Bringing Securities to the Masses: Trust Minimization, Tokenization and Decentralization
Amidst the hype and hyperbole about blockchain and blockchain-based applications, there’s a lot of chatter around scale and how, practically speaking, blockchain will make applications available to larger groups of people.
Scaling access to financial services to the most remote parts of our globe will require a new paradigm, a new way to think, a new solution. The registration, transfer, clearing and settlement of securities represents a significant part of the economic activity that are currently underserved by modern technological innovation. Blockchain technology is about to change all that.
An entire industry has already developed in just a few short years, full of an ambitious cohort of companies set to deliver new technology at scale on account of three proven principles:
- Trust minimization: making it easier to do honest business together
- Tokenization: turning anything into a unique digital asset
- Decentralization: reaching the masses.
In order to reach the masses, financial service providers will need to understand and leverage these three concepts, which can be found at the foundation of any peer-to-peer network. Once we grasp the nature of these 3 technologies, we can understand how they will inevitably disrupt our global capital markets. This article explores these foundations and how they will drive mass adoption of securities on the blockchain.
Trust Minimization
At the core of every peer-to-peer protocol on the Internet, we find Nick Szabo’s concept of trust minimization — a critical blockchain mechanism that codifies the network rules and operations in such a way as to allow participants to transact with one another in confidence, without having to spend time and effort building trust in one another or integrating third party tools.
Trust minimization occurs when we use technology to reduce the costs and difficulties associated to building trust with another party.
On a blockchain, this process begins with incentivising some users (called “miners”) to share their computing resources (computing power, disk space, network bandwidth) with the network. The network protocol then applies these resources to provide services to the users of the network.
So, where does the trust go? The trust is no longer a characteristic of the relationship between the two parties, but rather built in to the technology. Because the technology is open-source, individuals and organizations can review the rules of the network before deciding to participate.
This is a big departure from the centralized systems of yesteryear.
We used to have to rely on “trusted” agents and financial service providers to avoid fraud and safely trade securities. These agents today operate using a set of rules that are generally opaque and unknown to the investing public.
A blockchain network transparently brings these rules to light, and provides the ability to independently audit 100% of the transactions, in real time. All participants on the network — issuers, buyers, sellers, and their agents — can trade digital securities with confidence because the rules are programmed in the network.
Tokenisation
Tokenization is another foundational principle in a peer-to-peer system. This refers to the creation of unique digital items called “tokens” or “coins” that can be individually traced on the blockchain and are typically only available in limited quantity.
By combining utility and scarcity, the token acquires value in the eyes of the network users. These tokens serve at least two critical functions: they are needed by users who want to use the network, and they are needed as an incentive reward for the miners who provide computing resources to the network.
Since a token on a blockchain is a uniquely identifiable digital asset, these tokens can be used for more than just provide access to a service. We can, for example, associate the unique virtual token to a unique physical asset. The token may now be traded on a blockchain as a proxy for the asset.
When we look at how blockchain is being applied to capital markets, we can identify 2 categories of solutions: Security Tokens and Crypto-Securities.
A security token provides capital market services on a mixed-use blockchain like Ethereum. The computing resources provided by Ethereum miners are shared across any applications running on the blockchain.
This is a very common option, since Ethereum already boasts a very large mining community; this allows the security token development team to not have to worry about attracting miners to their project. The downside of a mixed-use network is that other non-related applications can also have an impact on the overall performance of the system.
Crypto-securities in contrast rely on a dedicated blockchain to “hard wire” the securities rules in the blockchain protocol itself. The downside to the creation of a specialized system is that it needs to attract its own group of miners and resources.
Decentralization
Peer-to-peer protocols define systems where participants can coordinate their activities together without the need for a 3rd party intermediary agent.
When we decentralize a process, we look for ways to replace agency with protocols. The transaction costs are significantly reduced since the protocol is reusable for all transactions, whereas specific agents and intermediaries are required for each traditional trade.
Blockchain has the ability to disintermediate third parties, significantly reduce transaction costs, and increase the scale of what is possible.
The value proposition for securities on the blockchain far surpases any of the technologies used by today’s “secure and stable” trading platforms. A peer-to-peer network that facilitates the creation and direct exchange of registered shares, representing a shift in equity markets towards more efficient, transparent operations, as well as greater accessibility to the investing public and issuing companies.
The barrier to entry for capital markets has typically reduced access for a large percentage of potential investors. Removing costs, time, intermediaries, and regional limitations through a blockchain exchange will open up access to an entire new market of investors.
The combination of trust minimization, tokenization, and decentralization are at the core of this peer-to-peer transformation. When we talk about scale, we are talking about how these three core tenets will decrease transaction costs and increase access to more participants and opportunities. Securities on the blockchain will revolutionize an industry and democratize capital in unprecedented ways.
