Blockchains, Networks, Protocols or Fantasies in Security Tokens: Part I
Yesterday, during the first day of Consensus NYC, Polymath announced their intentions to work on a tier1 blockchain for digital securities. The announcement, arguably, represents one of the most ambitious steps towards building an infrastructure optimized for digital securities from the ground up. I’ve been aware of this project almost since its inception and, at a recent conference, I mentioned that I would like to see more efforts like this in the security token space but I worried about the timing. A few months ago, I published a three-part essay about this topic(Part I, Part II, Part III) but, obviously, my thinking and the market has evolved since then. While, at first glance, the value proposition of a blockchain specialized in security tokens seems to make sense, that picture quickly starts becoming fuzzy when digging through the technological and business layers. Today, I would like to deep dive in the arguments in favor and against a tier1 blockchain for security tokens and correlate it with alternative approaches in the context of the potential evolution of the space.
The idea of a blockchain specialized in security tokens looks to remove any of the infrastructure dependencies on decentralized runtimes such as Ethereum. Many of the capabilities of blockchain runtimes such as decentralized consensus or semi-anonymous, computation-based trust impose really inflexible dependencies in the new generation of digital securities. However, linking those limitations to the need to a new tier1 blockchain at a time in the market in which we barely understand the requirements of digital securities seems a bit of a stretch. In the history of software technologies, the most successful infrastructure trends has been those closely aligned with new application requirements. Some times infrastructure precedes applications and other times applications drive infrastructure but the two trends evolve in relative proximity of each other. In the case of security tokens, the current generation of crypto-securities are barely pushing the boundaries of the Ethereum blockchain and I don’t believe we yet understand what capabilities will be needed beyond this point.
Thin-Protocols, Networks and Blockchains
In the current digital securities ecosystem, there are three fundamental approaches when comes to dealing with infrastructure capabilities:
· Thin Protocols: Tier2 protocols that address capabilities such as compliance, identity or financial primitives on top blockchain runtimes.
· Networks: Recent efforts such as Provenance or Symbiont are looking to build tier2 networks specialized on digital securities running on top of blockchain runtimes.
· Blockchains: Tier1 blockchain runtimes that specialized in security tokens.
The relationship between these three different schools of thought from an evolutionary standpoint can be seen in the following diagram.
The overarching question is which capabilities of digital securities can be addressed by each infrastructure layer. A quick analysis is shown below:
As you can see, most of the key infrastructure building blocks of digital securities can be addressed with a tier2 network or side-chain model. So if that’s the case, what are the real requirements for a tier1 security token blockchain. In my opinion, it boils down to two fundamental capabilities:
· Consensus Protocol: New consensus models based on identity that account for lawful transfer or ownership of assets.
· Incentives: Models that reward the different nodes in the network based on their participation in the lifecycle of security tokens.
Do Security Tokens Need a New Consensus ?
This is a question at the core of the debate of whether security tokens need a new blockchain or not. Established blockchain protocols such as proof-of-work(PoW) or proof-of-stake(PoS) rely on expensive machine computations to assert the transfer of ownership of a specific crypto asset. Given than security token transactions operate in an ecosystem where the identity of the participants are known, you can make the case the tier1 consensus are overkill and they fail to deliver the lawful transfer of ownership of assets. However, you can also make the case that a lot of those aspects can be handled with a tier2 blockchain protocol.
Do Security Tokens Need a New Incentive Model?
The current security token ecosystem is missing a robust incentive model and, as a result, is lacking any long-term network effects. Both security token networks and blockchains could incorporate incentive mechanisms that rewards the different participants in the network. While the incentive value proposition seems trivial, we shouldn’t underestimate the challenges of its implementations. Incentive models only work in networks of decent size and, if not, they can also become the main vehicle for security attacks.
Learning From History: The NOSQL Database Movements
The transition between applications and infrastructure has been a constant friction point of technology markets. A recent trends which dynamics looks awfully similar to the security token space was the evolution of the NOSQL and Big Data trends. Since the 1970s databases were ruled by a relational paradigm based on rows and columns. In the 1990s and early 2000s, there were several attempts to introduce new forms of databases optimized for other storage models such as key-value, graphs or documents. None of those attempts were particularly successful because the market needs were small enough that companies adapted those requirements on top of relational databases. It wasn’t until the last decade that relational databases hit a wall with the requirements for storing massive volumes of semi-structure and non-structured data faced by large internet companies. That tipping point were the origins of trends such as NOSQL databases or big data stacks that have become relevant components of modern technology architectures.
What the NOSQL industry teaches us, is that new requirements can be adapted on top of legacy infrastructure until they become so relevant that merit the creation of new infrastructure. Substitute relational databases by Ethereum and NOSQL databases by a security token blockchain and you will get my point 😉
The need for a security token blockchain is likely to be one of the hottest areas of debates in the digital securities market. While the conceptual need seems trivial, the market and technological viability is not very obvious. In a future post, I would like to deep dive into some of the specifics of a security token blockchain model.