Digital Securities: A Primer
By: Howard Marks
Tags: Investment, Tokenization, Finance, Crowdfunding, Bitcoin

Digital securities may be a new buzzword, but it makes sense when you think about it. In the past securities were paper, literally. Your ownership of a stock was written down on paper and kept in a warehouse somewhere. Now these securities are digital, and this is in itself is a huge step forward.

With digitization, a security now can have special properties, including the ability to track the owners of those securities digitally and the ability to trade those securities with minimal costs. In the past, you needed to wake the lawyer and pay legal fees in order to decide whether a security could be traded and, if so, to whom. Then you have to pay additional fees after a trading match is made, and then more fees after the trade. While these fees were great at keeping the legal profession healthy, these fees made most trades impractical, especially small ones under $50,000. Imagine spending $5,000 on a $10,000 trade. Then imagine spending $5000 on a $500 trade. The model just doesn’t work for investors wanting to trade small amounts of securities.

So how is this changed with digital securities? The simple answer is this: what the ATM did to the bank teller, digitization does to the broker, the lawyer, and everyone else in between the buyer and the seller. If a security is digitized, it is now possible to make a $500 trade in privately-held securities and come out ahead. Digitization gives small amounts of securities liquidity.

Why not pay $25 to a broker-dealer in order to buy or sell $500 worth of common stock or debt? You could argue that broker-dealers cannot live off $25 because the brokers have to pay expensive office rent for that view of downtown’s skyline and to maintain the ludicrous lifestyle of slick brokers. Fast cars, lobster, and cigars. Yachts, scotch, 3-acre homes, and a vacation cabin.

But if you pare down the excess, if you increase the raw number of trades, then it is possible for broker-dealers to run a business off these small fees. It is possible right now.

The future has landed.

So how does it work? A digital security is issued by a company or a broker-dealer and sold to investors when a company raises capital utilizing the JOBS Act. These are public offerings, and the securities can be sold to the general public, to thousands of investors should thousands of investors find the offering of worthy interest.

The company issuing the securities hires an intermediary who can write the smart contract on Ethereum or Stellar, two blockchains well-suited for this purpose, though there are certainly others. The smart contract is a token, a digital marker that will track the ownership of the security itself. It also has some other functions that we will get back to in a moment.

The next step in this process is issuance. To properly sell these digital securities to the crowd using the right exemption, investors have two options: Regulation A+ (often described as a mini-IPO, in which companies can raise up to $50M in a given year) or Regulation Crowdfunding (in which companies can raise up to $1.07M in a given year, but it is a leaner regulation and companies can launch faster and more cheaply than a Regulation A).

Then, the purchase. Once the investor has purchased digital securities through either a platform or a broker dealer, a transfer agent needs to record the transaction and then post it on the blockchain. This promotes transparency in the process as the general public can see how many securities exist, how many were issued, and which wallets own them. There is no privately identifiable information on the blockchain at anytime.

Trading securities is significantly easier because all of the information required to determine whether the trade is possible is located in the smart contract. When was that security issued? What exemption was used in its issuance? Is there a lock-up period during which that security can’t be traded, and if so, when does it end? Are there restrictions on who can buy the security? All of those questions are key to securities trading, and it’s possible to eliminate the attorney if the broker-dealer has confidence in the immutable and trusted information located on the blockchain.

Why is a broker-dealer involved? Securities laws are complex and designed to favor the use of a broker-dealer to handle transactions. Broker-dealers are companies supervised by FINRA, a regulator created by the SEC. FINRA’s job is to make sure those under their supervision are doing the right thing and providing accurate information to investors and only allowing legal trading, per the questions above and other restrictions. Add to this the complex regulations of 50 individual states when it comes to security transactions within their own borders, and you can now imagine why a broker-dealer is required. There is simply too much to keep track of.

However, the problem with broker-dealers is that traditionally they are heavy and expensive. This was true yesterday, but a new form of broker-dealer is emerging and getting their licenses. This new breed hails from the technology industry. Software is in their blood. They know how to automate everything and deliver shares for pennies instead of thousands of dollars.

Imagine a world where entrepreneurs can sell securities to consumers for very little costs, and those consumers can later sell them to others, either for a profit or a loss, but for very little costs in the actual transaction.

That world is coming, and digital securities are leading the way. Hello world.

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