Published Apr 20, 2020
By Ben Whitby, Regulatory Affairs at Qredo
Tokenization is already bringing blockchain to institutions, with financial giants like Nasdaq developing decentralized infrastructure for trading stocks and shares.But in the opposite way, security tokens could also eventually act as a bridge bringing institutions to the heart of blockchain: Cryptocurrency.
Though most security token startups are currently working with permissioned blockchains, the drawbacks of these networks—and the never-ending need for more liquidity and higher security—are likely to lead financial institutions to eventually seek out permissionless blockchains like Bitcoin and Ethereum.
Security Tokens on permissioned chains
The tokenization of equities is appealing for several reasons:
Secure ownership is preserved immutably on the blockchain ledger
Automated compliance can be achieved with smart contracts
Illiquid markets are opened up by letting investors divvy up stakes in hard-to-trade assets like collectible art, or individually buy up a few square meters each of a Tokyo apartment.
Lower fees for trading and the issuance of new securities
Most startups trying to realize these benefits are using purpose-built permissioned blockchains like R3's Corda and Quorum, the enterprise version of Ethereum.
This is because they are primarily concerned about lack of privacy and scalability holding back development, according to a study by Greenwich Associates.
"62% [of leading players] believe a permissioned network is most appropriate for security tokens” — Greenwich Associates, 2019
Scalability poses a major challenge for permissionless chains like Bitcoin and Ethereum. A Greenwich Associates study found that Security token developers were concerned that Ethereum's "well-known scaling challenges meant trading could be hampered during periods of high transaction volumes, such as the peak of the CryptoKitties craze."
Privacy — or the lack of it — is the other main problem. Financial regulators often demand privacy to prevent the spread of sensitive information, and protect the secrecy demanded by traders. This is difficult to achieve on transparent ledgers like Ethereum or Bitcoin where addresses can be mapped to known parties.
At present, these two major concerns about permissionless blockchains, along with minor problems like contentious forks, make permissioned blockchains a more popular choice for hosting security tokens.
But with developments in scalability and privacy under way, these issues could be just temporary roadblocks. And over time, shifting priorities are likely to make the many advantages of permissionless blockchains more appealing for security token networks.
Security Tokens on permissionless chains
Security and interoperability are two qualities of permissionless chains that are likely to rise to the top of the agenda as time goes on.
Security has been growing rapidly in significance as the world has become more technologically-advanced over the last few decades. Most recently, the transition to cloud and the proliferation of mobile devices has triggered a boom in cybercrime which threatens all industries using the internet—from healthcare, to logistics and finance.
Market analysts suggest this cybercrime is already starting to escalate to cyberwarfare, with nation states turning to technology to steal intellectual property and disrupt economic growth.
On a superficial level, permissioned blockchains provide more security than permissionless blockchains like Bitcoin because they have access control. But, this also makes them more centralized and vulnerable to attack.
Permissionless blockchains on the other hand are spread between so many nodes that traditional network attacks are not feasible. As Metcalfe’s law states, a network’s benefit increases exponentially for every new user in that network. In the context of cryptocurrency, this means not just enhanced security, but also deeper liquidity.
"The value of a network grows by the square of the size of the network" — Metcalfe's law
Interoperability is not yet an issue with small undeveloped security token networks, but is likely to become a bottleneck as soon as these networks get established.
If each set of security tokens have their own permissioned blockchain, we will end up with a collection of assets distributed between fragmented, incompatible chains — each suffering from limited liquidity. By issuing tokens on permissionless chains instead, securities can benefit from shared liquidity and global interoperability.
At the same time, the transparency offered by permissionless public blockchains could become an attractive feature — allowing investors to see the actions of publicly-held companies in real-time, instead of having to rely on discretionary disclosure.
As the security token ecosystem develops, we are likely to see Layer 2 networks like Qredo being used to connect growing chains, and provide a fast, cheap and secure way of sharing liquidity.
Ultimately, we may then see security tokens migrate towards open and decentralized blockchains like Bitcoin and Ethereum — in much the same way that the internet evolved from a private research network shared between computers connected in university labs, to a public standard.
With these permissionless chains forming the backbone of the new financial ecosystem, Layer 2 networks like Qredo can then address their shortcomings — helping security tokens to benefit from the security of underlying permissionless chains, while still taking advantage of the additional privacy and faster transaction speeds that come with permissioned chains.