24 June 2021

Security Token Report 2021: Practitioner’s perspective with Dr. Lewin Boehnke

Dr. Lewin Boehnke

Dr. Lewin Boehnke

CTO at Crypto Finance (Infrastructure Services) AG and Head of Research at Crypto Finance AG

About the author

Security tokenisation: this report looks at developments the banking sector needs to understand – beyond collectibles to equity, bonds, and self-custody.

Dr. Lewin Boehnke, CTO at Crypto Sorage AG and Head of Research at Crypto Finance AG, is one of the authors and research partners with Cointelegraph Research and Crypto Research Report. Read his article below.

Plumbing for the future of security tokens: Implementing KYC in bank transaction processes.

Decentralised finance is flourishing. With no central parties involved and few regulations in place, tokens are springing up all over. Most commonly, a public blockchain is also the medium of choice when multiple financial intermediaries cooperate to issue a tokenised product. Public smart contract platforms are becoming a sweet spot for a whole class of centrally issued securities. However, tokenised real-world assets offered by centralised and regulated issuers require Anti-money Laundering and Know Your Customer policies, and this form of centralisation opposes the decentralised nature of the network.

The precise obligations, which regulated financial institutions have, heavily depend on the details of the token. What
is the role of the institution? Is it the issuer of a product? Is it a custodian or co-custodian? In addition, the regulatory
situation of the asset itself, as well as the jurisdiction in question, factors in.
Standardising asset types and the corresponding token functionality will ease the handling significantly, but for the time
being, these are mostly customised considerations. Given these inconsistent obligations, it is difficult to build processes that integrate neatly with client wallets, have a familiar user experience for the holder, and enable well-established
processes for banks.
Consider the traditional operations when a client initiates a transaction, for example. Some checks are executed immediately and automatically, but if a transaction is flagged, it may be stalled, and may or not be executed after the pending checks.
Although such operations could be mimicked by a token smart contract, there are two drawbacks.

* First, many of the automated checks cannot be completed with a smart contract because e.g. they require confidential internal information. This can limit the approvable transactions immediately to very few cases — e.g., transferring
small amounts between users who are both asset holders already.

* The ideal solution is doing checks during the transaction. This process of going from an on-chain & off-chain checks
brings us to the second drawback: the user’s experience with the wallet will likely break completely. User wallets
expect a transaction to either make it to the chain, in which case the balances should be changed to reflect that, or
to fail, in which case, this is clearly indicated to the user. If a transaction check is pending off chain, the
intermediate on chain state cannot be interpreted by the user’s wallet. The balances in the users’ wallets only
change once a bank’s approval has been published on chain.

In other words, the blockchain simply cannot reach out to the bank, so the bank has to make an entry on the blockchain.
Besides such post-checks, two more options exist:

1. Pre-checks improve the situation by feeding information about the transaction or addresses into the contract before the holder attempts the operation.

2. and finally, (2) there is the ideal solution of doing all checks during the transaction. When the holder includes the
countersigning by the institution in the operation, the contract can check this and act accordingly. Despite being
the best option, in our view, this does require some additional plumbing. An ERC-20 contract, for example, does not
allow additional data to be provided. ERC-223 and ERC-777 do allow this, but they have very limited support from
wallet software. The additional pre-check between the contract and the bank would ideally be included in the wallet
as well.

There are still many challenges to solve before the plumbing is in place for blockchain technology to fully disrupt the
financial industry, but we are on it.

Read his article on the Security Token Report 2021 here.

Find the full Security Token Report 2021 here.

Read more