Tokenized Reserve: An Introduction
Reserves are backups for unexpected situations. The relief of knowing there is an extra stash to use can not be replaced. In sports, reserve players replace the newly injured players or in the military, reserve troops get added to win the battle. A tokenized reserve is a mechanism for a reserve fund on the blockchain. Blockchains can be a great store of value because of the decentralized nature of the protocol. Reserves on the blockchain should be a perfect fit only if they take advantage of the decentralized aspect. We need to rethink how a reserve fund should function in a decentralized environment to allow all users to benefit. A standard for reserve funds on-chain can help individuals or organizations create new community environments.
Rethinking the Reserve Fund
A traditional reserve fund for a person or an entity is set up with a bank, where accounting is handled by the bank’s systems. Banks have different policies based on several factors like compliance, fraud, or security to name a few. Transfer of funds occurs by one or a few authorized persons for the bank account. Authorized actions happen when the account owner wants to add funds, withdraw funds, or change an authorized person. Policies that enforce authorized actions within the bank’s systems, create trust between account holders and the bank. With the help of public infrastructure like government agencies, banking systems must follow compliance policies or face penalties.
The agency issuing policies determines the severity of the penalties. There is always good intent when issuers create policies but failure constantly occurs. In some situations, policies not being followed can last years before audits can catch the misconduct. For example, for failure to properly maintain electronic records for employee communications, the Securities and Exchange Commission, SEC, recently announced charges against Wells Fargo and 11 other smaller banks. This policy issued by the SEC did not relate to customer funds, but the misconduct dates back to 2019. After four years of misconduct, the SEC issued $549 million in penalties.
Within the web 3.0 community, it is understood that we are creating new systems to replace or improve traditional banking systems. Issuing policies, attaching penalties, and enforcing policies can be carried over to the blockchain without abandoning web 3.0 principles.
Reserve Tokens
There is no need to recreate the traditional banking environment for reserves on the blockchain. A rethink of how a reserve should function to allow all users a transparent experience is needed. A tokenized reserve creates a mechanism for a reserve fund that acts similarly to a fund using a traditional bank accounting system. Funds stored in a tokenized reserve belong to an owner but include other participants in the reserve actions. Similar to depositing funds with a bank, the account owner has trust in the bank, government agencies, and any other occasioned third party that operations are conducted properly. For instance, watching the movement of funds for suspicious activity.
A tokenized reserve offers an alternative by conducting audits with smart contracts. Authorization of which smart contracts are implemented onto the reserve will not be the job of a government agency but other users. Users can be any person or entity willing to participate. Participants are the auditors in the reserve making sure the reserve stays compliant.
Reserve owners have control of funds, but every withdrawal creates a new proposal. Details of a proposal should be made accessible to users off-chain. Reserve tokens are created for each proposal a user accepts. Authorized smart contracts by the users enforce policy onto the reserve. Based on the use case, the owner will be encouraged to follow their proposals or be subject to penalties detailed in a policy. A tokenized reserve does not explicitly mention how to motivate an owner to follow their proposal. Actions detailed in a policy can be used as a kind of motivation for owners to follow their proposals. Policies could restrict owner access, require certain conditions before withdrawal, or give ownership to a new owner. Smart contracts can make misconduct visible once they occur, then enforce penalties. Entities with multiple stakeholders can benefit from this approach.
A tokenized reserve is a type of community reserve where multiple stakeholders have an interest in its value growth and value utility. Actions in the reserve are made public to expose misconduct, like misuse of funds. Owners are creating a community to engage in new products with their stakeholders. A healthy reserve should have transparent deposits and withdraws, intending to preserve and grow the value stored in the reserve.
Why Use Tokenized Reserves
Funds should be used to help an entity grow. Using the community can help keep funds safe. There is still a probability that funds can be misused within a reserve, but all actions should be auditable to help mitigate failure. No need to rely on a third party like a government agency, smart contracts are used to enforce penalties during unfavorable conditions. As we move towards a world of tokenization, a different kind of reserve fund should be considered.
Future Work
There is more research needed to be done on tokenized reserve. Different use cases can be implemented to this logic to create new blockchain products. Currently, this mechanism is being shared to start the discussion about creating a standard for tokenized reserves. Developers can read the Ethereum Improvement Proposal #7425, which is currently in draft, at https://github.com/ethereum/EIPs/blob/master/EIPS/eip-7425.md. I encourage developers and engineers to contribute on the discussion post at https://ethereum-magicians.org/t/eip-7425-tokenized-reserve/15297. Any feedback will help. A reference implementation is located here https://github.com/jimstir/Reserve-Vault.
Developers should try to implement this proposal and create extension contracts that enforce the logic of tokenized reserves. I will continue to post relevant articles for further education. So stay tuned for future developments. A tokenized reserve could be used across the growing web3 ecosystem further promoting the use of tokenization in decentralized communities.
