Traditional blockchains like the Bitcoin blockchain allow for the free, unrestricted transfer of a digital asset. If seeking to issue securitized assets on a blockchain, the needs and nature of the blockchain will have to differ in order to meet the regulatory constraints involved in the issuance and transfer of securities. These requirements can be synthesized into roles and actions, both of which must be sufficient to allow us to create a permissioned environment on public or private blockchain.
If we’re dabbling in the blockchain world, there needs to exist a set of rules that determine, without human intervention, whether a transaction is valid or invalid. With Bitcoin, the blockchain determines when a transaction is valid or invalid. On blockchains like Hyperledger or R3 Corda, it can be possible to have the nodes or validators that are supporting the network determine whether a transaction is authorized or unauthorized. More recently, blockchains like Ravencoin, a purpose-built blockchain for securities allow for the validation of a transaction to occur in the blockchain itself without discretionary intervention. These blockchains don’t have “smart contracts” in the way that the term is used day-to-day.
There are also blockchains that are “VM-based”. That means that the blockchain has a Virtual Machine that can take a smart contract or business logic, process it along with the inputs, and record the output of the processing onto the blockchain. Blockchains like Tezos and Ethereum are “virtual machine based” and have the capability to run smart contracts.
The only difference is infrastructure support, if seeking to run a full blockchain, the level of support is much higher. If simply using a purpose-built blockchain or smart contracts to process business logic, then the infrastructure support requirements can be much less.
With this foundation, let’s dig into the roles and actions necessary to place a security on a blockchain.
With a traditional security, there exists different entities that interact with the security in different ways. For example, when a startup issues non-voting common shares to investors, the investors aren’t allowed to amend their shares and give themselves voting rights. That’s an action that only the issuer can undertake. When an investor purchases the equity, there’s only two things they can do with it, buy and sell. The blockchain or smart contract should be capable of enabling these different roles as shown below:
The issuer is the owner on the smart contract with the ability to authorize others to act as an administrator. The reason the administrator role exists is that the issuer may need a third party entity to manage the compliance. This administrator can be a transfer agent or a trading venue depending on the type of security. At the end of the day, the investor solely needs to be able to send and receive the security, we’ll save voting and other rights for another conversation.
Now that we have the various parties defined and their high-level capabilities, we can take a look at the more granular restrictions that can exist on the security.
If there’s one thing a blockchain is really good at, its preventing unauthorized interactions between parties. The Bitcoin blockchain is well-known for solving the “double-spending problem”, allowing for random people on the internet to interact with an automated payment network without compromising the integrity of the ledger. We use similar technology to prevent unauthorized transactions with the security.
Traditionally, securities transfer are paper-based in private markets or software-based in public markets. This leads to significant legal and processing costs due to the lack of consistent interpretation around the state or restrictions of the security. Based on our research, a batch of 600 transfers for an M&A deal is estimated to take $10k in legal work and a week or more. The blockchain can make these transfers, if authorized, instant.
Restrictions that are necessary to help the blockchain mimic securities regulations are shown below:
There are only so many blockchains that are compatible with these roles and restrictions, below we list them to save you some time.
R3 Corda — A popular, open-source, enterprise grade blockchain that enables, high-throughput interactions in a permissioned environment. Their TokenSDK is there purpose-built API for the issuance of securities.
Hyperledger — An open-source enterprise blockchain that enables smart-contracts in a permissioned interface. Although the control and validation can be at the blockchain layer, the SETH interface also enables the same familiar Ethereum interface.
Tezos — A smart contract capable blockchain that enables formal verification of smart contracts (the ability to test every single input and output) for higher security, higher integrity transactions.
Ethereum — A smart contract capable blockchain that enables smart contracts. The longest tested and most widely used blockchain.
Quorum — An Ethereum-based blockchain that allows for high-throughput, private transactions between multiple parties.
Blockstream Liquid Securities — A Bitcoin-based blockchain with an easy to use that enables private transactions. The easy to use interface reduces the risk and complexity involved in developing smart contracts.
Ravencoin — A Bitcoin-based blockchain that enables the issuance of assets. The current roadmap is working towards the roles and actions necessary to support securities.
These blockchains are the ones we found that can enable the compliant-issuance of securities. We leave this here with the disclaimer that just because something can be compliant, doesn’t mean it is. If you’re seeking to learn more, please don’t hesitate to contact us to learn more.
TokenSoft offers institutional-grade compliance solutions for blockchain-based securities. TokenSoft helps clients launch and manage asset-backed tokens and digital securities on the blockchain in a compliant and secure manner, regardless of jurisdiction. The TokenSoft process and suite of solutions cover the entire lifecycle of a digital asset, including investor onboarding, issuance, custody, and ongoing asset servicing.
Edited on Jan 20, 2020, please see the original here.