on the relief from exchange or dealer status. Potential TSV operators in particular may wish to assess whether their existing technology and business models can support permissioned access on public, permissionless infrastructure; the issuer-notice process; rights-equivalence verification; volume monitoring; synchronized trading halts; 10-minute public transaction reporting; and the extensive public notice and recordkeeping requirements.

Broker-dealers and other regulated firms considering participation should separately assess which of their existing obligations continue to apply at the participant level. The SEC’s specific request for comment on participant-level Regulation NMS relief suggests this may be an important area for industry engagement.

Public companies and other NMS stock issuers should prepare now by establishing procedures for identifying TSV notices and determining whether to permit or object to third-party tokenization. Procedures should establish expedited routing of inbound physical mail and email to ensure that notices from TSVs are received and addressed in a timely manner to preserve the issuer’s ability to opt out.

Mailroom teams, investor relations, corporate secretary personnel, and others who handle incoming correspondence should understand that receipt may start a critical 30-day decision period and should establish procedures for alerting the legal department. Because the Order does not establish a central repository or reporting mechanism for issuers who have elected to object to having third-party tokenized shares traded on a TSV, it is possible that issuers may receive notices from (and need to submit corresponding objections to) multiple TSVs.

Issuers may also consider engaging with the notifying TSV on important topics, such as shareholder registry maintenance, price dislocation risks, proxy solicitation, and other investor communications. Public companies that have already tokenized their own shares should be aware of this development and review operational procedures and potential impacts on the company’s share register, proxy solicitation, and voting processes.

HOW WE CAN HELP

Public companies and other NMS stock issuers, tokenized securities platforms, broker-dealers, liquidity providers, investment managers, technology providers, and other market participants may wish to evaluate how the Innovation Exemption affects their existing or contemplated tokenized-securities activities and whether issues arising from the scope or conditions of the relief warrant comment to the SEC.

Morgan Lewis lawyers are available to assist all stakeholders in evaluating eligibility for the exemptions, assessing the interaction between the Order and existing securities-market requirements, designing compliance and disclosure frameworks, and preparing comments to the Commission.