What will it take for centralized finance to embrace decentralized finance?
This is part of a series of articles from ConsenSys Codefi’s Q4 2020 Ethereum DeFi Report. Download the full report to learn more about token standards for assets and payments, NFT marketplaces, social and community tokens, DAOs, flash loans, wrapped Bitcoin and Filecoin, lending projects and more.
In 2019, Societe Generale issued a €100 million ($112m) covered bond as a security token on public Ethereum. A month prior, Santander settled both sides of a $20 million bond transaction, also on public Ethereum. Both instances represented the first big tests in whether institutions could settle traditional financial assets on a global permissionless network. While real world assets have been tokenized on permissioned versions of Ethereum, such as a €350 million real estate fund on ConsenSys Quorum, there are challenges to bringing centralized finance to decentralized finance.
In DeFi, no one but the token holder can decide whether or not to transfer a token, which is one of the core promises of Ethereum: that trust should be in the core of a protocol rather than in a public or private authority.
In traditional finance, the maintenance of a registry falls on large institutions like central security depositories, transfer agents, or even issuers themselves. ERC-20 tokens do not contain a function for allowing a third-party to control who it is sent to, and for what purposes. So for example, if an ERC-20 were to represent a real estate bond, regulators would not be able to prevent valuable assets meant for a country’s development from ending up in personal bank accounts or liquidated as luxury goods (like what happened with the 1MDB scandal in Malaysia).
So how can an asset be both permissionless, but still have some controls necessary for legal jurisdictions? Like most things in Ethereum, the engineering work is happening on the standards level, namely the ERC-1400, which is a hybrid Ethereum token designed for traditional financial assets. The ERC-1400 possesses the property of both a non-fungible token (like an ERC-721) and a fungible token (like the most common ERC-20). Since it is compatible with the ERC-20 standard, it remains compatible with the majority of existing tools and platforms. But it also has more controls so it can comply with requirements for asset issuers.
ConsenSys Codefi has taken the ERC-1400 idea further, by proposing a Universal Token for Assets and Payments. Like the ERC-1400, it is compatible with ERC-20s, so it can interact and be transferable on DeFi apps. But importantly, it introduces a new type of token hold, in which a user can grant someone else the power to transfer tokens on their behalf, or forbid a user from spending the tokens for something not agreed upon. This is more optimal than the allowlist / denylist concept in the ERC-1400, because it guarantees the certainty of execution when transferring a token representing a real-world asset with a token representing cash by preventing a user from using the token for something else not defined by the trade order. Bringing up the 1MDB example again, if the development fund had been tokenized according to the Universal Token standard, the government of Malaysia could have prevented the funds from being embezzled by Jho Low in the first place without having to spend millions in auditing and legal fees.
The Universal Token standard has the following features:
- For control mechanisms, it offers a module for certificate checks and a module for allowlist checks + it offers the possibility to force transfers
- For reliability of investor registry, it provides a module to create token holds
- For certainty of delivery-vs-payment (DVP) execution, it includes token holds for atomic DVP, and Hash Time Locked Contract (HTLC) mechanism for non-atomic DVPs
- For interoperability, it offers an ERC20 interface
Because Ethereum is so adaptable, it’s these types of token standards that will continue to be tested with real use cases in 2021 to more fully bring the centralized finance sector to decentralized finance. For assets to contain the benefits of DeFi, but also satisfy the requirements of traditional finance, a more modular approach is necessary, so that certain features can be turned on and off during a token’s life cycle. As laws around tokens evolve, so too can traditional finance slowly migrate towards more “decentralized” arrangements. For existing DeFi applications, soon they too may become compatible with an increasing number of token standards.
Codefi Assets Sandbox
Codefi Assets Sandbox is a testing platform that will allow financial institutions to assess and explore digital assets in a simulated digital ecosystem. The Assets Sandbox can be customized to the environment in which a financial institution operates, allowing experimentation, learning, training, and demonstration. If you would like access, you can fill out this form.