Challenges Facing Digital Securities

Digital securities are a very recent phenomenon. The idea of digital securities only became popular in 2017. This was a major contributing factor in the cryptocurrency boom that took place during the same period of time. There are many financial analysts who believe that digital securities have a very bright future. However, there are others who also believe that there are some small challenges that need to be surmounted before digital securities become the norm.

In this article, we will first understand what digital securities are and how they are different from digital assets. We will then have a look at the major challenges facing the digital securities industry.

Digital Securities vs. Digital Assets

Digital assets represent something which has value. The records of the ownership of such assets are kept using distributed ledgers online. It needs to be understood that in this case, the asset itself is digital. Common examples include cryptocurrencies. Digital assets only exist in the digital world. For instance, cryptocurrencies have very little value in the offline world.

Digital securities, on the other hand, are a representation of an asset which may or may not be digital. The record of ownership is still kept on a distributed ledger online. However, the asset need not be digital. For instance, shares and bonds of an industrial age brick and mortar company can also be held as digital securities.

Since digital securities can be used by a wider range of industries, they have more commercial application. As a result, they are becoming more popular as compared to digital securities. However, there are many challenges that these securities face. Some of them have been listed below.

Challenges Facing Digital Securities

  • Privacy: Blockchain technology is basically used when the records have to be held on a distributed ledger and made public. However, digital securities have a different privacy requirement.

    In the case of securities, information cannot just be released to the public. There are well-established protocols which are highly regulated by quasi-government agencies all over the world. These agencies have been created with the sole purpose of preventing market manipulation by preventing the leakage of sensitive information.

    To top it up, there are stricter privacy rules like GDPR, which need to be complied with as well. Digital securities have a long way to go. They need to combine the convenience of blockchain technology with the strict privacy requirements mandated by securities law.

  • Monitoring Transactions: Digital platforms which issue digital securities monitor the transactions taking place in the underlying security. This obviously gives them an unfair advantage.

    For instance, traders who buy and sell Bitcoin can see all the transactions happening in Bitcoin at a given time. This creates information asymmetry. At any given point in time, these traders have more information than other participants in the marketplace. Since they are not restricted from making personal trades simultaneously, brokers of digital securities have an unfair advantage over other investors.

  • Preventing Money Laundering: It is common knowledge that digital securities and assets are now being used by powerful criminal organizations to launder money. Before digital securities become mainstream, this problem needs to be tackled. Regulators all over the world want to prevent financial transactions being undertaken by criminal organizations.

    Digital securities, therefore, need to be smart. These securities need to be able to identify whether the buyer is KYC compliant. The exchanges issuing digital securities will have to create a foolproof mechanism to ensure that these securities do not fall into the wrong hands.

    It is possible to either manually vet the individuals undertaking the transactions or to build a software to do so. However, in both scenarios, an additional outlay of cash is required. This will drive up the cost of using digital securities, which will discourage their large scale adoption in the long run.

  • Compliance: Securities are traded at several exchanges all over the world. Each exchange has its own rules and regulations. Often, these rules and regulations are enforced on the exchange by the government. As a result, complying with different regulations is a necessity, not an option.

    For instance, for some kind of securities, there is a restriction regarding that they can only be sold to an “accredited investor.” Also, in many cases, some securities cannot be sold to some institutions like pension funds. The software that manages digital securities needs to be smart enough to ensure that these ever-changing rules become easily programmable and enforceable.

  • Controllable: Lastly, digital securities need to be controllable by the party, issuing them. This is opposed to the way bitcoin and blockchain functions in general where no single party can control the entire system. However, in the case of digital securities, control is necessary. This is because many times, securities may have to be forcibly transferred to other parties because of a court order. They may also have to be forcibly transferred if majority shareholders decide to sell the shares, but minority shareholders resist such a sale. Once again, making digital securities controllable is possible. However, it changes the costs involved, and it also changes the basic nature of the securities.

The bottom line is that digital securities are still a relatively nascent concept. It is likely that they become popular and overtake the dematerialized securities that we now hold. However, it seems like a long way away since there are still a lot of challenges that digital securities need to overcome.

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