Tokenization: Countries Leading The Cause

Introduction 

In our previous article, we explored Asset Tokenization‘s uses, benefits and challenges. Security token products (STO’s) are identified as one of the great innovations of the digital assets market. This distinctive approach enables companies to simply monitor, allocate and regulate their activities operating with blockchain technology. Legal standards remain a main concern for issuers and traders of global security tokens.  Some countries tend to fare better than others in applying tokenization and blockchain technology. Below we explored six countries leading the cause for tokenization services. 

Switzerland

Equipped with a rich heritage of financial security, strong privacy laws and pragmatic authorities, Switzerland [1] is a natural choice for developing Blockchain applications. With over 900 projects [2] and the world’s ‘cryptocurrency hub’, it has managed to pass several business-friendly laws and amendments that set clear rules for technology development. A few well-known projects on tokenization include Tokenestate (a self-issue security token), Mt Pelerin and SwissRealCoin (Real estate security token). Nonetheless, its main attraction is the country’s decentralized exchange ‘SDX’ (SIX Digital Exchange), a fully integrated issuance, trading, settlement and custody infrastructure for digital assets, regulated by FINMA. Given its good track record of established cryptocurrency projects, the country may become a hub in the field of tokenized security in the next few years. This fact can be further leveraged by one of the most promising financial service token developments: Ethereum and Tezos. Both are decentralized blockchains that permit the development of public applications and smart contracts, allow and help every idea on decentralization to be carried out in the most efficient way possible and have chosen its foundations to be located in Zug, Switzerland.

USA

Likewise, supported by the world’s most heavy-handed regulator (SEC) and a battle-tested legal framework for securities that includes a large body of case law, the United States is undoubtedly a major player in Blockchain technology and tokenization. In order to tokenize U.S. real estate properties, systems such as RealT [3] enable tokenizing property ownership in the United States, preserving all legal rights and protections that are offered by traditional ownership of real estate. As the home of the world’s leading hedge fund investor base, the United States [4] has the largest institutional shareholder funds. Due to the early implementation of innovative technology in the industry, the country is recognized as a leading region in the tokenized solutions market. Future case examples may include CoinList and venues Kraken and Coinbase, exchanges that currently have no securities listed but are in a position to funnel liquidity into such projects in the near future. Likewise, distinct finance-friendly states include Delaware and Wyoming. Although Delaware is a state known for its low corporate tax environment, it has yet to establish a legal framework for digital assets. Wyoming, on the other hand, has passed over a dozen blockchain-friendly laws to facilitate transactions involving digital assets, up to March 2019 [5].

Canada 

Canada’s low energy cost, high internet speeds, and favorable regulations are expanding its technology sector. Despite high compliance costs, the country has a stable legal system and the prospect of licenses for exchanges dealing with token securities are very accessible. Along with it, in the finance industry, the Securities Exchange launched a blockchain-based clearing house, that would ‘allow companies to issue conventional equity and debt using a digital token representing a share in a business’ [6]. 

Luxembourg 

Recognized for its pragmatic legal and regulatory approach, Luxembourg continues to ensure its attractiveness as an important hub for financial services operations. The current regulatory structure does not precisely deal with the legal treatment of digital tokens. However, the situation in Luxembourg is aligned with the EU’s vision, given that several regulations are based on the European Union’s legal framework. The country is known as one of the most blockchain-friendly nations [10]. 

Liechtenstein

Liechtenstein has taken an important step towards blockchain technology. The adoption of new regulations aims to expand investor protection, prevent money laundering and establish economic clarity. The law verifies that Liechtenstein will be the first country in history to have comprehensive regulation of the token economy by regulating civil law issues in relation to the protection of customers and assets, as well as establishing satisfactory supervision of the various service providers in the token economy [11]. 

Malta 

The curious case of Malta. It is a small nation known for its passion for blockchain due to embracing this technology from the start, not only in terms of security token regulation [7], but also in the broader blockchain field. In addition, by submitting security tokens in Malta, multinational companies have contributed to establishing the region’s reputation as an investment destination. Last year it became the world’s first country to establish official regulations for cryptocurrencies. With the publication of the consultation document on the Security Token Offering MFSA Capital Markets Strategy [8] and also by calling the specialist community to deliver feedback, the state encouraged the improvement of digital securities. Unfortunately, every major advance that it has carried out does not seem to have the expected outcome, given that almost 70% of firms have given up on getting licensed in blockchain services in the region [9].

Conclusion 

The above list is not exhaustive and as tokenization services continue to expand, new markets will start embracing the possibilities and regulations related to blockchain. Some states, as the ones mentioned above, will reap the benefits of having a head-start in this industry and be the go-to markets for tokenization solutions. 

As a blockchain technology integrator based in Switzerland with global ambitions, Scalable Solutions is building bridges towards the new world of digital assets through state-of-the-art white-label solutions and a wide range of innovative value-added services, including tokenization. Get in touch with us here to find out more.

 

 

References:

[1] EY (2019), Tokenization of assets. Volume I, 2020. https://assets.ey.com/content/dam/ey-sites/ey-com/en_ch/topics/blockchain/ey-tokenization-of-assets-broschure-final.pdf

[2] Musharraf, Mohammad. “New Swiss Laws Provide Solid Ground for Blockchain and Crypto.” Cointelegraph, Cointelegraph, 10 Sept. 2020, cointelegraph.com/news/new-swiss-laws-provide-solid-ground-for-blockchain-and-crypto. 

[3] RealT, Inc., 15 Oct. 2020, realt.co/. 

[4] “Token Issuers.” Securities.io, www.securities.io/businesses/token-issuers/?skey=USA. 

[5] “Wyoming’s New Frontier for Blockchain and Digital Assets.” MGA, 20 Mar. 2019, masur.com/lawtalk/wyomings-new-frontier-for-blockchain-and-digital-assets/. 

[6] “Canadian Securities Exchange Launching Blockchain-Based Clearing House, Challenging TMX | CBC News.” CBCnews, CBC/Radio Canada, 13 Feb. 2018, www.cbc.ca/news/business/cse-tmx-blockchain-clearing-exchange-1.4533814. 

[7] Passed 3 legislations on July 2018: “Malta: Europe’s First ‘Blockchain Island’.” 150sec, 5 Aug. 2019, 150sec.com/malta-europe-first-blockchain-island/11979/. 

[8] Security Token Offering MFSA Capital Markets Strategy

[9] “Malta’s Cryptocurrency Flop: 70% of Firms Have given up on Getting Licensed.” MaltaToday.com.mt, 24 Apr. 2020,  www.maltatoday.com.mt/news/national/101920/maltas_blockchain_flop_70_of_crypto_firms_have_given_up. 

[10] “Are Token Assets The Securities Of Tomorrow?” https://www2.deloitte.com/content/dam/Deloitte/lu/Documents/technology/lu-are-token-assets-the-securities-tomorrow.pdf

[11] Dünser, Thomas. “The Liechtenstein Blockchain-Act.” Ecri.eu, Government of Liechtenstein,12 Mar. 2019, www.ecri.eu/system/tdf/thomas_duenser_1.pdf?file=1&type=node&id=155&force=0. 

 

General Sources: 

Bank of Canada (2018), Jasper Phase III, Securities settlement using distributed ledger technology, October. https://www.payments.ca/sites/default/files/jasper_phase_iii_whitepaper_final_0.pdf

Capital Markets and Technology Association (CMTA) (2018), Blueprint for the tokenization of shares of Swiss corporations using the distributed ledger technology, October, http://www.cmta.ch/wpcontent/uploads/CMTA-Blueprint-for-the-tokenization-of-shares-of-Swiss-corporations-1.pdf

Thomson, Andrew. “Top 10 Companies Innovating in Tokenization of Assets.” VentureRadar, 19 Sept. 2019, blog.ventureradar.com/2019/09/19/top-10-companies-innovating-in-tokenization-of-assets/. 

 

DeFi Apps: Asset Tokenization

Introduction

The nature of blockchain-based applications is decentralization, and their main purpose is to re-launch common financial and non-financial services that use centralization to manage transactions between users. Previously, we dove into two major decentralized finance (DeFi) applications: Stablecoins and Exchanges. We will now turn our attention to yet another significant use of Blockchain: Asset Tokenization.

Asset tokenization can be regarded as one of the next steps in the evolution of transactions. When considering mediums of exchange, we evolved from Limestone [1] transactions to precious metals, commodities-backed paper money, plastic cards, electronic money, and potentially to CBDC in the near future (Central Bank Digital Currencies).

The process of tokenization creates a bridge between real-world assets and their trading, storage and transfer in a digital world. The corresponding process is built by using blockchain technology.

What is asset tokenization?

The tokenization of assets refers to the process of issuing a blockchain digital tradable token [2] that represents ownership rights in a real asset – in many ways similar to the traditional process of securitization, with a modern twist. These security tokens are created through a security token offering (STO), which can produce different tokens such as equity, bond and utility tokens. Security token offerings aim to comply with the security’s regulatory framework at the jurisdiction of issuance and where the offering is marketed.

Tokenized assets can be either directly issued on the blockchain or as conventional securities that are tokenized at a second stage. The latter involves securing the asset in a custodial vault and issuing the digital token to be subsequently traded in secondary markets.

Depending on the source selected, there are many classifications for tokens. The most comprehensive one describes five non-mutually exclusive token categories [3]:

  • Platform tokens benefit from the blockchain they are build upon, gaining enhanced security and the ability to support transactional activity; 
  • Security tokens permit the transfer of ownership;
  • Transactional tokens function like traditional currencies, however often with added decentralized benefits;
  • Utility tokens are integrated into a blockchain protocol and are used to access the services in that protocol. They have a special quality where the platform provides security for the tokens, and the tokens provide network activity to strengthen the platform’s use and economy; and 
  • Governance tokens that set the basis for refining the decision-making process, allowing stakeholders to collaborate, debate, and vote on how to manage a system.

The most conventional ones are Utility and Security tokens, and are the subject of this article. 

What assets can be tokenized

As a next step, we will analyze what types of assets can be tokenized. Theoretically, any and every asset can be tokenized, but we’ll endeavor to categorize them under a series of concepts.

Tangible v intangible

The primary difference between tangible and intangible is that tangible is something which a person can see, feel or touch and thus they have a physical existence, whereas, the intangible is something which a person cannot see, feel or touch and thus does not have a physical existence. Essentially, tangible assets are characterized by their physical form while intangible are abstract.

Fungible v non-fungible

There are two types of assets that can be represented as blockchain tokens: Fungible assets and non-fungible assets. Fungible assets are interchangeable. An example of this is paper currency, where all same-currency bills hold the same value and are interchangeable. They can also be divisible (dollar into cents for instance). 

Non-fungible assets, on the contrary, are unique and not necessarily interchangeable. For example, a real estate asset is typically unique. It is distinguished by its footage, location, materials, etc. No two real estate assets can be equal because they occupy distinct physical spaces. Consequently, they have differing values and they are usually indivisible.

Fungible and non-fungible assets can be represented digitally by a token on blockchain. There are however, theoretically possible combinations via connected smart contracts.

 FungibleNon-fungible
TangiblesPaper currency, Precious metals (gold, silver)Real Estate, Art
IntangiblesDigital coins, equity, debtPatents, licenses, trademarks, Int property

Table 1: Asset categorization

Main benefits & challenges 

Many of the benefits and disadvantages of asset tokenization are inherent to the Blockchain technology they are based upon.

Advantages

  • Immutability and transparency. Digital decentralized ledger transactions are an immutable record of ownership, with automatic auditability. A security token has this quality and is capable of having the token holder’s rights and responsibilities embedded. These characteristics promote transparency of transactions, allowing to revise transactional data through enhanced information recording and sharing. 
  • Universal accessibility. A constant reminder of blockchain benefits is inclusion. Tokenization can leverage the fact that virtually anyone with a smartphone and internet connection can access markets that they previously couldn’t. It can open up investment opportunities to a much wider audience as a result of tokens being infinitely divisible and having lower transaction costs, thus reducing minimum investments and time frames.
  • Cost effective. Transaction, liquidation, clearing and settlement processes are optimized on tokenized asset transactions. The use of smart contracts [4] in these processes minimizes the need for intermediaries, hence speeding up transaction times. Furthemore, it cuts the costs incurred through a near-immediate transfer of ownership and updates the continuously reconciling ledger.
  • Diversification through fractionalization. Tokenization may allow for the split of assets, dividing ownership into smaller claims. Retail investors, for example, may therefore gain access to asset classes and risks that may have been otherwise beyond their capacity, and can thus participate in capital markets with lower minimum tickets or portfolio sizes. Similarly, access can be gained on investments that weren’t usually available to small retail investors, not because of their high entry costs, but because of their business nature (private equity, for example).
  • Compliance. Tokenization can potentially offer new possibilities of automated compliance with regulatory requirements. For example, in jurisdictions applying a limit to the number of investors allowed to participate in an offering, such a limit may be programmed and built into the smart contract used for the distribution of tokenized securities.
  • Efficiency. Efficiency gains to be acquired are more important in those markets where there is a high complexity in its process, there are multiple levels of intermediation, speed is low and costs are high, or in markets with a deficiency of trust. As such, a large scale and wider adoption of asset tokenization can be more easily envisaged for private placements of non-listed securities, small-sized bond issuance or private equity/venture capital funds [5].
  • Liquidity. The tokenization of assets (especially private securities [6] or illiquid/thinly traded assets like art) permits them to be constantly traded on secondary markets; liquidity increases with improved access to a broader trader base. This benefits investors on both ends by minimizing the illiquidity premium paid.

Challenges

  • Securitization. Transparency of collateral, legal clarity of tokenholder claims in relation to underlying assets, protection, pool manager duties, etc. are often critical factors in traditional securitization markets and should be given equal weight in the new tokenization systems. 
  • Data quality. It should be highlighted, however, that the quality of the data that is inputted into the blockchain is critical for the robustness of information recording and sharing. DLTs do not resolve the ‘garbage in, garbage out’ dilemma; poor data input quality (e.g. malicious or erroneous ‘oracles’ feeding external data into the network) will result in a transparent, immutable, time-stamped repository of unsound or flawed outputs.
  • Governance. Governance issues, particularly relevant to fully decentralised ledgers, relate to the difficulty in identifying a sole owner or node accountable for the full network. The absence of a single accountable point is a problem that also arises when regulating DLT networks, or when responsibility for a failure in the network needs to be assigned.
  • Trading. Parallel trading of tokenized assets both on-chain and in conventional markets risks creating a bifurcation of markets for the same asset with negative consequences on liquidity conditions and a potential heightened risk of arbitrage [7].

 The benefits and challenges of asset tokenization can be summarized in the following chart.

Fig 1: “Benefits and risks of asset tokenization” [8]

Our Tokenization Service

SCALABLE’s Tokenization platform offers our clients the ability to issue cryptocurrencies, security, and utility tokens as well as quickly deploy smart contracts. By tokenizing real estate, commodities, shares, and high-value goods, we channel liquidity where it previously did not exist. With our immutable ledger, diminished costs by issuing native tokens, automated compliance guaranteed by the use of smart contracts, and unmatched liquidity, we provide tokenization that ensures that our customers receive superlative market services. Find out more by booking a demo

 

 

 

 

References:

[1] Goldstein, Jacob, and David Kestenbaum. “The Island Of Stone Money.” NPR, NPR, 10 Dec. 2010, www.npr.org/sections/money/2011/02/15/131934618/the-island-of-stone-money?t=1603753241173. 

[2] A digital token can be described as a piece of software with a unique asset reference, properties and/or legal rights attached.

[3] “The Different Types of Cryptocurrency Tokens Explained.” Maker Dao Blog, 11 Feb. 2020, blog.makerdao.com/the-different-types-of-cryptocurrency-tokens-explained/. 

This is a functional classification. Regulators can use separate categories. The Swiss indirect tax categories, for example, inclue: Asset token, payment token, utility token and hybrid token.

[4] Smart contracts are software algorithms integrated into a blockchain with trigger actions based on predefined parameters

[5] Conversely, public equity markets in developed economies benefit from highly automated and efficient processes where the potential for efficiency gains through the use of DLTs is very limited. Importantly, such markets enjoy high levels of trust by their participants

[6] This does not mean that tokenization of private debt or equity will necessarily overcome asymmetric information issues and difficulty in assessing credit risk related to small companies. Fundamental impediments to the assessment of creditworthiness of SMEs will persist in tokenized markets, although enhanced transparency and availability of data could alleviate part of the information issue, while disintermediation and automation could reduce costs and increase the efficiency of issuing and administering SME securities involving multiple layers of intermediation and a relatively high administrative burden/complexity (e.g. documentation)

[7] Alternatively, it could be argued that if the number of markets an asset trades in increases, the smaller the chances of finding arbitrage opportunities.

[8] SERIES, O. B. P. The Tokenisation of Assets and Potential Implications for Financial Markets. https://www.blockchainwg.eu/wp-content/uploads/2020/03/The-Tokenisation-of-Assets-and-Potential-Implications-for-Financial-Markets.pdf

General Sources:

Laurent, P., T. Chollet, M. Burke, and T. Seers. 2018. “The tokenization of assets is disrupting the financial industry. Are you ready?” Triannual insights from Deloitte. (19). pp.62-67.

Deloitte (2018), The tokenization of assets is disrupting the financial industry. Are you ready? Inside Magazine issue 19, November, https://www2.deloitte.com/lu/en/pages/technology/articles/tokenization-assets-disrupting-financialindustry.html

Forbes (2018), A First For Manhattan: $30M Real Estate Property Tokenized With Blockchain, 3 October, https://www.forbes.com/sites/rachelwolfson/2018/10/03/a-first-for-manhattan-30m-realestate-property-tokenized-with-blockchain/#d3ba39948957

Exchanges: Centralized v Decentralized

Introduction

Following our series of posts regarding DeFi, we’ll take the opportunity to dive deeper into exchanges. We will carry out a brief introduction and jump straight into the technicalities that characterize exchanges.

What are Exchanges? 

As initially described in our article on the Decentralization of Finance, exchanges are traditional financial institutions that act as intermediaries between parties. Exchanges function as marketplaces and bring together users that intend to trade different assets. Historically, only physical assets (such as commodities) could be traded in these exchanges, but this has evolved by leveraging the benefits of technology, thus establishing online venues to shorten the distance between participants. Nowadays, the most frequent assets traded on these exchanges include not only commodities, but also derivatives and other financial instruments (stocks, bonds, etc).

How do Exchanges work?

Traditional (centralized) exchanges (CEX) are run by organizations that oversee their day-to-day operations such as (technical) maintenance, security, and growth. Essentially, they provide a chain of direct services that include Custody, Transfer and Matching. The opening part of a classic exchange process can be summarized as:

  1.     Users deposit funds from a “personal” account into exchange’s account
  2.     Funds go to custody storage
  3.     Increased balance on trading account
  4.     User is able to trade 

 

Nonetheless, background processes entail dynamic interactions between various agents that transfer detailed information, such as regulatory bodies (SEC, for example), brokers, various markets (primary, OTC), electronic communication networks, exchange’s and users “wallets,” and others.

The specific attributes of exchanges that are valuable depend on whether the participant is a user, market maker, the exchange handler, etc. There are, however, some that share common ground and are of vital importance, influencing the economic outcome of those involved:

Scalability and its costs. Traditional exchanges still possess the largest quantity of players  and deepest order books. 

Custody – Security. Centralized exchanges have custody of their users’ funds. Having loose security over custodial wallets produce an incentive for hacker attacks. Plenty of hacks have been carried out on exchanges over the past nine years, with losses exceeding USD 300 million in 2019 alone [1]. 

Established clients. Regardless of the ground-breaking technology an exchange may be based on, it will not thrive without a base of market makers that can provide liquidity at scale. Liquidity is provided by market makers (suppliers), and taken by retail and large institutions (demand). An intrinsic circular problem persists in that mass adoption is required to generate liquidity (attract market makers), but liquidity is in itself a driver of adoption (demand users). Essentially, liquidity breeds liquidity.

Latency. Fundamentally, this is the time it takes for a transaction to make a round trip and be processed. The lower the latency, the better it is for taking advantage of market opportunities and the lower probability of being taken advantage of.

Up/down time. Since cryptocurrencies are highly volatile and listed on hundreds of secondary markets, exchange downtime means major losses for the user in terms of opportunity costs, not to mention the importance of the possibility to swiftly unwind losing positions [2]. 

Back office. Regulatory authorities require KYC (Know Your Customer) and AML (Anti Money Laundering) applications to oversee market practices in the spirit of protecting customers. It can be seen as both a benefit or a disadvantage, having to provide personal information as a requirement for trading digital assets in centralized exchanges.

A list of advantages and disadvantages of classic CEX includes but is not limited to:

AdvantagesDisadvantages
High liquidity
Margin tradingCustody Risks
HFT & AlgorithmsRegulation
Fiat Bank AccountsNo anonymity
More trading pairs

Decentralized Exchanges

Alternatively, state-of-the-art Decentralized Exchanges (DEX) operate through a set of rules – or smart contracts – that allow users to trade cryptocurrencies in a peer-to-peer manner. The most common platform to create DEXs is Ethereum, a public network (blockchain) that provides first layer infrastructure that anyone can develop on. 

A true decentralized exchange needs no accounts, sign-ups from users, or any form of ID verification. It also minimizes or avoids altogether major fees seen with centralized exchanges (deposit, withdrawal, transactional fees, and the like). There are, however, transaction fees [3] that pertain to the blockchain use and are conventionally denominated ‘gas’ prices for executing smart contracts.

Still, the main attribute that defines them is that they are non-custodial. Essentially, DEX doesn’t have access (either through custodial wallets or private keys) over users’ funds.

These key characteristics of DEX introduce some much needed advantages over traditional exchanges; the anonymity that comes from no registration processes, the relative safeness in the face of honey-pot hacking [4], transparency, and lower costs.

In contrast to centralized exchanges who can trade crypto-to-fiat (USD, EUR), DEX can only trade crypto-to-crypto pairs. The reason behind this difference mainly resides in KYC and other regulations. Analogously, DEX can currently only provide a small number of market orders (buy, sell, stop limit, etc) when compared to its centralized counterpart, and is only now developing other services (such as margin trading).

The path to fully decentralized exchanges

Even with the cardinal improvements on Blockchain technology applied to exchanges, there is still a considerable way to go to achieve full decentralization [5]. The road included advances that evolved from traditional central limit order book, to off-chain order book, off-chain execution/on-chain settlement, and automatic market makers (AMM). These advances are often thought out to be enhancements over specific CEX shortcomings, but end up with difficulties of their own. 

DEX and the impact on Liquidity

As we previously mentioned here, at SCALABLE we believe liquidity to be a major factor to the success of any exchange. Unfortunately, it is a characteristic that DEX has yet to conquer. This resides in the current ability of DEX to only handle a fraction of the volume of CEX, impeding the back and forth conversion of large amounts of currency. 

Some inherent issues in decentralized exchanges that affect its ability to challenge centralized liquidity include:

  • On chain trade collision. Open order-book methods allow for various market “takers” to simultaneously attempt to fill the same order.
  • Limited exchange pairs. The decentralized nature prevents the option of exchange participants to trade crypto-fiat currency pairs.
  • Front-running. Open order-book methods also permit front-runners (actors that gain the ability to see order flow before it is processed) profit by placing intermittent trades with a higher transaction fee, incentivizing miners to include their transaction in the block ahead of the trade they were able to view in the order book. There are indications that next-gen DEX [5] can resolve this issue by adopting the concept of virtual balances.
  • False liquidity. In a series of cases, exchange handlers faked their order book by replicating other exchanges [6]. 

There are, however, projects that aim to algorithmically provide liquidity utilizing automated market makers (AMM). Uniswap, for instance, is getting predominant attention. Buyers and sellers pull liquidity from the smart contract directly and receive a price quote based on the token quantity desired and the liquidity available. Uniswap will always quote a price regardless of the order size by asymptotically increasing the price as the size of the order increases.

Below we can appreciate the liquidity of the main crypto trading pairs on coin360. coin360 provides data aggregation services on the different liquidity pools on trading pairs over various exchanges, as well as their price quotations and spreads for distinct order sizes. Tight quotation differences for various order sizes minimizes slippage in trades, a characteristic specially dominant for traders or institutional participants who execute sizeable trades.

Source: coin360 liquidity book [7]

 

Main exchange’s order books for BTC/USDT, price/volume data

Conclusion

Despite constant advances in the exchange space relating to centralization and its shortcomings, there is still a long road ahead of improvements to carry out before reaching full decentralization for those that desire it. Centralized exchanges continue to carry a range of benefits that give their users peace of mind and easier accessibility to trading, such as choice when it comes to matching pairs and ability to buy cryptocurrencies with fiat. KYC and AML practices can also provide a sense of security for exchange users. 

SCALABLE Exchange Technology

At SCALABLE, we are committed to provide the best of both worlds. Through our technology, we’ve helped a multitude of both centralized and decentralized exchanges launch and grow to new heights. Our exchanges speed meets the highest industry standards with door to-door latency of less than 800 microseconds, sophisticated cryptography and robust internal controls to form an all-in-one solution that has never been compromised, direct orders to the industry’s deepest books, and up-time > 99.99% under institutional grade SLA.

 

 

References:

[1] “A Comprehensive List of Cryptocurrency Exchange Hacks.” SelfKey, 13 Feb. 2020, selfkey.org/list-of-cryptocurrency-exchange-hacks/. 

[2] K. Christidis and M. Devetsikiotis, “Blockchains and Smart Contracts for the Internet of Things,” in IEEE Access, vol. 4, pp. 2292-2303, 2016, doi: 10.1109/ACCESS.2016.2566339.

[3]  These fees can be quite sizable for small traders when inefficient systems are used, such as Ethereum.

[4] In January 2018, Kraken initiated an upgrade estimated to take 2 hours that ended being +48 hours down and costing users thousands of dollars.

[5] Such is the case of Synthetix.Exchange’s improvement proposal. To account for front-running, the post-trade waiting period gives oracle the time to verify between the new prices and initial ones, and  in case the price was affected by the trade, the trader is now owed/owes Synth. The process repeats itself, calling a settle function that settles each trade difference.

[6] Lin, L. X. (2019). Deconstructing decentralized exchanges. Stanford Journal of Blockchain Law & Policy, 58-77.

[6] Shevchenko, Andrey. “For Some Reason, Wash Trading Happens on Decentralized Exchanges Too.” Cointelegraph, Cointelegraph, 25 July 2020, cointelegraph.com/news/for-some-reason-wash-trading-happens-on-decentralized-exchanges-too. 

[7] https://coin360.com/liquidity-book. Accessed October 23nd, 2020 at 13.30 UK time.

General sources:

“All You Need to Know About A Decentralized Exchange.” ICOholder Blog, 7 Dec. 2018, icoholder.com/blog/decentralized-exchange/. 

CoinGecko, Ong, B., Lee, T. M., Lau, D., Azmi, E., Kho, K., Jin, T. S., … Gries, M. (2020). How to DeFi.

“Decentralized Exchanges vs. Centralized Exchanges: Overview.” ConsenSys, consensys.net/blog/news/decentralized-exchanges-overview-benefits-and-advantages-over-centralized-exchanges/. 

Deme, Balazs. “Decentralized vs. Centralized Exchanges.” Medium, Herdius, 24 Jan. 2018, medium.com/herdius/decentralized-vs-centralized-exchanges-bdcda191f767. 

Wearn, Alex. “CEXs Vs. DEXs: The Future Battle Lines.” CoinDesk, CoinDesk, 5 Oct. 2020, www.coindesk.com/cexs-vs-dexs-the-future-battle-lines. 

“What Is a Decentralized Exchange(DEX)?” DCX Learn, 19 Mar. 2020, www.dcxlearn.com/trading/what-is-a-decentralized-exchange-dex-2/. 

Xie, Linda J. “A Beginner’s Guide to DeFi.” NAKAMOTO, NAKAMOTO, 4 Jan. 2020, nakamoto.com/beginners-guide-to-defi/. 

Understanding Stablecoins in a World of DeFi

Introduction

Many know of Bitcoin as the first mainstream application of Blockchain Technology. Few are aware of the intricate underlying mechanics that give its form. Unfortunately, it is best known for its volatility. Ranging from nearly 1,000 USD to 20,000 USD in less than a year and back to 4,000 USD a year later, the digital coin has had a hard time fulfilling one of the objectives it set out in the beginning; that is, to “fix” the shortcomings of fiat currencies (such as ease of globalization) without losing its benefits (being a means of payment, value reserve, and maintaining a stable relative quotation). Stablecoins are the next step in the technology evolution ladder, and have come to address Bitcoins’ shortcomings. 

But what is a stablecoin?

A stablecoin is a Blockchain application in the new world of Decentralized Finance (DeFi). Much alike Decentralized Exchanges (DEX) and innovative decentralized lending and borrowing platforms, stablecoins are an improvement over established systems. 

Stablecoins are cryptocurrencies whose architecture enables them to be pegged to another asset. Essentially, their price is set to follow the price of another asset. Stablecoins pegged to USD are the most popular, but there’s no limit to the possibilities and we’ll be exploring more below. It achieves its quotation through a straightforward process. The issuer (Tether, for example), acquires in collateral (USD) the amount of stablecoin that should be issued, and every time the circulating supply has to be increased, a proportionate increase in collateral is required. 

What types of stablecoins are out there?

There are two things we need to keep in mind to understand this: the pegged asset and the collateral. As we mentioned, the most common type of stablecoin has a 1:1 ratio with fiat currency, such as USD. There are, nonetheless, other types of stablecoins with different pegged assets (Euro/Franc, Gold, other cryptocurrencies, etc). On the far side of the range, we can find uncollateralized coins that use blockchain-based algorithms as a kind of central bank, whose sole purpose is to control the ‘money supply’[1] to make sure the coins will always trade at the same ratio. 

Among the most popular in the vast realm of stablecoins, we can find Tether (USDT) by Tether Limited, TrueUSD (TUSD) by TrustToken, and Paxos Standard (PAX) [2]. Also worth mentioning we encounter DAI, a non-fiat collateralized cryptocurrency whose transparency can be seen on-chain at all times. It manages to hold its stability by locking Ether (ETH) into a contract in a system called a Collateralized Debt Position (CDP), where a user wanting to acquire DAI sends the ETH to a CDP and can withdraw DAI from there. Additionally, EOSDT, a dollar-pegged, collateral-backed currency that leverages underlying EOS and BTC has recently come to life. The stable currency is insured by Equilibrium and adds extra liquidity to the market.

Benefits of stablecoins:

  • Most cryptocurrency exchanges in the world only allow users to trade one digital token for another. That is because converting fiat currencies into cryptocurrencies is a relatively complicated process, which involves dealing with banks and regulators in different jurisdictions, so stablecoins serve as a gateway for investors to enter the crypto-asset market. 
  • Not a long ago, the only alternatives to hedge volatility (daily price volatility of cryptocurrencies can range from 5% to 160%) [3] in digital asset markets were insurance policies and derivative contracts. With the appearance of stablecoins, participants can now instantly switch to stable assets.
  • Stablecoins can be used for everyday transactions, such as buying coffee, paying salaries, or buying real estate — thus facing fewer barriers to mass adoption than traditional cryptocurrencies, which often come with low transaction speeds and high fees in addition to current volatility.
  • The best of both worlds: stablecoins leverage the benefits of cryptocurrencies — such as transparency, security, immutability, digital wallets, fast transactions, low fees, and privacy — without losing the guarantees of trust and stability that come with using fiat currency (like the US dollar or Euro).

Disadvantages of stablecoins:

  • The harsh truth is that most stablecoins fail [4] (though this is historically true, it doesn’t speak to the current ones. Fiat/Crypto-based stablecoins have a higher chance of survival, while commodity-backed stablecoins have the highest closing rate). When they fail, they may or may not be redeemable for the promised amount. Some projects even allow issuers to freeze funds. Tether for example at one point had “We do not guarantee any right of redemption or exchange of Tethers by us for money” in its Legal Section [5].
  • Stability versus centralization: The majority of stablecoins are centralized, which opposes the nature of decentralization in blockchain itself. Fiat-backed stablecoins require trust in a centralized entity (i.e. a bank). Recent case examples include the KuCoin hack [6], where stablecoins issuers Bitfinex and Tether froze up to 33 million USD in USDT, and BitMEX facing federal charges [7] by the Department of Justice and Commodities Future Trading Commision, possibly following the same actions.
  • A secondary issue with these assets is inherent to how they are established. The common fiat-pegged currencies tend to suffer the loss of power of purchase in conjunction with the pegged asset. To set an example, the US economy has been presenting an annual average inflation rate of 3.22% [8] for the last 100 years, and the USD has fluctuated between EU 0.67 – 0.956 over the last ten years. In the case of another cryptocurrency as the collateral asset, one could also be exposed to its volatility.
  • One of the biggest challenges for stablecoins is “scaling”. It is difficult for reserve-backed stablecoins to reach a level where liquidity is deep enough to support interesting applications of the technology. Backers will have to invest millions or even billions in each coin. It could potentially create a cap on how fast a stable coin can grow.

For a further analysis of stablecoins and what influences their success (particularly a view on oil), consider the following article

What can SCALABLE do for you?

SCALABLE provides professional white-label digital asset exchange technology, which allows users to trade over 500 digital assets against every major stablecoin, with the possibility to list trading pairs against fiat currencies through seamlessly integrated banking and payment processors. Moreover, the custodial or non-custodial white-label Wallet infrastructure allows users to securely store, send and receive all major stablecoins. Our liquidity solution also provides the deepest books and top liquidity, allowing successful trading without risk of slippage.

 

References

[1] Also known as elastic supply or adaptive money. Currencies under this model include Ampleforth (AMPL), Yam.finance (YAM), Based.Money (BASED), etc.

[2] “Stablecoin Cryptocurrencies.” CryptoSlate, cryptoslate.com/cryptos/stablecoin/. 

[2] Emily Perryman et al. “A List of Stablecoins You Need to Know About.” Coin Rivet, 17 Jan. 2020, coinrivet.com/a-list-of-stablecoins-you-need-to-know-about/.

[3] “STABLECOINS: An Overview of the Current State of Stablecoins.” Blockdata. https://download.blockdata.tech/blockdata-stablecoin-report-blockchain-technology.pdf

[4]  See https://www.coinopsy.com/dead-coins/ for an updated list of active and dead coins. 

[4] Boddy, Max. “Research: Only 30% of Known Stablecoins Are Live and Operational.” Cointelegraph, Cointelegraph, 28 June 2019, cointelegraph.com/news/research-only-30-of-known-stablecoins-are-live-and-operational.

[5] Dinkins, David. “Tether Really Isn’t a Scam, Company Promises.” Cointelegraph, Cointelegraph,5 Sept. 2017, cointelegraph.com/news/tether-really-isnt-a-scam-company-promises. 

[6] “Kucoin Hacked for $150 Million in Bitcoin; Bitfinex and Tether Freeze $33 Million of the Stolen Funds: Exchanges Bitcoin News.” Bitcoin News, 9 Oct. 2020, news.bitcoin.com/kucoin-hacked-for-150-million-in-bitcoin-bitfinex-and-tether-freeze-33-million-of-the-stolen-funds/.

[7] “Bitmex Charged With US Rules Violations – Owners Face Criminal Charges, Prison: Regulation Bitcoin News.” Bitcoin News, 3 Oct. 2020, news.bitcoin.com/bitmex-criminal-charges-prison/.

[8] McMahon, Tim. “What Is Quantitative Tightening?” US Inflation Long Term Average, 1 Apr. 2014, inflationdata.com/Inflation/Inflation_Rate/Long_Term_Inflation.asp.

[9] “Board of Governors of the Federal Reserve System.” The Fed – Foreign Exchange Rates – H.10 – October 13, 2020, www.federalreserve.gov/releases/h10/hist/dat00_eu.htm. 

[9] ECB. “Stablecoins – No Coins, but Are They Stable?” IN FOCUS, no. 3, Nov. 2019, www.ecb.europa.eu/paym/intro/publications/pdf/ecb.mipinfocus191128.en.pdf.

The Decentralization of Finance (DeFi)

Introduction

Financial institutions [1] were created to fulfil various societal needs and mechanisms to facilitate certain transactions. The primary role of financial institutions is to provide liquidity to the economy and permit a higher level of economic activity than would otherwise be possible.

From providing funding, lending, and exchanges, to enabling money to move around the world by arranging deposits, withdrawals and transfers, interactions with financial institutions are an everyday reality for a large part of the population. But what at the time seemed like an evolution to a new, better scenario, could now be viewed as another actor being replaced in the chain of innovation.

Centralized Finance

Traditional (centralized) finance can be defined as a system where centralized actors (financial institutions) offer a range of services that aim to provide efficient resource allocation, whether between actors or through time. It accomplishes this by serving as intermediaries between parties, while keeping users’ private data.

Compared to its previous state, traditional finance created massive wealth and connections that would otherwise not exist. Additionally, it exponentially increased the speed of globalization and brought with it all its benefits (“free” trade, labour movement, capital flows and better communication, among others)[2]. Unfortunately, its centralized nature means the benefits have gone to individuals with easier access to this system (i.e developed economies with proper connectivity, infrastructure, transparent institutions, etc). 

Some of the societal needs it fills – at least partially – include, but are not limited to:

  1. The safeguarding of savings
  2. Facilitating efficient allocation of capital to support economic growth
  3. Providing broad access to ­financial services products and services
  4. Providing ­financial protection, risk transfer and diversification
  5. Collecting, analysing and distributing information for better economic decision-making
  6. Providing effective markets and financial resilience

 

Nevertheless, these attributes of the classic model of centralized finance carry certain disadvantages, such as:

  • Not accessible worldwide. Rising inequality and filter mechanisms (credit ratings, for example) prevent it from achieving universal inclusion.

  • High costs and low transactions. Even though today’s processes are the most efficient historically speaking, large friction inconvenients still exist. Delays of several days on money transfers abroad, as well as clearing and settlement processes do not provide an ideal timeframe. On the borrowing side, it can even take months and endless paperwork before an entrepreneur gets the funds to start a business.

  • Low trust in financial institutions and governments. The financial crisis exposed the shortcomings of the traditional financial system and resulted in diminishing users’ trust in the capacity – and willingness – of both governmental and financial institutions to act correctly. It highlighted the need for it to be better.

  • Reactive regulation. Regulatory uncertainties are some of the major issues plaguing the current financial system, and don’t provide an appropriate incentive structure to participants.

  • Risks. The structural way financial institutions are interconnected impedes the mitigation of systemic risk and cascade effects. Analogously, major risks faced by banks and related financial institutions include credit risk, interest rate risk, market risk, and operating and liquidity risks. Even though there are instruments for estimating and quantifying each risk (such as VaR, duration, sensitivity analysis), many of them produce very sensitive results and are subject to the user’s judgement [3].

  • Centralized. Each transaction, independent of its type, must go through at least one intermediary (or institution) before reaching a destination, automatically allowing third parties to access personal information. Moreover, this attribute implies that centrally stored information can suffer multiple damages caused by external attacks, internal inefficiencies, etc.

 

The Decentralization Process

With the revolution of present finance systems in mind, technological advances resulted in Blockchain, the ground-breaking decentralized technology concept that aims to bridge existing gaps and make finance accessible to everyone. It achieves true decentralization by distributing and storing identical ledgers (of transactions made) in each participant node of the network (chain), and securing them through high-end cryptography. Additionally, consensus protocols are in place to ensure fault tolerance and security of the chain. Instead of financial institutions, “smart-contracts” act as intermediaries in peer-to-peer transactions.

The superior factors that differentiate DeFi from traditional finance can be grouped into:

 Autonomy: There is no centralized authority or intermediaries, such as a bank, with the ability to freeze your account, seize your assets, or block your transactions. There is a note to be made on this point; even though DeFi ultimately aims for full decentralization, current applications always carry a modest degree of centralization. Stablecoins, for example, can freeze.

Accessibility: Virtually every person with a mobile phone and internet connection can benefit from the advantages of decentralized finance. Of the approximate 1.7 billion adults that remain unbanked, roughly two-thirds of them have access to mobile phones [4].

Tradability: Every non-digital asset traded in the traditional finance realm can be tokenized and traded (cheaper and faster) through decentralized finance. Every-day shrinking fees and faster transactions also set the basis for mass adoption and easier tradability.

Transparency: DeFi data is publicly available. Reserves on a DeFi bank can be easily checked, or research for accurate loan rates be carried out. 

But the predominant factor of Blockchain technology resides in that anyone can develop decentralized applications within open networks (such as Ethereum). For every application traditional finance can have, decentralized applications share its benefits without their main disadvantages (there are, however, some aspects that are seen as drawbacks uniquely associated with decentralized apps) [5]. 

 

Major DeFi Apps (DApps) [6]

StablecoinsDecentralized Insurance
Decentralized ExchangesDecentralized Lending & Money Markets
Asset TokenizationAsset Management tools
Staking Collateralization
Risk ManagementAlternative Savings
KYC & IdentityMarketplaces 

 

Conclusion 

The applicability and versatility of DeFi provides a tempting alternative path to centralized finance. This can be verified by the growth this system has had since its inception – actual total value locked in DeFi amounts to 10.5B USD [7]. Nevertheless, both centralized and decentralized structures have a role to play in our daily lives, each with their benefits and shortcomings. We will further explore key decentralized applications mentioned above in future articles – subscribe and stay updated.

 

SCALABLE – Our Solutions

At SCALABLE we provide a wide range of white-label services that include Exchanges, Liquidity, Asset Tokenization, Custody and Wallets. We know how daunting the shift to new technologies can be and thanks to our teams’ vast experience in both traditional finance and the blockchain industry, we can help bridge the gap between the two industries. Schedule a DEMO to find out more.

 

 

 

References 

[1]  Financial institutions include banks, insurance companies, brokers, pension plans, funds, exchanges, etc.

[2] For an in-depth academic survey of globalization, see Kose, M. A., Prasad, E., Rogoff, K., & Wei, S. J. (2009). Financial globalization: a reappraisal. IMF Staff papers, 56(1), 8-62.

[3] Carey, M., & Stulz, R. M. (2005). The risks of financial institutions (No. w11442). National Bureau of Economic Research.

[4] Demirguc-Kunt, A., Klapper, L., Singer, D., Ansar, S., & Hess, J. (2018). The Global Findex Database 2017: Measuring financial inclusion and the fintech revolution. The World Bank. Chapter 2: The unbanked.

[4] “Financial Inclusion on the Rise, But Gaps Remain, Global Findex Database Shows.” World Bank, www.worldbank.org/en/news/press-release/2018/04/19/financial-inclusion-on-the-rise-but-gaps-remain-global-findex-database-shows. 

[5] Including lack of oversight, assistance or legal framework.

[6] A list of DApps can be found on the Ethereum DeFi Ecosystem. This list is by no means comprehensive.  https://defiprime.com/ethereum

[7] “DeFi Pulse: The DeFi Leaderboard: Stats, Charts and Guides.” DeFi, defipulse.com/.

General Sources

Campbell, Lucas. “DeFi Market Report for 2019 – Summary of DeFi Growth in 2019.” DeFi Rate, 12 Feb. 2020, defirate.com/market-report-2019/. 

Desjardins, Jeff. “The 7 Major Flaws of the Global Financial System.” Visual Capitalist, 11 Sept. 2019, www.visualcapitalist.com/7-major-flaws-global-financial-system/.  

CoinGecko, Ong, B., Lee, T. M., Lau, D., Azmi, E., Kho, K., Jin, T. S., … Gries, M. (2020). How to DeFi.

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