Digital securities on blockchain promise to revolutionize the securities industry. The expectations include increased transparency and liquidity, automated compliance and simplified operations. However, despite the potential, the growth of the market is not very exciting due to the operational and regulatory obstacles.
In the last few months a trend emerged towards blockchains designed specifically for securities. They are expected to solve problems restricting the growth of the industry. But are they really an answer? In this article we review existing solutions and assess whether they have a potential to kickstart the revolution.
Why blockchain for securities?
Storing securities in digital ledger creates exciting opportunities of making their transfer easier, opening companies access to global investors, making fraud nearly impossible and many others. However, this requires multiple parties having different degrees of access to this ledger: investors that create requests to modify company ownership when investing; а company that can approve such requests and view its entire shareholder register; а monitoring regulatory body that can see requests but does not approve them; etc.
This requires advanced cryptography to manage access and ensure safety given the highly sensitive nature of this data. Blockchain technology can satisfy security requirements, enabling digitalization of securities.
The problem with general-purpose blockchains
Currently, general-purpose public blockchains, mainly Ethereum, are used for digital securities. They have several inherent limitations problematic for traditional businesses and financial institutions.
- Built-in anonymity of users. It not only raises costs for companies that should do KYC themselves but also makes them create complicated procedures that restrict transfer to other users. The need for whitelisting makes issuer a bottleneck in a number of potential transactions and limits liquidity.
- Lack of privacy of transactions. Even though the wallets are anonymous, transaction and ownership structure are seen to everyone. This, for example, means that the size of a venture investment into a startup would be automatically disclosed, that the strategy of a private equity or a hedge fund could be derived, etc.
- Inherent crypto features: internal settlement is done via cryptocurrency, holding tokens requires having a crypto wallet, etc. For many traditional investors and businesses cryptocurrency has a very bad reputation and stops them from investing in securities on blockchain. In our practice, we have encountered many investors that have already lost their money during an ICO rush and will not invest in crypto assets ever again.
- Lack of built-in protocols for different types of securities.
- Lack of built-in operations with securities except the most basic transfer.
All of these require implementing protocols on top of general-purpose blockchains that limit functionality and significantly raise costs of deploying a token, which may reach tens of thousands of the US dollars. Many processes remain manual, which means that the risk of fraud and error remains.
Complicated in use and expensive at the same time, existing tech does not work neither for institutions that want more high-quality software, nor for small businesses that seek lower prices.
To the author’s knowledge there are currently 4 projects aimed at the development of a securities-specific blockchains: Ownera, Polymesh, Smartlands Network, and Stobox Network. This does not take into account closed single-enterprise Networks, such as Swiss Digital Exchange.
Ownera is a single project that has already launched a first version of its network. However, after more than half a year there is no public data about traction and big deals.
The two primary features of the Ownera Network are underwriting nodes and regulatory app stores. All securities are underwritten in a sense that they can only be created by licensed financial institutions that hold the so-called “underwriting nodes”. This ensures higher trust in the Network but significantly limits the scalability because it is complicated to make big traditional bodies move in and they eventually become bottlenecks.
Regulatory app stores enable deploying pieces of code that represent regulations. Issuers of assets will be able to choose among these apps and pay a certain fee. This is good for scalability and reduction of cost of development but makes a critical value proposition of the network dependent on external parties.
Polymesh is being developed by Polymath, one of the oldest companies in the digital securities industry. Polymesh is similar to traditional crypto networks as it has a native utility token used as a gas and a reward to holders of nodes. Anyone can become a holder of a node but only authorized institutions can be validators. Similarly to Ownera, development of the regulatory layer is on the shoulders of issuers and a community.
The Smartlands Network is similar in the fact that it is based on a native utility token. Its internal structure is more differentiated than in Polymesh. It is built using Cosmos protocol, which allows deploying multiple interoperable blockchains. In order to cater to a more diverse client audience, alongside public Smartlands Network interoperable private blockchains for institutions may be deployed.
Another interesting thing about SN is that instead of making compliance automated it has compliance oracles – institutions that can review, approve or reject transactions. Although it contradicts the dream of automated compliance, it is realistic that in the first stages transactions in other Networks will require approval. It is questionable, however, whether such a way is viable in the long-term.
The distinctive feature of the Stobox Network is that it will have a regulatory layer built by Stobox and not by other providers. It is also intended to have more sophisticated operations with securities and securities types built-in. As a drawback, it makes development more expensive and complicated but also makes the Network key value proposition not dependent on external providers.
Please, note that given the early stage of all projects above, the description may become irrelevant over time.
The road ahead
Mass adoption of any technology requires it becoming relatively cheap and easy to use. It happens when thousands of businesses around the world start deploying applications built with this technology, looking for product-market fit.
With digital securities the cost of doing business with them is still high, mainly due to the regulatory burden. Built-in regulations facilitate compliance from an operational perspective but there is still cost involved in the licensing of securities service providers.
The way to solve this problem is to recognize that all businesses that operate on top of recognized securities-specific blockchains do not require licensing below a certain revenue threshold. This can unlock the creativity of millions of minds around the world to work collectively on expanding the digital securities market and accomplishing the dream of tokenizing all assets in the world. Merging tech and legal infrastructures should be a focus of all companies operating in the space. Achieving this may take years of development and negotiation but the effort will be worth it.
Conflict of interest
The author is working for one of the organizations reviewed in the articles and may be biased in its review.