FAQ

Security tokens are digital representations of securities (e.g. debt, equity, real estate) on a blockchain. Like traditional securities, security tokens are subject to regulation and need to conform to strict compliance standards.

By leveraging blockchain technology, security tokens allow for many traditionally cumbersome and highly manual processes to be automated, while providing a golden source of truth that all parties can rely on.

The security token market is expected to balloon to $1.5T in Europe alone by 2024 and Deloitte predicts that security tokens will become a mainstay of the future securities landscape.

‍

There are two ways that security tokens can be created. The first is through asset tokenization, which is when a traditional financial asset that exists off-chain is represented on-chain, making it a ‘tokenized security’. An example of this would be tokenizing an existing share certificate.

The second is through asset origination, which is when a financial asset is defined and exists only on the blockchain. These assets are often described as ‘natively digital securities’.

The traditional securities lifecycle is very inefficient, which limits scale, cuts into profit, and constrains product offerings for banks, broker-dealers, asset managers, issuers and investors alike.

Digitizing securities on the blockchain can bring benefits including:

• Increased efficiency: Blockchain can reduce costs associated with bond issuance by almost 90% and can significantly reduce costs associated with other processes (i.e. corporate actions, reconciliation) through automation and transparent record keeping.
• Reduced compliance cost: The financial industry spends $181b per year on compliance and this is expected to increase as rules grow in scope and complexity. On blockchain, rules are programmed directly into the security token, which reduces the risk of error and makes it 30-50% cheaper to manage complex compliance requirements.
• Improved liquidity: There is $4 trillion locked in private equity and trillions in real estate. By removing administrative and technological roadblocks, tokenization opens assets up to a global investor pool, provides a way to trade previously illiquid assets, and stands to narrow the 20-30% illiquidity discount currently levied against private companies.
• Increased transparency: Security tokens give issuers, investors, and agents access to the same source of truth, which helps the cap table stay up-to-date and reduces disputes around record keeping.
• Facilitated innovation: Outdated financial infrastructure and manual processing requirements limit the type, scale, and availability of product and service offerings. Programmable smart contracts and a shared ledger open the door to fractionalized real estate, liquid revenue share agreements, dynamic ETFs, and other previously unmanageable offerings.

Learn how a blockchain built for digital securities can help enable these benefits by reading the Polymesh Pillar Series.

‍

Polymesh is an institutional-grade permissioned blockchain built specifically for regulated assets. It streamlines antiquated processes and opens the door to new financial instruments by solving regulatory challenges around identity, compliance, confidentiality, and governance through key design principles built into the base layer of the chain, rather than as external add-ons.

When it comes to creating and managing digital securities, Polymesh’s specificity gives it (and the applications built on it) a distinct advantage over those using general-purpose blockchains.

• Identity – Securities issuance and transfer requires a known identity, but most chains are built for pseudonymity. Polymesh uses a customer due diligence process to ensure all actors on the chain are verified and all transactions are authored by permissioned entities.
• Governance – Contentious forks in the chain present significant legal and tax challenges for tokens that are backed by real assets. Polymesh uses an industry-led governance model to prevent hard forks and guide the evolution of the chain.
• Compliance - Solutions built on top of general purpose blockchains struggle with processing the complex logic needed to comply with regulations. Polymesh builds compliance into the chain, enabling faster processing and lower protocol fees that can scale as demand and complexity of regulation grows. Additionally, a modular architecture empowers Polymesh to accommodate changes in regulatory or business requirements.
• Confidentiality - Most market participants need their position and trades to remain confidential, but anyone can see holdings on general-purpose blockchains. Polymesh has engineered a secure asset management protocol that enables confidential asset issuance and transfers.
• Settlement - Settlement challenges prevent the blockchain from serving as a golden record for asset ownership. By creating assets at the protocol layer, Polymesh is able to provide a simplified approach to transfers that provides instant settlement without prefunding, prevents unwanted airdrops through trade affirmation, and can offer deterministic finality.

Node operators (or simply operators) run a program that verifies the mathematics associated with transactions and puts transactions into blocks. They do not ensure that transactions comply with securities regulation (that’s done by the compliance rules built into the security token).

Permissioned node operators are one of the aspects that makes Polymesh different from general-purpose blockchains. Transactions involving securities need to be written to the blockchain by known, trusted entities but most blockchains allow pseudonymous entities to author blocks. On Polymesh, only permissioned capital market participants that meet specific criteria can write transactions.

Polymesh is a proof-of-stake chain built using Parity’s Substrate framework. To secure the chain, operators and stakers work together. Stakers economically back the operators of their choice and both are then rewarded or fined based on the operator’s performance.

‍Learn how and why to become a node operator on Polymesh.

‍

The early security token industry lacked standardization, so every security token was built differently. This created unnecessary friction where every market participant — especially custodians and exchanges — needed to perform not only business due diligence on every token they supported, but also technical due diligence.

To tackle this problem, Polymath proposed a unified standard for security tokens on Ethereum, with the goal of ensuring a token’s code met specific requirements and organizations could integrate it without costly and time-consuming technical due diligence. This standard, ERC 1400, is a collection of other standards integral to creating a security token and has since been adopted by organizations including ConsenSys and BNP Paribas.

ERC 1400 was built on Polymath’s earlier ST20 protocol and Polymath Token Studio creates tokens using the standard. It also laid the foundation for Polymesh.

‍Learn more about ERC 1400.

‍

The race toward market standardization isn’t about one standard winning over another; instead, the shift from a marketplace full of bespoke security tokens to a more homogenized approach provides clarity, guidance, and best practices for market participants. Developed with this belief in mind, ERC 1400 has evolved from a single ERC to a library of security token standards that each represent a different facet of the lifecycle, trading, and management of securities on Ethereum.

These standards are self-contained but can be combined in different ways to reflect the specifics of the asset class and jurisdictions across the globe, while still remaining interoperable across the ecosystem. ERC 1400 can apply off-chain data to transactions to include necessary real-world input and authorization, and because ERC 1400 smart contracts are modular by design, issuers on Token Studio can go back and make changes to rules and configurations without having to create a brand new token.

‍

On general purpose blockchains, digital assets are programmed using smart contracts and as a result, custodians, exchanges and other market participants have to integrate each asset into their environment individually.

By contrast, assets on Polymesh are created at the protocol layer. What that means is that instead of having to create a smart contract for each asset, the issuer creates the token natively on Polymesh. As a result, no additional standard is needed to ensure that tokens are created consistently. What’s more, market participants can integrate once with the Polymesh blockchain and then quickly onboard new assets without having to set up each one individually.

‍

Our experience with ERC 1400 and with its many proponents has allowed us to refine requirements for security tokens and gather feedback on market needs. While the standard goes a long way towards making Ethereum more suitable for securities, there are still gaps in functionality and scalability.

ERC 1400 goes a long way towards making Ethereum more suitable for securities, but as a general purpose chain, there are still gaps in functionality and scalability. Our experience with the standard and with its many proponents has allowed us to refine requirements for security tokens and gather feedback on market needs. Polymesh is a blockchain we are building specifically for security tokens. It uses ERC 1400 as a foundation and layers in additional capabilities around identity, compliance, confidentiality, and governance.

‍