Do Security Tokens Need a New Blockchain? Part IV: How About a Sidechain?

This is the fourth and final part of an essay exploring the thesis of a new blockchain specialized on security tokens. In the first part we presented the arguments justifying a blockchain for crypto-securities as a natural evolution of the space. The second part explored some very tangible challenges that might make a security token blockchain a very unpractical exercise. The third part deep dived into the specific architectural components and protocols that might be needed in a security token blockchain. Today, I would like to explore a middle ground argument and present the idea of an Ethereum sidechain specialized in security tokens. You should think about some of the concepts explain in this article not as a brand-new thesis but more as a pragmatic implementation mechanism for some of the elements of a crypto-securities blockchain.

As explored throughout the different parts of this essay, the idea of a blockchain specialized in security tokens has a very strong value proposition as well as some very tangible drawbacks. On one side, a new blockchain will address some of limitations of Ethereum when comes to security tokens and will incorporate aspects such as disclosures, ownership claims, asset representations as first class constructs that can be used in the implementation of crypto-securities. On the other hand, a new blockchain won’t be able to take advantage of the rich protocol ecosystem existing in Ethereum and it will have to build entire communities of developers, expert nodes, exchanges and many other key components of the security token market.

The increasingly number of arguments both in favor and against a security token blockchain present a very interesting dichotomy. The absence of a new runtime for crypto-securities means that we will have to keep hacking our way through Ethereum and, in the best-case scenario, build a number of tier2 protocols that simplify and creation and management of security tokens. However, embarking on implementing an entirely new blockchain for security tokens might mean years of infrastructure development without any practical applications being delivered which can result very risky to this nascent ecosystem. Somewhere in the middle (or at least I like to think so 😉 ) is the idea of using a new decentralized runtime integrated to the Ethereum mainnet that can offload computations related to security tokens while still leveraging Ethereum-based protocols. Enter the security token sidechain.

A Sidechain for Security Tokens?

The “sidechains” concept was first introduced in the paper “Enabling Blockchain Innovations with Pegged Sidechains”, circa 2014 by Adam Back et al. The paper describes “two-way pegged sidechains”, a mechanism where by proving that you had “locked” some coins that were previously in your possession, you were allowed to move some other coins within a sidechain. A sidechain can take advantage of the crypto protocols in the main chain but extend their capabilities by offloading specific sets of computation to isolated environments which can then be reflected in the main chain.

In the context of security tokens, a sidechain can be used to enable horizontal capabilities of the crypto-securities lifecycle which are difficult to implement in the Ethereum runtime. However, a security token sidechain will still be leverage Ethereum-based crypto-security protocols such as Securitize’s DS Protocol or Fluidity’s Two-Token Waterfall running on the Ethereum mainnet. What specific capabilities of security tokens will be implemented at the sidechain level and which ones will remain in the main chain? Well, at a high level, computationally expensive aspects such as disclosures, compliance, integration with external data sources, voting/governance or privacy can be good candidates for the sidechain while crypto-financial protocols for equity, debt, derivatives etc seem to be better suited for the Ethereum blockchain.

Benefits of a Security Token Sidechain

Architecturally, sidechains are never an ideal solution are more like a necessary evil to live with the limitations of blockchain mainnets. When comes to security tokens, a sidechain runtime feels like the type of solution that can help advance the infrastructure of security tokens without neglecting all the progress made so far. Among the benefits of a sidechain specialized on security tokens we can list the following:

· Scalability: By offloading computations to a sidechain, security tokens will be able to achieve new levels of scalability.

· Privacy: Privacy protocols can be easily integrated at the sidechain level.

· Ethereum Interoperability: Tokens in a crypto-securities sidechain will be pegged to the Ethereum mainnet.

· Disclosures: A sidechain for security tokens might remove the computation burden for storing disclosure documents related to security tokens while still asserting the right levels of privacy.

· Compliance: Building compliance logic as Ethereum smart contracts could be a bit of a stretch. A sidechain specialized in security tokens could simplify this process by using richer and simpler programming models.

· Crypto-Financial Protocols: The interoperability with Ethereum will allow a sidechain for security tokens to leverage sophisticated protocols such as Dharma or dYdX in security token transfers.

· Exchange Interoperability: A sidechain specialized in crypto-securities won’t impose any additional effort to integrate with security token exchange.

· Simplicity: Implementing a sidechain for security tokens is orders of magnitude simpler than the effort of building a new blockchain runtime.

Some Technologies that can Enable a Security Token Sidechain

One of the benefits of the thesis of a sidechain specialized in security tokens is that it can leverage several platforms that have been emerging in the sidechain space. The continuous struggles of Ethereum have triggered a wave of innovation in the sidechain space creating many of the key building blocks that might be relevant for a security token sidechain. Below, I listed some of my favorites:

· Parity Substrate: The recently released Substrate provides a relatively simple mechanism for implementing new blockchains pegged to any Parity blockchain. Substrate leverages technologies such as WebAssembly, Libp2p and AfG Consensus to provide both the infrastructure and the programming model for implementing new sidechains.

· Blockstream Elements: One of the most established projects in the sidechain space, Elements has been mostly optimized for the Bitcoin blockchain but many of its mechanisms work well on Ethereum.

· Skale: A new entrant in the space, Skale Labs is building one of the first implementations of the Ethereum Virtual Machine (EVM) on a Plasma chain. Skale’s goals is to bring fully permissionless, scalable, layer2 infrastructure integrated with the Ethereum mainnet.

· POA: POA Network is an Ethereum sidechain that uses Proof-Of-Authority as its main consensus mechanism. Many of the ideas in POA related to the identity of the nodes are relevant to security tokens.

· Loom: Loom Network is an Ethereum sidechain also based on Plasma. The platform has been live for a few months supporting some large scale projects like multi-player games.

The idea of an Ethereum sidechain for security tokens is certainly controversial but intriguing nonetheless. By combining the protocol richness of Ethereum with more advanced computation capabilities, a sidechain might provide the right level of compromise to enable the first runtime specialized in security tokens.