In recent month, a number of new projects launched with headlines touting the launch of a security token. The following examines the viability and efficacy of security tokens in the context of blockchain-based systems for the purpose of securities creation and handling.
The term “token” took on new meaning with the emergence of blockchain-based systems. To understand a token’s function within the context of blockchain, one must first understand the nuances of blockchains and blockchain technologies.
The term “blockchain technology” refers to a cryptographic encryption method which links hashed data in a consecutive manner. The method is described in a paper first shared in 1999, and is also referenced in the Bitcoin White Paper. In a wider sense, the term blockchain by itself refers to a decentralized, open, public ledger that makes use of the aforementioned cryptographic implementation to time-stamp and secure transaction records. The latter implementation, which was introduced with the launch of the Bitcoin blockchain, is sometimes unnecessarily referred to as public blockchain.
The decentralization component of public blockchains allows anybody with the right hardware to operate a node, making transactions recorded in these types of ledgers extremely difficult to reverse. The necessary open collusion by a majority of network participants is unlikely to occur as the resulting distrust in the network would erode the colluding parties’ investment in computing power and/or allocation of virtual assets (stakes) in the blockchain needed for the manipulation to begin with. Because of these features, public blockchains are also referred to as “trust-less networks,” and the recorded transaction are considered immutable, a quality which enables peer-to-peer transactions of blockchain-native elements (coins) and digital solutions created on a public blockchain via qualified smart contract: token.
Tokens can be classified based on standardized smart contracts (protocols) adopted by a public blockchain, which allows the transfer of these assets to any wallet or exchange complying with the standard. The most common standard today is Ethereum’s ERC-20 Token Standard. The standard is supported by most digital wallets and more than 200 exchanges. To date, more than 200,000 different token types have been created using this standard. The ERC-20 token standard provides a protocol for simple, fungible digital assets but is lacking any provisions for complex instruments, such as securities.
‘Permissioned Blockchains’ and Tokens
Databases and networks operated by individual companies and consortia that use blockchain-type encryption schemes are sometimes referred to as “permissioned blockchains.” However, while transactions recorded this way may be more secure, participants in these systems are still required to trust the network provider not to alter records and to continue to operate the network. Operators of these systems might create additional requirements needed for the exchange of virtual assets such as tokens, however, these dependencies do not constitute protocols until they are adopted by a public blockchain. As a consequence, virtual assets created with the use of a proprietary standard cannot be transferred using a wallet or exchange complying with the protocol of a public blockchain and can therefore not considered to be tokens.
In the context of public blockchains, tokens — including security tokens — are based on established protocols that allow the transfer of these assets from and to wallets and exchanges, which support these standards without the need of a third party. As of today, no public blockchain offers a “security token standard” or “security token protocol.” Due to this lack of a security token protocol on any existing public blockchain, any exchange of assets created through these systems will necessarily require these platforms to provide access to the data stored in their databases for identity and asset validation. Claims by providers using the aforementioned terms are aspirational and are limited to databases and, in some instances, application programming interfaces (APIs) maintained by these platforms.
While some authors define security tokens as “any blockchain-based representation of value that is subject to regulation under security laws,” they fail to address the nuances between blockchain-secured transaction systems and blockchain-based standards that create new transfer protocols. The later implementations provide a revolutionary advancement over previous marketplaces, enabling a peer-to-peer exchange of the underlying asset. The former is an incremental improvement over existing securities exchanges, using databases and — since all new entrants are startups — carry the risks associated of untested systems and companies. So, rather than reducing counter-party risk, these newly created middle-men are opening the doors to new failure risks.
Call to Action
It should be trivial for any blockchain developer to code a simple “oracle” to verify the token nature of any given instrument. Please connect with me if you are working on one or if you are interested in creating such an oracle.