Digital Asset Security

Digital asset securities are defined by smart contracts, which automate key functions like dividend distribution, voting, and compliance. This enables:

• Automated compliance (e.g., enforcing transfer restrictions for accredited investors).
• Real-time settlement (T+0) versus traditional markets (T+2).
• Dynamic features like revenue-sharing agreements executed automatically upon triggering events.

These assets are engineered to comply with securities laws from issuance through secondary trading. Core mechanisms include:

• Embedded KYC/AML: Identity verification is required before a wallet can receive the token.
• Transfer Restrictions: Smart contracts can enforce rules, such as limiting trades to verified investors or specific jurisdictions.
• Regulatory Reporting: Transactions are recorded on an immutable ledger, providing a transparent audit trail for regulators.

Digital securities enable the tokenization of high-value assets, dividing them into smaller, more affordable units. This increases market accessibility and liquidity for assets like:

• Real estate (commercial buildings, residential properties).
• Private equity and venture capital funds.
• Fine art and collectibles.
• Infrastructure projects. Each token represents a verifiable, fractional share of the underlying asset's economic value and rights.

All ownership records and transaction history are maintained on a distributed ledger (e.g., a permissioned blockchain). This provides:

• Immutable audit trail: A permanent, tamper-proof record of all transfers and ownership changes.
• Real-time transparency: Investors and issuers can view the cap table and transaction history in near real-time.
• Reduced reconciliation costs: Eliminates the need for intermediaries to reconcile disparate ledgers, reducing operational risk and cost.

While subject to regulatory constraints, digital securities are designed to be traded on Alternative Trading Systems (ATS) or other regulated venues. This creates potential for:

• 24/7 trading on global platforms, unlike traditional market hours.
• Reduced settlement risk through atomic swaps and instant settlement.
• Increased capital efficiency for investors in traditionally illiquid assets like private company shares or real estate.

While operating under a regulated framework, digital asset securities can be designed for compatibility with broader decentralized finance (DeFi) infrastructure. This enables potential use cases like:

• Collateralization: Using tokenized real-world assets (RWAs) as collateral for borrowing in DeFi protocols.
• Composability: Integrating security tokens into structured products or automated investment strategies via smart contracts.
• Cross-chain functionality: Asset representation on multiple blockchains to access different liquidity pools and ecosystems.

Digital tokens representing a debt obligation, such as a bond or promissory note. Holders are entitled to interest payments and principal repayment.

• Real-world example: Real Estate Investment Trusts (REITs) issuing bonds as digital securities.
• Key feature: Enables fractional ownership of large debt instruments, increasing accessibility.
• Mechanism: Coupon payments are often automated via smart contracts, defining interest rate and maturity.

Digital tokens representing shares in an investment fund, such as a mutual fund or exchange-traded fund (ETF). The token's value is tied to the fund's underlying portfolio.

• Real-world example: Arca Labs' ArCoin, a tokenized U.S. Treasury fund.
• Key feature: Provides blockchain-native exposure to diversified asset baskets.
• Benefit: Enables 24/7 trading and settlement, unlike traditional fund structures.

Tokens that entitle holders to a percentage of a project's or company's future revenue or profits, rather than equity ownership.

• Structure: Functions like a decentralized autonomous organization (DAO) treasury distribution mechanism.
• Use case: Common in decentralized finance (DeFi) and creator economies for aligning investor and project incentives.
• Legal consideration: Often structured as investment contracts under the Howey Test.

Understanding what qualifies as a security is defined by legal tests, not technology. The key regulator in the U.S. is the Securities and Exchange Commission (SEC).

• The Howey Test: The primary U.S. test for an investment contract. It assesses (1) investment of money, (2) in a common enterprise, (3) with an expectation of profit, (4) derived from the efforts of others.
• Security Token vs. Utility Token: A utility token provides access to a product/service, while a security token represents an investment. Many tokens can be hybrid or change classification.

KYC is the foundational process of verifying the identity of clients before or during business engagement. It is a critical subset of AML programs. Key steps involve:

• Identity Verification: Collecting government-issued ID, proof of address.
• Beneficial Ownership: Identifying individuals who ultimately own or control legal entity customers.
• Ongoing Monitoring: Periodically updating customer information and risk profiles.
• Sanctions Screening: Checking customers against global watchlists (OFAC, UN).

A specific AML requirement mandating that Virtual Asset Service Providers (VASPs) share originator and beneficiary information for certain transactions. Key aspects:

• Applies to transfers between VASPs (e.g., exchange to exchange).
• Thresholds vary by jurisdiction (e.g., US: $3,000, EU: €1,000).
• Required Data: Sender's name, account number, physical address, and for beneficiaries, name and account number.
• Technical solutions like the InterVASP Messaging Standard (IVMS 101) and proprietary protocols are used for compliance.

Regulations governing how digital assets are held and protected on behalf of clients. These rules address the unique risks of crypto custody.

• Segregation of Assets: Client assets must be held separately from the custodian's own assets.
• Proof of Reserves: Auditable proof that custodian holdings match client liabilities.
• Private Key Management: Requirements for secure generation, storage (e.g., HSMs, MPC), and access controls.
• Insurance: Often required to protect against theft or loss, both internally (crime policies) and externally (custody-specific coverage).

Laws prohibiting manipulative or deceptive practices in digital asset markets, analogous to traditional finance rules.

• Wash Trading: Artificially inflating volume by trading with oneself.
• Spoofing & Layering: Placing and canceling orders to create false market depth.
• Front-Running: Executing orders based on advance knowledge of pending transactions (e.g., in a mempool).
• Insider Trading: Trading based on material non-public information about a token or protocol. Enforcement is increasing, with actions by the SEC and CFTC.

Mandates for reporting digital asset transactions to tax authorities and customers.

• US Form 1099: Brokers must report gross proceeds from sales and, starting 2025, cost basis information to the IRS.
• EU DAC8: Expands crypto-asset reporting for tax purposes, requiring EU Crypto-Asset Service Providers to report transaction details.
• Capital Gains/Loss: Protocols and institutions may need to provide users with transaction histories for tax calculation.
• FATCA/CRS: Global frameworks for the automatic exchange of financial account information, increasingly applied to crypto.

A smart contract audit is a rigorous, manual and automated review of a smart contract's source code to identify security vulnerabilities, logic errors, and inefficiencies before deployment. Conducted by specialized firms, audits check for common flaws like reentrancy, integer overflows, and access control issues. A public audit report is a critical trust signal in DeFi.

Cold storage refers to keeping private keys completely offline, air-gapped from internet-connected devices. A hardware wallet is a dedicated physical device (e.g., Ledger, Trezor) that generates and stores keys offline, signing transactions internally. This provides superior protection against remote hacking, malware, and phishing attacks compared to hot wallets (software connected to the internet).