Regulatory Divergence in Tokenized Stocks: Balancing Innovation and Investor Protection Under the SEC's Innovation Exemption Framework

The tokenization of traditional securities is reshaping the financial landscape, but the regulatory frameworks governing this innovation remain fragmented. At the heart of this divergence lies the U.S. Securities and Exchange Commission's (SEC) proposed "innovation exemption" under its Project Crypto initiative, which seeks to streamline the issuance and trading of tokenized stocks while navigating the pushback from traditional market participants. This article evaluates the SEC's approach against the traditional exchange model, analyzing how each framework addresses investor protection and market fairness-and the risks inherent in their contrasting philosophies.

The SEC's Innovation Exemption: A Framework for Flexibility

The SEC's innovation exemption, unveiled in 2025, aims to foster digital asset innovation by allowing tokenized stocks to bypass certain traditional securities regulations. Under this framework, tokenized securities must be fungible with their traditional counterparts, share the same CUSIP number, and grant equivalent shareholder rights, such as voting and dividend privileges according to the SEC's framework. Trading is permitted on national securities exchanges and through FINRA-regulated broker-dealers, ensuring alignment with existing infrastructure according to Nasdaq's proposal.

Chairman Paul Atkins has emphasized that the exemption is designed to reduce regulatory ambiguity while preserving investor protections. For instance, the SEC's token taxonomy distinguishes between digital commodities (not securities) and tokenized traditional assets (subject to securities laws), clarifying that economic reality-not the label "token"-determines regulatory treatment according to the SEC's statement. The agency has also proposed tailored rule amendments for custody, trading, and offerings of digital assets, signaling a commitment to innovation according to regulatory developments.

However, this approach has drawn criticism. The World Federation of Exchanges (WFE), representing major exchanges like Nasdaq and Deutsche Boerse, warns that broad exemptions could erode market integrity by allowing crypto platforms to bypass longstanding safeguards. "Crypto companies should not be permitted to operate under a different set of rules than traditional exchanges," the WFE stated, stressing the need for a "level playing field" according to Reuters. Similarly, the Securities Industry and Financial Markets Association (SIFMA) has called for guardrails such as transaction caps and duration limits to prevent unequal trading ecosystems according to SIFMA's analysis.

The SEC's Innovation Exemption: A Framework for Flexibility

In contrast, the traditional exchange model prioritizes integration of tokenization within existing regulatory frameworks. Nasdaq, for example, has proposed a blockchain-based system for tokenized securities that adheres to the national market system's rules. Under this model, tokenized stocks settle on a T+1 basis, retain identical order types and fee schedules, and maintain transparency in execution priorities according to Nasdaq's proposal. Nasdaq's CEO, Matt Savarese, emphasized that the firm's goal is to "enhance efficiency without compromising investor protections" according to Yahoo Finance.

This approach aligns with SIFMA's stance that tokenization should not dilute the principles of market fairness. By requiring tokenized securities to function within the same regulatory boundaries as traditional assets, the model avoids fragmented liquidity and inconsistent pricing. For instance, Nasdaq's proposal ensures that tokenized shares are subject to the same investor protections, such as best execution standards and transparency requirements, as their paper counterparts according to Nasdaq's proposal.

Critics of the SEC's exemption argue that the traditional model's rigidity could stifle innovation. Yet proponents counter that it preserves the stability of financial markets, which have thrived under decades of consistent oversight. As SIFMA noted, "Functionally equivalent roles in digital asset markets should be subject to the same regulatory oversight as traditional intermediaries" according to SIFMA's letter.

Risks of Regulatory Divergence

The tension between the SEC's innovation exemption and the traditional model underscores broader risks in the tokenized stock market. First, fragmented trading ecosystems could emerge if crypto platforms exploit exemptions to create parallel markets for substantively identical assets. SIFMA warns that such fragmentation could weaken safeguards, leading to unequal access for investors and distorted pricing according to SIFMA's analysis.

Second, the use of distributed ledger technology (DLT) introduces unique challenges. While the SEC's token taxonomy aims to address these, critics argue that DLT's complexity-such as smart contract vulnerabilities and cross-border jurisdictional issues-requires more granular oversight according to the SEC's speech. For example, the SEC's Spring 2025 Regulatory Agenda includes proposed amendments to custody rules for digital assets, but these remain untested in practice according to regulatory developments.

Third, the innovation exemption risks creating a regulatory arbitrage scenario. If crypto platforms face lighter compliance burdens than traditional exchanges, they may attract issuers and investors seeking lower costs, further eroding the latter's competitiveness. The WFE has explicitly cautioned against this, noting that "unequal regulatory treatment undermines investor confidence" according to Reuters.

Conclusion: Striking a Balance

The SEC's innovation exemption and the traditional exchange model represent two visions for tokenized stocks: one prioritizing flexibility and experimentation, the other emphasizing stability and consistency. While the former could accelerate adoption of blockchain-based financial instruments, it risks fragmenting markets and diluting investor protections. The latter, though more conservative, ensures that tokenization does not compromise the foundational principles of fairness and transparency.

For investors, the divergence highlights the need for vigilance. Tokenized stocks traded under the SEC's exemption may offer efficiency gains but could expose investors to higher risks in less-regulated environments. Conversely, traditional exchange models provide familiarity but may lag in innovation. As the SEC finalizes its framework, the challenge will be to harmonize these approaches-encouraging technological progress without sacrificing the safeguards that have long underpinned market integrity.