Security Tokens – reconciling distributed ledgers and centralised ledgers


The Distributed Ledger Technology (DLT) used in Blockchains has enabled the emergence of a new type of digital asset: cryptocurrencies, the first of which was the famous Bitcoin.

This new digital asset has proven to be very different from previous digital assets, the first of which go back to the dematerialisation of financial securities. In contrast to financial securities, no actual rights are attached to cryptocurrencies. Moreover, there is strictly speaking no identified issuer of these cryptocurrencies, since they are created in a process called "mining", carried out by a variable number of participants called "miners". This is why some people liken them to a digital form of commodities.

As for former digital assets, the ledgers - files used to indicate the existence and ownership of financial assets - are ledgers centralised by an entity that is either itself the issuer of the securities (the securities are referred to as "Registered") or the Central Securities Depository ("CSD"), accompanied in general by Custodians (the securities are then referred to as "Bearer"). In certain cases that are deemed sensitive, regulations require issuers to use trusted third parties – the CSD or Custodians – e.g. in the case of securities that are the subject of a public issue such as listed securities.
In the eyes of regulators, when regulations demand a trusted third party, this trusted third party is deemed responsible for the tasks carried out. It is not simply a case of providing a service where the delegator remains responsible for the regulators of the outsourced tasks.

It was obviously not possible to apply this centralised ledger model to Bitcoin and other cryptocurrencies as, firstly, there was no issuer per se and secondly, the founding principle of DLT1 is based on the absence of a trusted third party, as the trust is presumed to be ensured by the technology itself. DLT has therefore been a real revolution by enabling the creation of new digital assets where, in the absence of an issuer and trusted third party, the responsibility for updating the ledger was transferred to the miners, i.e. to all or some of the holders of these digital assets.

As Blockchain was originally custom-designed for the development of cryptocurrencies, clearly, the question is whether it is possible and above all relevant to want to use it for other types of digital assets and particularly for those based on the existence of an issuer such as security tokens, the name given to financial securities when they are deposited and held through a Blockchain.

Essentially, whereas the legitimacy of the Distributed model is obviously not an issue for cryptocurrencies, which are digital assets without an issuer and which could not exist outside their original blockchain, how can we understand the role and responsibility of the issuer of security tokens?

Blockchain technology applied to financial securities seems to make the traditional distinction between Registered and Bearer securities obsolete. For security tokens, it appears possible to combine the main advantages of Registered securities (transparent ownership of securities) and Bearer securities (speed of transferring ownership of securities).

We note however that this distinction between Registered and Bearer is somewhat French. For the issuer, it is simply a question of knowing who is entered in its ledger; is it the ultimate beneficial owner directly or simply a representative of this ultimate beneficial owner, who may remain unknown to the issuer.

Blockchain technology does not prohibit an investor from continuing to be represented with the issuer but the possible use of an intermediary is no longer required, for purely technical reasons.

The absence of a trusted third party in a blockchain means that the issue concerning the responsibility for ledgers only arises between the issuer on the one hand and the community of miners on the other.

Given the impossibility of transferring responsibility from the issuer to a trusted third party in a blockchain, it would seem logical for the regulator to request that, like the Registered method, the issuer of security tokens retains responsibility for the securities issued and that, therefore, necessary and sufficient means are made available to it in the blockchain so that it can exercise this responsibility.
For the issuer in particular, this involves the possibility of regaining control of its ledgers if necessary. We could therefore compare the issuer of security tokens with the driver of a self-driving car. In both cases, it must be possible to deactivate the autopilot to regain control of the vehicle in the event of a problem. In very practical terms, this means that it must not be possible to hack the security token ledgers since, unlike cryptocurrencies, the issuer should always be able to correct any anomaly in its ledgers.
If cryptocurrencies are, by construction, captive of their original blockchains, this must not in any way be the case for financial securities, the issuer of which is supposed to be able to freely choose between the centralised method and distributed method in keeping its records. As the issuer must be able to freely change the place of deposit, the transition from one of these methods to the other should also clearly be possible at any time.

Note that the digital assets representing central bank or commercial bank currencies are, like financial securities, digital assets with an issuer and therefore very different from cryptocurrencies.

Finally, DLT is much more than a technology as it requires rethinking the responsibility of various actors. The existence of an issuer and the need to ensure a level of security for investors in security tokens that is at least equal to that of non-tokenized securities, means that the management of a distributed ledger for security tokens is inevitably much more sophisticated than that of a distributed ledger for cryptocurrencies.  Therefore, in blockchains recording security tokens, the necessary and sufficient modules must be developed to guarantee such a level of security.
In fact, it is only under this condition that Blockchain and its distributed ledgers can be positioned in the eyes of investors and regulators as a real alternative to centralised ledgers secured by trusted third parties.

1 DLT: Distributed Ledger Technology

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Directeur du Knowledge Management Stratégie et Infrastructures de marché - SGSS