Fractionalizing Investment Securities: Using FinTech to Expand Financial Inclusion

Recent innovations in financial technology, or “FinTech,” are enabling the fractionalization of shares of stock, bonds, and other investment securities into units (“fractionalized securities”) that are small enough for virtually any investor to afford. In a new article, we show how this fractionalization can fundamentally expand financial inclusion for investors and, by enlarging the pool of invested funds that businesses can borrow, also increase financial inclusion for small and medium-sized business enterprises (“SME”s). We also show how fractionalizing investment securities could help the European Union reach its goal of creating a capital markets union.

For perspective, we observe that FinTech itself has been around for decades. The advent of computers, for example, made it feasible to transmit and settle payment orders electronically, to facilitate cross-border payments, and to develop online banking. And fractional ownership has been around even longer – in the form of shares of stock (fractional ownership of firms) and bonds (fractional ownership of claims for repayment of debt issued by firms).

However, recent FinTech advances, including in blockchain cryptography, are enabling the development of a market for fractionalized securities. In this market, these securities may be more efficiently traded under so-called smart contracts, which are governed by mathematical algorithms that replace human-managed intermediaries. Lower trading costs and much smaller units of investment can profoundly expand the universe of potential investors. Whereas a hypothetical retail investor would need to invest hundreds or thousands of dollars to build a diversified portfolio of shares of stock and bonds, she much more affordably could build a diversified portfolio of fractionalized securities. FinTech-enabled fractionalization thus can greatly increase the number of retail investors participating in capital markets. Both in the United States and abroad, that number is relatively small. In France, only 6 percent of the population, and in Mexico, only 1 percent of the population, invests in securities, and even in the United States, one-third of adults are not investing.

By expanding the universe of potential investors, fractionalized securities can expand the pool of invested funds that businesses can access. This has special significance for SMEs, which comprise 90 percent of businesses worldwide, represent 50 percent of worldwide employment, and are critical to economic growth. Like all businesses, SMEs rely on financing to operate and expand their activities. Because of their relatively small size, SMEs lack the economy of scale to cost-effectively access capital market funding. They therefore have been forced to borrow through financial intermediaries such as banks. That, however, can limit the availability and increase the cost of financing to SMEs, creating an estimated multi-trillion dollar financing gap for them. FinTech-enabled fractionalization can enable SMEs, for the first time, to directly access low-cost capital-market funding by issuing their own fractionalized securities, thereby increasing their available funding and lowering the cost of financing.

Notwithstanding these benefits, we show that fractionalization can give rise to a range of risks, including liquidity risk – in this context, the risk that an investor might be unable to resell her fractionalized securities (and thus unable to realize a bargained-for return on her investment therein). Although there are robust secondary markets for the trading of shares of stock and bonds, it is far less clear that there is a viable secondary market for the sale of fractionalized securities. Illiquidity is the main cause of bankruptcy as well as a major systemic threat to the financial system, which poses risks to issuers, investors, and the public. We analyze how regulation could limit these risks while preserving fractionalization’s benefits.

For example, the fractionalization of investment securities is currently only regulated through securities law. Although securities law would require disclosure of the risks (including liquidity risk), it does not substantively regulate them. We examine how to better apply securities law to fractionalized securities, including through more tailored disclosures and issuance-registration exemptions. Additionally, we examine regulating beyond securities law, including creating a more viable secondary market by allowing registered centralized exchanges to trade fractionalized securities, protecting monetary integrity by requiring decentralized finance (DeFi) exchanges to adhere to know-your-customer and anti-money-laundering standards (and explaining how that requirement could be implemented), and protecting consumers by setting investment limitations for retail investors. We also subject the proposed regulation to cost-benefit analysis to ensure that its protections are cost-effective.

Our regulatory analysis also addresses the (mis)perception that smart-contract-enabled transactions intrinsically lack imperfections because their governance by mathematical algorithms virtually eliminates human error. Furthermore, we discuss how (and the extent to which) the regulation of fractionalized securities should be harmonized internationally. And to help readers understand all this, we attempt to accessibly explain the rudiments of blockchain cryptography, DeFi, and smart contracts.

This post comes to us from Steven L. Schwarcz, the Stanley A. Star Distinguished Professor of Law & Business at Duke University School of Law, and Robert Bourret, a class of 2023 J.D. candidate.  It is based on their recent article, “Fractionalizing Investment Securities: Using FinTech to Expand Financial Inclusion,” forthcoming in 84 OHIO STATE LAW JOURNAL (2023) and available here.