Oct 20, 2020
This post is part of a series that analyzes how Digital Securities can benefit from DeFi protocols bridging Decentralized and Centralized Finance in a Hybrid approach (#HyFi), and the different aspects that need to be taken into consideration to leverage this ecosystem while remaining within compliance requirements. You can read Securitize’s introduction to HyFi hereSecuritize’s introduction to HyFi here.
Digital Securities, blockchain-based representations of financial instruments, are subject to a number of restrictions regarding who can hold them and what transactions are allowed for them based on the existing regulation. I’ve covered the meaning and workings of such restrictions in other posts, so I will not go to much detail about this here, since what we want to focus on is how that impacts the use of DeFi protocols.
Regulatory controls for Digital Securities are usually enforced by whichever system is responsible for managing the digitalization and keeping the record of ownership for the security (the traditional concept of a ‘ledger’). In the current DeFi ecosystem, that system is comprised of the smart contracts supporting ERC20-compatible tokenization.
But a vanilla ERC-20 smart contract providing tokens that do not enforce additional controls will not be a proper representation of a security. Among other reasons, basic ERC-20 will allow token transfer of ownership without any knowledge of the recipient. That would be a compliance issue for securities since the recipient could be an individual that should not be allowed to hold them (for instance if they are a resident of a sanctioned jurisdiction). Knowing the parties involved in a transaction is a process called KYC (Know Your Customer), which is a regulatory requirement. A solution like Securitize’s DS Protocol issues ERC20 tokens that will prevent this from happening.
Once a potential investor has a wallet that can be identified by the underlying protocol (i.e. being in the Registry Service for a DS Token and not being subject to specific limitations based on the investor profile and the security itself), they will able to participate in controlled trades with other potential token holders.
Thanks to the capabilities of smart contract composability, those compliance controls can interact with other smart contracts in the DeFi ecosystem. For instance, the AirSwap atomic swap smart contracts can be used to arrange an exchange of assets directly between investors, but when they compose with the smart contracts of the DS protocol, it is ensured that if one of the assets is a Digital Security, that exchange will happen in a compliant way.
New smart contracts can use ERC20 functions to provide different mechanisms for value exchange, while Digital Securities embedded compliance support will keep the required regulatory controls on the assets.
Leveraging ERC20 mechanisms, the AirSwap smart contract can ensure that the exchange of a Digital Security for another asset happens only when authorized by both parties and in an atomic way, meaning that either both assets are fully exchanged or none is. This avoids the risk of one party fulfilling their commitment and the other backing up but keeping the received assets. The process is performed strictly peer-to-peer: at no point do the assets need to be held by a third party (like an escrow provider) or a smart contract.
The blockchain registers the full process, and the corresponding registry records that track the ownership status can properly reflect the exchange. (like Securitize’s Digital Transfer Agent function does).
Digital Securities issuers using the Securitize platform can provide to their investors this capability with our Instant Access product, which integrates the AirSwap smart contract technology seamlessly into their investor dashboard.
But atomic swap is not the only option that can be used when integrating Digital Securities with DeFi capabilities. That is the interesting aspect of leveraging an ecosystem: new smart contracts can also use the ERC20 functions to provide different mechanisms for value exchange, while Digital Securities embedded compliance support will keep the required regulatory controls on the assets. This mix of Decentralized Finance capabilities with the compliance controls that must be centralized by the asset manager or their agents, brings a new HyFi (Hybrid Finance) approach to the scene.
And so, instead of doing a direct p2p trade with AirSwap, an investor may buy some Digital Securities from an UniSwap pool or a Balancer private pool. The compliance enforcement of the DS Protocol smart contracts will ensure that only an authorized investor will be able to trade with them, and any operation to buy securities from such a pool from an unidentified or unsuitable investor will not be allowed.
Now the question is: is it possible to deposit Digital Securities in an UniSwap pool to produce such liquidity? I will cover that scenario in a future post, so stay tuned.