ICI Provides Recommendations to Regulators on How to Oversee Tokenization

The Investment Company Institute ("ICI") published a white paper with recommendations to regulators on how to oversee tokenization of securities.

The white paper described two models of tokenization: (i) the issuer-sponsored model, in which an issuer puts its own securities on a blockchain, which becomes the official ownership record, and (ii) the third-party-sponsored model, in which another firm creates a token representing the underlying security. The paper identified two variants of the third-party model: a custodial variant, in which the third party issues a token representing the underlying security (such as a tokenized security entitlement) while holding the underlying in custody, and a synthetic variant, in which the third party issues its own separate security (such as a tokenized security-based swap) that provides synthetic exposure to the underlying. 

The white paper noted that third-party-sponsored models carry added risk, since investors may not grasp their rights or their exposure if the sponsor fails. The white paper flagged additional risks of tokenization, including the following:

• Tokenized and non-tokenized markets may fragment, raising best-execution and fair-pricing concerns.
• Tokenized and non-tokenized versions of a security could trade at diverging prices.
• Demand and depth of tokenized markets could affect liquidity and increase volatility.
• Smart contracts may face code vulnerabilities, cybersecurity threats, lack of standardization, regulatory uncertainty, and enforceability concerns.

The white paper also pointed out the benefits of tokenization: tokenized money-market funds already trade peer-to-peer around the clock, faster settlement reduces failed trades, and smart contracts can lower operating costs.

The ICI recommended the following principles for policymakers:

1. Embrace Innovation. Regulators should welcome blockchain and tokenization as the next step in a long history of technology making markets cheaper, faster, and more accessible.
2. Protect Investor Choice and Competition. Rules should be technology-neutral and let the marketplace decide what works, rather than picking winners or favoring any particular platform or business model.
3. Make Rules That Actually Work. Regulations should be practical and adapt to how new technology is used, not rigidly applied from a pre-digital era.
4. Keep Core Investor Protections Intact. No matter how the technology evolves, the basics must remain: informed investors, protected assets, disclosed conflicts, and fraud-free markets.
5. Require Clear Disclosures About Tokenization Models. Investors must know exactly what they are buying, especially when a third party tokenizes a security without the original issuer's involvement or endorsement.
6. Be Agile, Not Rigid. Regulators should write principles-based rules focused on outcomes and update them as technology evolves, giving market participants clear and fair notice of their obligations.
7. Let the Transition Happen Gradually. Tokenization should be optional, not forced, with the shift to blockchain allowed to happen at a natural pace without sudden mandates or unnecessary delays.