"Reading the Merkle Leaves" - Two Catalysts for Digital Securities

Phil Liu
Feb 19, 2019

Two articles last week postulated that digital securities and security token offerings are not ready for mainstream adoption. Yet, firms are making incremental efforts that move the space forward. A Coindesk article summarized a panel discussion at ETHDenver where panelists basically agreed that the infrastructure needed for mainstream adoption of digital securities is years away. A separate article posted on Medium called STOs “near death,” “lifeless” and “zombies.”

Image result for ethdenver panel
ETHDenver Panel

I take the perspective that digital security products with substantial mainstream excitement are around the corner and will herald a new wave of financial product offerings. We aren’t years away but rather months away. After all, a year, in blockchain/crypto terms, is a few lifetimes. But, I believe that in order for that mainstream adoption to occur, there has to be a couple catalysts:

  1. Improved security and recoverability
  2. A new blockchain securities settlement system

Improved Security and Recoverability

Ten years after the original Bitcoin paper by Satoshi Nakamoto, security of cryptocurrencies remains a conundrum. On the one hand, the power to own and control one’s crypto remains in the hands of the legitimate holder rather than a central authority. On the other hand, if the legitimate holder has been negligently or criminally dispossessed of his/her private keys, the crypto is most likely lost forever. So the use of private keys in crypto has been both central to its existence as well as its confusion to the mainstream, non-cryptospheric, public.

For mainstream investors — both institutional and retail — the idea that they themselves are solely in control their cryptoassets is both irresponsible and reckless. Those in the cryptosphere are familiar with the dogma, “Not your keys, not your coin”. But for investors who are used to having third-party intermediaries, like custodians, holding assets that can be recovered in the case of death, illness, negligence or fraud — not having a 99.9 percent backup plan for lost or stolen crypto recovery is simply an unacceptable risk.

Some asset-backed digital securities such as those issued by venture capital or real estate funds are already utilizing backend operations technology that allows for the recreation, freezing, and reissuance of security tokens in the event of unexpected loss (whether due to negligence or fraud). However, almost all of the tokens issued in ICOs in the last two years have no inherent technology that would allow such recovery. Fortunately, startups (such as Arwen) and old-line financial firms (such as Fidelity) are stepping in to fill this void. I remain very optimistic that vastly improved security and recoverability solutions are around the corner.

New Blockchain Securities Settlement System

The existing financial system is regulatorily and operationally complex, exclusionary and inefficient. Blockchain and crypto is supposed to solve these issues. While everyone in this space has discussed repeatedly how decentralization, blockchain, and crypto have the potential to be more inclusive and efficient, the complexity of regulations applied to crypto securities has not been well studied. Rather, the gut reaction of many crypto evangelists is to argue that securities laws are anti-decentralization and designed to protect the wealthy (at the expense of the other 99 percent).

Philosophical arguments aside, the current securities regulatory system has come about as a result of reactionary responses to various financial crises:

  • The Great Depression
  • Savings & Loan
  • The wrong-way bets of the hedge fund Long-Term Capital Management
  • Enron and financial statement manipulation
  • The Housing Bubble and the Great Recession

Each new responsive set of regulations addressed a shortcoming of the previous regulatory framework that came before. In addition, each new set of regulations also added more restrictions, reporting, records, notices, confirmations, intermediaries, and monitoring to the securities laws that are in place today. Every crypto project that issues a digital security has to comply with these existing laws, which brings me to my point…

It may be a long time waiting for securities laws to change to accommodate the current state of blockchain and crypto-based digital securities. I believe the path to faster adoption is instead to conform the technology to existing securities laws. I also believe the path to mainstream acceptance of digital securities offerings is to build the technology backend to track real-time transactions down to the personally-identifiable information of KYC/AML-approved individuals. That’s what regulators, institutions and even mainstream investors expect and desire. Again, there are companies working on these types of solutions, including Arca, and I am very optimistic that portions of these innovations will be coming to fruition in the near term, and the rest will be realized in the intermediate (6–12 month period) term.




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