An Introduction to Token Standards in Regulated Markets
Token standards are vital for ensuring regulatory adherence, market transparency, interoperability, and legal certainty as the use cases and adoption of DLT continues to gain traction
The Relevance of Token Standards
Digital tokens have the potential to not only replace many traditional financial instruments, but perform additional economic functions. Within regulated markets, native digital asset tokens (where the entire asset lifecycle is DLT based) and tokenised assets or non-native digital assets (referring to the process of issuing a digital representation of a real thing) can reshape the securities services value chain by implementing a network in which data flows seamlessly — shared either simultaneously or at speeds so rapid that it feels simultaneous.
Token standards enable tokenisation by providing guidelines that ensure consistency, interoperability, and efficiency within — and sometimes across — Distributed Ledger Technologies (DLTs). These standards define the rules and functions that govern how token contracts (a subset of smart contracts) are created, issued, and managed. By adhering to token standards, developers can design tokens that are compatible with various wallets, exchanges, and decentralised applications (DApps), promoting seamless interaction and transfer of tokens across different platforms.
Despite the transformative potential of tokenisation, issuing security tokens presents complexities due to the absence of a one-size-fits-all solution. Even within a single blockchain ecosystem like Ethereum, the number of different token standards offering varying functionality appears to be almost endless. Selecting the right standard is essential to ensuring that tokens function as intended and operate within applicable legal frameworks.
Whilst regulation will dictate the fundamental requirements for security tokens, a thorough assessment of token standard functionality, implementation, and security vulnerabilities is important. This evaluation becomes crucial when considering the deployment of token contracts on a blockchain mainnet.
Immutability Considerations
Immutability considerations related to deployed token contracts arise from the inherent nature of smart contracts on blockchains like Ethereum. Once a smart contract is deployed, it becomes immutable, meaning its code cannot be altered or updated. This immutability poses challenges for developers who may need to make changes to the contract in the future, such as fixing bugs, adding new features, or adjusting parameters.
While immutability ensures security and trust by preventing tampering with a contract’s code after deployment, it limits the flexibility of developers to adapt to changing circumstances or requirements. In the context of token contracts, this means that any decisions made during the initial deployment become permanent and cannot be modified without re-deploying a new contract.
The inability to modify deployed token contracts can lead to issues like being stuck with initial parameters that may no longer be optimal, challenges in informing users about changes or upgrades, and the risk of losing customers to competitors offering more flexible solutions.
Mitigating Immutability Challenges
Re-deploying smart contracts is time-consuming and requires extensive testing. Each re-deployment poses a risk of errors that could compromise security and disrupt operations. Furthermore, fragmentation of data and functionality from multiple re-deployments could lead to inefficiencies and complexities in system management.
To maintain efficiency, security, and consistency in DLT systems, minimising the need for re-deployment is advised. Below are three non-exhaustive examples of how this could be achieved:
1. External Databases or Off-Chain Solutions: A simple way to minimise the need for re-deployments is to store non-essential logic and data in external databases or off-chain solutions. In scenarios where extensive/sensitive data storage or complex logic is required, utilising external databases or off-chain solutions combined with common security token standards such as ERC-20, ERC-1400 or ERC-1404 can be efficient and cost-effective. These external storage options can include traditional databases, cloud storage services, decentralised storage networks, or specialised data management systems tailored to specific needs.
2. Proxy Contracts: Proxy contracts serve as intermediaries that delegate function calls to separate logic contracts, enabling upgradability in smart contracts. While proxy contracts provide a mechanism for upgrading the logic contract by changing the address stored in the proxy, they lack a modular permission system, leading to an all-or-nothing approach for upgrades and requiring special care when accessing data within the logic contract post-upgrades.
3. The Diamond Standard: ERC-2535, also known as the Diamond Standard for smart contracts, introduces modular smart contract systems that address the limitations of traditional proxy patterns. This is achieved by introducing facets, where each facet holds the external function logic that a proxy contract (like a diamond) can call upon. As there are no restrictions on the number of facets that can be added, ERC-2535 enables granular upgrades by adding, replacing, or removing specific functions or groups of functions within a Diamond smart contract without re-deploying the entire logic.
While ERC-1400 and ERC-20 are token standards focused on the functionality and compliance of the tokens themselves, ERC-2535 is a standard for designing the underlying smart contract architecture in a more modular and upgradable way, which can be beneficial for complex token systems.
Proxy contracts and diamonds (ERC-2535) are interesting concepts, but their suitability depends on the specific context and requirements of the underlying asset class, or smart contract system. Developers should weigh the benefits of using ERC-2535 (or proxy contracts) against complexity and security considerations.
Final Thoughts
DLT’s capabilities like digital assets, self-executable code (aka smart contracts), immutability, and decentralisation create new regulatory and operational considerations around implementation, governance, data management, security, anonymity, and code errors.
In regulated financial markets, the potential of tokenisation presents an exciting opportunity for innovation and efficiency. However, to fully realise the benefits of this technology without compromising investor protection or market stability, collaboration between regulators and market participants is essential. By working together, regulators can establish clear guidelines and frameworks that ensure compliance with existing laws and protect investors from potential risks associated with tokenised securities. Market participants, on the other hand, play a crucial role in providing insights and feedback to help shape regulations that balance innovation with operational feasibility.
I hope you enjoyed this overview of token standards in regulated markets.
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Citations:
- Digital Tokens — A Legal Perspective (IMF)
- Not All Smart Contracts Are Immutable: Create Upgradable Smart Contracts
- Codefi ERC1400 Assessment
- Exploring ERC-2535: The Diamond Standard for Smart Contracts
- HackMD Discussion on ERC-2535
- EIP-2535 on GitHub
- Binance Academy: Token Standards
- The Power of Token Standards
- Security Token Market
- Solidity Developer: EIP-2535
- Warning: Contract Code Size Exceeds 24576 Bytes on Upgradeable Proxy
- Ethereum’s Maximum Contract Size Limit Is Solved With Diamond Standard
- FCA Discussion Paper 2017
- Regulating Blockchain, DLT and Smart Contracts
- DLT in Payments, Clearing and Settlement
- ERC-1400: Security Token Standard
