Blockchains, Networks, Protocols or Fantasies in Security Tokens Part II: Consensus, Identity and…

This is the second part of an essay that explores the thesis of a tier-1 blockchain specialized in security tokens. In the first part, we debated the viability of a crypto-securities blockchain compared to a tier-2 security token network or just frameworks based on security token protocols.

Today, I would like to deep dive into some of the existential dilemmas at the core of the security token blockchain thesis and present a series of tough questions that need to be addressed by any technical platform in the space.

At this point, it’s pretty obvious that the security token market will see the emergence of new networks outside the Ethereum main-net. Projects like Ownera, Provenance, Symbiont and the recently announced Polymesh are already dabbling into this area.

The question remains whether any of these models will evolve as a tier1 blockchains or will remain as second tier frameworks on top of an existing blockchain runtime. From my perspective, that distinction is fundamentally based on whether the security token will require a new tier 1 consensus protocol for committing transactions.

The Consensus Dilemma

Exploring the viability of a tier1 consensus for security tokens is at the center of the blockchain thesis. I personally find many of the arguments used both in favor and against the idea of a security token consensus protocol lacking a bit of technical and financial rigor.

To frame this argument properly, let’s try to decompose a security token consensus mechanism into a series of atomic primitives. In an exchange of securities between two parties, a consensus mechanisms needs to assert four fundamental steps in order to ensure the validity of a transaction:

· Identity: Are you who you say you are?

· Asset-Ownerships: Do you own what you claim you own?

· Compliance: Is the transaction valid in the current regulatory context?

· Valid Ownership Transfer: Can a unit of account be atomically and safely transferred between the two parties?

In a typical security token architecture, the underlying blockchain tier will resolve the consensus for the financial validation of the transaction while the security token layer should arrive to consensus in terms of identity, asset-ownership and compliance.

In the previous diagram, the features outlined on the second level(orange colored) can be clearly modeled as part of a new consensus protocol optimized for security tokens. The question we need to answer is whether the first level(blue colored) is also part of that consensus protocol or remains part of the underlying blockchain runtime.

The answer to that question is based on another of the existential dilemmas of blockchain protocols: identity vs. decentralization.

The Identity-Decentralization Dilemma

Consensus protocols in existing blockchain runtimes rely on expensive mathematical computations in order to ensure the validity of a transaction without relying on a centralized authority. That model allows to replace identity with computations in order to make assertions about a transaction.

If we think about consensus protocols from the perspective of the identities of the network participants we can arrive to some fascinating conclusions:

· Thesis 1: In a sufficiently decentralized system, identity assertions about a subject can be validated based on the consensus of different parties instead of on the target subject.

A corollary of the previous thesis tells us that identity and decentralization act as opposing forces in a consensus model. In other words:

· Thesis 2: The need for consensus in a decentralized network decreases linearly as the number of identities of the participants increases.

One of the important differences of security token transactions compared to mainstream blockchain interactions is that in the former the identities of the participants are well-know. Having an identity layer simplifies and, in some cases, removes the need for computationally expensive consensus mechanisms at the security token level.

So here is where I think the proponents of security token blockchains are walking a very fine line. If we live in an ecosystem in which all the identities of the participants are known, then you can make the case that we don’t need any form of decentralized consensus and, if that’s the case, do we really need blockchains at all or just some form of immutable ledgers? Using a politicians approach, I think the answer is somewhere in the middle.

· Thesis 3: A security token network should rely on a decentralized consensus protocol between validators whose identities are well-known and their reputation can be validated in the network.

Proof-Of-Authority(PoA) is a type of consensus mechanism that relies on identity as a first class citizens. In PoA networks, consensus is achieved by referring to a list of validators (referred to as authorities when they are linked to physical entities). Validators are a group of accounts/nodes that are allowed to participate in the consensus; they validate the transactions and blocks. PoA doesn’t require solving computationally expensive puzzles to commit a transaction. Instead, a transaction simply has to be signed off by the majority of validators, in which case it becomes a part of the permanent record.

A variation of PoA that incorporate the four primitive discussed previously: identity, asset-ownership, compliance and ownership transfer validation might be a good option for security token networks. However, is not a clear answer by any stretch of the imagination.

For all the benefits of PoA consensus protocols, they are incredibly vulnerable to game theoretic attacks as they don’t rely on large, decentralized networks. In the context of security tokens, those vulnerabilities are even more critical.

Some Tough Questions About a Security Token Blockchain

The answer to whether the market requires a blockchain specialized in security tokens is related to the consensus and identity-decentralization dilemmas. However, there are other very difficult questions that also need to be considered. For the most part, I don’t claim to have many clear answers to these but I think they should be the subject of a deeper debate.

1. Do security tokens require a new consensus protocol? I tried my best to answer this one 😉

2. Does a security token network require a new incentive model? I am inclined to say yes.

3. What would be the capabilities of a security token network? Proof-Of-Ownership consensus, privacy, crypto-financial protocols, governance, custody….

4. What’s the ultimate goal of a security token blockchain? I would say on-chain first digital securities without an off-chain counterpart.

5. Can a security token network be built on top of Ethereum as it gets better? Possibly…

6. Wouldn’t existing blockchains launch frameworks for digital securities? We should be ready for that mess…

7. Consortium blockchain model haven’t worked until now, why do we think security token networks will work? Irrational optimism…

8. What’s the best runtime to build a security token network? Quorum has the programmability and compatibility with Ethereum, Hyperledger Fabric has the penetration in the financial sector which is also needed.

9. Do we know enough to build a robust security token blockchain? With only five security tokens actively trading in the market, I would prefer to see better tier2 security token network models first but I don’t really know.

10.What happens if the big financial firms launch a security token network/blockchain? We are likely to say this was a bad idea to being with 😉

The idea of a blockchain specialized in security tokens is certainly pushing the boundaries of innovation in the space. Although the value proposition is far from clear, the emergence of some of these projects are going to reveal aspects of the market that we are not even thinking about at the moment.

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