The following text provides a description of potential implementations of the ERC-1404 standard. It is by no means designed to provide a prescriptive implementation; as with any issuance, you should seek guidance from counsel on the specifics of your implementation plans.
For those new to ERC-1404, an important point is that it does not explicitly contain features to induce vendor lock-in. This was part of the ethos in creating it: to achieve a higher ethical bar and serve the interest of all parties.
ERC-1404 was designed for issuers, exchanges, individuals, and other regulated entities that have an interest in holding or facilitating the trade of digital securities. ERC-1404 provides for a more decentralized arrangement because it offers the ability to provision additional administrators. This allows the standard to better align with administrative, regulatory and scalability needs as the token becomes more engrained in the blockchain enabled financial fabric of tomorrow.
In the world of digital securities and security tokens, traditional blockchain tokens are treated in a similar fashion as traditional securities. Equity in a startup company carries a fixed amount of shares, multiple classes of shares, and the ability to create more shares. Digital securities that represent equity in a company must carry the same abilities. Using ERC-1404, additional administrative activities can be supported:
These activities are optional and bespoke to a particular entity’s governance requirements. This is not meant to be an exhaustive list of all of the features but provides an overview of some of the features that have been required by various clients of TokenSoft.
These administrative activities may have to be undertaken by the issuer or potentially a third party.
In a traditional company, with traditional shares, it is generally the issuer and its counsel that manage the initial authorization of shares and any subsequent changes to the cap table. Any private placement transfer or share issuance needs to be authorized by the issuer and their counsel prior to being reflected on the companies books and records.
What happens if an issuer needs to scale this process to a global audience? Below we evaluate several models for enabling scale. We take a look at a single issuer set up as the administrator of their own compliance requirements, an issuer which designates another entity to administer their compliance requirements, and a model which incorporates both.
A single issuer may seek to have its token trade using a peer to peer model. That means that users custody their own assets and can trade directly with individuals or through a registered Broker Dealer / ATS. A single issuer seeking to deploy an ERC-1404 token may also administer its token itself. If seeking to add an additional user, there are several points of friction which we can track here:
The time to create, submit and confirm a blockchain transaction may vary based on internal business processes and the underlying blockchain. An entity operating on a permissionless blockchain may wait anywhere from three to 10 confirmations, which takes the equivalent of 10 to 30 minutes. An entity operating on a permissioned blockchain such as R3 Corda would have faster throughput.
The total time it takes for a user to register and qualified to receive a token can be defined as:
An issuer may seek to administer the smart contract itself and on behalf of an exchange that is allowing for the resale of the issuer’s token. This is a more common scenario that is materializing and we can explore the tradeoffs. The administration function is now managed by a single entity and the exchange is not managed by a secondary entity. The second entity requires information from the issuer prior to allowing for any trades.
There are centralized protocols and decentralized protocols that enable this information exchange. The centralized protocols require that the exchange acquire information about the token and the prospective token holder from the issuer or their technology providers servers. Decentralized protocols are structured such that information about the prospective trade and the prospective trade can be done solely with interaction with the underlying blockchain.
Thus the total time required for a round trip would be:
This the total time required for a round trip would be:
The primary difference here is that the time to make an HTTP request can greatly outweigh the time it takes to make a local read operation. When a local read operation is performed, it does not require a network request over the public internet and is more akin to reading information from a locally hosted database.
In order to meet scalability or regulatory demands, an issuer may choose to provision other entities to handle the administrative activities that digital securities may entail. One possible scenario would be with public equities. In public markets, it is common for an issuer to use a transfer agent to manage the books and records. For example, if a regulator wanted to know who was holding shares of a public company at any given time, it would make a request to the transfer agent. The transfer agent also has the ability to manage additional activities such as issuing more shares or managing escheatment or voting.
An issuer may want an exchange to manage or co-manage the whitelist for its security. In order for this to come to fruition, the transfer restrictions would have to be well understood by the exchange, so as not to put the issuer out of compliance.
Although upfront coordination costs exist in this case, the overall time to register for a user is drastically reduced. Now, either the issuer or the exchange can register the user to enable the individual to hold the token. If this is the case, the total time to register a user is now equivalent to that of a single issuer enabling a peer to peer trade:
The ability to have multiple administrators is a great scalability feature supported by ERC-1404 and in fact, it provides limitless scale. A large organization could add any number of administrators — an infinite number really, so when we think of the potential scale, it’s “to the moon.”
We’re excited to continue to bring our experience in building scalable blockchain infrastructure to companies while helping them plug into the existing regulatory environment. If you’d like to learn more, please feel free to reach out to TokenSoft Inc.