The Securities and Exchange Commission (“SEC”) issued an order approving proposed amendments (the “Proposed Amendments”) by The Nasdaq Stock Market LLC (“Nasdaq” or “Exchange”) to the Exchange’s rules to enable trading of certain securities in tokenized form during the pendency of a tokenization pilot program (the “DTC Pilot”) operated by The Depository Trust Company (“DTC”).

THE PROPOSED AMENDMENTS

Definition of Security

The Proposed Amendments amend Nasdaq’s definition of a security to mean, in part, a “security” as defined in Section 3(a)(10) of the Securities Act of 1933, that is either listed on the Exchange or traded on the Exchange pursuant to unlisted trading privileges.  The Proposed Amendments will permit securities to be traded on Nasdaq in:  (i) traditional form, meaning a digital representation of ownership and rights that does not use blockchain technology; or (ii) for the duration and under the terms of the DTC Pilot, in tokenized form.

Fungibility and Equal Rights

A share of a tokenized security is tradable on the same order book as, and with the same execution priority as, its traditional counterpart, provided the tokenized security is fungible with, shares the same CUSIP number and trading symbol as, and affords its shareholders the same rights and privileges as, a share of an equivalent class of the traditional security.  A tokenized security will be deemed to provide the same rights and privileges as a traditional security if, among other things, it conveys:  (i) an equity interest in the underlying company; (ii) a right to receive any dividends issued by the company to its shareholders; (iii) a right to exercise any voting rights to which shareholders are entitled; and (iv) a right to receive a share of the company’s residual assets upon liquidation.

Eligible Securities

Securities eligible for tokenization will be limited to: (i) securities in the Russell 1000 Index at the time the service launches, as well as any subsequent additions to the index (notwithstanding subsequent removals); and (ii) ETFs that track major indices, such as the S&P 500 index and Nasdaq-100 index.  Nasdaq plans to publish periodic alerts to identify the securities that may be traded in tokenized form.

Order Entry and Tokenization Flags

The Proposed Amendments will amend the Exchange’s Order Entry Rule to establish the process by which Nasdaq market participants eligible to participate in the DTC Pilot can indicate their preference to clear and settle an eligible security in tokenized form.  To do so, the participant will select a designated flag at the time of order entry.  This flag will communicate the participant’s preference regarding the form of the security (tokenized or traditional) and may include additional information or instructions required by DTC, such as the selection of a blockchain and digital wallet address.  Nasdaq’s systems will not verify whether a market participant qualifies to participate in the DTC Pilot or whether a security qualifies as an eligible security at the time of order entry and tokenization flag selection.  Similarly, Nasdaq will not assess DTC’s ability to execute a tokenization order for other reasons, including when a participant seeks to mint a token on a blockchain that is incompatible with the DTC Pilot or deposit it in a wallet that is not registered with DTC.  Therefore, if, at the time of order entry, the market participant is not an eligible market participant, the security is not an eligible security, or DTC is otherwise unable to execute the tokenization preference, DTC will settle the executed order in traditional (non-tokenized) form.

Execution Priority and Order Routing

The Proposed Amendments will amend Nasdaq’s Book Processing Rule to clarify that execution priority will not be impacted by the fact that an order contains tokenized securities or indicates a preference to clear and settle securities in tokenized form.  The Proposed Amendments will also amend Nasdaq’s Order Routing Rule to provide that when the Exchange routes orders in eligible securities that eligible market participants have designated for clearing and settlement in tokenized form, the Exchange will communicate this tokenization instruction to DTC upon receiving an execution for an order that was routed to another trading venue.

IMPLEMENTATION TIMING

The Proposed Amendments will become effective once the required infrastructure and post-trade settlement services are established by DTC.  Nasdaq will notify its members in an alert at least 30 calendar days before the Exchange begins trading securities in tokenized form.

CONCLUSION

The SEC’s approval of the Proposed Amendments marks a significant development in the integration of blockchain technology into traditional securities markets by establishing a framework for trading tokenized securities within existing regulatory structures.  Nasdaq has indicated that alternative forms of tokenization and clearance and settlement are also under discussion, and that future adoption of alternatives to the DTC Pilot will be undertaken by means of a separate proposed rule change filing.

For a discussion of the DTC Pilot, please see our Legal Update.