The Time is Now for Digital Securities

When I’m pitching potential investors and customers, I have a slide in my deck that answers the question Why Now? for digital securities. Because even though digital securities have only been around a few years, there is an expectation among many that the space should already be developed. In reality we are just getting started, and changing regulatory attitudes are the number one reason Why Now.

On December 23rd, 2020 the US Securities & Exchange Commission (“SEC”) released guidance on how broker-dealers can maintain custody of digital asset securities[1] - whose record of ownership is recorded using blockchain technology. It is my belief that this represents an inflection point in the evolution of digital securities; this is the clearest guidance the SEC has so far given and offers a roadmap for solving one of the thorniest issues in the digital securities space.

A Brief History of US Digital Securities Regulation

Regulators in the US did not formally start addressing digital securities until July 2017 when the SEC issued the so-called DAO (Decentralized Autonomous Organization) report[2], which leveraged a 1946 Supreme Court case and the “Howey Test”[3] to conclude that DAO tokens were in fact securities and offered in violation of US federal securities laws.

Following the DAO report, the SEC proceeded to bring a number of enforcement actions, while emphasizing that participants in the space needed to ensure that all token offerings were sold in compliance with the Securities Act and that trading platforms were compliant with the Exchange Act. It was around this time I had the ‘light bulb moment’ for Texture Capital – a vision to create a licensed broker dealer and Alternative Trading System (“ATS”) to enable issuance and trading of securities using blockchain technology.

The problem was that while there was a lot of guidance from the SEC on what not to do, there was not much guidance on what to do. The first specific regulatory guidance for would-be broker dealers in the digital securities space came just 18 months ago in July 2019 with the SEC/FINRA Joint Staff Statement on Broker-Dealer Custody of Digital Asset Securities[4], which described some non-custodial broker dealer models that the SEC and FINRA staff were more comfortable with. At the same time, the staff laid out a number of concerns they had around custody of digital securities, without offering any guidance about how a broker dealer might satisfy these concerns.

Texture Capital designed its business model to comport with the Joint Statement as a non-custodial broker dealer for digital securities; providing a novel way for clients raise capital using digital securities and for investors to trade these digital securities in an ATS. However, we recognized that to attract institutions to the space – which is vital for long term adoption – it would be necessary to provide custody of digital securities or rely on a third-party digital security custodian. But until this recent announcement, there was no guidance on how to do so.

Digital Securities Custody

The Customer Protection Rule of the Securities Exchange Act (a.k.a. rule 15c3-3), describes custody as ‘physical possession and control of securities’. Rule 15c3-3 was adopted in 1972, long before even the internet, let alone blockchain technology, so the concept of physical possession and control is therefore difficult to apply to securities that are digital and exist on a distributed blockchain network, where many different parties have a copy of the blockchain. In addition, the SEC has expressed a number of concerns about other aspects of the technology such as safekeeping of private keys, risks of network forks (in which duplicate copies of securities may be created), and the risk of theft or hacking.

The Commission’s statement does not specifically address methods or technology a digital securities broker dealer should employ in order to take custody, but rather indicates they will not be subject to enforcement action provided the broker meets certain conditions designed to mitigate risks. These include:

• Limiting its business to digital securities only (i.e. cannot also conduct traditional securities or cryptocurrency activities).

• Maintaining policies and procedures to ensure digital securities are compliant with regulations, protected against loss, theft, forks, hacking and other technological risks.

• Adequately disclosing risks to customers.

We commend the SEC on taking this action:  with these guardrails in place, digital securities broker dealers like Texture Capital are able to develop their own solutions rather than adhere to proscriptive technological implementations. This ‘market mechanism’ will ensure that innovation can flourish while ensuring appropriate investor protections.

The Time is Now

This is why I firmly believe the time is now for digital securities. The technology is available, we can issue securities using blockchain, we can trade the tokens in our ATS, and now there is a roadmap to implement digital securities custody solutions – the last remaining foundational block to a new digital securities ecosystem.

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[1] https://www.sec.gov/rules/policy/2020/34-90788.pdf

[2] The DAO, or Decentralized Autonomous Organization, sought to raise capital via a 2016 token offering that would be used to invest in other projects as voted on by token holders. The DAO report can be found here:  Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO

[3] https://www.sec.gov/corpfin/framework-investment-contract-analysis-digital-assets

[4] https://www.sec.gov/news/public-statement/joint-staff-statement-broker-dealer-custody-digital-asset-securities