The Roaring Twenties were a time of remarkable prosperity, as America’s wealth more than doubled between 1920 and 1929.
For the first time, many Americans owned cars, radios, and telephones. Even luxury brands like Gucci, Jaguar, and Ducati emerged in the 20s. It all came to a screeching halt on Black Tuesday — October 29, 1929 — when the bubble popped and stock prices completely collapsed.
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Back then, investors couldn’t pull up their Robinhood accounts and see live ticker prices —they were printed by a ticker-tape onto paper, which literally couldn’t keep up with the pace of falling prices. Thus, declining prices led to panic selling, creating a vicious downward spiral.
Moreover, buying on margin was introduced in the 1920s, which allowed investors to place enormous stock orders with just 10% to 20% down. In other words, you could invest $100,000 even if you only had $10,000. When prices fell, brokers called in these loans, wiping out the life savings of many margin buyers.
Naturally, these massive losses destroyed confidence in the economy, and people were afraid to leave their money in the hands of banks, pulling out all their cash. Ironically, many banks didn’t have enough cash on hand to accommodate these “bank runs” and had to close, leaving even more life savings in the gutter.
As Americans flocked to gold, the Fed tried to increase the value of the dollar by raising interest rates, thus reducing liquidity, but without funds, companies laid-off employees, furthering the economy’s downward spiral.
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During the ensuing Great Depression, the average worker lost three years’ worth of savings— going from unprecedented prosperity to immense suffering.
Hoover’s Legacy
Soon after Black Tuesday, President Herbert Hoover was elected, making the Great Depression the defining issue of his presidency.
In those years, millions of Americans lived in slums, derogatorily nicknamed “Hoovervilles,” although the dominoes were already falling well before he was elected.
Poor Americans slept under “Hoover blankets” (old newspapers), drove “Hoover wagons” (automobiles without an engine, pulled by horses), and wore “Hoover leather” (shoes lined with cardboard when the sole wore through).
That’s a painful legacy to leave as a President.
Franklin D. Roosevelt
Roosevelt didn’t want to inherit the same negative image, so he needed a plausible solution to America’s ails, as well as someone to blame. He needed a scapegoat.
Of course, he would never win by blaming the people who bought on margin or panic sold. Those are the voters! He did, however, find another group to blame: Securities issuers.
His campaign rhetoric bolstered the theory “that the crash was caused by the dishonesty of those who issued ‘worthless securities.’” Securities regulations became a major talking point for Roosevelt in the 1932 Presidential election. As one of the three pillars of The New Deal, FDR promised widespread financial reforms.
These promises led to a sweeping victory for Roosevelt, and he made good on his campaign slogans. The first major reform was the Securities Act of 1933, which requires that investors receive information on securities being offered, and prohibits any misrepresentations or deceit in the offering of securities.
To create a more powerful regulatory body, Congress would need a good reason and one that makes average American investors out to be the victims. In 1934, Congress reviewed manipulative tactics used in the 1920s, like investor pools.
One notable example was the “Radio Pool,” in which a group of investors bought and sold Radio Corp. of America stock amongst themselves to build a record of rising prices and volumes, manipulating an increase in value. Shares jumped from under $100 in 1928 to over $500 before the Black Tuesday crash.
Soon after, Congress wrote the Securities Exchange Act of 1934, creating the Securities and Exchange Commission and giving it broad powers to register, regulate, and oversee basically everything to do with securities.
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A generation after the enactment of these regulations, economics researcher George Stigler published a blistering criticism of the effectiveness of the SEC.
While champions of the SEC like FDR claimed that it was needed to stave off thieves in finance, Stigler revealed that the data to support this was cherrypicked, “would not meet academic standards of accuracy,” and however viewed “do not make the case for the need for more regulation.”
Finally, Stigler found that there was no significant difference in returns of securities before and after the SEC, questioning the idea that securities regulations provide significant benefits to investors.
A generation later, in 1981, economic researcher Greg Jarell came to the same conclusion, finding that the data “do not support the widely held view that securities offered during the period of the later 1920s were generally overpriced by the purchasers.”
It seemed that the SEC wasn’t actually benefitting investors. Ultimately, the SEC was a political tool for FDR.
In spite of this, the SEC is alive and well today. Americans are still forced to adhere to the regulations made to fulfill campaign promises from around 90 years ago.
Further, crazy pumps and crashes in the stock market still happen all the time — with seemingly little intervention from the SEC. For example, below we can see the stock price of Kodak pump from around $2 on July 27th to over $33 on July 29th (due to leaked information ahead of an official announcement), before crashing down to $17 on August 4th.
Visualized by Apteo. Data from Yahoo Finance.
What the SEC does put a lot of focus on are private offerings. Any offering of securities in the US — be it equity, debt, or hybrid securities — must be regulated, or must file to be exempt. A common exempt securities offering type is called Regulation D, and to invest in a Reg D offering, you literally need to be a millionaire.
Rule 501 of the SEC’s Reg D states that only accredited investors may invest in Reg D offerings, defined as those with a net worth of over a million dollars, or with an extremely high past and present income.
This is a big problem. It means retail investors can’t easily invest in many extremely high-growth assets, like early-stage startups. Millionaires can, and often get richer doing so. Retail investors must wait until the startup “goes public,” after which you’ll see far smaller (or even negative) gains compared to a startup going from seed stage to IPO.
Companies that don’t adhere to these regulations and register, or file for an exemption, face severe consequences. For instance, the SEC fined the Canadian company Kik $100 million for conducting a non-compliant ICO, which was deemed to be a securities offering.
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How was the United States Securities and Exchange Commission able to fine a Canadian company? The SEC has a global reach, and the Kik token was available to American investors, so the SEC chose to demonstrate their power even outside America’s walls.
It’s not just that the SEC is outdated: Securities themselves are outdated.
Inefficient
Besides being rather exclusive, the process of both buying and issuing private equity or debt is slow and expensive. A private placement offering, for instance, calls for a Private Placement Memorandum (PPM), which costs up to $35,000.
On the other end of the spectrum, doing an Initial Public Offering (IPO) costs a whopping $4.2 million, as well as fees worth 4–7% of gross proceeds.
Illiquid
Even once a private security is available for sale, there’s not much liquidity. In other words, if you buy a private security, there likely won’t be a buyer on the other end, so you’re stuck holding your illiquid asset.
This is why early-stage startup investments are largely considered “all or nothing.” If the startup never gets acquired or goes public, your security will likely become worthless, given that you have no means to trade it.
Indivisible
Another problem with many securities is that they’re not easily divisible. For example, if you want to invest in high-growth assets like limited edition cars, fine art, cruise ships, diamonds, or even parking spaces in dense cities, the minimum investment is extremely high.
In 2016, for example, an F12tdf (a nice car) sold at a Los Angeles dealership for $1.5 million. Its initial purchase price was around $450,000, yielding incredible returns. If the car is kept in mint condition, one can only imagine its value in 10, 20, or 50 years from now.
The problem is, you can’t invest in fractions of a car. Whether you have $450 (0.1% of the base price) or $45,000 (10%), high-value securities are off the table.
Burdensome
Recall that the Securities Act requires regular reporting. This entails manually filling out boring paper documents, a tedious process that all public companies must go through on a regular basis, even in 2020.
In short, securities are inefficient and burdensome, while private securities, in particular, suffer from illiquidity and exclusivity.
The securities industry has been virtually unaltered since the 1930s. It’s remarkably outdated and lacking innovation, so the obvious instinct is to look to modern technology for an answer.
After all, apps like Robinhood completely changed investing in the stock market, so perhaps we can revamp investing in the private market as well.
Indeed, there is a technological solution, called “digital securities,” or alternatively “security tokens.” These are simply securities on Distributed Ledger Technologies, like the blockchain, which is chosen because it enables the secure transfer of securities without an intermediary.
Like virtually any digital asset, whether it’s an email or an instant message, digital securities can be easily, instantly transacted, and without fees. These are already revolutionary upgrades over traditional securities.
This enables greater liquidity as well, as seamless transactions are simply a pre-requisite to having many buyers and sellers available at any time in a marketplace. Traditional private securities can’t be seamlessly transacted, so there aren’t many buyers and sellers in private markets.
The Technology
This isn’t some far-off dream or theory: Digital securities are already here. A simple example of digital security technology is called ERC-1404, the “Simple Restricted Token Standard,” which adds compliance functions to the ERC-20 standard that sparked the ICO boom in 2017.
Here’s what it looks like:
contract ERC1404 is ERC20 {
function detectTransferRestriction (
address from,
address to,
uint256 value
) public view returns (uint8);
function messageForTransferRestriction (
uint8 restrictionCode
) public view returns (string);}
These simple functions let issuers enforce SEC-mandated restrictions, whether it’s making sure minors can’t invest, that a non-accredited investor can’t invest, or that a non-US-citizen can’t invest. One could even bake KYC/AML measures into digital securities themselves, saving billions of dollars.
Since there are over 1,000 Ethereum developers out there (coders that can build with this technology), talent is not the issue.
The Elephant in the Room
In spite of these drastic improvements, we can’t forget that securities regulations limit the usability of digital securities.
Every issuer of a digital security still needs SEC approval, and if it’s a Reg D digital security offering (DSO) or security token offering (STO), investors will need to prove that they’re millionaires. Digital securities make securities more efficient, but they don’t negate the onerous regulatory requirements.
Suppose you wanted to make it easier to raise capital in Africa by creating an equity crowd-investing platform — as now it’s incredibly difficult for entrepreneurs to raise money. If you wanted to allow Americans to invest, you’d have to meet the same stringent SEC requirements as everyone else. The same principle applies to any securities offering, whether it’s to enable easier investments in alternative energy or simply raise money for a new project.
Digital securities also require their own exchanges, which have regulatory hurdles of their own.
Industry Confusion
Even if there were regulatory clarity — which there isn’t — the digital security industry suffers from both a lack of unity and a lack of understanding.
Earlier, I mentioned the ERC-1404 digital security protocol, but there are many others, like ERC1400, R-Token, S3, CAT1400, DS-Token, and more. These different protocols lack interoperability, which means that different digital securities exchanges would be needed to accommodate all these different technologies, spreading liquidity thin.
Further, the industry is still in its nascency, and the potential of digital securities hasn’t been realized. For example, if you were to Google “erc20 security token” or “erc-20 security token,” you’ll find hundreds of articles claiming that a given token is a security token while using the ERC-20 protocol — which is impossible.
The entire point of digital securities is that they add additional compliance functionality to protocols like ERC-20, so you can’t just call a standard ERC-20 token “digital security.”
Market Size
In spite of the regulatory and technical barriers, revolutionizing the securities industry is a worthy endeavor.
Simply put, the potential market of digital securities is the market of securities. Digital securities are securities 2.0, as any security can be digitized (or “tokenized”).
For example, you can buy tokens to get fractionalized ownership of supercars with CurioInvest, or invest in gold with Aurus tokens, or invest in tokenized real estate with realT.
There are very real ways to bring efficiency, liquidity, and greater compliance to the stale securities industry.
As with any superior technology, eventual adoption is inevitable, but there are huge hurdles in the way. Notably, securities regulations have around 90 years of progress to catch up on.
In spite of the challenges, it’s worth it to get involved in this space, as trillions of dollars of securities will go truly digital.
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