The United States’ securities markets are among the most diverse, liquid, and transparent in the world. Indeed, the dominance of the United States’ financial markets is one of its most potent competitive advantages. Healthy financial markets attract foreign investment and feed economic vibrancy and growth, which form some of the foundational aspects of the United States’ overall wealth and international influence. To cement this advantage for the 21st century, American policymakers should open U.S. securities markets to new technologies, which would expand the universe of investable assets and attract a new, broader group of investors to buy into these markets.
Building a regulatory framework to allow for the issuance of securities on a blockchain and to track their ownership on distributed ledgers would count as a major, progressive step forward and would improve the functioning of these securities markets. “Digital Securities” are distributed ledger-based representations of value that have the underlying characteristics of traditional securities and are subject to regulation under the U.S. (or other jurisdictions’) securities laws. These representations of value can be anything from stocks to bespoke investment contracts, but importantly, should not be confused with cryptocurrencies such as Bitcoin or other types of functional blockchain based assets that are not securities.
This article explores some of the innovations tracking the ownership rights of securities on an immutable, universal ledger. These ledgers would be accessible to multiple market participants and would bring the United States securities markets to the cutting edge of investment technology.
Rapid Settlement, 24/7 Access
Digital securities’ rapid settlement and 24/7 availability could enhance the liquidity and depth of securities markets, crucial ingredients to market integrity and efficient price discovery.
The liquidity of an asset refers to the ease with which it can be sold in a timely manner and the costs associated with the sale, either in terms of transaction costs or the acceptance of a lower price in order to find a buyer in a reasonable time (for example, an investor may be willing to discount the price of her asset below its fair value in order to quickly complete a sale). According to the Brookings Institution, “we care about market liquidity because it affects the returns for investors, such as those saving for retirement or college, and the costs to corporations, governments, and other borrowers. Further, illiquid markets are more volatile, which adds additional risks to investments. At the extreme, volatility can help trigger or exacerbate financial crises. Even the average level of volatility matters, as it is factored into interest rates demanded by investors and paid by borrowers.”
Moreover, with greater liquidity often comes greater market depth, which is a market’s ability to complete large transactions without affecting the price of the underlying security. Intuitively, depth enhances market integrity and efficient price discovery because it reduces the risk that large transactions will artificially distort an asset’s price.
Deep, liquid markets attract investors because they give investors the confidence that the market price of an asset reflects its true value and that the asset could be sold quickly at or near its fair value. Indeed, the ability to quickly monetize an asset at fair price is so valued by investors that “many buyers and sellers are willing to pay a significant amount to execute transactions quickly,” according to Brookings.
From a broader perspective, the liquidity and depth of asset markets are prerequisites to the sound functioning of the entire financial system. Indeed, between March 1, 2020 and June 1, 2020, the Federal Reserve not only announced dozens of leverage ratio reductions, lending programs, and international central bank partnerships but also restarted directly purchasing assets (“quantitative easing”) to support the liquidity and depth in the markets of assets ranging from junk bonds to the U.S. dollar itself.
While not everyone agrees with quantitative easing, enhancing the private liquidity and depth of U.S. financial markets benefits individual investors and the entire economy alike, and distributed ledger-based digital securities can play a part in enhancing both faster transaction settlement and 24/7 global availability.
Transaction in digital securities could potentially be executed and settled in minutes, much faster than even some of the most liquid securities today. For example, while stock exchanges like the New York Stock Exchange (NYSE) can execute securities transactions rapidly (i.e., successfully match a buyer and seller at a given price), the settlement of the transaction (i.e. actual transfer of ownership) can take up to two business days and require several entities’ participation to complete. On the other hand, digital security transactions potentially could be settled in minutes (or even seconds), allowing investors to quickly monetize their assets with confidence. This could unlock the markets for securities that are now mostly illiquid and allow for the settlement of transactions, such as LP and LLC interests, that typically occur bilaterally and can take days or weeks to consummate.
Moreover, in the United States, existing securities markets operate for 6.5 hours, five days a week, with some market participants enjoying access to extended trading windows. For most investors, liquidity is nonexistent outside of normal trading hours. Nevertheless, the world keeps turning when public markets are closed, and material events that can affect the price of securities can happen at any time. Indeed, public companies often release material information outside of regular market hours when only select market participants can trade. Gaps in trading hours can also distort price movements; for example, investors in U.S. markets often “buy into the weekend” or “sell into the weekend” based on what events they expect the weekend to bring.
Efficiently reflecting new information into asset prices is the essential function of markets, and enabling all market participants to complete transactions whenever new information becomes available would improve the functioning of U.S. securities markets. Tracking the ownership of securities contracts on a distributed ledger could offer an efficient mechanism to create true 24/7 markets.
In addition to speed and availability, a distributed ledger brings transparency. Market participants can see market data and transactions in real time using their own electronic devices and without relying on expensive software or equipment or a third party broker. While today many can log in and view their brokerage account online, real professional grade market data is only available to a select few.
Fractional Ownership: Financial Inclusion
Digital securities can not only expand access to investing for underserved U.S. citizens but also improve U.S. companies’ ability to raise capital by offering global access to securities. Put in more technical finance terms, the theory behind the capital asset pricing model (CAPM) becomes closer to a reality as the digitization of assets would allow for both a greater amount of assets for investment and for a greater number of persons to access those investments.
Investing is critical to long term wealth creation, but not all constituencies in the United States have equal access to financial markets. Indeed, in retirement, white Americans earn income from assets at over twice the rate of black and hispanic Americans. Over the long term, risky but relatively high-yielding assets like securities outperform traditional savings or debt investments, so disparate investing behaviors can exacerbate the wealth gap.
Digital securities can contribute to closing the investment gap by lowering barriers to investing. For example, only the largest, most sophisticated individual and professional investors have the ability to purchase expensive but well-performing assets like real estate, art, and sports teams. However, digital securities could create markets of fractional ownership for high-priced assets, expanding individuals’ ability to participate in the long term benefits of investing regardless of their initial wealth. Today, 44 percent of Americans own stock while just over four percent did in 1952, and the further democratization of securities markets could play a small part in ameliorating the racial wealth gap.
While retail investors today can achieve a version of fractional ownership of public companies through mutual, pension, and exchange traded funds (ETFs), these services charge ongoing fees to cover overhead that can significantly reduce returns over time. The explosion of the ETF industry over the last decade evidences significant demand from retail investors for low-cost fractional ownership of securities, and distributed-ledger based securities could offer investors direct ownership at lower cost.
People have propounded fractional ownership for years, but without distributed ledger technology, it has been ultimately in-administrable or costly for retail investors. Now, the application of blockchain could help open this long-closed door.
Global Access: Capital Formation
Moreover, expanding access domestically and internationally to U.S. securities markets would benefit U.S. companies and the domestic economy. Entrepreneurs’ ability to efficiently raise capital to fund business ideas is one the United States’ most potent economic competitive advantages, so much so that “facilitat[ing] capital formation” is one prong of the Securities and Exchange Commission’s mission.
Intuitively, fractional ownership and global access — features inherent to distributed ledger based assets — would further facilitate capital formation because they would expand the pool of potential investors. For example, a recent auction for a distributed-ledger based asset received bids from 132 countries. Expanding entrepreneurs’ ability to raise capital catalyzes innovation and economic development, and digital securities offer features that further facilitate capital formation. While offering securities to a broader group of people has its own inherent risks, the ability to “right size” the individual investment amount due to fractionalized ownership ameliorates much of this concern.
Also, providing opportunities and access to capital to entrepreneurs means providing opportunities for minorities who own 28.8% of small businesses (2012 data) in America but operate “with substantially less capital overall — both at startup and in subsequent years — relative to their nonminority counterparts,” according to the Small Business Administration. Providing new and community based ways to raise capital, which have historically been reserved for the elite, can help finance a new generation of innovation and entrepreneurship.
Securities regulations are extremely complex, and their requirements are dependent on factors such as asset type, investor type, buyer jurisdiction, seller jurisdiction, and issuer jurisdiction. In contemplating a global securities market, attention must be devoted to what these elements mean and what they are a proxy for. Moreover, a diverse ecosystem of market participants should and can be responsible for different aspects of the regulatory regime, meaning that they must all coordinate with one another to maintain regulatory compliance and validate asset ownership. Currently, the web of actors responsible for discrete regulatory requirements creates costs, creates trading and settlement latency, segments markets, exclusion and reduces liquidity, all detrimental to the healthy functioning of markets. Of course, however, the regulations themselves are specifically designed to root out bad behavior and protect investors.
Digital securities are programmable, meaning that these critical regulations can be hardwired into the architecture of the security itself. Such a system of “inherent compliance,” combined with the transparency and immutability of distributed ledgers, would streamline market participants’ regulatory requirements and enhance regulators’ ability to monitor compliance with the law. Regulators could have a real-time view into the tracking and functioning of markets and to audit or examine the immutable record of transactions whenever necessary.
The potential applications of automated regulatory compliance are diverse and nascent, but some simple examples illuminate their promise: (1) A digital security could include a coded restriction that would only allow the security to be transferred to certain pre-approved wallet addresses (such as known institutional investors for non-public securities); (2) similarly, digital securities could be restricted to certain amounts or lot sizes depending on the identity of such whitelisted address, to minimize risk to certain investors, (3) Digital securities could have encoded lockup periods depending on the type of security or the jurisdiction in which a sale takes place; and (4) A digital security could create a capitalization table updated in real time universal to all market participants. Indeed, reducing compliance costs while protecting investors and promoting market integrity would significantly improve the United States’ capital markets and help it maintain its prominence in an increasingly global world.