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Wreckage of Unregulated Exchanges Highlights Importance of Investor Safeguards

Securitization Enables Investing in Traditional Financial Instruments and Real World Assets

Dec 11, 2022

Digital assets like cryptocurrencies and NFTs were one of the fastest asset classes to gain in “value” over the last two years – and the fastest to collapse in value, too. The crash of FTX and Alameda Research is a major news and financial event, but it’s hardly a one-off. The wreckage of FTX and Alameda is piled atop that of Celsius, Voyager, Three Arrows, and others who avoided regulations intended to protect investors. Indeed, another big name – BlockFi – announced its bankruptcy just two weeks ago. The spectacular rise and fall of these previously respected names, as well as crypto and NFT prices, demonstrate both the importance of investor protection regulations and of investing in assets that actually have an underlying value.

Tokenized securities are one way of investing in traditional financial instruments or real world assets consistent with existing investor protections. Let's look at some of the main differences between tokenized securities and other digital assets like crypto and NFTs.

What Are Tokenized Securities? What Are Security Tokens? What are Digital Asset Securities?

The same thing. Security tokens are a form of exempt security which record ownership rights on the blockchain. They are referred to by the U.S. Securities and Exchange Commission as “Digital Asset Securities” but can also be called tokenized securities, for short. Security tokens enable the entire securities lifecycle to be recorded on the blockchain: from origination to trading on secondary markets. This provides benefits for both businesses raising capital and the investors allocating it.

For businesses, security tokens use smart contracts to automate repeat labor and increase operational efficiency. For investors, security tokens can provide greater potential access to liquidity by enabling shorter duration lockups and true ownership over securitized assets.

What makes security tokens different from digital assets such as crypto and NFTs is that security tokens use blockchain technology primarily to keep track of securitized assets that already have an established value. Digital assets use blockchains to build consensus, and then go on to trade that consensus as value. While both security tokens and digital assets share some key features such as using smart contracts, they remain fundamentally different. And this is largely due to the time-honored process of securitization.

What Is Securitization?

Securitization is the process of converting typically illiquid assets into marketable securities. By converting assets into securities, it becomes possible to buy, sell, and trade those securities using regulated entities such as transfer agents and alternative trading systems.

Instead of deriving value from consensus and usage alone, security tokens use securitization to provide investors with real-world value. And this enables traditional assets such as real estate or private equity to be pooled together and offered fractionally. For example, assets like real estate have a market value. When a company owns multiple pieces of real estate, they can be combined together and repackaged to be sold as securities on behalf of the company. And by putting these securities on the blockchain, investors can truly own their shares and gain greater access to potential liquidity.

While security tokens use the blockchain to record and transfer value, they do not have the same financial attributes of digital assets. As seen above, digital asset security tokens rely on traditional financial assets to provide value and use regulatory exemptions to enable investing. Digital assets fluctuate wildly in value in part because they do not have these attributes. And when the value goes to zero as with the collapse of Terra / Luna, investors are not protected.

How Investor Protections Help Investors Navigate New Territory

Investor protections help keep investors whole and are just one part of regulatory oversight that was introduced in the aftermath of the Great Financial Crisis. Formally known as the Investor Protection Act of 2009, this piece of legislation was brought forth by the Dodd-Frank Act to mitigate the potential fallout from future financial crises.

The Investor Protection Act created a committee with which the SEC could consult regarding new financial products, fee structures, and trading strategies, and increased protection for whistleblowers.

Together, these acts enabled greater transparency for investors, as well as a way for securitized assets to gain regulatory protections. While digital asset innovators have been encouraged to consult the SEC’s FinHub to ensure that their new financial products fit within established regulatory parameters, not all do. For example, FTX did not follow established regulatory guidelines and investors took the hit. On the other hand, security tokens provide investors with real-world value consistent with current regulations and enable similar protections that traditional exempt securities provide.

For investors who understand the benefits of blockchain technology, security tokens remain a viable alternative to investing in digital assets. They provide the efficiency, transparency, and true ownership that digital assets enable with the added benefit of providing real-world value and a regulated ecosystem to operate within.

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