Do Security Tokens Need a New Blockchain? Part III: The Building Blocks

This is the third part of an essay that explores the benefits and challenges of blockchain specialized in security tokens. In the first part we presented the arguments justifying a blockchain for crypto-securities as a natural evolution of the space. The second part explored some very tangible challenges that might make a security token blockchain a very unpractical exercise. With strong arguments both in favor and against a security token blockchain, it might be time to dig a little bit deeper and explore some of the actual capabilities that would be present in this type of blockchain.

Almost everyone in the security token market agrees that we need a new/better infrastructure for crypto-securities. The way we are implementing security tokens today barely addresses some basic equity use cases and it is mostly useless in most sophisticated tokenization scenarios. Furthermore, the lack of infrastructure is one of those invisible factors preventing investors to participate in security token offerings. The broader question is whether the new security token infrastructure will materialize as part of a new blockchain runtime, as tier2 protocols in existing blockchains or maybe as a hybrid model that uses a side-chain pegged to a general purpose blockchain like Ethereum.

In order to build a more intelligent opinion about whether the market needs blockchains specialized in security tokens, we might need to explore some of the key components of this type of runtime. If security tokens need a new blockchain, how would it look like?

The Building Blocks of a Security Token Blockchain

Among the thesis in the market about a security token blockchain, some of the most thoughtful arguments have been captured by SpiceVC’s managing partner Ami Ben-David in his Ownera thesis. Conceptually, Ownera presents the core building blocks of a blockchain specialized in security tokens. I certainly have had my good share of disagreements with Ami about some of the ideas in Ownera but I, nonetheless, find some of the concepts in his thesis very compelling. The subject of blockchain specialized in security tokens is incredibly complex with no clear black and white answers. Using passionate, generic arguments instead of intellectual rigor to analyze this subject will only do a disservice to this nascent industry.

To understand a possible architecture of a security token blockchain, we can imagine two main tiers. The tier1 will represent the core blockchain runtime and will include the core components and protocols of a decentralized security token network. The second tier will host protocols that are relevant in most security token scenarios.

Using that high-level architecture as a guideline, let’s start exploring some of the key concepts that are relevant to a security token blockchain.

Tier1: Blockchain Runtime

As illustrated previously, a core runtime for security tokens can be divided into two main classes of constructs: components and protocols. Components abstract the main participants in a security token network while protocols model the interactions between those participants. The following figure represents some of the most basic components and protocols that should be considered in a security token blockchain.

Components

A security token blockchain should include the following components:

· Assets: An Asset represents a legal ownership claim of a physical or virtual entity. Concretely, Assets can be represented by a set of documents that prove existence and ownership of a specific entity.

· Owners: Owners are entities or individuals who have ownership over specific assets.

· Validator Nodes: The existence and ownership of assets should be established by legally reputable financial institutions. These institutions should participate in the blockchain network as validator nodes that are responsible for functions such as asset onboarding, custody or removal.

· Expert Delegate Nodes: A security token blockchain network should be composed by nodes that represents different players in the architecture of financial systems. Expert Delegate nodes abstract functionalities such as legal assessments, broker-dealers, clearing-custody and other key participants in of crypto-security transactions

Protocols

Some of the key protocols that should be considered in a tier1 security token blockchain runtime include:

· Tokenization: The most basic protocol of a security token blockchain will be responsible for creating an on-chain representation of real assets.

· Identity: Participants and assets in a security token blockchain should be uniquely identifiable both legally and technically. A KYC-type protocol to establish identity for all nodes should be a key element of a security token blockchain.

· Ownership-Consensus: A consensus protocols that asserts the validity of a transaction not only on financial correctness but on the immutable transfer of ownership on different assets.

· Privacy: The ability to establish privacy protections on different information sets related to assets and owners should be a key building block of a security token blockchain.

· Oracles: Just like in other blockchains, Oracles will be responsible for accessing off-chain data that is relevant to crypto-securities.

Tier2: Crypto-Securities Protocols

A second tier of a security token blockchain should enable protocols that are relevant to security token transactions.

· Crypto-Security Primitives: Protocols to implement debt, equity or derivative tokens should be present in a security token blockchain.

· Compliance: There are hundreds of compliance rules that are relevant to security token transactions across different asset classes, industries and jurisdictions. A security token blockchain should include a simple way to implement those compliance rules in a way that can used in security token transfers.

· Disclosures: Owners and Validators should have the ability of disclosing material information that can be relevant to the price and validation of a security token. The mechanics of such disclosures should be abstracted in a security token protocol.

There are many other interesting building blocks that could be relevant to a security token blockchain but, hopefully, this article was able to cover some of the most important ones. Whether you believe in the thesis of a security token blockchain or not, there is no doubt that the security token industry will greatly benefit from the implementation of some of these building blocks on different runtimes.