Security Token Efficiency
Updated: Mar 4
A design review of ERC-1404 and other security token standards
One of the main benefits being touted for Security Tokens is liquidity. Allowing the technology to evolve into a global settlement layer for assets will connect anyone, anywhere in the world, and enable them to participate in the global investment economy. With added liquidity, investors will have more options to choose from, and high-quality issuers can command higher prices or raise more funds.
At odds with this goal, however, is the cost incurred when transferring assets on the blockchain. If it costs a large amount of money to transfer ownership of an asset on a blockchain, then liquidity will be dampened. Since one of the main selling points of Security Tokens is global liquidity, issuers and investors should understand the impact of transfer costs when choosing both a Security Token model, and also the underlying blockchain it runs on.
The Cause of a Higher Transfer Price
On most blockchains today, the cost to transact on the network is directly related to supply and demand. The more people who are competing to transact on a fixed supply of bandwidth for transactions, the higher the price one needs to pay in order to get to the front of the pack and have your transaction go through before others.
Each blockchain has a different set of parameters for throughput. Since each blockchain also has different capabilities and has chosen different tradeoffs for security vs throughput, it’s never an apples-to-apples comparison, and costs can vary widely.
Below is a chart showing generic asset transfer prices, as of December 2019, in USD terms. Stellar and Liquid have built-in asset capabilities, while Tezos and Ethereum have smart contract-based assets (FA1.2 and ERC-20, respectively). Demand on the network will cause some chains to a spike in cost while others will stay flat, so don’t assume these relative prices are fixed when projecting into the future.
On blockchains with smart contracts, an additional cost can be accrued when transacting, depending on the amount of processing or storage that the transaction requires. A standard ERC-20 transaction on Ethereum costs less than an ERC-20 transaction that is checking permissions or whitelists, which can be a requirement for regulated securities. Depending on the standard that is being used, the gas costs can be quite large.
Below is a chart showing relative costs of different Security Token standards on Ethereum, including ERC-1404, TokenSoft’s developed open standard for restricted tokens like securities. Some of the standards incur more costs than others due to requiring more processing and storage costs when a transfer is invoked. Exchanges and end-users will look for alternatives if fees grow too high relative to the value being transferred.
If you distributed quarterly to 10k users with the DS Protocol, it would cost approximately $28k per year in Ethereum network fees, using Dec 2019 network stats.
Approaches to Lower Costs
An obvious choice might be to just choose a cheaper blockchain when deploying a new token, but it’s not always so simple. A big roadblock to releasing Security Tokens is that the infrastructure might not be built out quite yet (though at TokenSoft, we are leading the charge). For regulated securities, you can’t just roll out a token without being able to monitor and verify you are complying with regulations.
For the existing blockchains that are starting to see adoption, another approach that should be considered is leaving everything off-chain, except for what is absolutely required to be on-chain. For example, if an off-chain compliance engine can whitelist users to hold a security depending on a number of requirements (country of residence, KYC, accreditation, etc), then there is no reason to store those items on-chain and incur a cost to store and check those values for each attempted transfer. Instead, an off-chain compliance oracle can verify all the requirements and set a yes/no flag on the account, which requires minimal processing to check during a transfer.
A drawback to removing all compliance logic off-chain though is that users may not understand the reason why transactions are failing. For example, if a user has passed KYC but resides in a blacklisted country, a failure to transfer that just returns a “failed” result is not helpful. Our approach at TokenSoft is to maintain as much compliance logic off-chain while leaving enough on-chain to understand why a transfer is not allowed. Our open-sourced ERC-1404 standard exemplifies this and has the added benefit that a user’s wallet can check whether a transfer will succeed before it is attempted, and also show the user a human-readable error message explaining what went wrong.
In the future, we will likely see the marketplace coalesce around a unified standard for Security Token compliance enforcement, with smart contracts that balance efficiency and capability. ERC-1404 is already being used by a number of issuers planning SEC-registered offerings (Read ERC-1404’s one year review for more information). Likewise, new blockchains may evolve to address the Security Token market directly, or new layers may be built onto the existing chains to support throughput. Whichever standard or blockchain wins will need to target the ultimate goal of liquidity for investors and issuers to unlock the value that is promised with this emerging technology.
Interested in learning more about TokenSoft, ERC-1404, or issuing Security Tokens? Contact us at tokensoft.io.
TokenSoft is a leading platform for issuers and investors in security tokens and other financial assets on blockchains. From financial institutions to IPOs, our technology supports the full lifecycle of a security including investor onboarding, distribution, custody, and ongoing asset servicing.