Witnesses Urge Legislators to Address Tokenization Risks

Witnesses before the House Financial Services Subcommittee on Digital Assets, Financial Technology and Inclusion ("the Subcommittee") advocated for additional regulations to facilitate the development of the tokenization of real-world assets.

In a Subcommittee memorandum, staff defined tokenization as "the process by which an entity creates a unique, digital representation of an asset that can be transacted and stored with blockchain technology." The staff highlighted two proposed bills: (i) to "conduct a study to assess whether additional guidance or rules are necessary to facilitate the development of tokenized securities and derivatives products;" and (ii) to "require the Federal Reserve, Federal Deposit Insurance Corporation, Office of the Comptroller of the Currency, and the National Credit Union Administration to jointly submit a report on trends in the use of blockchain technology to tokenize traditional assets."

Subcommittee Chair French Hill (D-AR) highlighted recent bipartisan support for comprehensive digital asset market structure legislation which passed the House (H.R. 4763, the "Financial Innovation and Technology for the 21st Century Act") but distinguished those efforts from those of tokenization, which, he said "deserves its own distinct conversation and prioritization." He emphasized the potential of tokenization to modernize US markets by reducing costs, increasing transparency and improving efficiency. Mr. Hill criticized regulatory barriers that hinder innovation and called on regulators to embrace modernization.

Mr. Hill introduced the witnesses as "individuals actively leveraging tokenization to improve and enhance both our capital markets and our banking system." The following witnesses testified:

• Securitize Co-founder and CEO, Carlos Domingo outlined his company's efforts to create a compliant pathway for tokenizing financial assets, including obtaining necessary registrations and licenses to facilitate the issuance, trading and settlement of tokenized securities. He described inefficiencies in private capital markets and how blockchain can reduce the need for intermediaries and provide more efficient lifecycle management for securities. He emphasized the need for clear definitions of digital asset securities, regulatory support for special purpose broker-dealers, the acceptance of public blockchains and the recognition of digital transfer agents. He urged new legislation (i) to enable the safe and compliant use of blockchain in financial markets and (ii) to keep pace with progress in other jurisdictions like Europe and Asia.

• Depository Trust and Clearing Corporation ("DTCC") Global Head of Digital Assets, Nadine Chakar highlighted DTCC's history of automating financial transactions. She noted DTCC's acquisition of DDA, aimed at facilitating the lifecycle processing of tokenized financial assets. She emphasized the potential benefits of tokenization, such as increased efficiency, lower costs and broader investor access. However, she pointed out potential risks, including security vulnerabilities, compliance challenges and the need for interoperability among different tokenization approaches. She reported on several DTCC projects regarding digital assets.

• Sidley Austin Partner and Head of FinTech and Blockchain, Lilya Tessler emphasized the need for existing regulations to be adapted to fully realize the benefits of tokenization. She described examples of tokenized assets, such as securities, bank deposits, gold and real estate and noted that current regulations apply to these assets regardless of their form. Ms. Tessler emphasized the importance for regulatory clarity and flexibility to enable the capabilities of blockchain technology, such as smart contracts, automated compliance and real-time data sharing. Ms. Tessler also discussed the challenges faced by market participants, including regulatory uncertainties and the need for qualified custodians for tokenized securities. 

• American University Washington College of Law Professor, Hilary J. Allen cautioned that while tokenization can enhance efficiencies, it can also introduce new risks. She argued (i) increased financialization of assets could lead to speculative bubbles and financial instability, similar to the 2008 financial crisis, (ii) speed and automation associated with tokenization might increase market volatility and reduce opportunities for human intervention during crises and (iii) software vulnerabilities and cyberattacks could increase operational risks.