What is a security token? (And what it is not?) — Part 1

A couple of days back, Sean and I were chatting with a major US Blockchain VC explaining our security tokenization platform. We like to keep things simple here at Konkrete.io — security tokens are securities represented on the blockchain.

1 security token = 1 share or unit.

Nothing more, nothing less. We don’t tokenize further because that would mean an additional, unnecessary financial/legal layer.

We believe security tokens are simply the next evolution of how shares (and other security types) are recorded. Earlier there was pen and paper, then came online centralized registries, and now we have distributed registries. Each of these makes the operations of securities more efficient without changing the regulatory requirements of issuing a security.

So it came as a bit of surprise to us when the VC claimed we are not actually tokenizing securities. We are putting them on the blockchain, he said, but that is not tokenization. I was intrigued, and I asked him for his interpretation of tokenization., or what he thought a token really was. He replied that a token is “a signed information packet”.

Aha! Now we were onto something — a clear position that can objectively be proven or disproven.

During the call, I opted not to question his interpretation (if you are going to wave a wad of cash at an early-stage startup, chances are you will get a receptive audience). To call a crypto token a signed information packet, however, is to misinterpret what a token really is. A token is not a tangible independent entity with its own existence, either physically or virtually. Rather, crypto tokens are the balance of what is left — or, using the technical term, they are unspent transaction outputs, or UTXOs.

In the Bitcoin world, if you start with 100 BTC and send Alice 10 BTC, at the end of the transaction you will have 90 BTC and Alice will have 10 BTC. What you are always shown is the balance — that is, what you have left. This balance is derived as the net result of all the transactions; it is (in this example) what is you hold as your BTC.

The transactions are ledger entries, and they do not have an independent existence. A BTC or a crypto coin or token is not its own object. It is simply what is left over.

An information packet is more of a TCP/IP internet term. The term “signed data package” is not generally used in the Ethereum whitepaper, which nevertheless has this to say:

The term “transaction” is used in Ethereum to refer to the signed data package that stores a message to be sent from an externally owned account. Transactions contain:

• The recipient of the message
• A signature identifying the sender
• The amount of ether to transfer from the sender to the recipient
• An optional data field
• A STARTGAS value, representing the maximum number of computational steps the transaction execution is allowed to take
• A GASPRICE value, representing the fee the sender pays per computational step

So, transactions have information or attributes associated with them, and tokens are simply the outcomes or balances of those transactions. Tokens are not the key information — they are what is left after the transaction completes. The key information is in the transactions, which define who sent what to whom.

The difference between Ethereum and Bitcoin is primarily in the way in which Ethereum introduces scripting in the transition states. So, instead of simple pluses and minuses, you can build in programmatic logic, opening up new possibilities. Ethereum also stores the latest balance, eliminating the need to go back each time to the genesis transaction to derive the latest state.

Tokens built on Ethereum or other similar platforms follow a similar logic. They are not information packets in their own right. To say it again, they are the balance of the transactions.

Coming back to our VC friend, after a bit of digging he explained that you can have a blockchain without tokens. That is perfectly true. Hyperledger and other chains, for example, record the movements and authenticity of diamonds, which do not have tokens. The diamond is recorded on the blockchain, but this does not mean it is tokenized.

So, according to our VC friend, just because we are recording our securities on the blockchain does not mean we are tokenizing them.

This is a legitimate argument, but lets dig deeper. Why do tokens even exist in Bitcoin or Ethereum, etc.? We know that a blockchain can function without tokens because there are real-life examples of this. So why have tokens at all?

The answer lies in the fundamental premise of decentralized consensus. Bitcoin introduced the concept of Proof of Work. Miners have the right to add a transaction to the block they mine, which gives them 12.5 BTC — effectively their reward for maintaining the system. Thus, coins and tokens are the reward for maintaining trust in the system in a decentralized manner. Without tokens or coins, decentralized consensus is hard (or impossible, in the opinion of many). Blockchains without coins or tokens are effectively centralized in some way.

The tokens built on top of Ethereum, and meta-coins built on top of Bitcoin, are using the underlying chains consensus mechanism to maintain system integrity. They are not creating something of their own, although they do maintain their own independent ledger.

A security represented on the blockchain, however, maintains a one-to-one relationship with a share or other form of security and is effectively a crypto token. It may not be the ERC 20 token (which is traded on a bunch of crypto exchanges), but it is a partially fungible, distribution-controlled ERC 981 (or some other similar standard) crypto token. Such tokens maintain their own independent ledgers and, because they are fungible (across each other), they are different than, say, putting a completely non-fungible asset such as a house or a diamond on the blockchain.

You end up maintaining 2 books:

1. a securities book, which tracks the change in balances of the shares (or units) in question; and
2. a cash book, which tracks the change in balances of your cash.

If you start with $100 and buy 30 shares worth $1 each, your securities book would show a balance of 30 and your cash book would show a balance of 70. If you sold 10 of the shares for $2 each, you would have a securities balance of 20 and a cash balance of 90.

You are maintaining a book of transactions in units that are fungible across each other in the same security (but not across different securities) and tracking the balances of who holds what and calling them tokens. The fact that you are dealing in shares or units, which are fractionalized representations of the asset in the first place, means that these balances become security tokens as soon as they are on the distributed registry.

Putting securities on the blockchain is security tokenization.

Plain and simple.

It does get a little more complicated, especially around the question of whether shares on the blockchain are simply a representation of the shares (thus representing a claim on the shares) or are the actual shares. An analogy might be the difference between cash in your hand and in your bank account.

We will investigate this in the next article.