Introduction
Tokenized capital markets are moving from concept to reality, offering faster settlement, broader access, and new forms of investment. In Canada, the Canadian Securities Administrators (CSA) is now actively exploring tokenization, the creation of digital representations of real or financial assets or rights on a blockchain or similar technology, and the market infrastructure to support transactions and the servicing of such financial instruments.
Legal clarity and adaptation of current regulatory frameworks are essential to unlocking the full potential of tokenized markets. Clear laws and rules mean investors can use tokenized instruments confidently, and market participants can build market infrastructure faster.
This post examines the key legal and regulatory challenges in tokenized markets and highlights practical pathways to support innovation, safeguard investors, and help shape the future of Canada’s capital markets.
What Are Tokenized Capital Markets?
Tokenization is the creation of digital representations of real or financial assets or rights using blockchain or similar technology. Unlike traditional securities, these digital tokens can be transferred directly on-chain, enabling faster settlement and programmable features and automated servicing capabilities.
However, tokenization highlights the challenges with existing legal and regulatory frameworks that are built around market intermediaries. These structures and corresponding market rules that require routing transactions through intermediaries are designed to address settlement, counterparty and systemic risks. With tokenization, questions arise around the role of intermediaries, ownership recognition, enforceability, settlement finality and whether blockchain records can replace traditional registries.
Global initiatives illustrate both promise and complexity: in traditional markets, DTCC has piloted tokenized securities services, and NASDAQ is exploring tokenized securities trading. Many of these initiatives may reflect a transitional state – e.g., requiring conversion of traditional securities into token form and dual recordkeeping – and may not reflect the target state.
Tokenization addresses a key issue in today’s capital markets – settlement risk. Blockchain technology and smart contracts can remove some of these frictions. However, the laws and rules need to adapt to establish settlement finality.
The figure below shows how on-chain atomic settlement using tokenized securities and stablecoins can significantly reduce settlement risk provided that laws and regulations are updated to reflect this capability. However, settlement risk shifts to operational risk, and issuer credit risk and liquidity risk for the holder of prescribed stablecoins if conversion is delayed.
Solutions to reduce these risks for the holder include:
- Implementing a robust stablecoin regulatory framework with strong governance and risk mitigation can enhance market confidence that prescribed stablecoins are always exchangeable for par value.
- Giving qualified stablecoin issuers a settlement account with the central bank. Improve interoperability between stablecoin infrastructure and real time payment rails like LYNX to enable near real time conversion at the option of the holder. E.g., When operating times are not fully aligned, some of the risks shift from holders to regulated liquidity providers for stablecoins. Cross-border payments (not shown) introduce another layer of complexity.
Legal and Regulatory Challenges
Legal clarity on tokenized securities remains a core requirement.
Regulatory guidance from the SEC and/or the CFTC in the US, MiFID II in the EU, Germany’s Act on Electronic Securities, and Switzerland’s DLT Act show a range of approaches on a variety of matters to provide greater clarity.
Other critical matters supporting tokenization include the following:
- Settlement finality establishes when transactions are legally completed – obligations are discharged and ownership is established. Clear laws and rules help market participants manage risks around issuer credit risk and enforceability.
- Digital Asset Custody (DAC) solutions must be robust. Safeguarding private keys requires strong technical expertise and operational resilience, and aligning custody requirements across jurisdictions remains complex as laws around digital assets evolve.
- Operating standards and market practices must evolve to match technical capabilities and operational risk management. Faster settlement cycles, pre-funding vs net settlement, error correction and on-chain dispute resolution require consideration. In a future where technology platforms perform activities of market participants, strong governance and clear boundaries between the roles and responsibilities of a technology service provider vs a registrant will be key.
- On-chain market data infrastructure must meet quality, auditability, interoperability and compliance requirements. Fragmented data solutions risk non-compliance and can undermine investor protection.
Regulatory Considerations
Regulators are guided by the principle of “same activity, same risk, same regulation.” In tokenized markets, these activities are performed with potentially fewer intermediaries. Policy decisions regarding legal recognition and settlement infrastructure are likely to influence architectural design choices and competitive positioning. Global examples still illustrate varying approaches and regulatory outcomes are influenced by risk tolerance and local market and regulatory structures. Global interoperability means greater alignment on critical questions of ownership rights, establishing settlement finality, and maintaining cross-border enforceability. The impact of rules on business economics will also influence the pace of innovation and adoption.
CW3 Recommendations
Tokenization of capital markets will evolve at a different pace for different sectors and markets. For sectors with established market intermediaries and arrangements, the transition may require an interim pathway enroute to a target state. For less developed market sectors, the path to a target state may be more direct.
The five matters below are believed to affect all market sectors:
- Legal foundations: Amend laws to clarify digital asset holder rights particularly under insolvency of an intermediary, and recognize blockchain networks as legal registers. Provide interim guidance for classification and taxonomy.
- Settlement asset design: Recognizing prescribed stablecoins for on-chain settlement will require adaptation of payment and settlement laws. A core policy issue that affects design is the current requirement for money settlement that will require the integration of stablecoin arrangements with traditional payment systems including the central bank. While stablecoins can function as an on-chain settlement instrument in capital markets today, its adoption by institutional investors particularly as wholesale settlement infrastructure requires more collaborative analysis.
- Digital asset custody: Align prudential and market rules, focusing on enforceability and operational resilience.
- Operating and governance standards: Establish operating rules for evolving participant roles, settlement finality, error correction, and dispute resolution.
- Market data infrastructure: Collaborate with regulators, security experts and auditors to reduce fragmentation and operational risk, promote compliance, and maintain auditability.
The Path Forward
Collaboration between legal experts, regulators, and market participants is crucial to create coherent, interim pathways. Longer term, proactive legal reforms will ensure tokenized markets are innovative, resilient, and investor-friendly. A clear legal and regulatory framework can unlock the full potential of these markets while safeguarding trust and stability.
Conclusion
Tokenized capital markets offer transformative opportunities. Their success hinges on addressing legal and regulatory challenges today and a vision of a target state. With clear foundations and regulatory pathways, Canada can support innovation and position tokenized markets for sustainable growth, benefiting investors, institutions, and the broader financial ecosystem.
