Security tokens have evolved exclusively as public blockchain scenarios but that trend seems to be rapidly shifting. In the last few months, I’ve talked to at least a dozen of startups that are embarking on the journey of building crypto-security platforms for permissioned blockchains. These types of solutions seem obviously targeted to enable the infrastructure for banks and institutional investors to leverage security tokens while mitigating the risks of public blockchains. Whereas the value proposition of permissioned blockchains for security tokens might look clear in the short term, there are some very interesting economic and technological arguments that should be considered for the long-term viability of this trend. Today, I would like to present some ideas about permissioned-blockchain models in the security token space.
The arguments for permissioned blockchain models for security tokens seem to be the obvious answer to the requirements of large institutional investors to participate in the ecosystem. In the eyes of large financial institutions, the risks of public blockchains today clearly outweigh the benefits of tokenization creating a roadblock for the adoption of this new financial instrument. At a first glance, permissioned blockchains seem to eliminate the risks of public blockchain runtimes while allowing institutions to leverage the benefits of crypto-securities. However, that value proposition becomes blurrier as you factor in the possible evolution of the security token ecosystem.
A metaphor that I find incredibly useful when thinking about permissioned blockchains for security tokens is what in mathematics is called a local maximum problem. Given a specific problem and a timeline, a local maximum is a process that finds an optimal solution for a set of neighboring solutions in a given moment in time. However, given a large enough timeline, the ultimate goal of a solution if to find a global maximum or the most optimal solution across the entire spectrum of candidate solutions. Very often, achieving a local maximum precludes a solution from optimizing towards a global maximum solution.
The friction between local and global maximum is hard to see at first given that is human nature to frame every large problem as a series of small problems. However, when comes to technology markets, a set of optimal solutions in the short term does not equate to an optimal solution in the long term. An analogy often used to describe the local maximum challenge is like “climbing Mount Everest in a thick fog with amnesia”. You can’t see far ahead to identify the global solution and you have trouble evaluating progress in the short term.
In the context of security tokens, permissioned blockchain models can be seen as a local maximum problem. While the value proposition of permissioned blockchain models clearly addresses the immediate concerns of large institutions when comes to adopting crypto-securities, it might result counter productive in the long term. To be more specific, a global maximum for the security token industry is to create runtimes that work effectively for large institutions as well as retail investors, everything else is a local maximum challenge. This argument is far from trivial and requires a deeper analysis so let’s dig into the details.
The argument of public versus permissioned blockchains can elicit the deepest passions within the security token community. However, looking at this problem through a lens of pragmatism, we can list some solid arguments on both sides.
Some of the clear points in favor of permissioned blockchain runtimes for security tokens include:
· Privacy: The lack of privacy models in public blockchains is a big challenge for the adoption of security tokens. Permissioned blockchains offer native privacy capabilities and can be hosted within the confines of a customer’s network.
· Scalability: Even though security tokens don’t exhibit any relevant trading volume, early adopters still see the scalability limitations of the Ethereum blockchain as a major challenge. Permissioned blockchain offer scalability and network growth patterns that can be adapted to the requirements of specific customers.
Permissioned blockchain models also introduced major challenges for early adopters of security tokens:
· Tradability: By definition, permissioned blockchain models will constraint security tokens to a small pool of large institutional investor limiting the potential tradability of those assets.
· Fragmentation: Imagine a financial ecosystem in which assets are issued on heterogenous and not compatible blockchains. The adoption of permissioned blockchain architecture will increase the fragmentation of the security token ecosystem by a relevant order of magnitude.
· Interoperability with Exchanges: Security token exchanges are in a very early stage, but nobody doubts that they will be an incredibly important building block of the ecosystem in order to achieve liquidity and tradability. Permissioned blockchain models intrinsically assume that liquidity will be constrained to small pools of investors. In order to leverage security token exchange, permissioned blockchain architectures will require custom integration work which adds another layer of complexity to its value proposition.
· Lack of Protocols: Most of the great crypto-financial protocols that we use in public blockchains require large networks in order to be effective. In that sense, there is not a clear for permissioned blockchain models to leverage that existing IP creating a technical debt from a very early stage.
· Limited Programmability: By definition, permissioned blockchain models for security tokens are not focus on enabling programmability in crypto-securities. Given that I believe programmability is the biggest benefit of the entire security token ecosystem, I find this to be a major limitation of the permissioned blockchain approach.
I feel the number one challenge that startups building permissioned blockchain platforms for security tokens ignore is the difficulty to organically growth a network in this kind of constrained ecosystem. Even companies like IBM, with virtually unlimited resources at their disposal, are struggling to build large consortium network for Hyperledger solutions. Building a robust blockchain network requires rare combination of several factors including a decent number of participants, the right incentive mechanisms, scalable consensus models and an active commitment of the participants to contribute to the growth of the ecosystem. In the absence of that, any blockchain network is not more than a glorified ledger.
In the case of security tokens, small networks mean limited network effects which negates many of the benefits of security tokens to begin with. Additionally, the lack of network effects limits the adoption of relevant protocols and make the network vulnerable to all sorts of attacks.
Like any other local maximum problem, the challenge of balancing the benefits and weaknesses of permissioned blockchains for security tokens is not very trivial. We know the limitations of public blockchains and, based on the previous analysis, the risks of pure permissioned blockchain models. Trying to think in a longer term horizon, there are a couple of ideas that I think are worth exploring in this area:
One interesting model to achieve certain level of balance between public and permissioned blockchains in security tokens is to have permissioned security token sidechains with a pegging model to a public blockchain. In this architecture, institutions can still enjoy the scalability and privacy benefits of permissioned blockchains while relying on public blockchains to expand the access to retail investors and enable interoperability with exchanges and other protocols.
The opposite of the side chain topology is to think of a single security token network in which large financial institutions act as validators and compliance enforcers but in which retail investors can also participate. In this model, privacy would be enforced as a first class citizen allowing to restrict access to different sections of the network to a specific set of participants. This idea implicitly requires you to believe that security tokens require a brand new blockchain network which is an active area of debate in the community.
Permissioned blockchains are likely to become a relevant element of the security token ecosystem in the near future. Well-funded startups and large financial institutions are already working in initiatives in this area. While the benefits in the near term are clear, the evolution of the security token space might challenge these models in the near future. Achieving a model that works well in permissioned and public blockchain architecture is one of the existential challenges of the security token ecosystem.