Decentralized exchanges (DEX) are a leading example of Decentralized finance (Defi) platforms. A number of DEXes have come up since Uniswap was launched in 2019. They have helped create liquidity for investors in digital assets such as crypto currencies and stablecoins. Investors typically contribute pairs of digital assets in pools, and traders swap one digital asset for the other in a pair from such pools. Hence, creating asset pools, adding pairs of digital assets to such pools, and trading assets from pools are the three common operations in decentralized exchanges.
However, traditional capital markets (Cefi) where securities such as stocks and bonds are issued and traded function differently. Issuers get securities registered in depositories by registrars, followed by issuances where a security is offered for cash denominated in one or more fiat currencies. That way, securities are paired with cash but unlike on decentralized exchanges, issuers do not have to have both the security and the paired cash currency in hand. There is usually a process of price discovery in Cefi issuances, when underwriters, market makers and investors subscribe to issues. Issuers and their nominated registrars and transfer agents allot securities based on volumes and prices subscribed at, and the float for a listing of a security on an exchange is what traders start buying from and selling to. Investors and traders for regulated securities also have to be identified in compliance with KYC regulations before their subscriptions and trades can be settled, unlike in decentralized exchanges where anonymous crypto wallet holders can invest and trade.
Here, we describe how it is feasible to bridge Cefi security issuances to Defi liquidity pools. We have implemented the Verified Network which is a blockchain powered network of regulated financial service providers such as registrars and transfer agents, custodians and brokerages across multiple countries. Applications on the Verified Network enable financial service providers to
- issue tokenized securities registered in traditional, centralized securities depositories,
- enable market makers and underwriters to create pairs of an offered security and multiple other digital assets that they use to underwrite the offered security,
- run price discovery of tokenized securities on decentralized exchanges,
- do allotments and refunds of subscriptions from investors, and
- finally settle subscribed capital to issuers and transfer tokenized securities to subscribers, who can be investors as well as underwriters/market makers.
We are in the process of integrating with Balancer, and all work described here is being evaluated on the Ropsten Ethereum testnet.
Balancer allows independent developers and teams to create custom pools and for this use case of issuing security tokens on Balancer, we implemented a custom pool that extends the Balancer base pool and enables the following :
- Definition of a price band for price discovery during subscriptions in a primary issue of tokenized securities.
- Specifying the time by when subscriptions to a primary issue are to be closed.
- Dynamically changing weights of the assets (ie, the issued security and the assets such as stablecoins paired to them) making up the primary issue pool as the subscription (price discovery) process goes on. Changing the weights changes the price at which the issued security is available to subscribe with the paired asset (eg, stablecoin). Hence, changing demand for the issued security change weights in the pool which lead to price changes and which then influences demand for the issued security again. This process which repeats itself lead to price formation for the issued security.
- Reporting of subscribers and subscription data from the primary issue pool to the registrar of an issue for allotments.
- Refunds from the primary issue pool to subscribers whose subscriptions are not allotted securities.
- Draw down of subscription capital (ie, the asset paired to the issued security) from the primary issue pool for settlement to issuers.
Above, features 1 and 2 are provided as inputs to the Primary issue pool factory that creates primary issue pools. Feature 3 is implemented in the Primary issue pool itself. Features 4 is a callback from the primary issue pool to the issuing system (in our case, the Verified Network contracts). Features 5 and 6 are triggered by the issuing system but enabled by Balancer’s capabilities that allow third party asset managers to manage pool balances.
So, how do issuers and financial service providers get started ?
Issuers, which are usually businesses that issue shares or borrow by issuing bonds register on the Verified Network. Once their KYC/KYB is done, they can submit product documentation that are routed to respective registrars in that issuing jurisdiction. The Verified Network SDK allows regulated financial intermediaries such as registrars and transfer agents, paying agents, calculation agents and securities and cash custodians to integrate their existing applications to the Verified Network. Alternatively, they can also use the Verified Network applications to download issuer and product data, and upload or input data to approve issuer and investor KYC/KYBs, confirm product ISIN numbers, securities allotments, paid in subscription capital settlements, refunds, calculation of due distributions (such as coupon payments on a bond), pay out of distributions (such as dividends and interest to security token holders), and reporting of corporate actions (which vary from country to country and specified by depositories). The Verified Network applications currently supports reporting of over 50 different corporate actions to investors in tokenized securities on the platform.
To be able to integrate to the Verified Network or use any of its applications, financial market participants need to register on the Verified Network applications, submit licensing and business information which is approved by platform governance. Once this is done, financial service providers get access to custom built applications and any transactions signed by their private keys and calls using the SDK to the Verified Network are whitelisted. For managing issues of tokenized securities only, the following features are enabled
- Registration of new financial products to be issued and obtaining registration information on products submitted by issuers.
- Approval of products by registrars trigger creation of a security token initialized with the product’s attributes, registration of the security token in internal securities registries on the blockchain, and posting of the security token to a contract which is customized to manage interaction with a specific decentralized exchange.
- Interaction with the Defi pool (eg, decentralized exchange, here Balancer) to ask for offers from market makers/underwriters, starting and closing the issue for investors, and allotments and refunds for investors.
- Offers by the liquidity providers such as market makers and underwriters that are managed by the Balancer specific contract to create pairs and pools for each pair on Balancer.
- Calculation of distributions and payout of distribution to security token holders.
The Verified Network SDK has close to a couple of hundred functions to manage payments/settlements, issuing and distributions, and manage secondary trading and the next article will describe the key business processes for Cefi issuances on Defi platforms.
This work is to demonstrate that it is technically feasible to do regulation compliant issuing of securities on decentralized platforms.
Welcome to the future of capital markets !