Guide

Major Challenges Ahead for Digital Securities Adoption

While the digital securities arena has the potential to completely revolutionize the global capital markets as we know it, the phenomenon still has a very long way to go. Notably, certain key challenges present themselves in the form of regulatory uncertainties,  asymmetric information, legal ownership protections and surprisingly – scalability.

One of the main solutions for the aforementioned challenges to resolve themselves is to make the fundamental transition from a fragmented emerging segment, to that of a unified and collaborative digital securities marketplace.

Here we explore some of the key challenges facing digital securities, alongside some potential solutions that relevant stakeholders need to consider to ensure that the space can thrive on a global basis.  

Regulation and Regulatory Uncertainty

As the name suggests, digital securities are subject to the relevant securities laws in the jurisdiction in which they are offered. This creates a real challenge around how to incorporate existing laws in a new digital form.

What we see happening today is that the issuance platforms we mentioned earlier are developing new standards for issuing and trading digital securities. Each company is taking a different approach. This is problematic because eventually, the standards will need to reconcile to allow a compliant issuance process to take place across multiple platforms.

Another challenge is that this technology is still new, and regulators need to react. This results in regulatory uncertainty. In the US, if you want to have a qualified custodian arrangement, you need to maintain possession of the underlying assets.

The problem is that the SEC does not provide clear guidance on whether a custodian can have control over digital securities recorded on a distributed ledger. So no one can tell for sure whether they comply with SEC requirements. The SEC promised an answer by New Year, but with the government shutdown, we are still waiting.

Another example of this regulatory uncertainty can be seen in the tax world. Assume that a company issued digital securities and, based on the smart contract terms, it pays a fixed dividend income automatically for token owners. In an ordinary scenario, a company would have foreign shareholders from around one or two countries, but in a digital security offering, it would probably have multiple investors from multiple countries. Each country has its own tax treaty with the country where the company is incorporated, and different rates for withholding tax for dividend payments.

An elegant solution to solve this mess is for tax authorities to apply a fixed withholding tax rate for companies that issued digital securities; however, this requires legislation and time.

Asymmetric Information and Disclosure Standards

Let’s assume that we have the technical infrastructure and regulatory framework for companies to easily issue and offer their securities across the internet.

We need to ask ourselves a question: Why would an investor invest in a company halfway across the world?

The answer? Information and disclosures. Even if the regulators don’t enforce disclosure requirements for companies issuing digital securities in private placements (which I believe they will eventually do), companies will want to disclose information for their internet campaigns to succeed, attract investors and ultimately – even achieve liquidity.

In other words, companies will need to give up privacy and become transparent in order to access a larger investor pool and potential liquidity.

Scalability

The third challenge, which is a challenge for Blockchain in general and not only for digital securities, is scalability. What happens today is that in order to maintain the public ledgers of Bitcoin and Ethereum, we need significant computing power.

The decentralized structure and consensus algorithms that are currently used in those systems are limiting the number of transactions that can be processed, in comparison to traditional centralized systems. For example, because of a hard-coded limit on computation per block, the Ethereum blockchain currently supports roughly 15 transactions per second compared to, say, the 45,000 processed by Visa.

The problem is that decentralization and scalability are at odds. If one wants more scalability, one needs to compromise decentralization. Fortunately, there are many projects that tackle this problem. For example, the Bitcoin Lightning Network and other possible solutions.

This is a serious challenge for digital securities. In the current state of affairs, a reasonable solution would be to manage many activities in a centralized manner, such as for identity verification and other compliance requirements, and to use the Blockchain only for reconciling the overall balance of owners.

Ownership

Another obstacle, perhaps the most basic of them all, is ownership. There is a reason most current systems are centralized. Centralization enables efficiency. Today, issued securities are what we called registered instruments, which means the legal ownership of the security is recorded in a country’s designated registry. When Person A transfers their registered shares to Person B, the change in ownership is legally reflected in the relevant registry.

On the other hand, digital securities are recorded on the Blockchain, which works as a silo — it doesn’t interact with the outside world. So, a change in the ownership of a digital asset on the Blockchain doesn’t necessarily represent the legal change of property ownership.

I spent some time talking to industry leaders about this topic, concluding that there are two possible ways to overcome this challenge.

In the short term, the most logical solution would be for an issuer to use a special purpose vehicle (SPV). The shares of the SPV are legally recorded in the registry. Then, one issues digital security on the Blockchain, which represents ownership of the SPV and can be transferred easily. It’s not an ideal solution, but it’s already working efficiently in the secondary market for private securities.

The long-term solution would ideally be for regulators to accept ownership recording in decentralized ledgers as valid and legal.

During 2017, the Delaware Blockchain Amendment was passed. This amendment to the law allows all companies that incorporate in Delaware to issue shares and maintain their stock ledger on a Blockchain. There are still some barriers for companies incorporating in Delaware to maintain their stocks ledger easily on the Blockchain, but this amendment is significant — it essentially allows ownership to be recorded on the Blockchain.

Conclusion

Digital securities have the potential to democratize the global capital markets. However, There are still some regulatory, business and technological challenges to overcome before we see mass adoption. It will not happen in one day, but the future is bright.

The challenges I described here are just a few; there are others, and each challenge needs a solution. It is the need for the solution that it is the opportunity for companies and entrepreneurs to enter the space and develop new products and services that will address these problems.

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