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DeFi and Security Tokens — balancing compliance with new financial innovations

At Securitize, we have been tracking the growth of Decentralized Finance (DeFi) protocols and projects over the last few months with the intent of learning how we might improve upon these compelling innovations through the use of Digital Securities (security tokens).

The DeFi space presents an exciting opportunity to create dynamic new markets by utilizing different decentralized applications (DApps) running as financial smart contracts. These DApps run predominantly on the Ethereum blockchain today, where they can interact with each other and digital assets represented in tokenized form.

DeFi Pulse uses a great analogy that compares DeFi to Lego pieces where elements of existing financial software can be mixed and matched together on the blockchain to produce new and innovative financial products and solutions.

Composability of programmable assets is a key driver of DeFi protocols

DeFi is designed for digital assets, but what happens when these assets represent an underlying security that exists off-chain? How does DeFi and Digital Securities work together?

We believe that the relationship between securities represented digitally by tokens on a blockchain and DeFI is very important because the advantage of “programmable assets” can only be fully realized through composability, which is the ability to leverage capabilities available in the ecosystem that have not been built with a specific asset in mind.

Composability means that the thousands of developers and service providers working to make assets more valuable (through liquidity, usage as collateral, or as a part of an automatic portfolio rebalancing strategy) can do so without having to take any specific asset into consideration. This is the birth of a real ecosystem where new innovations for capital markets can thrive.

DeFi enables functionality that already exists in traditional capital markets in various forms, but that typically is performed by intermediaries requiring complex value chains and cumbersome manual processes. Capabilities like programmatic AMM (automatic market-making) can drive liquidity and generate arbitrage opportunities for Digital Securities, in which their value will factor market demand in the short term, but also long term value based on some traditional performance indicators (revenue flows, dividend distributions, repayments from asset redemptions). So there should be a way to benefit from those in the context of Digital Securities.

The advantage of composability comes from Digital Securities behaving in a consistent way in relation to digital assets, which in the DeFi world currently means being represented as ERC20 tokens on the Ethereum blockchain.

There are specifics to consider when dealing with Digital Securities, which are not simple “tokens.” One of the main issues is that securities are regulated and have several control mechanisms that must be enforced. If we want to consider the implication of using Digital Securities in this context, then the solution will not be pure “DeFi”, but more likely a “HyFi”: Hybrid Finance, which combines some decentralization aspects when dealing with smart contracts and protocols, with some centralized aspects derived from regulatory obligations from the asset manager and their agents.

A few months ago, we announced Instant Access as a way to trade tokens representing securities P2P between two investors, which was a massive leap forward, making securities easier to trade through a fully digital experience, where an owner of the shares makes an offer privately to another investor. They can then “swap” the security for a stablecoin (like USDC) instantly with no counter-party risk.

And while Instant Access is one of the building blocks for the introduction of Digital Securities into the DeFi world there remain a number of other challenges that need to be solved to be able to use the existing protocols, namely:

1. KYC’d identities, AML, and transfer controls. Digital Securities require holders’ identities to be known beyond a simple wallet address, AML checks being performed, and transactions may be restricted due to certain regulatory requirements. This must hold true when interacting with DeFi protocols as well. This is easily accomplished via the integration of tools like Securitize ID and our Digital Securities (DS) protocol.

2.- Authorizing the deposit of Digital Securities in a DeFi Smart Contract. Most DeFi protocols require being able to deposit tokens into a smart contract rather than a wallet, which produces a contract with pooled assets. This raises the issue of custody and control for the securities depending on who controls that smart contract. Regulators will also be highly concerned with the safety of the assets.

3. Pooled assets. If holders are depositing their securities into a pool, then the transfer agent for the securities must be able to discern the appropriate record holders of the securities while they sit in the pool. Such records are maintained by the transfer agent off-chain in what is usually referred to as Master Securityholder File or “cap table”.

4. A final topic of focus is the concept of receipt tokens, which are the tokens issued by DeFi protocols to represent the deposits made into their smart contracts. There are a plethora of new questions that must be resolved like: Are receipt tokens securities? If so, how do we control how they move around wallets, potentially changing investor’s hands? Even if the underlying securities represented by tokens are not, are receipt tokens bearer instruments?

We will attempt to address those questions in subsequent posts and how those fit with existing DeFi protocols, but today we want to announce a new and exciting integration with DeFi protocol Tinlake from Centrifuge (you can read their announcement here), one of the few DeFi protocols that enable real-world assets to participate in a DeFI protocol. Tinlake will be using the Securitize platform for investor onboarding and management, including KYC, accreditation, signing subscription agreements, etc.

Tinlake’s set of smart contracts pool NFTs that represent non-fungible real-world assets and use them as collateral to finance an asset in a stable cryptocurrency such as DAI or USDC. Asset Originators are able to create individual Tinlake pools per asset type, such as one dedicated pool for invoices and one pool for mortgages. For funders, risk and proceeds are shared for each pool but not across pools.

Currently, the receipt tokens for investors on Tinlake pools cannot be used by other investors (tracked by their wallet) to receive contributions from the pool, and the current pools enabled by Tinlake and its asset originators are short term loans that return the money to the investor within a short period of time. Therefore, there is little relevance in enabling liquidity for these tokens.

Centrifuge is looking at enabling rolling pools that reinvest the dividends, thereby enabling meaningful liquidity, but this will require more integration work with the DS Protocol to control the transfer restrictions and this will be an interesting extension of the current work.

DeFi is a fascinating space with rapid growth and many interesting innovations. We believe that with the right checks and balances and the involvement of regulated entities when necessary, these innovations can also be applied to Digital Securities in a “HyFI” format and benefit the capital markets space.

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