Market Players Envision Stock Exchange Powered by Blockchain

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As regulators crack down on the multibillion-dollar, fraud-tainted business of initial coin offerings, some market operators are exploring ways to bring them in line with U.S. securities law.

This week, a U.S. options exchange backed by Canada’s TMX Group said it would team up with online retailer Overstock.com to create the first regulated exchange for “security tokens,” which are essentially digital versions of stocks.

Security tokens use blockchain, the technology behind bitcoin, to manage the transfer of the shares from one owner to another. Unlike the tokens sold in many ICOs, they are designed to be compliant with Securities and Exchange Commission rules. Only a few security tokens have been issued to date.

While the idea of the tokens is largely untested and the exchange plan is far from gaining SEC approval, supporters say such tokens could transform the way startups raise money by allowing them to bypass venture-capital firms and effectively sell shares over the internet. Others say replacing stocks with security tokens will make markets more efficient and cut investors’ costs.

The SEC could still quash the concept, however, and traditional Wall Street players like banks, exchanges and central securities depositories have incentives to maintain the status quo.

Research firm Greenwich Associates, in a report Tuesday, called security tokens an “invasive species” that would lead to the extinction of traditional stocks. “Issuing [securities] on the blockchain is the future and a lot more efficient than the way we do it now,” Greenwich analyst Richard Johnson, the report’s author, said in an interview.

BOX Digital Markets LLC, a sister company of BOX Options Exchange LLC, said on Tuesday it would seek to launch the exchange for security tokens as a joint venture with digital-assets trading platform tZero.

Chicago-based BOX, the smallest of the five U.S. options-exchange operators, is about 40% owned by Canada’s TMX Group. TZero is majority-owned by online retailer Overstock.com. Overstock Chief Executive

Patrick Byrne

is an outspoken proponent of virtual currencies who has invested in blockchain companies, although his track record has been mixed.

A number of startups are working on security tokens. They include Harbor, which is focusing on tokens backed by real estate, and Polymath, which is developing tools for ensuring that trading in security tokens is compliant with relevant laws.

Harbor is backed by Silicon Valley venture-capital firms including Peter Thiel’s Founders Fund and Andreessen Horowitz, while Polymath raised $58.7 million in an private token sale that it registered with the SEC, according to a Jan. 25 regulatory filing.

Security tokens are different from the “utility tokens” typically sold in many ICOs available to the public. Utility tokens occupy a legal gray area. Many of the companies issuing them say they don’t fall within the SEC’s jurisdiction. But SEC officials differ, saying many utility tokens probably are securities under U.S. law, which would mean the ICOs in which they were sold were illegal.

In contrast, security tokens are securities—as the name suggests. They potentially could have built-in computer programs that force their owners to comply with SEC rules.

A a security token could only let itself be sold to an “accredited investor” under SEC Rule 506. This rule lays out the procedure by which many startups in the U.S. raise money. It limits the sale of shares to accredited investors, who need to have a certain minimum income and meet other requirements.

The BOX-tZero announcement comes as the ICO market shows few signs of slowing down. About $7.15 billion has been raised in such offerings so far this year, according to Token Report, despite the mounting regulatory scrutiny.

Overstock itself has drawn regulators’ attention. The retailer disclosed in March that the SEC had requested documents about a digital-token offering conducted by tZero, as part of an investigation. The probe does not mean tZero or Overstock are suspected of wrongdoing.

The BOX-tZero joint venture will be completed in the coming weeks, after which it will commence discussions with regulators, according to Lisa Fall, CEO of BOX Digital.

Instead of creating a new exchange, the plan is to use BOX’s existing exchange license to list security tokens, Ms. Fall said in an interview. She declined to discuss the timing of the process.

Teaming up with BOX could accelerate tZero’s long-running plan to digitize the U.S. stock market. Overstock unveiled tZero in 2015 with the goal of building a trading platform for digitized assets. To date, it hasn’t generated any revenue from commercially available blockchain-based services, Overstock reported in its most recent annual filing.

On the SEC probe, Mr. Byrne said in an interview that tZero has been in continuous contact with various divisions of the agency. He added that he welcomed regulatory scrutiny of ICOs, estimating that at least 90% of them were illegal.

“The ICO craze is the world of the past,” Mr. Byrne said. “In the past three to six months, everybody understands it’s going towards security tokens.”

Write to Alexander Osipovich at alexander.osipovich@dowjones.com

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