We hear and read enthusiastic statements on security tokens. After the emotion comes the engineering.
It may be a bit arduous to translate poetry into code, but processes, clearly defined in ordinary language, are transferable. Security tokens derived from classic securities stand before the gates, they will step over the thresholds. They will remain and even prevail only if they turn out to be cheaper, ensure faster settlement and imply less risk than the old system for securities.
What are security tokens? Do they function in a legal vacuum?
Security tokens are securities. These can be of all kinds, from equity to hybrid instruments to debt. Inevitably these are earthly creatures, thus governed by national law. There is no escape from statutory provisions which extend to:
- Formal requirements for the underlying agreements (terms and conditions, deposit, transfer)
- Process of issuing
- Regulatory requirements applying to intermediaries
- Trading in regulated secondary markets
- Transfers, possibly contingent upon the issuer’s consent
- Payments in cryptocurrencies or fiat money (interfaces with electronic wallets and classic bank accounts)
- Exercise of voting rights
- Obligations to keep holders of securities informed (investor relations)
- Disposal of unclaimed amounts
- Dispute resolution
Translation into code
Over the years many jurisdictions have jettisoned the necessity that securities be printed on paper. They do not even require a collective certificate representing the whole series. This opens the door to a translation of the terms and conditions and the rules for handling the securities into code. More specifically, ERC20 compliant security tokens and DApps embedded in the Ethereum blockchain are capable of incorporating many of the applicable rules.
Since much of an equity instrument’s DNA is embedded in statutory law and by-laws which are not and will not be coded, interest-bearing and convertible instruments provide more space for the fine-tuning of rules.
The transformation into code is not an easy task, for much of the legacy sets of rules rely on a specific technical environment which has developed over decades: Securities are credited to and transferred from, via a chain of institutions, securities accounts of licensed brokers or banks. They are traded on regulated exchanges or over the counter of regulated institutions. Even though the traditional network implies counterparty risks, this factor is properly contained. These structures are sophisticated, robust and approved by the regulators whose supreme task is to protect investors.
The benchmark for change
If the “legacy ecosystem” is not in charge anymore, its functional equivalent needs to be created almost from scratch. Such equivalent cannot just rely on the fact that it eliminates counterparty risk by operating without intermediaries. Any single detail needs to be at least as secure as the legacy system which represents the high benchmark.
If the new ecosystem includes elements of the secondary market (e.g. a decentralized exchange relying on the 0x protocol, investors will require it to be at least as fair and safe as a classic securities exchange. Payment streams triggered by maturities or transactions need to run as smoothly as a well-oiled ball bearing. Even a small hiccup would expose the new system to the risk of lost credibility.
Who can do the job?
Experienced back office specialists, indispensable and often overseen machinists of the banking industry, are the best source of information for programmers transforming specification sheets into code. Such codes should be tested by independent third parties, also programmers and back office staff. It would be irresponsible to reinvent the wheel.
In the end the results need to be retranslated from code into clear language which is to be communicated to investors. These wish to understand what they buy. They won’t read and won’t feel bound by smart contracts written in code.
Technical progress is not an end in itself
Unless the security token is technically at least as advantageous and low-risk as the legacy system, it does not deserve preference. Clear facts are needed to put away the worries of investors who are not desirous to see their money go down the tubes. Technical progress alone won’t convince them to expose their savings to risk. The word „blockchain“ is a fashionable buzz word. It does not designate a priority road.
Dr. Martin Bartels, LightFin