Platforms vs. Networks: Decentralization Vectors in Security Tokens

The subject of decentralization is at the forefront of some of the most passionate debates in the security token ecosystem. Whereas the security tokens movement was born as a result of the evolution of decentralized ledgers, the first generation of products in the space have shifted entirely towards centralized architectures. Several of the most revere thought leaders space have been vocal about the diminished role that decentralization should play in crypto-securities compared to the focus on areas such as regulation enforcement and just building better products. While nobody can argue with the value of regulation or better solutions, I think find that perspective a bit short sided. When comes to security tokens, decentralization matters. In fact, I would argue that decentralization is the single element that will determine whether security tokens evolve into a new asset class and financial ecosystem or stay as unsophisticated digital wrappers of existing forms of securities. A way to think pragmatically about decentralization is to answer what I consider the most important question in the security token space is: are we building products or are we building networks?

We Dream of Decentralized Networks but we Build Centralized Products

In the context of security tokens, the subject of networks vs. products is far from being a trivial one. Networks are brutally difficult to build but can create long lasting value. Products can deliver short term value but might become irrelevant in the grand scheme of technological revolutions. Some might argue that if we were setup to build a security token network, we wouldn’t have tokenized anything so far. On the other hand, if we continue approaching tokenization in a product-centric, centralized model, security tokens might not live up to its promise in the long term.

In today’s security token ecosystem, the concept of decentralization seems to be reserved for talks at conferences while products continue being built using increasingly centralized architectures. To understand the differences between the friction between centralized security token products and decentralized network, let’s explore the following matrix.

The Risks of Centralized Security Tokens

The benefits of decentralization in security tokens go beyond a fancy architecture style and can help to mitigate major risks in this nascent market. The increasing dependency on centralized models for security tokens might yield immediate benefit but are also introducing significant levels of fragility and risks into the market. There are many risks that can result from disproportional centralization in security token architectures but there are three that can bring the entire ecosystem to its knees:

· The Fragmentation Risk: Building crypto-securities is relatively simple from a technology standpoint which means that we are likely to see many token issuance platforms that achieve relevant in specific jurisdictions and industries. Without a network for those players to interoperate, the security token ecosystem might become increasingly fragmented to the point of not being very useful.

· The Leader Influence Risk: In a centralized security token model, some of the early market leaders can achieve asymmetrical levels of influence compared to the rest of the ecosystem. In that case, those companies can dictate the rules that move the market to their benefit.

· The Whale Risk: It doesn’t matter how successful a security token platform is in the short term, its unlikely to be comparable to a Goldman Sachs, Fidelity or J.P Morgan. In a centralized ecosystem, it only takes one of those big financial players to enter the space to become the dominant market force and, essentially, roll back to the previous mess we are trying to move away from.

· The Forkless Risk: Forks are ugly but are one of the factors that help to enforce the balance in crypto-networks. A centralized security token models prevents any forking mechanisms making it vulnerable to the influence of market leaders.

Decentralization Vectors in Security Tokens

Approaching decentralization in security tokens requires certain level of technological pragmatism. We are unlikely to become completely altruists and switch from the current centralized model to a decentralized network. Many might consider that the ultimate manifestation of decentralization in security tokens will be a new blockchain but that model also has very serious flaws. However, when we think about the next phase of security token architectures, there are three elements that are well suited for decentralized or semi-centralized models. I often refer to those as decentralization vectors.

· Compliance: No security token product can build all the compliance rules in the regulatory world. On-chain or hybrid compliance enforcement is a great candidate for a decentralized model. Imagine a network of regulators and validators that can assert that a specific crypto-security is compliant with a predefined set of rules.

· Disclosures: Contrary to what many might think, disclosures is an intrinsically decentralized activity. An entity might disclose some information about a security token and some other entities might validate the veracity of the information. A simple model like that can be incorporated into the current generation of security token platforms.

· Governance: Governance is non-existent in today’s security tokens but how long before that becomes a challenge. Crypto-securities are constantly subjected to governance decisions that mostly take place off-chain today. Adapting some of those governance models to on-chain mechanics is another low hanging fruit for security token platforms.

· Incentives: A decentralized network needs the right incentive mechanisms to grow organically. Without an incentive model, security token decentralization might continue being an elusive goal. Building a token-based incentive mechanism might be the first step towards achieving certain levels of decentralization in security tokens.

I tend to look at decentralization very pragmatically and understand that it’s a difficult challenge to tackle in the current state of the security tokens market. At the same time, ignoring the increasing levels of centralization in the security token ecosystem seems irresponsible to me. Compliance, disclosures, governance and incentives seems like the four simpler channels to introduce decentralization into security tokens. My goals with this article are simply to provide some perspective about what I consider the biggest decision that will determine whether security tokens evolve as a fragmented collection of products or as decentralized networks.

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