Digitized securities may become the more common method of securities ownership and secondary trading in the future, and one of the key benefits may reside in the ability to leverage the use of smart contracts to automate regulatory compliance for these securities, according to a new in-depth white paper.
Indeed, the newly released paper, Digitized Securities and the Promise of Automated Compliance, outlines how revolutionary this process could be and how smart contracts could be used to automate compliance with certain securities laws. The paper was produced by David J. Kappos, D. Scott Bennett, and Michael E. Mariani, all corporate partners at Cravath, Swaine & Moore LLP; in conjunction with Jeffrey M. Amico, legal counsel at blockchain start-up Fluidity Factora; and Christopher Pallotta, Vincent Molinari, Annemarie Tierney, and Peter Chiaro of Templum, a registered broker-dealer that specializes in secondary trading of digitized securities.
One result could be a significant reduction in administrative barriers and lengthy processes that result from securities law-related trading restrictions. This, in turn, could significantly improve secondary liquidity in private markets, the paper states.
Already, as the paper notes, the first generation of digitized securities — simply a digital representation of a security that can be programmed to automate certain functions and that exist on a distributed blockchain-like ledger — now being issued are “effectively traditional securities enveloped in a digital wrapper.” However, this does not mean the impact of these new digitized instruments should be discounted. In fact, similar to how the transition from “snail mail” to email didn’t change the underlying written messaging, it was the technological leap of the digitization of the process that held all the benefits and indeed, changed the way we communicate — both casually and professionally — dramatically.
You can download your copy of the white paper, “Digitized Securities and the Promise of Automated Compliance”, here.
As the white paper explains, the most promising benefits of digitized securities will be found in their technological underpinning and in the change to the way we have traditionally handled securities. In this case, we will see a significant benefit in the potential to use smart contracts to automate compliance with certain aspects of securities law, which currently can be an administrative burden, especially for smaller, private companies. Under the new process, this could all change for the better, the paper argues.
“Using a digitized security, an issuer could write certain transfer restrictions directly into the code of the smart contract, effectively enshrining certain key securities law requirements — like holding periods or shareholder caps — directly into the security itself,” the authors write. “Done properly, this could provide both issuers and regulators with assurance that applicable laws were being complied with, while also eliminating certain transactional frictions that make it difficult for investors to trade on secondary markets.”
The paper points out that many of these benefits will be initially and most deeply felt in the area of private securities in secondary trading and non-public issuers because “many of the applicable registration exemptions that are administratively burdensome to comply with could be rendered in code and enforced automatically.” This benefit would be possible because the distributed ledgers (blockchain) that would house these smart contracts would allow brokers, exchanges, custodians, and other various entities necessary to effect a securities transaction to all share a common, programmable data layer.
Further, by allowing these complex compliance checks to be enforced automatically upon any transfer of ownership, and without requiring any pre-trade clearance or post-trade intervention or reconciliation to ensure compliance and track ownership, much of that burdensome administrative work would be greatly reduced, if not eliminated completely.
Changing the status quo
“This marks a step-function change over the status quo in the markets for private securities, where there is currently a significant lack of infrastructure to facilitate legally compliant secondary trading at scale,” the paper explains. “Over the longer term, distributed ledgers may also gain adoption in public capital markets as well, streamlining not only settlement processes but other heavily intermediated functions like distributing cash flows and managing shareholder voting as well.”
This paper goes in depth into its subject matter; first, providing an overview and the benefits of distributed ledger systems at a high level, and describing their key advantages compared to existing technologies. Second, the paper summarizes the basic framework that governs securities offerings in the United States, as well as the significant administrative burdens that smaller private companies must comply with. Third, the paper details specifically how and where smart contracts could be used to automate compliance with certain securities law requirements, which could reduce a major barrier to secondary liquidity in private markets. Finally, the paper concludes by analyzing certain limitations that must be addressed in order for this technology to gain widespread adoption and evaluating which existing solutions are most likely to generate widespread adoption.
While the paper paints a bright picture of the administrative efficiency and compliance process gains that can be obtained through use of digitized securities, a distributed ledger, smart contracts, and the automation of compliance, it does carry an underlying warning of the dangers of ignoring this technological advancement and keeping on with the way things have always been done.
This revolutionary process “can offer real benefits to private market issuers and investors,” the paper states, cautioning that “the status quo simply remains too inefficient and cumbersome as we move into the digital age of financial markets.”