Security, Security… (+ Tokens)

TL;DR:
Real-world assets represented by ERC721 non-fungible tokens is one thing. Saying that this kind of token is a security is confusing, inaccurate and sometimes plain wrong. Let’s talk about Asset-Based Tokens, specifically to differentiate between an ERC20 token interpreted as a security and a project seeking to bring use-cases to the Blockchain with a non-fungible token.

Representing real-world assets on the Blockchain in a legally binding way requires a methodology wich includes the application of local regulation and partners, along with an in-depth knowledge of the underlying offline processes. The current regulatory body in many countries seems to be already up to the task, but a ‘Proof-of-Concept‘ is not there yet. CoopCoin aims to execute its first legally binding factoring on the blockchain in the upcoming weeks.

Security for techies

Back in a former life as Information Security consultant, questions about security were mainly concerned with an asset’s CIA: confidentiality, availability and integrity. We would help a company put a value to that digital or non-digital asset, identify and evaluate where and how they were stored (and backed-up…), exchanged through which networks, accessed by what software, controlled through which IAM and so on. The company would then have to estimate the financial impact of non-conformance to CIA requirements for each asset to finally implement the all mighty Information-Security-Management-System (ISMS). Relatively straight forward if one had the right questions to ask.

The word ‘security token’ in a Blockchain context seems to have become the ‘one-size-fits-all’ word for referring to the representation of real-world assets as tokens. This approach is a questionable choice of words and oversimplification. First, not every real-world asset falls under a security’s regulation framework (and those vary widely from country to country), and second, it imposes ‘fear’ regarding the feasibility of a project that wants to work with tokens representing real-world assets.

Information Security and ‘Securities‘ nonetheless have an important goal in common regarding the representation of real-world assets: One needs to ensure the asset’s

• Confidentiality: Who is the owner (or: how can one verify the owner)
• Integrity: Does the asset represent what it was supposed to initially
• Availability: Ensured through decentralization of Blockchain

ERC20- or ERC721 -Security?

At CoopCoin we prefer to talk about Asset-Based Tokens when we refer to a Non-Fungible ERC721 compliant Token(NFT) that is minted on CoopCoin to represent a real-world asset or its underlying claim. Scary enough that at times in talks with potential investors we have to explain what an NFT is, that it is unique and how it is different from an ERC20 Token.

The confusion is understandable and by no means their fault. Everywhere one can read of stories from cease-and-desist orders the SEC sends out to Blockchain projects. The reasons are numerous, but one of them is that promising the investor of an ERC20 Token a profit, makes it a Token that (in the USA) can be regarded as a security and as such the project most likely did not comply with applicable regulation when selling their tokens to whomever send them some funds. (If giving discounts on your Token for early buyers falls in the same category can only be speculated)

When reading or watching a conversation about securities on the Blockchain, I always hold and try to figure out which one they mean: the ERC20 Token or a ‘security‘ representing an asset. At times one wonders if the participants know the answer themselves.

Legally binding real-world assets on the Blockchain?

In many countries, from Chile to Mexico, the USA, European Countries and the even more progressive countries further east, digital invoicing, if not by law, is very common, often the norm. What does this mean for projects aiming to bring real-world assets onto the Blockchain?

At CoopCoin for example we will be factoring accounts receivable as our first business case.

Background: When a supplier (example: a Banana producer) sells goods to his client (example: a Supermarket), the client becomes the supplier‘s debtor and as such owes the supplier an amount of money (X) at a particular time in the future. Depending on the sector and the bargaining power, the debtor might have 30, 60, 90 or even more days to pay his debt. Recently those time frames have become ever longer, putting pressure on the suppliers as they have to finance their production and sales.

For this reason, companies turn to factoring, where they sell this claim of the invoice to an investor at a discount, so that they can receive a substantial part (maybe 70–80% of the total invoice) today, rather than in 90 days, and the remaining balance when the debtor pays the invoice, minus the discount.

To be able to factor the accounts receivable/invoice, various steps have to be undergone, for example:

• make sure that the seller of the invoice is its legal owner and he has fulfilled his duty to claim the invoice
• the invoice is of certain value, has not been paid already or been sold to a third party
• the debtor exists and its default-risk is adequate to the proposed factoring terms

Today many companies already use services which provide these assurances in digital form (for example from EDI systems). In the USA through SPSCommerce, DiCentral or EZCom alone more than 120.000 companies receive their legally binding orders in digital form. How did they get here? By defining certain norms for the systems and interfaces (APIs) to create interchangeable files that are worth real money (or assets for that matter). (The interested reader can also refer to the ISO/IEC Standard 20022 for financial institutions that is slowly becoming the norm for accounting)

CONCLUSION

Bringing real-world assets onto the Blockchain will require that local regulation is known and applied in the least manual way possible. Similar to digital invoices in EDI systems, the Blockchain equivalent needs to provide the same assurance of the tokenized asset, giving both the seller and the investor the ‘security’ of trading a Token that will hold.

In an EDI system, the company tenant provides the ownership, a company-user, and its password. On the Blockchain, this is similar to the Ethereum Address.

The tokenization of assets will have a big impact on traditional processes and has the potential to (for lack of a better word) disrupt industries and today’s players. Current regulation in certain countries should already be sufficient to start using the Blockchain to trade tokenized assets.

Advantages are not only the mere elimination of manual processes, increased speed or transparency, but the possibility for entirely new functionalities regarding the usage of assets, for example, their splitting and bundling, collateralization in markets such as MakerDAO and other creative applications..

We are excited to see various projects going a similar way, aiming to bring real-world assets onto the Blockchain. We hope that they will do so only after extensive due diligence respecting applicable regulation to not create bad examples, unnecessary claims and with bad press and ‘fear’.

Please have a look at our prototype video where we show some of the steps it takes to mint an invoice into a non-fungible token.