Trading Digital Securities: non-custodial and custodial marketplaces

Different methods to bring liquidity to security tokens

Mar 18, 2020

One of the main advantages that tokenization brings to securities is the potential for liquidity.

Current Digital Securities using Securitize’s DS Protocol represent private securities, with transfer restrictions that only allow their trading in certain circumstances. The DS Protocol smart contracts are responsible for ensuring that compliant trades are allowed and non-compliant ones are not permitted (this is managed by the Compliance Service). This, in the context of international regulations and depending on the specific security, may require limiting the total number of holders from a certain country, or limiting trades happening from outside the US to US residents.

This is also true when tokens are being transferred through some specific marketplace, but not all of them work in the same way; let’s take a look at how trading DS Tokens works behind the scenes.

Non-custodial trading

The non-custodial approach for Digital Securities seems to be favored by the latest SEC statement, and in practice means that tokens representing securities are always in a wallet controlled by the investor. Tokens only move wallet-to-wallet (seller-to-buyer) when a trade closes.

In some marketplaces, it is required for investors to pre-fund their accounts (wiring dollars or maybe sending Ether) in order to be able to buy securities. In these cases, to an extent, the marketplace is acting as an escrow for the funds sent by the investor, and they ensure the delivery-vs-payment by holding these funds. They may provide a full order-book service, with sell and buy orders posted anonymously by investors.

Non-custodial trading requires sellers to authorize the marketplace to be able to take the securities from their wallet at the moment a trade is performed. To do it, the seller must sign a transaction — usually, a standard ERC20 approve() call — when they post a sell order, and that authorizes the marketplace to take the tokens in the future. Signing transactions is not something evident to most investors, which is why in order to do this some sort of Web3 wallet, like MetaMask, is required. With these types of wallets, it is possible to trigger transaction signing directly from your browser.

Approval Transaction via MetaMask

The integration with Securitize / the DS Protocol for these marketplaces is related to the ability to onboard new investors so that they can hold securities and provide trade information. This is done based on two elements:

The RFE API, a mechanism which is used to provide the personal information of new investors back to the token issuer, so that they can have a full view of the Cap Table in real-time. Only authorized partners get access to this.
The DS Protocol Registry Service, that allows them to whitelist investors and wallets on-chain. Only authorized partners get access to this.

On top of that, the marketplace can use the preTransferCheck() method on DS Tokens to validate transactions before clearing them on-chain, to ensure that they will be correctly processed and approved before attempting them.

OTC marketplaces

The OTC marketplace model is slightly different from pure non-custodial trading. On one hand, OTC marketplaces may provide custodial services for the securities they facilitate the trading of, and usually don’t provide an order-book. Their model allows them to gather the interest from buyers and sellers and facilitate an agreement between both parties, and the execution of the trade itself. If they provide custody of securities, they are also able to set up a wallet for the seller and another for the buyer, so that during the trade:

The seller sends the securities to the wallet provided by the marketplace; during the trade execution, the marketplace will keep control of securities, acting as an escrow.
The buyer sends the funds required by the trade to the OTC provider.
The OTC then sends the funds to the seller and moves the tokens from the seller wallet to the buyer wallet (which they can do if they control both); they are acting in this model as an escrow agent, and guaranteeing the DvP.
The buyer can withdraw the tokens from the marketplace to a directly controlled wallet if they don’t want to keep them there.

The advantage of this approach is that the investor experience is simpler, and the provider can provide more value as a custodian.

Custodial trading

The custodial model is based on the marketplace keeping control of the wallets that hold the investors’ securities. This means that the partner will need to set up wallets for both the seller and the buyer. For the integration of DS Tokens the model will conduct wallet-to-wallet clearing of trades, so:

During the onboarding, prospective sellers will deposit the securities into the wallet provided by the marketplace. Since this is even before a trade is defined, this is actual custody and not simply escrow.
The marketplace model for funds may require an account to be funded in order to trade (have a “cash balance”).
There is an order-book in which buy and sell orders may be posted. If the marketplace holds a cash balance and custody of securities, there is no counter-party risk.
When a trade is matched, tokens will move from seller to buyer wallet (both controlled by the marketplace) while the corresponding cash balance moves in the other direction.
The buyer can withdraw the tokens from the custodial marketplace to a directly controlled wallet if they want to, while the seller may withdraw the funds from their cash balance.

The integration with Securitize / the DS Protocol is again based on the ability to onboard new investors and associate the custody wallets to existing investors.

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