The Death Of CLARITY Gives Rise To Some SEC Certainty

Last week, the Senate put the nail in the coffin of the CLARITY Act because a test vote (called a “cloture vote”) failed to garner enough support for the Senate to devote more time to moving forward with the bill. The CLARITY Act was a sweeping digital asset market infrastructure bill that would have helped to provide regulatory certainty to the marketplace and allowed all digital asset players to innovate without running afoul of the agencies that regulate the marketplace, specifically the Securities & Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC). 

As a fast follow to the disappointment over CLARITY, the SEC announced an “Innovation Exemption” order that grants “temporary, conditional exemption relief” for five years to specific players in the digital assets marketplace. There are two broad categories of parties who are affected by the Innovation Exemption order – Tokenized Securities Venues (TSVs) that the order exempts from the definition of “exchange” and dealers who provide liquidity in related liquidity pools that the order exempts from the definition of “dealer”.

Specifically, the order allows for the development of digital tokens that represent shares of stocks listed and traded on major U.S. exchanges (“National Market System stock” or NMS). The traditional shares would remain the underlying security and the tokens would represent those shares, allowing investors to trade the tokens rather than moving the shares directly. Described by SEC Chair Paul Atkins as a significant step forward, he also says, “[t]he Innovation Exemption, while temporary, would allow TSVs to trade tokenized NMS stock in a permissioned environment today while the Commission considers the need for additional action to facilitate onchain trading.”

The venues for trading the tokens, TSVs, are intended to create on-chain secondary markets that “bring together buyers and sellers of tokenized NMS stock”. Meanwhile, the TSVs are also able to provide automated market makers (AMMs) – blockchain-based trading mechanisms – that rely upon liquidity pools to support the trading, and these pools are called AMM Liquidity Pools. The liquidity providers to AMM Liquidity Pools are granted an exemption, also for five years, from the definition of “dealer” as defined in the Securities Exchange Act (Section 3(a)(5), and beyond providing liquidity, they may “also be engaged in additional activities that are indicia of dealing activity, such as quoting pricing to customers or entering into agreements to provide committed capital.” The exemption for such dealers is narrowly tailored and applies “solely within the limited context of AMM Liquidity Pools operating pursuant to” the order.

The authority to issue the Innovation Exemption, as described by Commissioner Mark T. Uyeda who is the chair of the SEC’s Crypto Task Force, is based upon the regulatory flexibility built into the National Securities Markets Improvement Act that Congress adopted to amend the Securities Exchange Act. He states, “[i]n the past, this authority has been used to allow the introduction of new products and services in a way that maintains investor protections and transparency, while providing observable data points to inform future policymaking. In that sense, use of the Commission’s exemptive authority to allow innovation is a well-trod path. Examples of popular products and models that grew from the SEC’s initial use of exemptive authority are money market funds, index funds, and exchange-traded funds.”

Meanwhile, Chair Atkins was certain to underscore that the exemption is “carefully considered and structured . . to provide important investor protections.” Those protections include all of the following – sanctions compliance; setting standards of access to TSVs that only allow certain participants to trade; assurance to holders of the tokens that they have “the same rights and privileges as the traditional securities, meaning that there will be no synthetics; and issuers of NMS stock have the opportunity to object and prevent their shares from trading on a TSV. 

In addition, the order provides that only U.S. persons may register as a TSV and that TSVs must provide written notice publicly and to the Commission at least thirty days in advance regarding their intention to operate. The blockchain solution being used by the TSV must be fully auditable and flexible enough to cease the trading of tokens within 30 days, should the issuer of the underlying shares choose not to allow such trading. The solution should also be transparent, with updated reporting on transaction prices, sizes, timing and direction occurring at least every ten minutes. 

Finally, the SEC order requests public comment on all aspects of the exemptions, but specifically poses 10 areas of inquiry. There is no deadline for submitting comments, and all comments provided will be posted on the SEC’s website, without redaction of personal identifying information.