Designing Effective Regulation for Blockchain-Based Markets.

• Author: Hughes, Heather

1. INTRODUCTION 899 II. THE EXAMPLE OF ASSET TOKENIZATION 902 III. STAKEHOLDER COORDINATION AND EFFECTIVE REGULATION 905 IV. CONCLUSION 907 I. INTRODUCTION

   Effective regulation of blockchain-based markets calls for coordination among lawyers, businesses, coders, and lawmakers. How might we achieve adequate coordination and why is it important? (1) This Article takes up these questions, using one example of an increasingly popular type of blockchain-based financial transaction: the issuance of tokens backed by off-chain assets. (2) The objective here is not to advocate for a particular regulatory treatment for asset tokenization, but rather to use this deal type as a springboard to discuss what "effective regulation" means in the context of blockchain-enabled markets. (3)

   The topic of regulation often conjures a public/private dynamic in which private actors generate and trade financial claims and public agencies control for excessive risks. (4) Focusing on a public/private dynamic, however, can obscure the regulatory role of complex private-law doctrines (contract and property) that enable enforceable deals in the first place. (5) Effective regulation of blockchain-based financial transactions will demand both (i) compliance with requirements such as registration of securities offerings, know-your-customer (KYC) rules, and the like, and (ii) attention to the contract and property rules integral to the enforceability of claims on assets. In the context of asset tokenization, security token issuances must comply with any applicable securities and other regulations. (6) Perhaps more fundamentally, security tokens must represent interests in assets that stakeholders can legally determine in the event of competing claims among investors, issuers, and third parties asserting rights in tokenized assets. (7)

   Commentators identify automated compliance as a benefit of transactions expressed as blockchain-based smart contracts. (8) Automated compliance mechanisms, so far, address the first regulatory challenge--compliance with securities laws and other agency-mandated, bright-line rules. (9) That is a great development. But asset tokenization depends upon the proper, legal transfer of assets to investors. In a tokenization that is structured like a typical asset securitization, this means proper administration of true-sale and non-consolidation rules, to make tokenized assets bankruptcy remote vis-a-vis the asset originator. (10) Might it be possible to design smart contracts for tokenization that ensure proper transfer of assets to the issuer, to automate compliance with property laws, thereby solidifying the claims of both investors and originators' creditors? (11) Could such a development enhance the value of security tokens? (12)

   These questions are complex. First, what constitutes a "proper transfer" of assets for purposes of securitization, and the potential claims of investors and originators' creditors, can be very difficult to establish in many cases. (13) Second, the difficulty of determining the legal scope of investors' rights in securitized assets relates to the value of an issuance. Legal uncertainty, generally speaking, can decrease the value of an issuance. At the same time, legal ambiguity can purposefully obscure the scope of property rights in a pool of securitized assets to increase value by creating an assignment to investors that is absolute on its face, but then is qualified with recourse that shields investors from depreciation. (14) Extensive recourse makes the securities better for investors, but in the event of bankruptcy, this same recourse may support a finding that the securitized assets are not the property of investors. (15) Rather, they are part of a bankruptcy estate against which the investors may assert claims along with various other creditors. This a worst-case scenario that investors of course want to avoid.

   In other words, the parties to financial transactions in many instances make a business decision that their deal is worth more to each of them if they defer the issue of pinning down the legal status of the assignment until there is a default. Default, at the time of closing, is a remote and unlikely event. This practical reality presents interesting issues for the effective regulation of blockchain-enabled transactions. If coders write smart contracts to dispose of tokenized assets upon default, how does that affect the efficacy of bankruptcy law's automatic stay? (16) How might we design smart contracts to preserve the function of the automatic stay? If such a design were possible, what type of regulation would require contracting parties to use it? If such a design were not desirable, how do we articulate this policy choice about the claims of originators' creditors?

   Lawyers, clients, coders, and lawmakers should explore whether blockchain-enabled smart contracts might automate compliance with private-law doctrines, perhaps cleaning up the legal underpinning of complex issuances. If blockchain technology enables the expansion and automation of raising capital against the value of various asset classes, it presents an opportunity to clarify the policy choices surrounding such transactions. The lessons that tokenization presents also are relevant, for example, in the contexts of blockchain-based secured lending, and securities repurchase agreements or "repos" (which are increasingly integral to cryptocurrency markets). (17)

   Part II describes asset tokenization and decentralized finance. Part III describes why effective regulation requires coordinated efforts among lawyers, clients, coders, and lawmakers. It describes current "law and code" projects that present the potential for a coordinated approach to regulation. Part IV concludes by stating the importance of imagining and implementing effective regulation for blockchain-based markets. We must think critically about what we regulate, who the regulators are, and how regulation supports markets. Failure to do so could squander the potential of emerging platforms.

2. THE EXAMPLE OF ASSET TOKENIZATION

   Technology companies have been developing platforms integral for the issuance of digitized securities, including debt instruments and asset-backed securities. (18) A digital security or token can reference any kind of asset, making interests in various types of assets tradable on blockchain platforms. Market actors may digitize assets for a variety of purposes. For example, real estate records on blockchain platforms involve digitized deeds created to improve a county's chain of title and decrease fraud. (19) An asset tokenization is when a company digitizes rights to assets in order to offer asset-backed tokens on a decentralized platform. This is a form of decentralized finance, or DeFi (20)--an issuance offered to purchasers on a blockchain platform. (21)

   Blockchain-based smart contracts (22) govern the terms of the security tokens. Market actors and regulators, including the U.S. Securities and Exchange Commission (SEC), identify tokenization of off-chain assets as an important emerging practice. (23) Securities broker-dealers are expressing increased interest in tokenized assets. (24)

   One advantage of security tokens is that they can be coded to ensure regulatory compliance. For example, if a given issuance must not involve more than a certain number of investors, the platform can disallow the purchase of shares by additional investors beyond the limit. When blockchain-based issuances "automate compliance," securities regulation, KYC requirements, anti-money laundering (AML), and transfer controls are the kinds of regulations platform developers and issuers typically target. (25)

   Digitization presents different issues for different asset classes. Issuing shares of a commercial building to multiple and diffuse purchasers of real estate-backed security tokens on blockchain could lead, for example, to maintenance issues if no investor has sufficient control or interest to make expenditures...