Security Tokens and The Digital Wrapper

Sep 13, 2018 · 16 min read

For the first time in history, it’s possible for anyone with a connection to the internet to quickly and securely send any amount of money, anywhere in the world, at little cost. The advent of permissionless blockchain networks like Ethereum upend our legacy financial systems, and promise to create more economic fluidity than ever before.

Blockchain technology has forced us to rethink about what’s possible during the exchange of value, regardless of that value’s form. The self-executing performance of smart contracts combined with distributed ledger technology underpins this idea. Small pieces of smart code can digitally enable the performance of valuable contractual deliverables without human engagement, helping automate the trustless transfer of our digital assets.

Man, that’s some pretty killer stuff.

In the not-too-distant future, tradable digital assets will include financial instruments like stocks, bonds, and investment contracts of all types and amounts. But why disrupt a financial system that seems to work so well? Does blockchain technology actually solve identifiable pain points that exist during the issuance and trading of securities? Aren’t our global financial systems already adept at handling the efficient exchange of financial assets?

My first article on security tokens covered the industry’s regulatory origins, starting with the Roaring 20’s, the Great Depression, and the Securities Act of 1933. In this article, I’ll cover the reasons why we should care about disrupting an aging securities industry. And where better to start than with a look back at the history of the US Postal Service.

Boston Beer and International Mail

Throughout the early 17th century, early colonists in modern-day Massachusetts struggled to share written communication both within and outside the new British colonies.

It was no wonder — many of these early settlers found themselves arriving to little public infrastructure. In order to more quickly advance their growing political and business interests, they knew a more standardized process was required by which to send and receive messages.

To complicate matters, many colonists still required significant amounts of communication with the places they left behind. A lot of the messages sent back and forth by sea touched on areas of political and professional significance, and it was important that the right systems be built in order to ensure legitimacy, accuracy, and speed.

In the late 1630’s, the Massachusetts Court appointed one of its most well-travelled taverns as the first official post office for overseas letters. The tavern was owned and run by a man named Richard Fairbanks, and for the next 25 years, Fairbanks’ tavern become Boston’s one-stop shop for beers and overseas mail.

Over the following decades, the North American mail industry began to solidify around this centralized model. A sender would write a letter by hand, seal an envelope, and drop it off at a designated tavern. In 1691, the British Crown created a grant to erect the official North American Postal Service. Later in 1775, Benjamin Franklin established the first national postal system, which laid the foundation for the US Post Office as we know it today.

With growing resources allocated to support this centralized model for message delivery, the USPS rapidly evolved. Over the next two hundred years, stamps eventually replaced stampless letters (the cost of postage was typically borne by the receiving party), automobiles replaced horse-drawn carriages, and built-in mail slots streamlined the commercial delivery process. With each innovation, message exchange thrived.

You’ve Got Mail

Three hundred years after Richard Fairbanks’ post office-tavern became the first hub, another Massachusetts man would play a significant role in the history of message exchange.

In 1971, a newly minted MIT-grad named Ray Tomlinson sent the first email from one computer to another using ARPANet, a US Department of Defense funded computer network. Although Ray’s two computers sat directly next to each other during this first exercise, the implications were immediately apparent. By 1973, email constituted 75 percent of ARPANet’s traffic.

Ray Tomlinson, the undisputed king of email.

Meanwhile, the USPS continued to double down on its centralized, paper-based model for message exchange. By the mid-1970’s, the USPS had changed its processing network to area mail processing — a technique that funneled the sorting process from small cities and towns to much bigger USPS regional facilities with expensive mail sorting equipment. Over the next few decades, the USPS continued to patch up their existing infrastructure, with the goal of incrementally increasing the throughput of paper-based correspondence.

Area mail processing by USPS, a paper-based messaging intermediary.

By 1996, free personalized email arrived with the launch of For the first time, any individual could create their own free email address and access it through their Web browser. Hotmail’s famous tagline at the bottom of each message served as one of the internet’s earliest examples of virality, foreshadowing just how powerful this new medium of digital exchange could be. In just one year, over 8.5 million users signed up for the free service.

As email usage increased, mail sent by USPS moved in the opposite direction. In the year 2000, roughly 100 billion pieces of First-Class Mail (letters, postcards, and small packages) were sent through USPS, a number that represented strong growth compared to the years prior. By 2020, USPS predicts that only half that amount of First-Class Mail will be sent, a number that continues to drop each year.

Email and The Digital Wrapper

How exactly did this happen? The answer lies in the digital wrapper. A new digital format, wrapped around our communication, made the sending of letter-like messages easier, cheaper, and faster than ever before. Under an expensive, centralized, paper-based model, USPS just couldn’t compete.

At first, email replaced paper only by improving on its core value propositions — email streamlined process (it was easier to prepare), reduced fees (it was cheaper than paying for materials and postage), and sped up delivery (it became near-instantaneous to send messages peer to peer, as opposed to sending through a centralized entity).

However, over time new and unique features were rolled in to email that better utilized it’s digital wrapper format. These features included things like file exchange, smart replies, read receipts, and easy search and storage of past correspondence. In that way, the digital wrapper is kind of like Katamari, the video game about a magical (and highly-adhesive) ball that swallows up everything from street lamps to stadiums, incorporating their properties as it rolls through the universe.

The digital wrapper didn’t just envelop correspondence — it enveloped audio, video, and valuable analog content of all different shapes and sizes, empowering each to digitally interoperate their features with one another. As a result, the functionality of message exchange was enhanced, and a new ecosystem of communication flourished.

Today, sending your college buddy a quick update about your KISS tribute band is as seamless as dropping a YouTube link in the body of an outgoing email. Your recipient can accurately track the video’s total view time, its upload date, and how many views the video has post-upload, which was previously impossible to access or convey under an analog model of communication.

Simply, the digital wrapper enhanced correspondence not just by improving the status quo, but by creating new, transformative benefits that better utilized the digital wrapper format.

The Benefits of Digitally Wrapped Securities

So what will the digital wrapper eventually do for securities? Here’s a few of the benefits often shared by those who wish to see our financial assets trading on the blockchain:

Interoperability. Securities trade today is inhibited because our assets are walled off from one another. Public stocks, like interests in NIKE or APPLE, trade and settle on segregated broker databases. Private securities, like ownership equity in startup companies, live on law firm servers. Real estate deeds are tucked away in home file cabinets. Simply, our assets don’t have the ability to communicate — or interoperate — with one another. Ethereum, and the ERC-20 token standard, provides a standardized method for us to place a digital wrapper around our securities, allowing them to interact with one another in an automated and compliant fashion. This interoperability may lead to some pretty amazing downstream innovations.

Global Market Exposure. By baking legal restrictions and geographic compliance into security tokens, securities can be legally issued, purchased, and traded on a global scale. Exposure to a worldwide investor pool may lead to healthier competition in our financial markets, more accurate pricing of assets, and globally-diverse investor portfolios.

Improved Regulation. Under a model built on a transparent and immutable ledger, regulators will have a far easier time keeping track of system manipulation or fraud. Current systems provide little insight into possible abuse by actors in the ecosystem, and regulators may likely prefer transactions inscribed on a permanent, tamper-proof ledger. In addition, some believe that because compliance can be programmed into the smart contract itself, lawmakers may one day require all forms of securities to take a digitally wrapped form.

Access To Fractional Ownership. Due to the unique divisibility of blockchain tokens, digitally wrapped securities may remove some of the friction to owning expensive assets like fine art and real estate — assets previously inaccessible due to minimum investor requirements. The ability to fractionalize securities opens up a world of dividend-generating opportunities (e.g. a stake in a chain of hotels) and stable alternative assets (e.g. a collection of fine art) to new investors, leading to better portfolio allocation and diversification, regardless of one’s net worth.

Improved Design Space. Professor Stephen McKeon has artfully stated that programmable securities will massively expand the universe of what we can securitize. Eventually, digitally wrapped securities will provide for new financial innovations like complex revenue sharing, cross-asset referencing, and the unbundling and rebundling of individual asset characteristics through tokenization. Because of this improved design space, the future of our financial markets may look wildly more efficient (and juiced up) than they do today.

Uh, Why Are We Doing This Again?

Whether it’s stock in a public company or shares in a private fund, securities today are regulated pretty much the same way as they were right after the Great Depression. Sure, legal issues still make their way up to the US Supreme Court from time to time, and specific provisions in the Securities Act are illuminated or refined by law. But for the most part, the same laws that governed securities in the 1930’s are the same laws that will govern security tokens. Security tokens are just the same old securities, represented by a new digital token.

So if we’re not swapping out the content of securities, and we’re not changing the laws that regulate them, what’s so transformative about security tokens?

The problem (at least today) isn’t that we need a re-categorization of our financial assets, or that our securities laws need immediate revision. The problem is that the current infrastructure built to support the issuance and trading of securities is either clunky, or in some cases, basically non-existent. With security tokens, we can unlock a significant amount of trapped value, which will usher in new economic fluidity in both our private and public markets.

The Private Markets

When we talk about the biggest and most transformative benefits of security tokens, we’re often talking about our private markets. Don’t get me wrong, there’s still a ton of benefits that security tokens will bring to our public markets (more on this below), but the most explosive value will certainly be felt in the private markets.

Private markets are markets for things like real estate or fine art, ownership equity in early-stage startups, LP shares in investment funds. It’s basically stuff that isn’t traded in public markets like NASDAQ or NYSE, but still happens to fall under the regulation of our US securities laws.

For example, even though there are roughly 3,600 publicly traded companies in the United States, there’s actually a much larger number of small businesses in the US — over 30 million — that are privately held. This is a pretty massive number. In fact, trillions of dollars in securities were privately sold in the US in 2017, which is an awful lot of value trading privately.

Today, private securities are traded…well…kind of privately. Unlike our public markets, there’s not a ton of infrastructure built to support the trading of private securities, which has led to problems over the years. When stuff isn’t publicly available or accessible, willing buyers and sellers are going to have a hard time finding each other.

So why are security tokens such a massive opportunity in the private markets? The answer is liquidity. Or rather, solving for the current lack of liquidity.

Liquidity refers to how costly it is to convert assets into cash. Currencies are the most liquid asset since they can be converted to other currencies at very low cost. Other liquid assets? Stocks in public companies are fairly liquid, since those can be converted to cash typically within just a few days. Treasury bonds, too.

Which assets can’t convert into cash quickly? Typically, it’s a long list of stuff you’d find in the private markets. Definitely real estate — have you ever tried to sell a house? Expensive collectibles like fine art, while incredibly valuable, can be notoriously difficult to sell. Ownership stakes in private companies, like venture-backed startups or even lifestyle businesses, can be difficult to turn into cash. At the end of the day, all of these assets take far longer to convert into cash than stuff you can find publicly listed.

In September 2018, Andy Warhol’s 14 Small Electric Chairs was tokenized and sold at auction.

The illiquidity of private assets has some pretty significant consequences. When investor cash is tied up in an illiquid asset, that investor is prevented from using his or her cash to support other new investments. In the aggregate, illiquid investments can inadvertently place a stranglehold on future innovation. Illiquid investments can also hamper economic activity by limiting the overall fluidity of money. When your cash is tied up in stuff that can’t sell, you can’t use that cash to buy other stuff.

Due to illiquidity, private securities often trade at depressed values. Future buyers know they’re buying something difficult to sell later on, so they’ll naturally pay less for that asset now. In addition, when a desperate seller needs to unload an illiquid asset immediately, they’ll often be forced to discount the asset (even further) with the hopes of improving their chances of finding a willing buyer.

In contrast, our public markets allow any US investor to buy stock in a publicly listed company, with the confidence that there’s a ready market of buyers and sellers trading those investments with frequency in the background. This market liquidity has unlocked a tremendous amount of economic value for publicly traded companies, and has helped create massively scalable corporations like Apple, Microsoft, and Amazon.

In the paragraphs above, I mentioned that security tokens will provide 24/7 interoperable trade, will have exposure to regulated global markets, and will provide access to high-valued private securities through asset fractionalization.

When we apply those killer ingredients to our private markets, it becomes clear that there’s a massive opportunity to unlock a tremendous amount of trapped value. Through tokenization, the digital wrapper takes the liquidity seen in the public markets and brings it to the private markets. As a result, security tokens will enable the scalable trading of private assets on a regulated, global scale — trustless and intermediary-free.

The Public Markets

Much like USPS, the infrastructure for our public markets was originally built around a paper model. Paper certificates were an effective way to represent an investor’s ownership interest in securities, and after purchasing stock in a public company, an investor would receive a unique certificate proving their ownership rights.

Today, the SEC provides investors three different ways by which to hold their securities, although most publicly traded assets are almost exclusively held in only one way — street name. The street name system was built on top of a reconciliation process called book-entry, a somewhat-simple-but-also-kind-of-complicated way to quickly track securities moving back and forth between buyers and sellers.

Here’s the general idea — in the public markets today, paper stocks are no longer physically transferred between buyers and sellers when they’re bought and sold. Instead, accounting entries are simply changed in the books of the stockbrokers where investors maintain accounts. This system works because brokers are actually the true legal owners of most stocks traded in the public markets today.

Oh, you thought you actually owned the stuff you purchased in the stock market? Think again.

When you buy public stock through stockbrokers like Fidelity, Charles Schwab, TD Ameritrade, or E*TRADE, all your beneficial rights as an investor — like voting rights or dividends — actually flows to the brokers first, who then pass it on to each individual investor.

Think that’s complicated? This layered ownership stack I just described isn’t quite technically true either. In reality, the named legal owner of pretty much every publicly traded stock in the United States is a company called Cede & Co. (Cede), a nominee of the Depository Trust Company (DTC).

Uh, what?

In 1973, to help remedy the growing number of paper shares transferring back and forth between buyers and sellers on Wall Street, the DTC was created to kick off the book-entry method of ownership we still use today in our public markets. Book-entry meant that XYZ shares didn’t actually change hands during transactions between buyers and sellers. Instead, the net number of XYZ shares on each stockbroker’s internal database were later shared, tallied, and reconciled on DTC’s independent database.

In 1996, the DTC decided that all stocks would now be kept in the name of its partnership nominee, Cede. Since then, Cede’s sole business purpose has been to efficiently process transfers of stock certificates in the US Stock Market, on behalf of the DTC.

In case you’re still confused, here’s a breakdown of how the public markets operate today:

If you own publicly traded stock, what you really own is an entry in your broker’s database, and your broker has an entry in Cede’s database.

Once you sell the stock (that you don’t actually own), your broker will take your entry out of your account on your broker’s database, and Cede will take it out of your broker’s account on Cede’s database.

Cede will add it to the buyer’s broker’s account on Cede’s database, and the buyer’s broker will add it to the buyer’s account at the buyer’s broker’s database.

You got all that, right? Yeah, it’s a mess.

DTC’s system of share ownership was likely born of good intentions, although today it just looks like an expensive and inefficient upgrade of a slow, centralized, paper-based framework. As a result, our present-day public markets run on a system where we don’t actually own anything, controlled by multiple rent-seeking intermediaries at each stage, with sometimes wildly inaccurate share management and relatively slow settlement times across the board.

So why do security tokens provide an opportunity for disruption in the public markets? With email, we created a global ecosystem with frictionless information transfer. With security tokens, we’re creating a global ecosystem with frictionless value transfer. With a digital wrapper applied to publicly traded securities, we can now swap out the horse-drawn carriage, the stamps, the mail slots — the rails by which value is moved from A to B in our public markets.

For the first time ever, a digital wrapper around our ownership interests allows us to trade our public interests faster, easier, and cheaper…all on a global scale. By baking in compliance and proactive regulation at the token level, we remove the current value provided by rent-seeking intermediaries, and create far more efficient public markets.

So the three biggest benefits to public markets by security tokens? In my mind, it’s improved accuracy, reduced costs, and faster settlement/deal execution:

Improved Accuracy. A system built on the backs of private databases, controlled by multiple independent intermediaries, is a system ripe with mistakes. Regulated security tokens trading on public ledgers offer an unprecedented amount of accuracy and record-keeping in our public markets.

Reduced Costs. Our public markets are fraught with intermediaries at every stage of trading and custody. With fully regulated tokenized securities (and, eventually, fully peer to peer securities trading), we eliminate unnecessary structural intermediaries and streamline the trading of our publicly traded interests.

Faster Settlement and Reduced Fraud. Our current system is built on days-long settlement times, with unique opportunities for bad-actor behavior during long black box periods. Under a security token model, trading and settlement are transparent and near-instantaneous, leading to much faster deal execution and less opportunity for market manipulation.

Ready. Search. Swap.

AirSwap is Ethereum’s leading decentralized trading platform, with institutional-grade tools for frictionless counterparty discovery and peer-to-peer transfers of assets. With Ethereum, anyone can create ERC-20 tokens. With AirSwap, anyone can seamlessly swap them.

How is AirSwap’s decentralized trading platform disrupting the way we trade our digital assets?

AirSwap never takes custody of your assets.

AirSwap never takes fees on your trades.

AirSwap has built a powerful system of search, eventually allowing for the discovery of any ERC-20 token, including digitally wrapped security tokens of all types.

Since the earliest days of regulated securities trade, markets have always longed for reduced friction and greater liquidity. Why has this been so difficult to achieve at scale? The mechanisms to create and trade financial assets take enormous amounts of energy, expense, and centralized integration.

Today, we find ourselves on the precipice of a new world where every asset imaginable can be seamlessly tokenized and represented digitally. The digital wrapper gives us the power to easily create, configure, and trade these assets.

AirSwap is a commitment to create a world filled with frictionless value transfer. Fluidity is a commitment to organize the world’s financial assets, and bring each one into the digital age.

We’ll see you on the other side.

More about Fluidity

Special thanks to Michael Oved (@ovedm606) and Professor Stephen McKeon (@sbmckeon). For more security token stories, research, and insights, follow me on Twitter @derekedws.


Rebuilding Finance for a Frictionless World

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