Cheat Sheet n°3: Standardization, finance and blockchain
The term “standardization” for security tokens is necessary. It means the use of a baseline protocol standard for tokens and various “good practices” followed by everyone where the foundation are Identification and Permission.
The baseline protocol standard is the ERC-20 (Ethereum)
It is a set of smart contracts that govern basic transaction rules. Most of the wallets are ERC-20 compatible. Meaning, if you want to maximize your reach, it’s good start. (Now let’s complexify the model) On top of this, you need to use an Identity management to set of rules know as ERC-725/735. This family of smart contract allows “humans, groups, objects and machines” to sign transactions/documents/access and claims some rights. It’s also useful for any Proof of Authority where you stake your Identity in order to participate in a transaction on the blockchain. You also have the ERC-820 specifically designed to maintain the registry. Recently, was made public the ERC-1400 (family) basically merge all of the previous functionalities to simplify the issuance of “Tokenized Securities” (therefore, the compliance protocols are missing…) and add new libraries of functions such as ERC-1594 which splits out the core functionalities for the security tokens, the ERC-1643 for document management (for the countries not allowing yet the registration on a distributed ledger) and ERC-1644 which give enforceable capabilities in case of any problem.
Unfortunately, the ERC-1400 is still based on ERC-777 (which do not derive from ERC-20) and therefore limits the interoperability.
This is why we’ve built the NyX Standard
A set of digital contracts standard, designed for issuers and buyers of financial instruments
The objective of this new standard is to replicate on the Tezos blockchain the entire financial infrastructure of issuance, purchase and exchange of securities as it exists today, in order to streamline, accelerate and secure transactions.
The Nyx standard will leverage the Tezos blockchain to automatically secure and execute over 160 predefined business rules, thereby reducing transaction costs and avoiding a great number of administrative errors, specifically on compliance topics.
The Nyx standard will enable:
- The creation of a global register of immutable financial transactions operating on a basis of harmonized rules: unlike conventional paper contracts, smart contracts are indeed all built on the same model and readable by all computers.
- The creation of an anonymized database of investors thanks to cryptographic methods of “Zero Knowledge Proof, fully secure and accessible 24 hours a day by issuers of financial instruments and regulators.
- The automatic verification of the conditions of transferability of the securities: the numerical identity of each investor will be recorded on the blockchain so that they can verify directly whether they fulfill the exchange conditions or if, on the contrary, restrictions apply.
- The control and the automatic encrypted statement of transactions which were carried out at all times
In concrete terms, 4 smart reference contracts will be developed:
- 1 smart contract for digital identity management: nationality, typology of investors, level of qualification… each investor will enter information on the Equisafe platform only once. They will then be verified (Know Your Customer test) and then registered for the time being that is authorized by local regulation (ie. One year in Europe).
- 1 smart contract to create a digital representation of the company issuing securities and related regulations: the issuance of deeds requires the prior registration of the company on the blockchain. This will allow the technology to directly evaluate whether a buyer meets the conditions for subscription to capital, or if the maximum number of shareholders has been reached.
- 1 smart contract for materialization of securities registers (shares, funds and bonds).
- 1 smart contract allowing the custody of the titles directly on the blockchain.
Smart contracts will communicate with each other and form a new kind of standard that has an unprecedented level of granularity. The Nyx may allow the holders of equity securities to hold their general meeting, vote and exercise their rights (such as dividend rights) in a completely dematerialized manner handling on-chain lifecycle management of the securities.
A technological standard accessible to all
The standard should be unveiled to the general public in early 2020, after being deployed in a first use case on the Equisafe platform.
The latter will offer a very easy-to-use interface for issuers of financial instruments who will only have to enter directly the necessary information to create their smart contract. Each contract will be customizable according to the local compliance rules.
The Nyx standard will be available in open source (MIT license), to allow all developers to access and improve it if they wish by incorporating additional features, maximizing the interoperability that is expected by financial infrastructure.
Nomadic Labs, a R&D lab working on the Tezos protocol, will ensure its good implementation on the blockchain.
Far from some standardization endeavor done from the open source community, we can deep dive in what we think are basic components to push the industry forward.
In terms of philosophical approach regarding the standardization, the library/”protocol” should be a set of compliance oriented smart contracts in order not to fall in some classical collateralization and to have a real on-chain governance (that is why we preach for decentralized exchange rather than classical centralized one). This would open up the reach of the offering set from a particular jurisdiction to many others, taking into account reporting obligations, trade restrictions, KYC/AML restrictions, and support to investors during the whole lifecycle of the securities. (This is why co-customization is key, we have to bring to the table lawyers, tax advisers, auditors, regulators and every other counterpart in the value chain)
The value (down the line) is:
- The reduction of costs for issuers which should increase the number of offerings and therefore should induce more market depth in the long run;
- Allow for rapid settlements of trades which should decrease the number of entitlements and so intermediations and create a frictionless market with new investment behavior;
- Ease the reporting requirements which should open up the dark side of Finance and help the regulatory entities do their job more effectively.
The set of smart contracts should be of course modular enough to be flexible to the issuers needs, adaptable to regulatory rules and updates, and accessible to the right investors (specifically in the case of private placements where issuers may impose limits on the number of investors, country of residence, to the typology of investors (individual, professional, accredited)…). Thus, unlocking Interoperability is key for the promise of Liquidity. If everyone creates its own closed ecosystem there will be no liquidity, and it will be the failure of Security Tokens. So, we’re not a big fans of “end to end” platforms nor we’re big fans of utility token to access an ecosystem, first, it’s not needed, two, it creates only more friction in the market (it’s not going to help adoption, neither deployment of such technology).
At EquiSafe, we have identified three main points that must be properly handled in order to drive main adoption:
- In order to have token traded onto several exchanges, encoding the compliance and issuer’s restriction rules (linked to the shareholders agreement and distribution method (Prospectus, Private placement…)) has no sense if we don’t use the blockchain because it brings interoperability.
- Identity is a real concern, for Privacy issues but also in the case of front running transaction in the pool prior validation which could leads to miners’ manipulation and spams.
- Custodianship is the missing part of the puzzle. Large and well-known Custodians MUST get in the ecosystem, otherwise no institutional will.
Technically speaking, we have four required participants in order to sustain the ecosystem:
- Issuers: create and sell Digital securities/Security Tokens to fund their business and operations.
- Investors: pass KYC/AML checks in order to hold and trade those Digital Securities. This allows the automation of transfer and acquisition rules.
- KYC/AML Providers are trusted entities that provides Identity (as a service) checks for other network participants. Their shared ledger is one of the factors that decrease time for checks and thus costs and avoid operational mistakes that could leads to fines. (Do you think it’s legitimated that for 5 investments you pass a 5 KYC/AML Checks? Humm… Moreover, do you believe that your lawyer creates value by reading the contract and all legal documents to verify if the sale is permissible? This time is billed from €500 to €2000 whereas Equisafe can do this into 1 second. Then, the lawyer can focus on added value tasks, get more clients etc.)
- Custodians: that should hold “tokens” if you apply their last job to this new model. However, the tokens are in a smart contract in the blockchain. Therefore, they hold the private keys that redirect to those tokens. However, for security and insurance reasons, you may wish to delegate the safekeeping of the tokens to a smart contract managed by a custodian instead of the smart contract managed by your issuer.
Each investor has his Identity validated by a KYC/AML provider which assign a unique Hash ID associated with a wallet address or wallet addresses On-Chain (which count as one beneficial owner for the providers) which will rule how the investor interact with the custodian and the issuers. All of those, have specific smart-contracts that will mimic the old-fashioned way. Those smart contracts will rule the way they interact together, and a transaction will be validated once some permissioning modules are checked.
Also, any security standard should incorporate various recovery options in the case of the loss of the private key or if a court decision has to be enforced on tokens in circulation, as well as “sub-authorities” in order to control the level of a third party actors who might be dealing with your tokens/assets for you like an asset manager for example. As a reminder, the token is a new medium for containing information. Since the Mesopotamian era, we have gone from stone to paper. Today, we are moving towards the “Token”, a medium that can contain much more information than paper, this information can be transverse to everything that is related to the securities and can be moreover historized thanks to the timestamp provided by the blockchain and opposable to third parties thanks to the legal value of the timestamp. In short, we are moving from radio to HDTV all of a sudden.
Moreover, we’ve mentioned “Modularity” in order to be adaptable to the issuer’s constraints. For example, in the US, you can fill a “Red D” form, which force 12 months holding period for US-based citizen. Therefore, you don’t want to have them trading their tokens until the locking period is not finished, whatever the marketplace that is used. Traditionally, they didn’t have the titles in the first place so they couldn’t, but with blockchain giving back the value in the end of the investor you need to encode in the smart contracts those specific rules. “Modular” also, depending on the rights you want to give to the holder, dividends and/or voting rights and/or others. Adaptable, as the same protocol can be used to issue securities from more than 70 jurisdictions.
For more information, please go to Equisafe.io!