Defining Digital Securities: A How-To Guide
There are different types of "digital" securities that exist today. Here's how to know which yours is and what that means for operators, issuers, and market participants.
By Vertalo Team
If we’re being honest, this probably should have been something we put together as the very first post of this newsletter, since the background, history, and details around securities, and what form they take, all really matter. That said, hopefully this will be useful for those of us in this space, since there is a lot of opinion about how digital securities behave, and what the necessary treatment of them looks like, whether you’re a Transfer Agent, custodian, bank, or broker.
In this piece, we’ll take a look at the different classifications of securities and explore what that means for their treatment and what operators in this market need to be aware of with securities offerings and management.
Before we dig in to the definitions, we offer a brief background and history of securities to set the stage for the definitions. If you’d prefer to - jump directly to the definitions here.
Disclaimer: We are not attorneys, broker-dealers, investment advisors, or wealth advisors. Nothing presented herein is nor should it be considered as legal, professional, business, investment, or any other kind of advice. The information presented herein is done so for educational, informational, and entertainment purposes only. Always consult a licensed professional before taking professional, investment, or legal action.
A brief background on the history of securities
While there are many examples of individuals owning “secured interest” in private companies dating back thousands of years, the earliest examples we have of formally certificated ownership of private entities dates back roughly 400-500 years.
The reality of finding the first company to issue shares is really one of definition. Most agree that the first example of a joint-stock company was a french company called Société des Moulins du Bazacle sometime around the year 1350. There were 96 shares representing ownership in this company that could be bought or sold depending on the market value of the watermills owned by the company.
Skipping over several companies in the 1500’s that had shares that could be bought or sold, the Dutch East India Company is typically considered the first company to formally issue equities to the public, effectively conducting the world’s first initial public offering. Formed in 1602, they united a number of smaller trading companies in a consolidation effort, after which they formed their joint-stock company. The paper certificates for the Dutch East India Company could be bought and sold in open-air secondary markets, dealing face to face with those holding the paper certificates themselves. These face to face dealings with those selling securities would later form the basis for practically all stock exchanges around the globe.
In this early period of company formation & shareholder creation, these newly formed companies were more transient than the everlasting corporations we think of today; companies would be formed for an express purpose, then dissolved once that purpose was accomplished. In the case of trading companies whose businesses consisted of importing and exporting goods, the company would be formed prior to the voyage casting off, then immediately dissolved upon its return.
The process of granting ownership via equity in private companies flourished in markets all over the world, particularly in large cities, through the late 1800’s and early 1900’s, allowing entrepreneurs to access new capital, but also permitting bad actors to defraud unknowing or uninformed investors. This led to support for legislation and structure in the world of finance, banking, and securities.
With the Great Depression - and the severe financial losses felt by middle class America - as a formidable backdrop, the United States created the Securities Exchange Commission in 1934 under the Securities Exchange Act of 1934. This came immediately on the heels of the Securities Act of 1933, which brought with it two express objectives:
Requirements that investors receive financial and other significant information concerning securities being offered for public sale; and
Prohibitions against deceit, misrepresentations, and other fraud in the sale of securities.
The SEC was formed to both create standards for, and oversee the enforcement of, the objectives of both ‘33 and ‘34 Acts. These standards included many elements, such as corporate reporting, proxy solicitations, tender offers, insider trading, the registration of exchanges, associations, and others, through to the definitions for what is a security and enacting enforcement. Additionally the SEC created standards around how to treat these securities, including the establishment of a Good Control Location over the securities themselves.
Now, we’ve written previously about how the “Good Control Location” provision requires that brokers, custodians, or transfer agents, maintain an actual location of control over the asset - think paper certificates in physical vaults. This effectively means that securities must be overseen, leading us to coin a phrase we use often with customers and partners: “Securities are not sovereign.”
This also means that in theory it should not be possible for securities to get lost. With a blockchain or digital database implementation, this is an observable reality since critical shareholder & equities records can’t be mutated, destroyed, or otherwise changed without express permission, for example, being the broker or transfer agent of record.
That said, one rarely-considered side effect to the horrific attacks on September 11th, 2001, was the destruction of physical paper certificates held at the World Trade Center. Here you can see the National Museum of American History’s efforts in reconstructing damaged physical certificates in the wake of the attack. A digital approach to securities and shareholder data management means that attempts to destroy records should rightfully fail.
This is critical to our examination here, since the Good Control Location requirement, expressly required of brokers, custodians, or transfer agents, applies no matter what form the securities take. As we’ve said before, a strong observation of mine is that the fear from regulators with regards to the application of blockchain technology for securities centers around investor protections, which is the driving force behind the Good Control Location provision with regards to digital assets.
As we continue to migrate from an analog to a digital world, it’s important we remember and appreciate the regulations (even though we sometimes have a visceral disdain for them and how they function in reality vs. the purpose for which they were passed) and to work to create new frameworks for operating that maintain this awareness. Regulation is coming whether we’d like it to or not; it’s better to work with regulators to create approaches that make sense and provide stability than bury our heads in the sand and write off any attempt at regulation as nonsensical or unneeded.
With that background firmly in place, we can move on to our examination of the different forms securities can take.
Securities & the forms they take
There are four basic classifications of securities in capital markets:
Certificated Securities
Book Entry/DRS (if non-certificated)
Dematerialized Non-certificated Securities
Digitally Enhanced Non-certificated Securities
Digital Asset Securities
There has been a lot written about the types of securities out there and how to treat them, this is a chance to set the record straight based on our understanding of the different types that exist and how they should be conceptualized.
Certificated Securities
Many securities, especially legacy securities or products, fit this definition. Certificated securities are those that have physical, paper-based certificates. For these assets, including public market securities or NMS securities, there are paper certificates that are generated, held, or maintained either by a transfer agent, broker, or custodian.
For shareholders on the cap table that do not have printed physical certificates, the shares are still maintained on the shareholder ledger, in what is known as “book entry” form.
Originally, physical stock certificates were not able to have any sort of digital representation, first because we didn’t have the technology, and then because it hadn’t been implemented in a systematic way, but that changed through the creation of the “Direct Registration System” from the DTCC, which was launched in August of 2006. This allowed for investors to “dematerialize” their shares into a digital format, otherwise known as “book entry” shares. The Direct Registration System allows for more efficient capital markets activity through providing unique identifiers and a singular clearing and settling entity. One reason for the fragmentation in private markets is precisely because there’s no nationally available party to handle this routing, clearing, and settling function.
In fact, under the Wikipedia entry for “Book Entry” there’s a subsection entitled Private Companies that says this: “Adoption of book-entry systems among private companies has lagged adoption among public companies, public company transfer agents, and broker-dealers. This may be due to a number of misunderstandings and challenges unique to private company security issuance but, regardless, data suggest adoption of book-entry systems among private companies is growing rapidly.”
Vertalo’s mission is to connect and enable the digital asset securities ecosystem. This means that integrating the various players within private capital markets is core to our focus, from primary capital formation, to mid-life cycle securities data management, through to secondary liquidity and collateralized lending. Our mission is exactly why we’ve architected in a fully digital manner, with both digital dematerialized shares, as well as blockchain enhancements that add additional security and functionality.
Dematerialized Non-Certificated Securities
Vertalo, as a digital Transfer Agent, distinguishes itself as a non-certificated Transfer Agent. This means that we don’t, nor will we ever, send out paper certificates or portfolio statements through the mail, but instead we keep a digital copy that is dematerialized (not in paper form) that can be accessed through an online portal. Our ability and offerings via white-label and/or API make this particularly appealing for private asset issuers.
So why break out dematerialized non-certificated securities from book entry shares when they’re so similar? The reason we draw this distinction is that while many public transfer agents do and are able to deal with physical certificates, any non-certificated transfer agent would have to formally dematerialize paper certificates upon becoming the transfer agent of record, transmuting the records of the shares from paper to an internal digital ledger.
The process of dematerialization and digitization is something we’ve become quite skilled at, as many of our customers have come to us seeking to modern their equity stack and offer investors a portal for login, as well as Secondary Liquidity.
We will detail this extensively in an upcoming post, as part of a series we’re planning around the applications of blockchain technology in private markets, but when Vertalo engaged with XY Labs to support their existing shareholder base of 24,000 individuals, we had to work with ridiculously outdated data formats - formats plural, it wasn’t even standardized from one set to another - to import and properly digitize their cap table. The nuances and behavior of these data files took our team, who is extremely proficient at the ETL process, a number of weeks to process through. As companies seek to modernize their equity stacks, this familiarity and ability to work with data - management, manipulation, extraction, reporting - are all things operators should consider.
Statistically speaking, nearly all securities today exist in either book entry or dematerialized digital format.
Digitally Enhanced Dematerialized Securities
This is where it gets interesting, since we introduced the blockchain to the mix, but in an interim fashion rather than a full fledged firesale and replacement of existing infrastructure. The digitally enhanced distinction is one whereby the dematerialized digital copy still exists, and is, in the eyes of regulators, the security itself. The “enhancement” however, is simply that of a mirror copy, a courtesy of sorts, that allows investors to view something tangible (like a token on a blockchain). For all intents and purposes, the security IS the digital copy stored on the internal database, like that which a broker or transfer agent might use. The blockchain copy is a mirror copy for convenience or added functionality, like secondary trading, for example.
When issuers or investors talk about blockchain-based securities, the predominant method for adding blockchain features to a security is through this method of “digital enhancement.” The security itself is still maintained in a digital and dematerialized state in a database. This was also a driver for why Vertalo chose to bifurcate the issuance and tokenization process, something we write about here:
By separating the process of issuance and tokenization, you open up many different possibilities for issuers, investors, and brokers. One of the biggest benefits one can realize here is a partial cap table tokenization. For issuers, if you have investors who are interested in your offering but hesitant to invest in products built on blockchain technology, this process of separating issuance and tokenization allows you to have the best of both worlds. There can exist digital dematerialized securities in a digital ledger database, as well as the digitally enhanced blockchain-based tokens for those more savvy users, but blockchain in this case is a capability, not a constraint.
Here is some legal language (intentionally kept obscure for privacy purposes, although this does appear on the SEC’s EDGAR filing site, and is therefore public) from a partner of ours, “Digital securities are conventional uncertificated securities where the issuer arranges for a digital "courtesy carbon copy" of the transfer agent's share registry to be viewable on the blockchain to enhance the trading experience and may also be referred to as ‘digitally-enhanced securities’.”
If there are two copies of the security, one in a ledger and one on-chain, it begs the question, why use blockchain to enhance the security at all? What enhancements does it bring to the table? Valid question, and from where we sit blockchain can still provides operators with many benefits, including:
Transparency
Programmability
Audit Trail Capability
A shared ledger between two unrelated parties
Cryptography and/or hashing for security and pseudonymity
Liquidity via an ATS
Decentralized finance applications - including collateralized lending against tokenized assets
The ability for an investor to see the copy of their security, both in their wallet as well as on-chain
…among many others. As we move towards more application of blockchain for capital markets, this interim state between digital database and blockchain has seen tremendous support from regulators since it’s both assuaged their concerns around investor protections, but also allowed operators in this space to experiment with the technology and it’s countless applications.
Digital Asset Securities
Finally, we arrive at what most believe they’re talking about when they discuss blockchain-based securities. Digital Asset Securities are those assets that are fully chain-native, where the blockchain not only holds the ledger, but also serves as the source of truth for the shares themselves. Under this definition, the security token IS the security and there is no additional copy stored elsewhere like in the “enhanced” distinction.
With the hesitation of regulators globally, there are very few tokenized issuances that fit this definition. Even if the media and asset issuers themselves refer to these shares as “digital asset securities,” most of them actually fall under the previously defined “digitally enhanced dematerialized shares” interpretation.
Fully chain-native securities bring with it some interesting promises (and challenges!) but we’re far from seeing this sort of activity yet in the real world. One of the biggest benefits for a chain-native securities approach is intraday settlement, but as we wrote in our piece on fiction vs. fact (see below), the vast majority of securities transactions still are not settling on chain, mostly due to Anti-Money Laundering provisions that require the issuer to know, and continually check for sanctions against, their shareholders.
To be clear, the on-chain settlement is a perfectly solvable challenge, just one that requires a considerable amount of technical support from third parties, along with legal opinion on just how detailed you want to get in confirming, then reaffirming, the identity and ownership of the wallet you want to send funds to. The pseudonymous nature of blockchain wallets is the big concern, since wallets can be ported through private seed phrases, whereas bank accounts cannot. Two companies that are already working on this in real-time are Figure and Oasis Pro Markets.
A brief note on smart contracts for digital asset securities
This is one of the areas where we see many people theorizing, but not too many people applying the theory or seeking to understand the nuances of how smart contracts might be implemented in the space to deliver on the promise of disintermediation and efficiency.
Alexandra Damsker, coined a phrase several years ago on Clubhouse as many people sought to understand the impact that blockchain might have on capital markets, financial institutions, and the every day user. As an attorney and experienced operator in this space, she continually hammered this point home:
“Smart contracts are not smart, nor are they are legal contracts.”
We jokingly tell people it’s a heavy misnomer since both words, standalone or together, do not accurately deliver the meaning of what smart contracts are or can do. Smart contracts derive their value by being triggers that can be pre-determined and agreed upon, after which they can be written to the blockchain. The chain’s immutability then gives both parties the confidence to transact, as well as the knowledge that a trusted third party won’t be necessary, since the rules have been set, then written to a public database (the chain) that can’t be hacked, altered, or otherwise mutated.
While we love the idea of using smart contracts to cut out middlemen and unnecessary third parties - and indeed we see many applications for this in private markets currently - in securities there is a bevy of regulatory considerations that almost always require some form of licensed third party (brokers, custodians, transfer agents, RIA’s, chartered banks, etc.) to facilitate or complete a transaction. We’re not opposed to efficiency, quite the opposite, just accepting the reality of the current legislative world we live in.
The existing regulations and requirements mean that the smart contract architecture needs to be kept flexible to account for a changing regulatory and technical environment. But immediately this starts to hamper the benefit of smart contracts - their rigidity due to blockchains being immutable. How institutions adopt and apply smart contract frameworks is still something that is not clear, since there will almost always be some form of third party involved in the transaction. Rather than all third parties being removed, we foresee a reduction, but not elimination, in intermediaries through the application of blockchain in capital markets. To what extent this reduction occurs is yet to be determined.
The area where we see the most value and application in smart contracts and on-chain functionality with regards to securities will be through the collateralized lending against real world assets. This requires some deep critical thinking, since custody, lending terms, due diligence, loan origination, cash disbursal, term violation penalties, etc. all necessitate third parties and/or heavily technical & legal support. But broadly speaking, a tokenized security could directly interact with a lending contract, possibly from MakerDAO or Aave, in order to produce loans against pledged assets.
Conclusion
We produced this piece because we want to be sure our industry has a shared lexicon and understanding of what we’re talking about when we use the terms we’ve defined above, including digital securities, digital asset securities, or digitally enhanced dematerialized securities. The first time we heard the term “digitally enhanced dematerialized securities” several years ago it instantly planted a red flag in our mind - we didn’t know what a digitally enhanced security was, but was determined to learn.
One of our good friends and coworkers is Vertalo’s VP of Integrations, Kyle Brown, and since he first arrived he has always been laser focused on something known as domain-driven design, a concept first popularized by Eric Evans in his book by the same name.
Part of domain-driven design includes the idea of a ubiquitous and shared language, defined as follows: “Ubiquitous Language is modeled within a Limited context, where the terms and concepts of the business domain are identified, and there should be no ambiguity.” This means that within a given industry or domain, whether across teams or from a business to a customer, a term has a specific meaning no matter where you use it.
As an industry, let’s use specific and clear language, and remove ambiguity or confusion, when referring to these assets and the forms they take. This specificity should only move us forward in our communication, especially with those new to this space.
As the legendary Peter Drucker put it, “Communication is what is understood.”
Till next time.
If you found this informative or useful feel free to share with your audiences and tag us - especially on LinkedIn and Twitter.