A Few Thoughts on Security Tokens – Hacker Noon

As understood by an engineer with no background in economics, finance or trading

Our economy has evolved to consider and account for a variety of different assets: stocks, bonds, real estate, commodities, intellectual property, and many others. Trading some of these assets is constrained by their physicality, as it may be cumbersome to physically trade ownership, or even to subdivide the asset.

In order to help address this issue, we invented securitization. That’s the process of transforming ownership of an asset or a right into an easily tradable security. We predict that, with the emergence and maturity of blockchain technology, and the development of open standards, we will be enabled to expand on the concept and impact of securitization. We will do this through the tokenization of assets.

The digitization and standardization of securities trading has a long history already, but many of these systems remain walled gardens with no interoperability. They’re not open systems in which anyone, even with the right requirements, can participate at will. And they’re heavily intermediated by parties whose roles (providing trust and mitigating risk) could be made obsolete with the trustlessness, transparency and decentralized consensus of a blockchain system.

Now that we have the technological means to achieve it, tokenizing relatively illiquid assets and creating a market in which to trade these tokens is inevitable. Traditional, relatively illiquid assets stand to gain a substantial liquidity premium which, together with the slashing of fees due to disintermediation, represents an enormous market opportunity.

Advantages of security tokens

Tokenized securities are disruptive to modern financial markets because of their disintermediation potential, global exposure, and programmatic operation. A few advantages of security tokens are:

  • lower fees
  • access to a global pool of capital
  • faster settlements
  • fractional ownership
  • 24/7/365 markets
  • increased liquidity
  • no minimum investments
  • automated compliance
  • asset interoperability

All these combined should lead to a greater market efficiency, and the programmatic nature of these tokens will open the floodgates for new financial technology. Building a standardized protocol on top of which quants and other developers can dream up new financial products and services is paramount, as it truly enables innovation to accelerate in the space. Critically, this innovation would be permissionless, as it wouldn’t be limited to the R&D departments of the current large players in the financial space.

Standardization and interoperability

Standardization and interoperability are two crucial concepts in the movement for the opening up of financial markets.

Over the years the financial world has developed some standards, and it’s not a new idea. It would otherwise be impossible for your broker to hold shares in different companies using the same legal structure. Tokenization, however, enables us to take this concept to new heights by standardizing ownership in many different asset classes and making it possible for them to be held in the same wallet, used as collateral for loans, and straight up trading without the need for cash intermediation. I envision all asset classes to merge into a global pool of liquidity, interoperable through a common API.

Automated compliance

A great advantage of security tokenization is the potential for automated compliance. We’re experimenting with a token with embedded compliance: a compliance-native token if you will. This prevents the tokenized security from falling into the wrong hands, while maintaining disintermediation at the trading stage.

It’s easy to conceive of a naïve version of this technology. For those familiar with the ERC-20 standard, you can picture expanding on that contract with a restriction so that ownership transfers can only happen for addresses which have been registered as having undergone the proper level of financial due diligence (KYC/AML/CFT, capital markets regulations, investor accreditation).

These security tokens, with embedded compliance, should make the compliance process so seamless and auditable that I predict regulators will start demanding the tokenization of securities for these advantages alone. The enforcement of regulations will be that much simpler in this world. There’s good reason to believe this will happen, as we’ve seen regulators demanding technology adoption in the past.

Regulation will, inevitably, have to evolve. Some countries regulate the form under which some ownership transfer has to take place, or demand a physical paper trail. We believe that competitive pressures brought about by pioneer local financial markets will push other regulators to embrace this new technology.

A sample technical draft

Embedded compliance

Picture, as described above, a token instantiation contract which requires buyers to have undergone some level of KYC. The buyer would have to submit themselves to a thorough registration by an identity provider, such as Fractal ID. Upon successful verification, Fractal ID could provide them with a cryptographically signed claim of such KYC verification, which they can use as an attestation for the token contract to prove their eligibility to buy. At that point, the contract will allow a sale, by allowing ownership in the tokens to be attributed to this buyer.

An interesting possibility of the mechanism devised above is that the token contract doesn’t need to know the identity of the buyer, only that they underwent a required level of KYC, provided the contract trusts Fractal’s claims.

Automatic liquidity provisioning

This is an example of what a smart contract / application network could look like.

The example above provides the following functionality:

  • Onboarding/tokenization of offline assets
  • Registration of tokenized assets
  • Price discovery
  • Automatic loan applications
  • Liquidity provisioning
  • Loan insurance
  • Credit/reputation scoring

As an example, let’s assume a loan marketplace to which an investor has provided liquidity, to be provisioned for loans that meet certain acceptance criteria. For example, the loan must be collateralized by tokenized assets, insured by a third party, and only granted to individuals with a certain credit score. At this point, an individual can use their registered Cryptokitties, which are dynamically priced, as collateral for said automated loan. This loan is then managed by the escrow contract, which holds custody of the collateral and the provisioned liquidity. The user would make regular interest payments on the loan to this contract, which are passed on to the investor.

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