Why a Purpose-Built Security Token Blockchain?

Why a Purpose-Built Security Token Blockchain

The early days of the Internet

We often draw a parallel between 90s Internet and 2018 blockchain. But this is typically in relation to the financial status of cryptocurrencies and the crash of the .com era.

Today, I’d like to discuss this comparison from a very different vantage point: the evolution of technology.

In the early days of the Internet, hardware and software providers focused on driving innovation by building on an existing infrastructure: the telephone system. This infrastructure had already entered most homes, and, with the help of “modems”, was able to connect anyone to the Internet (remember that sweet sound of music your modem used to make as it opened a window into the “World Wide Web”?). Over the years, connection speeds continued to accelerate, growing faster and faster … from 9.6kbps (1984) to 28.8k (1994), finally reaching a whopping 56kbps (1998).

And so, providers went on to build software and services on this infrastructure. Before you knew it, you could send and receive emails, download research papers, access BBS, etc… Mainstream adoption accelerated as connectivity improved.

The development of standards improved the rate of adoption significantly. With standards in place, software companies could develop email clients, IM clients, or entire software suites that connected to third party service providers through mutually agreed-upon standard interfaces. And with this, came our first integrated experience. With much less expertise, you could browse the web, listen to music, check emails… it was a game changer.

  • Did it work? Yes!
  • Was it addictive? Totally!
  • Did it address the use cases known at the time? Somewhat.
  • Were there compromises? Absolutely!
  • Was it slow? Painfully!… but we didn’t even realize just how slow yet.

Over time, critical use-cases started to emerge. Use-cases so massive, they would either break the Internet, or never see the light of day because of a terrible user experience. The Internet, a fabric that connected all individuals and corporations around the globe, was going to empower us with new radical ways to communicate. The excitement was palpable, but not for Internet providers. Their ageing infrastructure, although “incrementally improved” with technologies like DSL was due for a complete overhaul. And so, enabled by massive technology advancements, a new high-speed, low latency Internet was born.

By then, the Internet was not the only use-case for the phone system, voice was still going strong, fax was being used (yes, there was a wrinkle in time where paper traveled from one place to another in a few seconds), but the medium that forced a complete shift from a general-purpose to a brand new, purpose-built architecture, was undeniably high-definition video. The bandwidth and low-latency requirements of high-definition video pushed the infrastructure over the edge, and the infrastructure overhaul made high-definition video a reality.

To summarize, the Internet did not start as the Internet we know and use today. It went through 3 major phases to get to where it is today:

  • Phase 1: Innovation, focused on an existing foundation
  • Phase 2: Standardization and collaboration of a rich ecosystem, which accelerated innovation
  • Phase 3: Re-imagining the core foundation to support the growth of key use-cases and create something so widely accepted, that it is used every day, by all ages, all over the world

What does that have to do with blockchain?

A comparison of the evolution of the Internet and the evolution of blockchain shows some striking resemblances. From its launch in July 2015 to today, Ethereum provided a fantastic foundation layer designed for innovation. A plethora of use cases were, and continue to be, tried and tested in its open, decentralized infrastructure. 300,000+ developers have embraced it — an unprecedented ecosystem and success, driven from community contributions. “Solidity” training classes are taught all over the world (Solidity is one of the languages used to develop smart contracts on the Ethereum blockchain) allowing new projects to emerge at a rapid pace.

In 2018, blockchain reached an important milestone when a very unique, very demanding use-case emerged: Security Tokens.

Like traditional securities, a Security Token is a financial instrument that represents evidence of an ownership interest in an asset; the difference is that it has been created digitally to unlock the power of the blockchain. Security Tokens can represent the ownership of traditional assets like equity and bonds or traditionally illiquid assets like private placements, real estate, or artwork.

What’s exciting about Security Tokens is their potential to disrupt the financial industry through efficiency, transparency, automated compliance, and liquidity; all while creating a new class of financial products. This opportunity to revolutionize the future of the traditional securities market is just too great to ignore.

Our goal, as an industry, as global citizens, and as entrepreneurs, is to leverage the benefits of blockchain to empower anyone to 1) tokenize any asset 2) in any jurisdiction and 3) have this asset trade across one or more jurisdictions with instant clearing and settlement. Let’s face it… It is an audacious goal, but then again, it is a rational goal when looking at the patterns of history. Wasn’t live streaming of high definition video just as audacious (or seemingly impossible) in 2001?

With the emergence of security toknes, standardization rapidly became an important topic. Security tokens are highly regulated and their creation, distribution, and transfer require multiple market participants to be able to communicate with clear and predetermined guidelines that are mutually agreed upon and enforced. The financial industry is built on standards, and an industry standard to govern security tokens was a gap looking to be filled. Several initiatives emerged, such as ERC884, ERC1400, ERC1404, or ERC1462. ERC1400, in particular, has been an ongoing collaborative initiative aimed at eliminating friction across industry participants and ensuring interoperability, including dependable and predictable programmable enforcement of regulation, which includes the necessary transfer restrictions between market participants.

But what makes security tokens so unique?

In short: identity, privacy, information asymmetry, and compliance.

Security tokens are highly regulated assets with a core dependency on the jurisdiction of issuance and the jurisdictions of the buyer and seller. For any asset to be created or traded, there is an implied need to associate an identity to each of these constituents. Solutions offered by today’s blockchains rely mostly on wallet addresses (a cryptic series of letters and numbers, or “public key”) for identity. Although a key feature for a blockchain like Ethereum, wallet addresses are simply not comparable to identities. Regulators and corporate officers must be able to see a list of shareholders names so they can actively engage with them and fulfill annual reporting requirements, as required by current securities laws.

But that does not mean all transactions must be visible to all. Transaction privacy is critical to institutions embracing Security Tokens. For them, their portfolio, and all operations initiated to structure and modify their portfolios are part of their intellectual property. None of their competitors canknow what they are investing in or divesting from.

Information asymmetry is another core challenge with existing blockchains. Financial systems already offer a variety of tools for Investors, especially Institutional Investors to perform product and price discovery in near-real-time. Any new technology would need to at least match, if not exceed, current capabilities to be even remotely interesting to existing industry participants.

Compliance, including transfer restrictions, is the foundation of securities. From issuance to secondary trade, whether through exchanges, ATS, OTC desks or simply peer-to-peer, regulation must be followed. And to make matters worse, regulations are specific to each jurisdiction.

But we cannot forget user experience, the lifeblood of all technology, including blockchain. Most blockchains were originally designed to facilitate the development of software. During the early stages of its introduction, any interaction with the blockchain required (and still largely does require) a certain domain expertise; an understanding of terms like “gas”, “private key”, “seed phrase”. As we all know, it takes a tremendous amount of self-control to not fall into a full-on panic when hearing “did you lose your private key”. A security token blockchain simply cannot aim for anyone to tokenize any asset anywhere in the world and require special knowledge, all at the same time.

Now’s the Time to Enter Phase 3…

Very exciting projects have embarked on tackling some of the key limitations of existing blockchains. Identity, confidentiality, information dissemination, transparency, and most importantly regulatory compliance are topics that are actively discussed in the blockchain community. Some of these projects are even in production, already demonstrating unequivocally how important it is to integrate these capabilities to attain our goal.

But will the combination of independent projects provide the underpinning for a scalable financial markets infrastructure that outlives all of us? We believe it will not! We believe that no blockchain today is set to support the tectonic shift that security tokens represent and that the only way to provide this infrastructure is to remember our learnings, actively engage with regulators and other industry participants to build a purpose-built foundational layer.

  • One for whom identity, confidentiality and compliance are native to the blockchain.
  • One that empowers issuers with the tools to seamlessly and selectively disclose information to their token-holders, without increasing the risk to their business.
  • One that is able to address the specific needs of large institutions while still being so simple to use that anyone can tokenize any asset they want, whether for the purpose of raising funds, or simply having an unequivocal, irrefutable representation of their fractional ownership of that asset.

Much like the Internet did a few years ago, security tokens, that unique and demanding blockchain use-case, has pushed the current infrastructure over the edge, and only an infrastructure overhaul will allow security tokens to reach their goal.

The time has come to rewrite the foundation.

How do I get involved?

Polymath has launched the Polymesh Initiative — An industry-wide initiative aimed at the release of a purpose-built security token blockchain. Bright, like-minded people like you are what the industry needs to reach our collective goal. Learn more at https://polymath.network/polymesh and if you want to contribute to the Polymesh Initiative, reach out to us using this form.

First published here

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