For the first time in history, assets can be sent as easily as information — peer to peer, near-instantaneously, at any size. The Bitcoin network’s open, immutable, transparent ledger—working in concert with unique incentives and powerful scarcity—has reshaped how individuals and institutions across the world think about money, and money-like value.
The opportunity calculus for security tokens is different than what I just described. Blockchain-based securities are distinct from the fixed-supply, bearer, store-of-value cryptoassets like BTC, ZEC, DCR, and others.¹
Instead — security tokens, and the trust-minimized contracting environment they operate within, may be best understood as a formatting revolution.
The Legal Layer
In the United States, the foundation of contract law and securities law originates out of two principles.
The first? Protection.
Contract law protects the promises we make with others — if we enter into a set of promises with a counterparty, we should be remedied if our counterparty’s promises go unfulfilled.² Similarly, securities law protects investors by providing them with information deemed significant, while prohibiting deceit, misrepresentation, and fraud.³
The second? Incentivizing value exchange.
When rule of law is understood across transacting parties, confidence in the system allows new value to enter, wrapped in legal contracts.
Over the last few hundred years, both contract law and securities law have evolved out of these two principles.
Judges play a critical role in advancing these principles. Under a common law system, when contractual disputes enter our legal forums, judges apply the reasoning used in prior cases to the new set of facts presented in front of them.
We call this system stare decisis⁴ — “to stand by things decided”.
Life is complicated, and so are the promises and obligations that we exchange with others. Leaving complex fact patterns up to human arbiters leaves breathing room for more equitable decisions — especially where the black letters of law may dictate otherwise.
Securities may best be understood as a special kind of contract. Simply, they are a kind of tradable contract for financial instruments — things like stocks, bonds, and investment pursuits.
Like contract law, so too has securities law been carved and shaped over time at the hands of human lawmakers and judges. For example, the Securities Act of 1933⁵ defined the types of assets covered by federal securities law — while simultaneously prohibiting things like deceit and fraud during the sale of them.
A year later, the Securities Exchange Act of 1934⁶ empowered the SEC with broad authority over all aspects of the securities industry, including the power to register, regulate, and oversee entities like brokerage firms, transfer agents, clearing agencies, and our nation’s securities exchanges.
Over time, a rich history of stare decisis has formed around these laws. One of the most famous examples — in 1946, the Supreme Court reasoned that an “investment contract”, a term previously left undefined in the Securities Act of 1933, should be evaluated using a flexible four-part test. We call this The Howey Test.⁷
To recap, we have the underlying rights and agreements that parties make with one another. We have an array of laws written and codified by our legislators — and the principles behind that lawmaking. We have human interpreters of those laws known as state and federal judges. And finally, we have a never-ending book of unique fact patterns that create a lineage of stare decisis in our country.
This is the legal layer.
The Formatting Layer
Throughout history, the legal layer has enjoyed a unique relationship with its corporal counterpart — the formatting layer. Where the legal layer focuses on laws, principles, rights, and remedies, the formatting layer focuses only on one thing:
Optimal formats for the legal layer.
As long as legal layers have existed, humans have sought out the best formats to amplify the law’s underlying rights, rules, and principles. We’ve seen this play out over history.
Let’s take contracts, for example. Under this framework, contracts have naturally gravitated towards formats that (1) better protect contracting parties, and (2) better incentivize the exchange of value — the two driving principles of contract law.
To anchor this in practice, let’s start at contract law’s first formatting layer — the oral contract.
Within the Roman Republic, stipulatio was a legal format created to facilitate binding oral agreements between two parties.⁸ The format required specific words to be stated in order to create “offer and acceptance” of the agreement, in the form of “question and answer”. By not requiring an intermediating scribe to a contract, stipulatio incentivized greater levels of participation in Rome’s economy, while creating sufficient legal protection around the agreement.
Flash forward to today, oral contracts are still deemed a legally enforceable contracting format across the world — a remnant of human’s pre-literate contracting history.
But that doesn’t mean the oral format is optimal for the legal layer.
Today, most oral contracts are ignored by modern contracting parties. Samuel Goldwyn, the 20th century Hollywood executive, once argued, “A verbal contract isn’t worth the paper it’s written on.”
The problem with the oral format? While it’s frictionless to enter into verbal agreements, the format doesn’t lend itself well to evidencing that the agreement was formed — not to mention, the specific terms of the agreement.
As technology improved over time, contracting parties gravitated away from the oral format — and toward formats that better harnessed the principles of its legal layer.
The Written Format
The written format had several “killer features” that rendered it superior to the oral format.
The first feature was durability.
The Code of Ur Nammu (2050 BC), the oldest legal writing on record, was carved on clay tablets.⁹ Importantly, clay’s durable format allowed the code to be read and understood thousands of years after its creation — including rules about tax, perjury, and courtroom procedures. In fact, the code’s unique “if this, then that” structure is credited for influencing much of lawmaking thereafter.
The second feature enjoyed by the written format was the signature and other authentication methods — which helped demonstrate the seriousness of an undertaking by evidencing an individual’s willingness to be held to its terms.
Magna Carta, the peace charter signed in 1215 between King John of England and the rebel barons, was hand written on parchment and signed with the King’s seal.¹⁰ Used in concert with parchment, King John’s wax seal was an important formatting feature used to evidence his intent to be bound — while simultaneously preventing downstream forgeries of the agreement.
The third feature enjoyed by the written format was its distributive power.
In 1439, Johannes Gutenberg optimized the paper making process by introducing the wooden printing press and movable type.¹¹ Gutenberg’s first major project advanced a different kind of legal layer — religious laws. Gutenberg’s Bible sold for 30 florins — a significant price reduction compared with the manuscript Bible, which typically required one year to compose by hand.
A few hundred years later, the first industrial revolution brought new advances in machine tooling, including the creation of the Fourdrinier paper machine (1799).¹² This modern paper machine dramatically reduced the cost of books and paper over the next century, and coincided with the expansion of basic education and the rise of world literacy. In 1820, nearly 90% of the world was illiterate. By 1950, that number had been cut in half.¹³
Armed with a proliferating paper-based format, and with literacy rates on the upswing — the legal layer made significant strides in its dual pursuit of (1) protection and (2) efficient value exchange. These principles were on full display in the famous Ferguson Farm case, Lucy v. Zhemer (1954), heard by the Supreme Court of Virginia.¹⁴
On December 20, 1952, Lucy and Zehmer met inside Zehmer’s restaurant and proceeded to drink significant quantities of distilled spirits. In time, they began to discuss the sale of Zehmer’s Ferguson Farm to Lucy.
Finally, Zehmer wrote on the back of the restaurant’s receipt:
“We hereby agree to sell to [Lucy] the Ferguson Farm complete for $50,000, title satisfactory to buyer.”
Zehmer signed the receipt.
The next day, Lucy hired an attorney to examine the Ferguson Farm title. Once assured title was clear, Lucy wrote a letter to Zehmer asking to close on the deal. Zehmer backed out, insisting that due to Zehmer’s intoxicated state, Lucy should have known the “receipt contract” was written in jest.
The Supreme Court of Virginia unanimously found in favor of Lucy, holding that the circumstances were such that a reasonable person would believe that Zehmer intended to enter into a serious legal contract.
A simple paper receipt, facilitating the exchange of value, and the protection of two individuals’ legal promises — the legal layer had found its best format yet.
Over the next few years, the underlying rights to assets — and the contracts humans made with others to own, trade, and manage those assets — thrived under the written, paper-based format. While oral contracts had allowed for frictionless contracting, written contracts were clearly the superior record keepers (durability), included evidence of a party’s intent to enter (signature/authentication), and by the mid-20th century, could disseminate with far greater ease and less expense (distribution) due to rapid advances in paper manufacturing.
But as trading exploded in the late 1960’s, U.S. markets began to wobble under paper’s weight. By the end of the 1960s, what was once the legal layer’s prized formatting tool — paper — was turning into a nightmare.¹⁵
In the public markets, stock certificates were spilling out across Wall Street — filing cabinets, tables, briefcases. Certificates were being delivered to wrong locations, or failed to be mailed at all — leading to costly mistakes. At scale, other new problems emerged as a result of paper’s format — damage, loss, theft. Between 1967 and 1970, $400 million in lost or stolen securities were reported.¹⁶
Back office expenses increased. Longer hours were required. On the streets, hundreds of bicycle messengers were employed to shuffle paper certificates back and forth between brokers. Eventually, exchanges were forced to close on Wednesdays, just to catch up on the administrative overload.
The paper format was failing in its pursuit of (1) protecting contracting parties, and (2) incentivizing the exchange of value. To match growing demand in the public markets, the legal layer for contracts and securities would need a new formatting upgrade.
The Trust-Dependent Electronic Ledger
In the second half of the 20th century, a new format began to emerge with the development of the microprocessor, and eventually trends in corporate and personal computing. Powered by small electrical circuits that could be turned on or off — the computer hit the mainstream.
Binary code, a computer language consisting of ones and zeroes, allowed humans to communicate with computers by defining how these machines took in information, stored and processed that information, and produced useful computer-readable outputs. Coding allowed for new tools and automated commands to develop into commercial applications.
In 1973, to help remedy the growing number of paper shares transferring back and forth between buyers and sellers on Wall Street, the DTC/DTCC was created to kick off the book-entry method of stock ownership we still use in our public markets.¹⁷
Today, the DTCC manages public market stock ownership as an entry on its electronic/digital database. Securities transactions on each stockbroker’s internal database are later shared, tallied, and reconciled on DTCC’s electronic/digital database.
And for privately held assets? Today, underlying rights to securities are often found in the form of electronically-signed and searchable PDFs on cloud-based storage (Dropbox), or as ledger entries on centrally-operated software (Carta) or spreadsheets (.XLS).
Looking back, it’s clear now that the switch from paper to electronic/digital unleashed tremendous value for the legal layer. Importantly — moving our public and private markets to electronic/digital optimized on the three core formatting features of the written format — (1) durability, (2) signature/authentication, and (3) distribution.
In regards to durability, ones and zeroes stored on databases no longer shared paper’s physical limitations. Unlike written contracts, digital entries could be trivially copied, shared, and saved across multiple electronic/digital databases. For example — after Hurricane Sandy destroyed $39.5 trillion worth of stock and bond certificates held by the DTCC, the firm announced that computer records had detailed inventory files of the damaged stock certificates, mitigating against total loss.¹⁸
For signature (authentication), there was also an important upgrade with the jump from paper to electronic/digital. By linking personal information to digital signatures, the legal layer began to recognize new forms of identity that could bind a contracting party — including things like Acrobat’s digital authentication system, or contracts made by email address. Where the first signature created the ability to codify a party’s intent to enter into a contractual obligation — the electronic/digital signature iterated on this feature by improving its speed, efficiency, and interoperability.
Finally, electronic/digital’s distributive quality also thrived as compared to the paper-based format. By coding legally enforceable content into ones and zeroes, contracts and assets could interoperate with computer-readable systems, and allow exchanges of these financial instruments to clear and settle much faster than ever before.
The electronic/digital database was the perfect format to match the modern realities of securities and contract (1) protection and (2) exchange.
The Trustless Digital Ledger
That brings us to today.
In 2020, much of what we recognize as our global financial system — and the contractual agreements within — have been captured by the electronic/digital format, trading from database to database across the world.
However, one major problem was left untouched during the migration from paper to ones and zeroes.
Today, the contracting environment for the world’s financial assets is built on a network of trusted third-party databases, resulting in severe fragmentation for assets and trading around the world.
Owners of securities trust away their assets to electronic databases held by banks (hundreds), broker-dealers (thousands), law firms (tens of thousands) — or leave them idle on segregated cap table software or cloud-based spreadsheets (hundreds of thousands).
And what does a trusted, siloed environment mean for the world’s assets and its markets? It means value extraction, mistake, and inefficiency across all stages of an asset’s lifecycle:
- Costly fees accrued as a result of trading ownership or issuing distributions across siloed databases.
- Costly record keeping, auditing, and reporting services for transactions across siloed databases.
- Costly legal compliance and opinion for transactions across siloed databases.
- Inaccurate shareholder accounting and reconciliation systems.¹⁹
- Inefficient clearing and settlement speeds.²⁰
- Loss of appraisal/voting rights.²¹
As history has dictated over the last three thousand years, the legal layer will continue its inevitable march to locate more optimal formats over time — specifically where formats better pursue the principles of the legal layer.
And so — the terminal format for how securities and contracts are created, traded, and owned? This is a pursuit that will continue in perpetuity. It’s not whether the legal layer will adopt a new format — but what the next one will be.
Today, all signs point to blockchains as the next formatting layer.
In 2008, Satoshi Nakamoto published the Bitcoin whitepaper.²² Nakamoto gamified the double entry accounting process by creating a “third entry” — a dominant record of an event between two transacting parties, accepted as the truth by all parties.²³ Distributed computers all over the world — unrelated to an underlying transaction — were incentivized to provide costly amounts of electricity to power third-party receipt services for any transaction on the Bitcoin blockchain.²⁴ As a result, parties could trust that the transaction was accurately debited and credited, without having to trust their counterparty.
Over time, we learned that this type of data structure could track and store any kind of information reduced to ones and zeroes — including ownership rights to assets covered by a legal layer.
Like securities and contracts.
So — “why blockchain” for securities? Simply, using blockchains will unlock securities from the trusted, siloed, databases of the world — into an environment that enables trustless settlement and contracting.
In the context of the formatting layer, a “trustless” recording format optimizes on the three core formatting upgrades of the “trusted” recording format — (1) durability, (2) signature, and (3) distribution.
Compared to the durability offered by our current siloed system for securities, trustless ledgers offer unprecedented accuracy and record-keeping. Further, a blockchain’s transparency allows problems at both the asset and contract level to be seen and understood quickly — providing issuers, regulators, and contractual parties improved oversight to fight mistake, fraud, and abuse in our asset markets.
For signature (authentication), blockchains improve on the siloed database model by opening the door to a trustless, interoperable network for personal identity — in turn, removing the risk of storing personally identifiable information (PII) in multiple centralized databases around the world.
For distribution, blockchains are also a significant upgrade on the siloed database model. Our current matching and settlement systems are built on weeks/months-long matching periods (private markets) and days-long settlement times (public markets). Trustless ledgers offer the potential for transparent, 24/7, fractionalized, global, near-instantaneous matching, trading, and settlement — for any digitally-wrapped financial right or interest.
In the aggregate, these benefits make the distributed ledger a non-trivial formatting upgrade.
The formatting upgrade could stop there, and I believe that would be enough to bring the legal layer to its next evolutionary point. But trustless ledgers also unlock a new killer feature for the legal layer.
In 2018, Collaborative Fund’s Stephen McKeon wrote the following in his piece, The Security Token Thesis²⁵:
“The current stage of security tokens is analogous to broadcasting a radio program on television. We’ve just begun to tap the expanded design space for securities that it facilitates and we just don’t know how it will evolve from where we stand today. It could be a huge canvas for creativity over the next decade…”
I’ve had the last couple years to think about this idea, and I believe digital sovereignty is the heartbeat behind a new design space for financial assets. With digital sovereignty, individuals enjoy stronger ownership over their financial assets — one without siloed intermediation — and an improved influence on the security’s contracting environment over the asset’s lifecycle.
Attorney Gabriel Shapiro may have put this best, in his long-form paper Tokenizing Corporate Capital Stock²⁶:
“The [unique selling point] of blockchain technology is that it furthers the values of individual asset sovereignty by creating the technological predicates necessary for ordinary persons to hold, manage and transact with assets in an environment that is trust-minimized while also being secure.”
Over the last six months, we’ve started to see the earliest signs of how digital sovereignty will power a wildly expansive design space for the future of asset ownership, management, and exchange:
- Blockchain-managed “startups” may stream vested equity to founders, advisors, employees, and investors as it is earned in real time — providing each stakeholder new optionality and sovereignty in how that equity is used upon receipt.
- Securities issuers can provide direct and immutable messages, memos, dividends, voting, information, and marketing across a security’s pool of stakeholders — bridging together consumer markets and capital markets in previously impossible ways.
- Global investors can swap blockchain-based dollars for security tokens representing interests in US-based real estate — and later trade those security tokens on a P2P decentralized platform without requiring an intermediary or human counterparty to contract with.
- Blockchain-based credit facilities may allow security token holders to trustlessly collateralize their tokenized asset in a debt position, and mint a synthetic asset pegged to the US Dollar without requiring an intermediary.
- Blockchain-based decentralized autonomous organizations (DAOs), coupled with legal layer entities like LLCs, can creatively interoperate together in a trustless environment to streamline and improve governance, contractual undertakings, and for-profit opportunities — as a result, improving a number of inefficiencies and inequities that exist within the existing VC model.
These are just some of the earliest experiments highlighting digital sovereignty.
Over time, as more of the world’s assets reduce down to ones and zeroes onto distributed blockchain ledgers, an efficient and trustless global contracting environment will emerge. Humans and computers will paint together across a blank canvas — creating new forms of value, and value exchange, difficult to imagine in 2020.
The legal layer will evolve to accommodate — as will the laws, rules, regulations, and stare decisis wrapped within, better pursuing its principles of (1) protection and (2) incentivizing value exchange in a new open and permissionless formatting layer.
This is the power of digital sovereignty.
This is the formatting revolution.
Special thanks to Professor Stephen McKeon (Partner, Collaborative Fund), Gabriel Shapiro (Attorney), and Professor Mohsen Manesh (Professor, UO Law) for their feedback during the construction of this piece.
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¹ Value Capture And Quantification: Cryptocapital Vs Cryptocommodities (Burniske) — https://www.placeholder.vc/blog/2019/4/26/value-capture-and-quantification-cryptocapital-vs-cryptocommodities
² Restatement Second of Contracts — https://www.betterblackletter.com/wp-content/uploads/2019/02/Restatement-2nd-of-Contracts.pdf.
³ The Laws That Govern the Securities Industry (SEC.gov) — https://www.sec.gov/answers/about-lawsshtml.html.
⁴ Stare decisis (Cornell Law School, Legal Information Institute) — https://www.law.cornell.edu/wex/stare_decisis.
⁵ Securities Act of 1933 (Cornell Law School, Legal Information Institute) — https://www.law.cornell.edu/wex/securities_act_of_1933.
⁶ Securities Exchange Act of 1934 (Cornell Law School, Legal Information Institute) — https://www.law.cornell.edu/wex/securities_exchange_act_of_1934.
⁷ Securities And Exchange Commission v. W.J. Howey Co. et al. (Cornell Law School, Legal Information Institute) — https://www.law.cornell.edu/supremecourt/text/328/293.
⁸ Stipulatio (Encyclopedia Britannica) — https://www.britannica.com/topic/stipulatio.
⁹ The Code of Ur Nammu — https://en.wikipedia.org/wiki/Code_of_Ur-Nammu.
¹⁰ Magna Carta (Encyclopedia Britannica) — https://www.britannica.com/topic/Magna-Carta.
¹¹ Johannes Gutenberg (Encyclopedia Britannica) — https://www.britannica.com/biography/Johannes-Gutenberg.
¹² Fourdrinier Machine (Encyclopedia Britannica) — https://www.britannica.com/technology/Fourdrinier-machine.
¹³ Literacy: Our World In Data — https://ourworldindata.org/literacy.
¹⁴ Lucy v. Zhemer (Justia) — https://law.justia.com/cases/virginia/supreme-court/1954/4272-1.html.
¹⁵ The Remaking of Wall Street, 1967–1971 (HBS: Business History Review) — https://hbswk.hbs.edu/archive/the-remaking-of-wall-street-1967-to-1971.
¹⁶ The solution to Wall Street’s 1960s paperwork crisis could also save bitcoin (Quartz) — https://qz.com/370553/what-the-cigar-chomping-schleppers-of-1960s-wall-street-mean-for-bitcoins-future/.
¹⁷ The Depository Trust Company (DTCC.com) — https://www.dtcc.com/about/businesses-and-subsidiaries/dtc.
¹⁸ DTCC finds 1.3 million soaked securities in Sandy-flooded NY vault (Reuters) — https://www.reuters.com/article/us-storm-sandy-securities-idUSBRE8AE02G20121115.
¹⁹ Dole Food Had Too Many Shares (Bloomberg) — https://www.bloomberg.com/opinion/articles/2017-02-17/dole-food-had-too-many-shares.
²⁰ SEC shortens settlement cycle for securities trades (Reuters) — https://www.reuters.com/article/us-usa-sec-settlement-idUSKBN16T1SW.
²¹ Bullish on Blockchain: Examining Delaware’s Approach to Distributed Ledger Technology in Corporate Governance Law and Beyond (Harvard Business Law Review) — https://www.hblr.org/2018/01/bullish-on-blockchain-examining-delawares-approach-to-distributed-ledger-technology-in-corporate-governance-law-and-beyond/.
²² Bitcoin: A Peer-to-Peer Electronic Cash System (Satoshi Nakamoto) — https://bitcoin.org/bitcoin.pdf.
²³ Bitcoin: an Accounting Revolution (Permabull Nino) — https://medium.com/@permabullnino/bitcoin-an-accounting-revolution-40efcb903d7b.
²⁵ The Security Token Thesis (McKeon) — https://hackernoon.com/the-security-token-thesis-4c5904761063
²⁶ Tokenizing Corporate Capital Stock (Shapiro) — https://gabrielshapiro.wordpress.com/2018/10/28/2/