News

The high cost of popular growth stocks like Apple and Google, which trade at well over $100 per share, can be a barrier to investment for everyday Americans. But innovations in financial technology (fintech) are changing that by enabling the fractionalization of securities, including the splitting of whole shares into smaller pieces for purchase by small investors.     

The online trading platform Robinhood, for example, has been selling fractionalized equity securities since December 2019, allowing investors to buy, say, 10 percent of a Berkshire Hathaway Class B share for $50, rather than a full share for $500.   

But “democratizing markets” by lowering the barrier to investing is just one of the potential benefits of fractionalized securities, according to Steven L. Schwarcz, the Stanley A. Star Distinguished Professor of Law and Business at Duke Law School. Small- and medium-sized entities (SMEs) can also use them to issue and sell equity and debt securities directly to small investors — including through decentralized finance (DeFi) platforms — giving those businesses a potential source of new capital at lower cost than borrowing from banks.  

Accompanied by a regulatory framework to reduce risk, “this fractionalization can fundamentally expand financial inclusion both for investors and for businesses,” write Schwarcz and co-author Robert Bourret JD ’23 in Fractionalizing Investment Securities: Using FinTech to Expand Financial Inclusion.  

Filling the financing gap faced by smaller businesses     

Historically, long-term investing in the stock market has been an effective tool for building wealth, with stocks in the S&P 500 generating an average annual return of more than 10%. A person who invested $10,000 in an S&P 500 index fund 40 years ago would have about $250,000 today, in inflation-adjusted dollars and with dividends reinvested.   

About 62% of Americans are exposed to the stock market, most commonly through retirement plans, but only about 21% own individual stocks directly. In France, only 6 percent of the population invests in securities, and in Mexico, only 1 percent does, Schwarcz notes. Greater access to fractionalized securities can lower barriers to market entry by allowing people to begin investing with small sums. And by putting less money in any one asset, investors can afford to diversify their portfolios with a greater variety of securities — an important strategy for reducing investment risk, Schwarcz and Bourret write.

But fractionalized securities can also help fill the financing gap faced by SMEs, businesses with fewer than 500 employees. SMEs, which account for the vast majority of businesses worldwide, often struggle to access capital due to their smaller size and higher relative risk, Schwarcz and Bourret write. Such businesses face a $5.7 trillion gap in unmet financing annually.  

In the U.S., where the small business loan market is estimated at $1.4 trillion, SMEs generally must turn to banks, where they face high interest rates and fees and stringent lending standards imposed after the 2007-2009 economic crisis. As a result, more than three-quarters of U.S. SMEs report challenges with obtaining financing.  

Alternative financial services such as peer-to-peer lending platforms, through which individuals extend loans to firms and to other people, have arisen to fill some of that gap. But Schwarcz and Bourret argue that SMEs could raise capital to operate and expand at minimized cost by selling fractionalized securities as digital tokens on platforms powered by “smart contracts” — algorithms that execute transactions automatically, cutting out bank overhead.

Offering portions of shares of equity or debt securities to an expanded pool of potential investors, they also write, “would allow an SME to get funding as it comes, rather than having to wait for—and without being conditioned on—its full loan request being fulfilled.” 

Regulating to control risk  

This relatively new class of assets also comes with risks, most notably the possibility investors won’t be able to liquidate their holdings when they need cash. While many whole securities have a wide and deep secondary-resale market, a fractional security might not find a ready buyer when the holder needs to sell it.

“Even if a retail investor is intellectually aware of the risk, if they think they're going to make a ton of money they may invest a lot of their net worth,” Schwarcz said. “And if something happens, they could end up saying, ‘I need to pay for my housing or for food. I have all these fractionalized securities, but I can't sell them. What do I do?’”   

Potential investors also may find it difficult to evaluate an SME’s creditworthiness without the financial disclosures that U.S. regulators require of public companies. They have little recourse should a company experience financial distress or use funds raised for other purposes. And DeFi platforms themselves carry risks such as fraud and lack of transparency and accountability.  

Schwarcz and Bourret propose a regulatory framework to address these risks. Credit risk could be mitigated by requiring SMEs to disclose to investors the same information they would submit to a bank if they were applying for a loan. DeFi platforms could be brought under regulatory supervision. And liquidity risk could be mitigated by requiring security issuers to describe to potential investors the extent of any secondary market for the asset and also by limiting the amount that individuals could invest based on their income and net worth.  

“At least until there is greater liquidity for fractionalized securities, a purchase limit should be imposed to help protect retail investors from risk,” Schwarcz said.   

“People like you and I don't want to put so much of our money into this where if there's a loss we can end up going bankrupt and losing everything.”