While the Ethereum blockchain has its strengths, it also has drawbacks. Polymath’sPolymesh aims to address those flaws, chief product officer Thomas Borrel said.
Polymath enables companies to sell their own security tokens which provide people the opportunity to invest in anything from real estate to royalties. Founder Trevor Koverko has long been an advocate of the merits of security tokens and since Mr. Borrel joined the company in 2018 they have been working on the technology, beginning with holding discussions with various ecosystem participants to determine their interest.
That level was high, and Polymath built their first version on Ethereum and market tested it.
“That worked out well,” Mr. Borrel recalled. “We saw 60, 70 security tokens created in the first six months.”
The discussions continued with custodians, exchanges and others with a role in an asset’s life cycle. A common theme in those meetings was the lack standardization was challenging for companies, as each one had their own technology and due diligence. The entire process was inefficient.
To address those drawbacks Polymath hosted 25 stakeholders for a three-day workshop, where experts such as lawyers, former regulators, exchange members and KYC and tax experts came together to work on a solution.
The result was the ERC 1400, whose goal is delivering a unified framework for all security tokens. Building off the ST20 protocol, it provides standards for core compliance components, document handling and notification, security token controls and permissions including delegation and forced token transfers, and partial fungibility.
Among those using the ERC 1400 were BNP Paribas, who issued a security token transfer proof of concept with cloud-based crypto wallet provider Curv; and Society General, who teamed with the Banque de France to issue a settlement token
“We saw this standard being embraced and adopted by large institutions,” Mr. Borrel said. “What it meant to us in that 2019, late 2018 phase is banks and big institutions started coming to us and saying ‘Tell us about security tokens, tell us about ERC 1400. What are the benefits? What can we do with this?’”
The Four Frictions
More discussions ensued and they identified four frictions with the ledger, beginning with governance. If a hard fork ensues and two tokens are produced, that could produce issues when the tokens represent a fraction of ownership in an asset such as a building. Which token represents ownership? Do both? Is one a dud? What prevents the holder from selling the worthless one to an unsuspecting investor?
Probablistic finality, where the chance of blocks reordering as new blocks pile on top of them diminishes, doesn’t provide enough assurance for the finance industry, Mr. Borrel explained. They want deterministic finality, so when the transaction is finalized it cannot be undone save for an opposite transaction.
The second issue was identity, Mr. Borrel explained. Who is part of the transaction? Who is writing to the chain? What if a transaction fee goes to a miner in a sanctioned country? Allow that and you’ve broken a rule and run afoul of regulators.
How do you prevent that with public permissionless infrastructure?
“How we see this being solved is a lot of private chains being put out,” Mr. Borrel said. “From our perspective identity needed to be built right into the chain.”
Next to be addressed was confidentiality. While blockchains such as Ethereum and Bitcoin can show participant’s holdings and trades, big institutions don’t want someone figuring out their strategies and front running a billion-dollar trade. They want their intellectual property protected.
Compliance was the final point. Mr. Borrel said their experience working with Ethereum for more than two years revealed some significant challenges with its ability to effectively process a large number of complex transfer restrictions which issuers would expect to be automated.
“Our analysis has shown that a significant contributing factor to this issue is the fact that, on Ethereum, both the asset and its transfer restrictions are programmed as smart contracts,” Mr. Borrel explained.
One such issue was transactions would fail because the rules and restrictions required in order for a transaction to be compliant would overwhelm the Ethereum blockchain and exceed its gas limit.
“Our team actually ran into this issue in 2019 and had to do some research to address this,” Mr. Borrel said. “While they did manage to move past this limit of the Ethereum blockchain, the key learning was that if we could exceed that limit with a transaction with a single jurisdictional transaction, cross-border transactions, where rules and restrictions are even more complex, were likely going to be hindered by the ability of the chain to process the rules. In other words, the ability to automate compliance and other critical operations would be limited by the Ethereum blockchain itself.”
The solution was to build compliance into the ledger and to include all tokens in the base layer and not in a series of smart contracts on top of the chain.
“With PolyMesh, all assets are created at the base blockchain layer, and key transfer restrictions are enforced by the chain itself (with no smart extensions). Settlement does not rely on smart contracts either,” Mr. Borrel said. “That said, and to maximize flexibility, third parties are also given the ability to develop their own custom smart extensions (aka smart contracts) for specific transfer restrictions or other critical actions that should be automated. This distribution of ‘work’ between the base layer and smart contracts ensures PolyMesh can handle large and complex transfer restrictions and other automated operations.”
The entire process was validation of the need for a chain to be specifically built for security tokens, one without the problem of variable gas leading to massive transaction fees, Mr. Borrel said.
“The whole idea of the ERC 1400 is to automate and simplify transaction control,” Mr. Borrel said.
Issuers need to address KYC procedures, lockups, Regulation D specifics and other factors such as volume restrictions. Perhaps founders want to ensure one doesn’t leave in the middle of a raise and kill the value for the remaining one, for example.
“The lesson learned from this was if we get into that type of issue with singular jurisdictional trades, as we get into multi-jurisdictional trades, the chain is not going to be able to address and automate all the trading restrictions that we want it to automate,” Mr. Borrel said. “And when your mission is to automate and simplify capital markets that’s not really acceptable.”
This issue only arose when Polymath started talking to bigger firms, ones with greater compliance responsibilities, Mr. Borrel added.
PolyMesh was purposefully built to address governance issues while ironing out such problems as drastically fluctuating gas fees that deter bigger institutions concerned about the costs of asset management across the life cycle.
“When your transactions cost 20 times just because someone thinks of a new idea then it’s very hard to manage,” Mr. Borrel said.
Mr. Borrel welcomes Ethereum 2.0’s move from proof of work to proof of stake and its upcoming support for smart contracts. He’s also excited about the growth of DeFi, where, once Polymath has a native digital product, they will be able to drive benefits at a rapid pace. They align well together, as the value in security tokens is in the creation of products which were not possible or economically feasible before.
“The idea is to augment, not replace, capital markets,” Mr. Borrel said.
By issuing its Green Bond on a blockchain, HSBC reduced its costs from $6.5 million to $750,000, Mr. Borrel said. He also mentioned a company wanting to tokenize a solar wind farm where excess power could be sold to the grid with revenue delivered to shareholders. Under old systems such a concept wasn’t feasible with the high fees for a single wire transfer. Instead of $25 for a single wire transfer, the entire distribution could be completed with the ERC 1400 for 16 cents. Now imagine integrating such IoT information as weather patterns and power use patterns into a trading formula and it gets very exciting.
Exciting for us perhaps, but maybe not for the big institutions. But if you could aggregate 20 similar projects into one investment, they’ll take your call.
The system opens up all sorts of possibilities which are only limited by one’s creativity in seeking out and applying unique data sets, Mr. Borrel suggested.
“Hedge funds are already able to access satellite images of the parking lots of a major retailer to create a historical analysis of the relationship between vehicle volume and revenue. The combination of green bonds and IoT driven datasets allows for similar principles to be applied to a much larger pool of assets”
Best Tokenization Use Cases
What are some of the best uses for tokenization? Two are real estate and fixed income, Mr. Borrel said. Real estate is usually illiquid but now you can get all sorts of information on different developments. With automated structuring and capital distribution processes built in one can anticipate and address many deterrents in advance. There’s one immutable record which prevents something so basic as data entry mistakes.
“We have no intentions of being a broker dealer, of being an exchange, of being a custodian,” Mr. Borrel said. “We want to enable those organizations that do.”