A Different Way to Think About Security Tokens: Programmable Regulation

Security tokens are one of the most exciting developments in the crypto-asset space that is forcing us to rethink different aspects of the ecosystem from the technological, socio-political and economical standpoints. Recently, I was confronted with a scenario that made me look at security tokens through the regulatory lens and came out with a few unorthodox ideas that I thought I share with you guys.

If you read the recent wave of blog posts and articles (mine included 😉) about the key benefits of security tokens, you are likely to hear elements such as liquidity and fractional ownership often cited as the main advantages of the new crypto paradigm. In his famous article “The Security Token Thesis” Professor Stephen McKeon from the University of Oregon listed 8 main benefits of security tokens:

1) 24/7 markets

2) Fractional ownership

3) Rapid settlement

4) Reduction in direct costs

5) Increased liquidity and market depth

6) Automated compliance

7) Asset interoperability

8) Expansion of the design space for security contracts

Point #7[Automated Compliance] in Professor’s McKeon list is often ignored in favor of more sexier benefits such as fractional ownership and liquidity. However, in its current nascent state, point #7 might be the most important contribution of security tokens to the crypto asset space. In my recent work, I took the liberty of rename point #7 using another term that take us closer to its practical applicability: programmable regulation. Before we deep dive into the ideas of programmable regulation, let’s demystify some of the key beliefs behind the benefits of security tokens.

Things You Love About Security Tokens that Might Not be True (Just Yet)

With the excitement around security tokens comes a lot of uninformed opinions that paint a distorted picture of the realities of the space. If we want security tokens to succeed, we need to establish the right technological and economical rigor and ignore some of the hype. Liquidity and fractional ownership are two of those overhyped benefits of security tokens that they don’t quite correlate with the current state of the space.

Offering a liquidity channel to investors in alternative illiquid assets might become the greatest benefits of security tokens but is far from being trivial. For starters, liquidity in the security token space is limited at best and I feel many platforms are taking it for granted. One of the things I like about the Securitize platform, is that they seem to be one of the few that have presented a thoughtful and pragmatic approach when comes to liquidity models. Most of the security token offering(STOs) in the space have been undersubscribed and growing up that investor community is not an easy endeavor. Additionally, we need to factor in the company angle. As a private company, do you really want to have thousands of investors that are actively trading your tokens/shares? In the best case scenario, I can tell you that model doesn’t work for all companies as it opens the door to all sorts of gamified governance issues and can become a distraction from the real goals of the business.

Now let’s take fractional ownership. How many people do you think get excited about owning 1% of a Cezanne? Fractional ownership is a super interesting concept but, in my opinion, is more practical when comes to dividend-generating assets such as real estate leases and it might become unpractical in many other cases.

If liquidity and fractional ownership are not slam dunk benefits of security tokens then what is it? Let’s take a look at programmable regulation or as Professor McKeon calls it automated compliance.

Security Tokens as a Regulation Amplifier

Here is main takeaway of this essay and a very simple idea that made me change my perspectives about security tokens:

“Security tokens amplify existing regulatory frameworks into the crypto space and makes them programmable.”

Hopefully the idea didn’t sound completely stupid and you are still here 😉. Let me try to explain. For years, regulators have struggled trying to adapt compliance models from different types of financial products to crypto-assets. Most of those attempts have been futile as crypto-assets don’t behave like traditional financial asset classes; they are programmable, traded simultaneously on multiple exchanges, globally available, they don’t strictly behave like securities nor as commodities and dozens of other unique characteristics. As a result, most financial regulatory models simply don’t apply in the crypto space. We need a bridge that adapts existing regulatory frameworks to the crypto-assets. SECURITY TOKENS IS THAT BRIDGE!

Security tokens are the first type of regulated crypto-asset but its much more than that. Security tokens amplifies existing regulatory frameworks into the crypto space. Using security tokens as a vehicle, many regulatory models across different geographies can be adapted to the crypto world. Even more importantly, security tokens open the door to programmable regulation model.

Programmable Regulation

The notion of programmable regulation is an adaptation of the famous “the code is law” Ethereum mantra for the security token space. Programmable regulation is simply the idea of building regulatory, compliance and governance rules as smart contracts that can run across different blockchains. We are already seeing the first versions of this in basic forms of know-your-customer(KYC) and anti-money-laundering(AML) rules built into the first generation of security token platforms. Although universally adopted, KYC and AML are some of the most basic forms of regulations and definitely insufficient for the mainstream adoption of security tokens. However, programmable regulation allow us to use security tokens as a vehicle to program almost any regulatory model into enforceable smart contracts that can be used by different crypto-products.

Programmable regulation is a very abstract term and it doesn’t translate into a single technological approach. From an initial analysis, we can identify different types of programmable regulation that are relevant in the current generation of security token platforms:

· Token-Based Regulation: A crypto token is the atomic representation of any financial transaction in the crypto-asset space and, consequently, the smallest unit that can be regulated. Embedding regulatory and compliance rules into crypto tokens is certainly the most efficient form of programmable regulation. Harbor pioneered this approach with the introduction of the R-Token standard that has been adopted by other security token platforms.

· Composable-Token Regulation: I struggle to find a better name for this concept ☹ but here is the idea: As concepts such as the Harbor R-Token become more mainstream, we are likely to see variation of R-Tokens that serve as shell tokens to enforce specific types of regulation. For instance, suppose that we have a group of security tokens that represent commercial real estate leases in Manhattan and we would like to trade them in exchanges hosted in the European Union but that requires to be compliant with different regulatory models. In that scenario, we can imagine a Real Estate EU R-Token that aggregates the individual R-Tokens and enforces the EU regulations. This is a great example of programmable regulation.

· Exchange-Based Regulation: Many regulatory rules in security tokens can’t be expressed at the token level as they express more complex rules such as custody models, liquidity terms, etc. Security token exchanges like OpenFinance have the opportunity of creating programmable models that represent these regulatory constructs.

· Party-Based Regulation: A security token platform involves different parties such as issuers, auditors, escrow providers, legal delegates and many others. These parties are also subjected to regulatory models that can be programmed as smart contract. For instance, imagine a smart contract that abstracts the regulatory rules that need to be followed by any law firm within the European Union that is involved in the due diligence of security tokens. The Securitize platform includes the notion of a Compliance Service that sorts of serves that role.

Just as utility tokens and cryptocurrencies have become forms of programmable money, security tokens have the opportunity of becoming vehicles for programmable regulation. In this early days, the idea of programmable regulation can be, arguably, considered the greatest contribution of the security token space.