The SEC's New "Innovation Exemption": Five-Year Relief for Trading on Tokenized Securities Venues

Scope and Key Definitions

An AMM Liquidity Pool is a portfolio of crypto assets committed by liquidity providers and traded under the terms of self-executing smart contracts, which set prices algorithmically based on the ratio of the quantities of assets in the pool rather than by matching buyers and sellers through an order book. As users trade against those prices, or as liquidity providers add or remove assets, the smart contract rebalances the price of the assets offered for trading. Currently, such AMM Liquidity Pools do not trade tokenized securities because of several legal obstacles.

As described in our Commentary, "From Rigid Routing to Best Execution: SEC Proposal Could Reshape Listed Equities and On-Chain Markets," Regulation NMS's prohibitions on "trade-throughs" and locked and crossed markets conflict with the manner in which automated market makers ("AMMs") algorithmically determine prices without routing orders to potentially better quotes on other exchanges. While the rescission of these and other rules is pending, the Innovation Exemption provides immediate and ongoing relief.

The Innovation Exemption does not amend any rule, but instead conditions relief on compliance with an enumerated set of requirements. The relief conditionally exempts: (i) ) tokenized securities venues ("TSVs") from the definition of "exchange" in section 3(a)(1) of the Securities Exchange Act of 1934 (the "Exchange Act"); and (ii) certain Covered Firms from the definition of "dealer" under section 3(a)(5) of the Exchange Act. As a result of the exemption, a tokenized securities venue ("TSV") will not be required to register as a national securities exchange, operate under the exemption from registration available to an ATS, or be considered a trading center or market center under Regulation NMS.

Yet, the Innovation Exemption does not provide broad relief from securities laws to users, liquidity providers, and other participants in TSVs ("TSV Participants"). No primary issuances or initial offerings are permitted on a TSV; all offers and sales must be registered under the Securities Act of 1933 or exempt from registration, and the TSV must verify that the tokenized NMS stock provides holders the same rights and privileges as traditional NMS stock of an equivalent class, including the same economic interest, dividends, voting rights, and liquidation rights. Where the stock is tokenized by an unaffiliated third party, that third party must make related proxy materials and other issuer communications available to holders at no cost to the issuer or its shareholders.

The following key definitions shape the scope of the relief provided:

• "Tokenized Securities Venue" means an organization, association, or group of persons that brings together buyers and sellers of tokenized NMS stock by: (i) providing one or more AMM Liquidity Pools for permissioned participants to interact and agree to the terms of a trade; and (ii) setting standards for persons to access trading on such AMM Liquidity Pools. A TSV may make available for trading only a tokenized NMS stock that trades in a pair with another tokenized NMS stock, a non-security crypto asset such as a payment stablecoin issued by a permitted payment stablecoin issuer, or a tokenized money market fund.

• "Tokenized NMS Stock" means an NMS stock that is: (i) a security tokenized by, or on behalf of, the issuer of the underlying NMS stock; or (ii) a security tokenized by a third party unaffiliated with the issuer of the underlying NMS stock. The term does not include securities where a third party issues a crypto asset providing synthetic exposure to an underlying security, such as a tokenized linked security or a tokenized security-based swap, and it does not include rights and warrants.

• A "trading pair" is the combination of assets that a participant exchanges for one another in a given AMM Liquidity Pool, such as a tokenized share of common stock traded against a payment stablecoin. A pair may consist of two or more legs, but each leg must itself be a tokenized NMS stock, a non-security crypto asset, or a tokenized money market fund share; and any non-security crypto asset or tokenized money market fund share must be directly paired and traded alongside a tokenized NMS stock to be eligible for trading on a TSV. Each pair is generally a separate pool with its own reserves and its own price, so a single tokenized NMS stock may trade in several pools against different paired assets, and a TSV may be composed of multiple distinct liquidity pools containing different pair combinations for the same stock. Pair composition directly impacts liquidity provider economics: pools holding closely correlated assets generally expose providers to lower impermanent loss than pools holding assets with diverging prices.

• "Covered Firm" means any liquidity provider in an AMM Liquidity Pool that supplies liquidity in the form of tokenized NMS stock using proprietary capital and that may also engage in additional activities that are indicia of dealing activity, such as quoting prices to customers or entering into agreements to provide committed capital.

Conditions Applicable to Tokenized Securities Venues

To rely on the Innovation Exemption, a TSV must comply with several conditions, including the following:

• U.S. Person: The TSV must be a U.S. person and must therefore comply with the economic and trade sanctions programs administered and enforced by the Office of Foreign Assets Control.
  
  
• Opt-In Notice: At least 30 calendar days before operating, a TSV must publish a notice ("Notice") prominently on its publicly available website, written in plain English and presented in a clear, concise, and understandable manner, and within one business day of publication must notify the Commission in writing that it intends to operate under the TSV Exemption. The Innovation Exemption prescribes an extensive list of required Notice disclosures, covering governance, permissioning criteria, distributed ledger applications, AMM Liquidity Pool trading procedures, hours of operation, fees, conflicts of interest, systems safeguards, clearance and settlement, risks, service providers, trading oversight, and stoppages of trading. A TSV must revise its Notice on specified timelines, including 20 calendar days in advance of any material change to its operations or disclosures and within five business days of discovering materially inaccurate or incomplete information.
  
  
• Operating Conditions: Distributed ledger applications used by a TSV must be auditable, public, and deployed on a public, permissionless distributed ledger. A TSV cannot engage in financing activities, cannot borrow securities or non-security crypto assets on the TSV, cannot hypothecate or permit the hypothecation of such assets, and cannot extend credit to a participant to purchase tokenized NMS stock. A TSV cannot state that it is "registered" with the Commission or that its activities have been "approved" or "endorsed" by the Commission, and it must affirmatively disclose in its Notice that it is not registered. A TSV must make and keep current detailed trading and compliance records, preserve them in the United States while the exemption is effective and for three years afterward, produce them promptly to Commission staff in both human-readable and reasonably usable electronic formats, and consent to examination of those records at any time.
  
  
• Issuer Notice: Before making available for trading a tokenized NMS stock that was tokenized by a third party unaffiliated with the issuer of the underlying NMS stock, a TSV must provide written notice to that issuer ("Issuer Notice"), sent to the physical or email address for the issuer's principal executive offices listed on the cover page of its Exchange Act reports. Trading of that tokenized NMS stock may not commence until at least 30 calendar days after the issuer receives the Issuer Notice. If the issuer delivers a written objection on or before the 30th calendar day, the TSV cannot make that tokenized NMS stock available for trading and must amend its public Notice within five business days to disclose the objection.
  
  
• Trading Limits and Transparency: Tokenized NMS stock is tiered on the Limit Up/Limit Down Plan, with Tier 1 capped at 75 symbols and 0.25 percent of the prior month's average daily share volume in the relevant NMS stock, and Tier 2 at 250 symbols and 2.5 percent, in each case aggregated with affiliated TSVs. Exceeding a volume threshold after the first instance requires a three-month pause in that stock, while exceeding a symbol cap forfeits the exemption. A TSV must also publish U.S. dollar-denominated transaction data within 10 minutes, stop trading concurrently with any halt or suspension in the underlying stock, and notify participants and the Commission of significant operational events.

The Covered Firm Exemption

While providing liquidity alone does not necessarily constitute dealer activity, providers engaging in that and adjacent activities may trigger "dealer" status under the Exchange Act. The Innovation Exemption's carve-out for Covered Firms from dealer registration requirements addresses the uncertainty that arises when a liquidity provider engages in such activities, including providing price quotes to customers or committing capital under an agreement.

A Covered Firm's securities activities must be limited to activities related to the trading of tokenized NMS stock in an AMM Liquidity Pool operating under the Innovation Exemption, and it must trade solely for its own account and must not hold or custody customer assets. A Covered Firm must maintain records relating to its ability to maintain sufficient liquid assets to cover potential losses, any liquidity supplied, any liquidity provision or market making arrangement with a TSV, and any incentives, fees, rebates, or other compensation received. It must prominently disclose on any public-facing website that it is not registered as a broker-dealer, that it may enter into liquidity provision arrangements with a TSV, and that it may receive fees, tokens, or other incentives. It must also notify the Commission in writing of its role as a Covered Firm, including its business model, risk controls, regulatory contact, liquidity arrangements, compensation, and an acknowledgment that neither it nor any affiliate is subject to statutory disqualification.