Voting and Governance in Security Tokens

Security tokens are on their way to become one of the most important segments in the cryptocurrency market and certainly one of the most interesting ones. What makes security tokens so fascinating at this stage is that we are just building the first blocks of what can become a new financial infrastructure. The security token community is humble enough to admit that nobody has all the answers and we are just figuring things out as we go. Ranging from liquidity to regulatory concerns to the first models for exchanges, there are many aspects of the security token ecosystem that need to be figure out to allow the mainstream adoption of this new type of crypto asset. Among those factors, voting and governance will play a fundamental role in the next generation of security tokens.

Voting and governance are already super relevant in blockchain protocols so what makes these elements so relevant in the security token space. Well, while the voting and governance of blockchain protocols is constrained to aspects such as mining, minting or, in extreme cases, protocol changes; the entire lifecycle of security tokens seems to evolve around voting decisions. From asset registration to liquidity models, security tokens are constantly vulnerable to voting and governance decisions. Despite its relevance, I believe the work on voting and governance models for security tokens is in very nascent stages. From the lead platforms in the market, only Securitize seems to have factored in voting as a first class citizen of their protocol( at least from what I’ve seen so far).

Off-Chain and On-Chain Voting

Arguably, what makes voting and governance so challenging in the security token space is the fact that a significant part of the lifecycle of a toke takes place off chain. From the legal process to tokenize an asset to decision involving dividend payments or audit processes to validate the value of a token, security tokens are many influenced by many off-chain processes that require consensus and voting. From that perspective, any viable governance model for security tokens should factor in on-chain and off-chain voting.

On-Chain Voting

Just like traditional crypto-assets, security tokens face plenty of situations that require consensus by the participants in the network. To address those scenarios, security token protocols should include on-chain voting mechanics for the different nodes to submit and process votes. The Securitize whitepaper proposes a method of how these voting mechanisms could work.

On-Chain Voting Scenario: Dividend Distribution

Let’s take the example of a security token that represents a group of real estate leases similar to a real estate exchange-traded fund(ETF). The smart contract representing the token guarantees a quarterly dividend distribution based on the cash flow generated by the underlying assets. In this scenario, at the end of every quarter, auditors will assess the profit and risk of the different leases, determine the appropriate dividend and submit the proposal for voting across the different token holders.

Off-Chain Voting

Complementing the on-chain voting mechanisms, security token protocols should also consider many scenarios that require the legal and regulatory processes established in the off-chain world. To maintain a truly decentralized model, security tokens should facilitate off-chain consensus between different parties which can then be translated into on-chain actions.

Off-Chain Voting Scenario: Asset Valuation

Let’s take the same scenario of a security token that represents a list of real estate leases. The process of tokenizing those assets requires legal parties to validate the contracts as well as experts that assess the potential value of the token and the corresponding risks. The valuation of the security token needs to consider different factors such as duration of the lease, cash flow, risks of payment or default, etc. Upon completing their due diligence, the different parties can submit their findings and agree to the valuation of the asset. In the future, many of those processes will take place on-chain but the current stage of security token protocol needs to account for off-chain voting and consensus.

Game Theory Attacks in Security Token Voting

Just like traditional blockchains, security token voting mechanisms are vulnerable to different types of attacks. Which classic blockchain attacks such as 51% control are not that relevant in the security token space, the participation of off-chain parties opens the door to new vulnerabilities we haven’t seen before.

The Token Raid Attack

The token raid attack describes a scenario in which a large token holder can purposely drive down the price of a security token by manipulating other token holders. Let’s take the example of a security token with dividend distribution; upon receiving the dividend distribution proposal, a large token holder can indicate to other token holders his intention to vote NO and block any dividend issuance. That action drive down the price of the token incentivizing many of the token holders to sell their positions to the larger token holder.

The Insider Attack

Security token models are very vulnerable to asymmetric information attacks such as what happens with insider trading in public markets. Let’s take the example of a token that represents shares in a private company. There are many ways by which a token holder can obtain, non-material, public information about the state of the company, new product releases or fund raises etc that can be use as an advantage to manipulate the price of the target security token. Similarly, a competitor could filter fake bad news about a tokenized company to cause the price of the security token to go down and affect the investors and token holders.

The Blocking Attack

Imagine that a company launches a security token based on its assets. A competitors uses a third party vehicle to buy enough tokens to be influential on the voting decisions. After that, the competitor decides to block or delay any voting proposal so the token slowly depresiates in value and investors get frustrated. While this happens, the competitors launches a similar security token for his business and tries to influence the frustrated token holders to dump their positions and buy into his offering.