In a recent Medium article, TokenSoft CEO Mason Borda detailed the importance of compliance for the life-cycle of security tokens. One method of maintain such compliance, he says, is through the process of ‘whitelisting’: a method where token holders can control who holds their tokens.
Why the Emergence of Security Tokens is Inevitable
Security tokens are commonly predicted to be the next evolution of blockchain technology, bringing revolutionary advantages to both companies and investors.
They’re good for businesses since private companies can maintain ‘private’ status while raising capital through entirely new methods.
For investors, security tokens offer benefits— as detailed in our security token guide— that have never been seen in traditional securities. With fractionalized ownership of expensive assets, such as luxury property, more investors can access costly investments which have previously been restricted to a select few. Additionally, a significant increase in liquidity results from security token exchanges operating 24/7 and accessible across the globe. In the conventional securities realm, Wall Street restricts trading from Monday – Friday, 9:30 a.m. – 4:00 p.m., resulting in unnecessary illiquidity.
Importantly, the regulatory ambiguity which clouds the cryptocurrency space does not apply to compliant security tokens. The reasoning is straightforward: security tokens involve the tokenization of financial securities. Such securities existed, were traded, and were regulated long before blockchain technology came into existence. Hence, security tokens merely have to enforce the pre-existing regulations through tokenization.
Mason Borda, CEO of TokenSoft— a security token platform which ensures compliance throughout the life-cycle of security tokens— recently detailed one way in which such regulations can be tokenized.
An Explanation of Whitelisting with the ERC-1404
One aspect of compliant security tokens involves ensuring that only eligible token holders are indeed holding the tokens. An easy way to do this is through the creation of a list of approved addresses, called a ‘whitelist’, which represents authorized token holders.
Here’s how the process works, with the example of Tokensoft’s own ERC-1404 security token standard.
First, let’s look at an example with two participants in a token transfer: an owner of the smart contract, i.e. the issuer, and a token holder. An owner is the entity which creates a smart contract— representing rights to a security— on a platform such as Ethereum. A token holder is the entity which holds the token’s keys in a wallet and has the ability to maintain or trade the token.
To be clear, a smart contract is a pre-programmed digital agreement which performs certain actions when specific conditions are met. No third party is required. To illustrate the importance of this, Mason provided the following example:
“Let’s say J.K. Rowling authored a new book called ‘Vitalik Buterin and the Sorcerer’s Fork’. For her upcoming book, she is using a publisher called Frontier Book Publishers, which only allows customers to pay for the book with Ethereum. They could then deploy a smart contract — linked to their Ethereum address — which, whenever a payment is sent to Frontier, automatically and instantly sends 50% of the payment to Rowling as a royalty. Contrast this with the current fiat system, whereby a payment is first sent to Frontier’s bank account, and then Frontier must separately write a check or issue a payment to Rowling. This streamlining of an unnecessarily convoluted process is just one of the nearly limitless efficiencies that smart contracts can help create.”
Whitelisting allows for the issuer to ensure— through smart contract management— that only approved addresses can receive the tokenized asset. In this case, for regulated Security Token Offerings (STOs), issuers can create smart contracts which only allow for accredited or verified investors to possess their token. They could also be sure that token holders have passed necessary KYC and AML screening. The precise details of token holder requirements would be specific to each STOs sale-type.
The process of whitelisting is not just for an initial offering, but for secondary market trading as well, accounting for the entire life-cycle of a token. In clearly demonstrating this process, Mason continued with the previous example:
“To illustrate [whitelisting], let’s say J.K. Rowling wants to create her own coin, called HP-Coin. Rowling only wants her five friends to be eligible to hold the HP-Coin, so Rowling deploys an ERC-1404 smart contract with an empty whitelist of addresses. Over the course of the week, she schedules to meet with her five friends for coffee. In these meetings, she tells her friends about HP-Coin and asks that each sets up an Ethereum address to which she can send the coins. Once each friend has set up an address and given it to Rowling, Rowling can add each address to the whitelist. Once the addresses have been added to the whitelist, they are able to receive and send HP-Coin. However, once Rowling sends her friends HP-Coins, they can only send them to each other — as no other addresses have been whitelisted (i.e., given permission to hold HP-Coin).”
It’s important to mention that whitelisting only applies to permissioned blockchains, which enable issuers to restrict the transfer of their token. While Ethereum in and of itself is a public permissionless blockchain, some of its development layers, to include the application layer, allow for permissioning.
Ultimately, whitelisting provides security token issuers with a tool to make sure only approved entities can hold one’s token, thereby maintaining transparent regulatory compliance.
As the security token industry continues to take off, such tools will be absolutely crucial in ensuring a compliant and successful future.
What do you think of the concept of whitelisting? Will it play a vital role in the development of compliant security tokens? Let us know what you think in the comments below.
Image courtesy of Fintech Silicon Valley.