Note: The information contained in this blog post is solely for information purposes and does not constitute an offer to sell, or a solicitation of any offer to buy any securities. You should always consult your own financial, legal, tax or other advisers before participating in any securities transactions.

The first wave of “security token” (or “digital security”) issuances have overwhelmingly been exempt offerings of private securities. Yet, many emerging secondary trading platforms for security tokens appear to be designed based on the public securities trading model — as custodial, order book-based “exchanges.” If private securities do not generally trade on exchanges or custodial platforms, then the creation of such platforms actually introduces new intermediaries in the secondary market.

Instead of creating new intermediaries, we believe we can use this technology to make existing transactions more efficient. If private securities usually trade over-the-counter, then the question is: How can blockchain technology make over-the-counter transactions of private securities more efficient?

In the late 1990s, the Internet provided a new way for buyers and sellers to communicate. Electronic “bulletin boards” began to emerge as a way for parties to identify and connect with each other. But the realities of actually executing securities transactions in a compliant manner did not eliminate the use of intermediaries. Instead, electronic bulletin boards and other online communication tools just made it easier to identify counterparties in over-the-counter transactions, particularly for illiquid assets, even though substantial assistance from brokers and lawyers was still required to execute transactions.

If the Internet enables the free flow of information, think of blockchain technology as enabling the conditional flow of information — data must meet certain criteria before it can be validated on the network. We believe the combination of these foundational technologies sets the stage for a reemergence of digital bulletin boards as a practical way to trade digital securities — not because they necessarily eliminate intermediaries but because they can improve and automate certain aspects of their role.

The Swap Protocol enables peer discovery without an order book, without order matching and without transaction fees. Our smart contract solves for counterparty risk with “atomic swaps” that transfer assets simultaneously without any third-party custodian. While certain aspects of securities transactions cannot be automated, like investor due diligence and suitability checks, token contracts and whitelists can enforce restrictions programmatically and are easier to verify with the help of compliance protocols like Securitize’s DS protocol and Harbor’s R-Token standard. With our latest product, Spaces, projects and platforms can create their own space on AirSwap, setting their own on-boarding requirements and trading parameters. The combination of these tools allows an issuer, for example, to create a digital bulletin board for its digital securities where parties can post indications of interest and leverage the Swap Protocol, all in a “walled garden” environment.

In short, qualified parties can identify each other, negotiate directly peer-to-peer, and once terms have been agreed, execute a trade on their own using a smart contract that clears and settles the transaction on a wallet-to-wallet basis, directly on-chain.

With digital bulletin boards for digital securities, we have the potential to take a process in private security resale transactions that currently takes weeks, even months, and reduce it to days — with the execution, clearing and settlement of a transaction happening all simultaneously in a matter of minutes.

How did we get here?

Security tokens fundamentally differ from cryptocurrencies and consumptive tokens. Unlike their predecessors, which represent natively digital value (e.g. network or shared CPU value), security tokens are “tokens” in the more conventional sense of the term — simply a representation of something else — in this case, ownership of a real asset.

Using tokens to represent securities is obviously very different from (and for some, not quite as exciting as) using cryptocurrency as an incentive to secure a public blockchain. Still, digital securities continue to be one of the most hyped use cases for blockchain technology. Proponents of digital securities say they offer several potential benefits compared to traditionally-issued securities, including lower transaction costs and higher liquidity. In fact, the promise of digital securities has caused many traditional businesses in the securities industry, such as broker-dealers, online issuance platforms, and identity verification services, to retool (or even rebrand) themselves as security token-friendly.

It’s not hard to understand the hype — after all, digital securities are securities that are essentially wrapped in a uniform digital standard, which makes them easier to track and transfer. It’s only natural for technologists to expect fewer middlemen and more liquidity as a result. But while it may be easier technically to transfer digital securities than it is traditional securities, it is not any easier legally. Security tokens are still securities subject to exactly the same laws, rules and regulations, as any other security. This means where security tokens can trade is not a question of technology but a matter of securities laws. Said another way, digital securities will trade where securities trade.

Where do securities trade?

In the United States, securities trade on national securities exchanges, alternative trading systems, and in over-the-counter transactions, in each case often with the assistance of brokers and dealers.

Exchanges and other custodial platforms usually host order books that use matching engines to execute buy and sell orders. Brokers will buy or sell securities on exchanges on behalf of their customers, while dealers and “market makers” provide liquidity. Brokers and dealers also engage in off-exchange trading in over-the-counter transactions. To address counterparty risk, buyers and sellers set up accounts with the exchange or their broker, which takes custody of funds and will typically collect trading fees or other transaction-based compensation.

What securities should be digital?

Where a security will trade often depends on what type of security it is. Broadly speaking, securities can be divided into public and private securities. Public securities have more significant registration and disclosure requirements than private securities and are typically, but not always, offered by public companies. In the US, for example, general offerings of public securities must be registered with the SEC. Public securities trade on custodial exchanges or alternative trading systems, as well as over-the-counter. Public securities are highly liquid assets, in part, because they are already effectively digital. When public securities trade, in almost all cases, all that happens is account entries are updated — the paper securities stay put. The legal owner of almost all public securities is Cede & Co., a nominee of the Depository Trust Company (DTC), which tracks ownership of securities held in “book-entry” format. When parties trade using brokers, typically the broker will keep its customers’ securities in its own book-entry format, which it then reconciles with DTC. While this process may sound a bit convoluted, the centralized and standardized nature of DTC is one of the reasons public securities have so much liquidity.

The majority of private securities, on the other hand, do not benefit from a uniform book-entry system, are not digital, and have little-to-no liquidity. Private securities are offered in private placements exempt from registration. While exempt offerings are more cost effective for issuers, the resulting securities come with certain restrictions on transferability. For this reason (among others), many private securities do not trade on exchanges, and are instead traded over-the-counter. And even though over-the-counter transactions occur directly between buyer and seller, brokers or networks of dealers are usually needed to help identify potential counterparties, along with lawyers to help paper the transaction. Occasionally, buyers and sellers will find potential counterparties on their own using “bulletin boards” or other online tools. But even where buyers and sellers connect on their own, it hasn’t been practical for individual parties to execute transactions peer-to-peer without substantial assistance from intermediaries.

Bulletin Boards on AirSwap

With the right combination of tools, we can improve on the bulletin board model and expand potential liquidity for private securities by making each step of a transaction more efficient. Protocols and smart contracts make it a little easier to discover counterparties, a little easier to ensure and verify compliance, and a little easier to execute trades.

Take a hypothetical transaction relying on the private resale exemption under Section 4(a)(7) of the Securities Act. The exemption allows for resales of private securities to “accredited investors” (and also preempts state “blue sky” laws) but only if certain conditions are met, including delivery of certain issuer disclosures to potential purchasers, that the securities are part of a class that has been outstanding for at least 90 days, and that no general solicitation is used.

With traditional private securities, satisfying these conditions is simply not practical without significant intermediation. But with Bulletin Boards powered by AirSwap, we can improve the workflow of a transaction and reduce the extent of the intermediation required. Issuers can make the required disclosures available on their Space, while blocking interstitials can be used to prevent general solicitation. A Bulletin Board, like any Space, can be walled off, redirecting users to our broker-dealer partner, GB Capital Markets, for required investor suitability verification (e.g. KYC/AML), after which token contract “whitelists” can be utilized for on-chain verification of wallet addresses. Using the Swap Protocol, traders can identify each other, negotiate directly peer-to-peer and execute a transaction using a smart contract without ever giving custody of their assets to a third party and without paying a transaction fee.

With our non-custodial, non-order book, no trading fee model, we believe our technology stack is far better positioned to be integrated into the private securities market than alternatives that take custody, use order book matching engines, and wrongly assume that private securities will trade with the same frequency as publicly traded securities or cryptocurrencies.

Thanks to Stephen Wink, Patrick Berarducci, Michael Oved, and Don Mosites for their feedback.

If you’re a potential issuer, broker-dealer, or online platform interested in learning more about Bulletin Boards on AirSwap, please contact us. Have feedback on this blog post? Let us know.