Security Token Blockchains: Blockchains Built for Tokenizing Assets
11 July 2019
This will be an article about security token blockchains. But before we dive into this topic, let me start with a story about questions.
As someone who provides expertise in the blockchain and cryptocurrency space, people often ask me questions. Over time, I’ve noticed that the questions I get asked (by both clients and friends/family) show some sort of trend. Specifically, they signal the evolution of the market.
So what do I mean by this? Well, when we started our company back in 2017-2018, we often heard the question ‘What are tokens?’ Many people had just heard of bitcoin, and perhaps had heard of a way to raise funds by issuing a cryptocurrency. As such, this question quickly evolved into ‘What are Initial Coin Offerings, or ICOs?’. During the so-called ‘crypto bull run’, hundreds of people asked us this question, because they figured issuing a token (through an ICO) was a cheap way of funding their business.
Once cryptocurrency prices fell sharply and the hype died down a bit, we often got to hear the question: “What is a Security Token Offering (or STO)?’. And with interest in these Security Token Offerings rising, more often we heard the question ‘How should I issue a security token?’, and more specifically, ‘What technology should I use for issuing a security token?’.
The goal then of this article is to look at this last question. Not to answer it directly, but rather to give an overview of different blockchains that are purposefully-built to issue security tokens on, and the stage of development they’re in. More importantly, it should give you as a reader (who may be considering using specific technology for the issuance of a security token) the possibility to make an informed decision on which protocol to use.
Before we start, please note that this list is non-exhaustive. I’m certain that more security token blockchains exist, that may work or under the radar or some that I may simply have missed. If you would like us to add a specific project to the list, do send us a message on Twitter.
Why Create a Security Token Blockchain?
As stated, several security token blockchains exist. These blockchains have been specifically created to allow for the issuance of security tokens or asset tokens. In other words, tokens that represent a security such as a share in a company, a debt instrument, or a derivative.
But before we dive into the details, let’s first address the ‘why’. Why do such blockchains exist in the first place? What is the reason for any team or person to spend significant resources to create a purposefully-built security token blockchain? Do other blockchains, such as Ethereum or Stellar, not offer the functionalities needed to issue tokenized securities? After all, many security tokens have already been issued on Ethereum.
The reality however is that certain design decisions have been made in the base-layer of blockchains, such as Ethereum. These decisions sometimes result in less-than-optimal compatibility with specific requirements or restrictions that an issuer of a securities needs to adhere to. A very straightforward example of this is the speed and throughput of the Ethereum blockchain. While companies like SPiCE VC have issued an ERC-20 token on Ethereum, the reality is that settlement of a transaction of that token (which in this case represents a share in the SPiCE venture capital fund) could be slower than usual if the Ethereum network gets clogged, as it did during the Cryptokitties craze. Moreover, in the case of Ethereum, it may prove a legal challenge to determine when a transaction has officially settled.
If we expect many securities in traditional financial markets to migrate from legacy systems to blockchain technology, then it is obvious we need networks with faster transaction throughput. Similarly, when you want to issue a security token on a ‘traditional blockchain’, you may encounter issues with identity, privacy of transactions, aforementioned transaction settlement finality, and regulatory compliance. This gives you an idea behind the reasoning of many companies to create their own blockchain that is specifically built to facilitate the issuance of financial instruments.
So who are these companies? In this article, we’ll cover five security token blockchains: Codechain, Ownera, Polymesh, Ravencoin and Dusk Network. And let’s start with blockchains that are (initially) designed as ‘permissioned’ blockchains. In other words, not everyone has the permission to serve as a validator and add transactions to the ledger.
The first of these permissioned blockchains is Ownera. Ownera has been created by the co-founder of SPiCE VC and Securitize, Ami-Ben David. It was created on the basis of the idea that most capital in financial markets comes from institutional players. In order to transact securities on a blockchain on a large scale, you can’t use Ethereum (which is public but not created for institutional players), nor use something like Hyperledger Fabric (which is created for institutional players, but not public, thereby not openly accessible for anyone to use).
Instead, Ownera is a new blockchain based on Hyperledger Fabric, and is run by ‘Underwriting Nodes’. The issuer of a security token must choose an underwriting node which is responsible for verifying ‘KYA’ or ‘Know-Your-Asset’ and subsequent transactions. These nodes are (institutional) players such as investment banks that stake their reputation and future revenues on the assets that they represent.
Interestingly, Ownera plans to create a ‘regulatory app store’, in which issuers can choose specific jurisdictions that apply to their security and token issuance. This should make it easier for issuers to issue tokenized securities, regardless of jurisdiction.
Ownera is currently still in an early phase of development. The founders of Ownera showed a first version to the public in April 2019, with the hope of showing a full-feature platform 6 months later (so around October/November 2019).
Another interesting security token blockchain which uses a permissioned structure is CodeChain. This Korean company launched their mainnet in April this year. Some of the unique aspects of CodeChain is that it has certain features built-in.
For instance, CodeChain includes exchange features which are built on the (decentralized) 0x protocol. CodeChain offers this exchange next to other tools such as a wallet, transaction explorer and asset auditing tool. In addition, the blockchain uses sharding to achieve a throughput of between 1000 and 1500 transactions per second and instant finality.
Interestingly, CodeChain makes use of two tokens — a stake token used by validator nodes to stake on their reputation, and a fee token which is used by issuers to pay for transactions. Since its launch, CodeChain is working with a few different (mostly Korean) clients. Plus it is a good partner of cryptocurrency exchange Bithumb, which is likely to use CodeChain’s technology in the future.
The recently announced Polymesh is an upcoming security token blockchain which is the brainchild of tokenization platform Polymath and co-founder of Ethereum and Cardano, Charles Hoskinson. The blockchain will likely start out as a permissioned blockchain (though it may move to a permissionless structure in the future), whereby nodes will be incentivized with a specific token to verify transactions; similar to CodeChain.
Since this blockchain has just been announced in May 2019, not so much is known. Consider the following quote by one of the founders: “We’ll rather develop something good in 3 years than something bad in 6 months”.
While the previously mentioned projects have gone all-in on a solution with a permissioned ledger, other projects are working on openly accessible and permissionless blockchains for security tokens. Dusk Network characterises itself as a privacy-oriented blockchain with a security token standard that allows anyone to issue security tokens on the network.
Just like CodeChain, Dusk Network also features instant settlement finality, which seems to be a necessity for secondary markets. But what makes Dusk stand out, aside from its ‘permissionless-ness’, is that it preserves certain aspects that are not normally features of a permissionless ledger.
One of these is privacy, which is retained through the use ‘zero-knowledge proofs’. In short, this concept refers to the idea that someone can prove that something exists or has happened, without needing to disclosing the fact publicly. So how is this applied to security tokens?
Suppose a company issues a company share, as a token, on the Dusk blockchain. An investor, who wants to buy the token on the market, meets with another investor who wants to sell that specific company share. In the case of Dusk Network, they can settle their transaction trust-lessly in a peer-to-peer fashion, while proving that certain requirements are met — for instance that the buyer is part of the whitelist, or that he is based in a certain geographical area. Using zero-knowledge proofs, the investor can prove that these requirements are met, without having to reveal publicly who they are or where they are from.
Interestingly, the issuer can define other proofs that need to be satisfied. For instance, the issuer may set a maximum amount of shares that can be held by any one party — which is then something that a buyer needs to prove before a transaction can take place.
The reason for this built-in privacy, is that the Dusk team strongly believes that privacy is a prerequisite to prevent market manipulation; when the transfer of a security affects the market.
The last security token blockchain to cover here is Ravencoin, which launched its protocol asset layer in October 2018.
Interestingly, Ravencoin is a copy of Bitcoin which allows for its users to issue asset tokens. Ravencoin was specifically created for the issuance and transfer of any kind of assets (not just financial assets/securities). As it is a fork of the Bitcoin blockchain, it is the only blockchain in this list that makes use of a Proof of Work consensus algorithm.
Due to specific design choices (Proof of Work, block reward time of one minute, etc.) it is unlikely that Ravencoin will emerge as the security token blockchain, as it will probably not offer the speed or transaction finality (among other features) that institutional players will require. Nonetheless, Ravencoin is an interesting blockchain to keep an eye on, in part because it is a bitcoin clone.
What will the future of security token blockchains look like?
In this article we covered a few different permissioned and permissionless security token blockchains. But before we go into how we see the future, here’s a word of caution: several other projects exist that one may consider being ‘security token blockchains’. Take for instance Fusion, which launched its mainnet recently. Then there’s the quite much older Bitshares, plus crypto exchange Huobi recently announced it’s working on something called the Huobi Finance Chain. These projects have not yet been featured as ‘security token blockchains’, but they could prove to offer similar functionalities as the projects mentioned in this article.
With that out of the way, let’s consider what the future of security token blockchains will look like, with three main remarks. First, it’s very clear to us that security token blockchains have a long way to go. Some of these projects, such as Ownera and Polymesh, are still very much in the development phase. It will take at least another year before they see the light of day. And for the projects that have already launched their mainnet (or will do so this year), these also still have significant steps to take in terms of adoption.
Second, after analysing these different projects, both CodeChain and Dusk Network seem very promising. Both projects seem to have a great (development) team, and have built partnerships with major cryptocurrency exchanges, with Dusk recently listing its token on Bitfinex.
Third and last, the adoption of security tokens and security token blockchains is not just dependent on the right infrastructure. Even if all of these projects were fully operational, we might not see as much issuance activity as we would like to. This is because of path dependency. Companies that currently issue securities, whether these are debt instruments, equity or derivatives, use specific systems that do not allow them to easily switch to a different type of software. In other words, banks and financial institutions are filled to the brim with legacy systems that people rely on every day. So a switch to new software is a challenge, regardless of what this software actually is. And this path dependency and dependence on current legacy systems, is what makes up a large barrier to worldwide adoption of blockchains, and security token blockchains specifically.
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