The Innovation Exemption and the Hybrid Market In Between

The SEC has opened an important space for experimentation, and the market didn’t need much time to notice.

Within the first two weeks of the Innovation Exemption, prospective operators were publishing notices of their intention to launch Tokenized Securities Venues, or TSVs. There is a big difference between announcing a market and filling it with buyers, sellers and liquidity. Still, the speed of the response says something: give the digital asset industry a workable path to test a new market structure, and people will start building.

The SEC’s September 17 exemption gives qualifying TSVs a temporary, conditional route to trade eligible tokenized stocks without registering as national securities exchanges. Approved participants trade against a pool of assets contributed by liquidity providers, with software setting prices and executing trades under the pool’s rules. The relief lasts five years and comes with limits on stocks and trading volume, along with protections for shareholder rights and an opportunity for issuers to object to specified third-party tokenized trading. 

For institutions, the question is what it will take to use these markets once they exist. A trade may happen in seconds, but sourcing inventory, keeping track of ownership and rights, safeguarding assets, and understanding exposure across venues and conventional systems will take more work. Those connections will help determine whether a promising venue becomes a usable market.

The less photogenic parts of the financial system

The Innovation Exemption deserves the attention it is receiving. But a new place to trade does not, on its own, answer who owns an asset, how that ownership is recorded, or how the asset is safeguarded. If a token can move in seconds but the records and processes behind shareholder rights cannot keep pace, the market has solved only part of the problem.

The SEC has been working on modernizing other critical aspects of financial plumbing, too. Its September 1 transfer agent proposal would modernize rules for firms that maintain issuers’ ownership records and process securities transfers, including electronic and blockchain-based recordkeeping. Its October 1 custody proposal would address how investment advisers and regulated funds could custody crypto assets, including conditional use of state trust companies and limited self-custody.

Both remain proposals. Neither gives the market a finished operating model or answers how every firm involved will share responsibility. But taken together with the exemption, the proposals invite a broader conversation about how trading, ownership, custody and settlement could fit together. The practical test will be whether institutions can use the resulting market without having to solve those connections for themselves on every trade.

Connectivity as markets evolve

For institutions, that leaves a practical question: How much of tomorrow’s market will we need to build ourselves, and how much can we reach through trusted intermediaries and infrastructure providers? The answer becomes especially important during the hybrid period ahead.

Conventional and tokenized assets may coexist for years. Different venues will make different choices about blockchains, access, liquidity, custody, and operating hours. Institutions will need to work across that variety while continuing to serve clients through the systems they already use.

This hybrid period deserves as much attention as the destination. Operating across both worlds could become a continuing service institutions need and pay for, wherever the market ultimately lands.

Consider a market maker offering liquidity to a tokenized-stock pool. The trade itself may happen in seconds. Acquiring more eligible inventory, converting it into the right form, moving it to the right place, and managing the resulting exposure could take considerably more work. A pool cannot offer dependable liquidity if replenishing it is an adventure.

Or take an asset manager holding conventional shares and tokenized positions linked to the same issuer. Over time, a blockchain record could reduce reconciliation across systems. During the hybrid period, though, the manager has more to reconcile, not less. The task requires a coherent view of exposure, rights, distributions and corporate actions across both.

That is why interoperability matters at several levels: between blockchains, between TSVs, and between conventional and tokenized forms of an asset. All of these design choices have commercial consequences. The opportunity is to make those connections routine, so institutions can participate in new markets without rebuilding their operating model for each venue.

Re-bundling, not disintermediation

Steve Vallas and Richelle Cox of BlockchainAPAC explore a related idea in their paper, The SEC Innovation Exemption: tokenization can rebundle intermediation. Functions that conventional markets distribute across transfer agents, clearing and settlement infrastructure, market makers and exchanges may be combined or automated within fewer operating layers. 

Take clearing and settlement, for example. 

U.S. equities already generally settle on T+1, one business day after the trade. But the existing clearing and settlement system does much more than fill the time between execution and delivery. It provides netting, funding efficiencies, default-management arrangements and a legal framework for completing transactions. 

Atomic settlement links delivery of the asset and payment so that both happen together or neither happens. Properly designed, that can address the risk of delivering one side without receiving the other. But if a market also requires every trade to be fully funded and settled individually, it gives up the funding efficiencies that netting can provide.

Atomic exchange does not inherently require immediate gross settlement. That’s a design choice, and an important one. Equally, netting cycles do not need to arbitrarily fit to a day boundary; micro-batches hourly or on some other, shorter cycle could achieve a better balance between trade compression and time to settlement finality. The industry has an opportunity to combine programmability and faster asset movement with arrangements that use capital efficiently.

The useful question is what improves across the whole transaction. Does faster settlement release capital? Does prefunding tie more of it up? Can an institution move between venues without leaving inventory stranded? What happens when trading is open but a service needed to support it is closed?

Those are questions that will be answered through use. The Innovation Exemption now lets qualifying venues begin working through those questions in the U.S. under temporary, conditional relief from the exchange definition.

All assets are digital assets

At Talos, this convergence has been part of our thinking from the beginning. Our roots are in traditional capital markets. We brought that experience into digital assets and built infrastructure for institutions dealing with fragmented liquidity, continuous trading and different operational models. 

Our longstanding conviction has been that all assets will become digital assets. That shift will take time. Institutions will spend years in a hybrid period, operating across conventional and digital markets, with different venues, blockchains, custodians, and liquidity providers involved along the way. They should be able to access liquidity and manage risk without commissioning a small infrastructure project every time.

Talos is built for the hybrid period and for what comes after it: tools to reach new venues, move eligible inventory where it is needed, and maintain a coherent view of positions, rights and risk across both markets.

The exemption gives the industry room to demonstrate what better markets can look like. Early participants will help establish which designs attract liquidity, which improve economics, and which simply move complexity somewhere else. 

A tokenized market becomes compelling when institutions can do something useful more reliably, more efficiently or with greater choice. 

The door is open. Now it's time to build. 

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