Polymath, a security token issuance platform built on Ethereum, hopes to bring trillions of dollars of financial securities onto the blockchain.
Polymath envisions a future where stocks, bonds, private equity, venture capital and other asset classes are tokenized and traded without using the inefficient & costly traditional capital markets system. Enabling fractional ownership of assets using security tokens can bring liquidity to illiquid assets such as private company shares.
Security tokens created on Polymath can be fully regulatory-compliant. Since KYC and legal/compliance restrictions are built into the token, it can potentially be traded on any platform or exchange while remaining compliant with securities laws.
Security Tokens and STOs
With the SEC taking action against unregistered Initial Coin Offerings (ICOs), it is only a matter of time before other regulators follow. This greatly limits the scope for ICOs in their current form.
For the past two years, many ICOs and utility tokens were constructed as a workaround to having to comply with securities laws. Most ICOs and their utility tokens did not comply with securities regulations, protect investors, or derive value from underlying assets. It is no surprise that regulators took notice and demanded compliance.
Security tokens should offer this level of compliance.
Securities are tradeable financial assets such as stocks and bonds. They offer investors legal rights to underlying assets or cash flows, while protecting investors. Stocks, for example, enable investors to own part of a company and possibly participate in dividends and voting.
Security tokens allow this to be accomplished using cryptographic tokens on a blockchain instead of through traditional means. A Security Token Offering (STO) is basically an ICO or fundraise for regulatory compliant security tokens.
For these reasons, security tokens may soon see explosive growth. What is needed are simple, safe and legal ways to create and trade them.
Polymath wants to do for securities what Ethereum did for utility tokens, but on a larger scale: by migrating trillions of dollars of securities to the blockchain. The market cap for global stock markets alone is in the $80 trillion range. Polymath wants to become the preferred solution to guide issuers through the token issuance, legal, compliance and fundraising process. These security tokens will function as traditional securities that can pay dividends, have voting rights and have other features while remaining compliant with securities laws such as accredited investor laws.
Traditional finance has barely begun to embrace blockchain tech and Polymath hopes that it can be the catalyst in this area. Private equity, venture capital, and even some stocks and bonds, can be illiquid, have high transaction costs, or have high unit costs. Polymath aims to make securities trading more liquid, secure, and accessible through fractional ownership.
Tokenizing securities can streamline security issuance and trading processes by eliminating middle-men and inefficiencies. This makes issuing securities faster and cheaper for companies and will make trading cheaper for investors.
To this end, Polymath’s has created a security token platform on which regulatory-compliant tokens backed by any form of financial instrument can be built, issued and traded. Polymath features a modular design where issuers (i.e. the company or organization tokenizing their stock or assets) can pick modules and smart contracts with which to build and customize their security token.
Polymath is built on the Ethereum blockchain. Security tokens issued on the platform comply with the ST-20 token standard and can grant token holders voting rights and dividends among other features. Tokens can also represent ownership of a proportionate share of a company’s assets and/or profits.
In Polymath, security tokens and their available modules are managed by a set of registries:
- Ticker Registry: enables issuers to reserve their token symbols for token creation purposes;
- Security Token Registry: records all tokens issued on Polymath;
- Module Registry: contains developer-created ‘modules’ that can be used by issuers to add specific functionalities to their token, for example, setting token transfer rules, defining sale/purchase criteria, or dividend distribution rules. Modules are like token ‘add-ons’ that can be added, upgraded or removed by the issuer.
In addition, Polymath’s various partnerships (see the Partnerships section below) should provide robust compliance, security, and greater access to secondary markets for investors.
Polymath consists of four layers:
Layer 1: Ethereum
Polymath’s Token Studio dApp, its smart contracts and ST-20 protocol are built on, and powered by, Ethereum.
Layer 2: ST-20 Protocol
The ST-20 protocol enables the deployment of security tokens with in-built transfer restrictions. The ST-20 protocol controls who a token can be transferred to as well as transfer conditions in primary and secondary markets. This layer also contains Polymath’s core architecture, which includes its registries and modules.
Layer 3: Polymath Token Studio
The Token Studio is a dApp that allows issuers to create their customized security token and launch their own STO. Issuers need to:
- Register a token symbol
- Choose service providers (e.g. legal, KYC, custody)
- Create a token
- Set up offering details
- Whitelist investors
This blog post from Polymath offers guidance on testing out security token creation.
Layer 4: Marketplace
Developers offer STO smart contracts and modules for issuers to use. Modules are used to customize security tokens (e.g. dividends, voting). The marketplace should be open to external developers shortly.
The POLY Token
POLY powers transactions on the Polymath network, much like ETH does on the Ethereum network. Examples of POLY usage:
- Issuers: pay service providers and developers for tokenization services and pay additional fees for ticker symbol registration, token creation and STO setup;
- Developers: earn POLY for creating STO smart contracts;
- KYC and other service providers: earn POLY for verifying investors and performing other services (e.g. legal);
- Investors: pay KYC providers in POLY to be verified and whitelisted;
Service providers are paid in POLY, but the price for services is negotiated between the issuer and service provider. This protects the service providers from price fluctuations in the POLY token.
Fees payable in POLY to Polymath for tokenization and STO setup are quoted here.
Polymath’s ST-20 (a.k.a. ERC-1400) Token Standard
Polymath created the ST-20 token standard for security tokens, which has since been formalized under Ethereum’s ERC-1400 standard. Under this standard, only authorized investors can hold and trade tokens. Crucially, ERC-1400 tokens are backwards compatible with ERC-20. This means wallets able to hold ERC-20 tokens can also hold ERC-1400 tokens.
The Ethereum platform skyrocketed after establishing the ERC-20, which quickly became the industry standard for companies issuing tokens on Ethereum. Polymath hopes for the ST-20 standard to have a similar effect for security tokens.
This standard has built-in KYC and AML features. This KYC-aware token technology restricts transactions to authorized individuals and entities through smart contracts and its own whitelisting technology. Whitelisted wallet addresses of authorized individuals are stored on-chain in smart contracts whereas personal details are stored off chain by the issuer or their nominated KYC provider.
Solutions for Issuers and Investors
Polymath allows issuers to easily and securely create tokens, as well as access to secondary markets. Investors will receive protections seen in traditional securities markets and will have access to secondary market trading.
Medium of exchange flexibility
Issuers can raise funds either in ETH or POLY since all calculations have been pegged to fiat currencies such as the US Dollar. This insulates issuers from cryptocurrency volatility.
Investors can invest using either ETH or POLY, with prices pegged to fiat currencies and possibly even stablecoins in future.
Smart contracts assure issuers of receiving funds promised by investors. As soon as issuers fulfill the obligations stipulated in the smart contract (which is co-developed with authorized legal delegates), investor funds are automatically transferred.
Issuers should have fewer issues related to trades and settlements because these tasks are largely automated by smart contracts.
Since the obligations of investors and issuers are programmed into smart contracts, investor interests are protected if the issuer acts unlawfully or does not fulfil predetermined conditions.
Issuers have the option to implement forced transfers, allowing the issuer to force a transfer of tokens to satisfy court orders, for example.
Only authorized (or whitelisted) investors can contribute funds. Investors will be validated by an accredited third-party KYC/AML provider, thereby lowering the potential for fraud, money laundering, etc.
Polymath Core v2.0.0
Polymath introduced many interesting new features when it released Polymath v2.0.0 on 22 November 2018.
It is important to note that Core 2.0.0 is not backwards compatible with the previous version of Polymath (v1.3.0). However, Polymath will instruct companies who deployed tokens on v1.3.0 (prior to 22 November 2018) on migrating to v2.0.0. Issuers who deploy new tokens on v2.0.0 will automatically enjoy the new features.
Fundraising Pegged to Fiat Currencies
Issuers can now raise funds in ETH, POLY and/or any stablecoin including DAI, with the price pegged to fiat currencies (e.g. USD). Issuers can set their token price in USD but still receive ETH or POLY. This feature is introduced by the USDTieredSTO smart contract.
Polymath will obtain POLY/USD price feed from MakerDAO in addition to a ETH/USD price feed.
Pegging STO calculations to fiat currencies shields issuers from cryptocurrency volatility. Issuers won’t have to regularly update filing documents to reflect changing crypto exchange rates.
Forced transfers enable issuers to transfer tokens between accounts regardless of predefined rules and restrictions.
Forced transfers are controversial in the crypto world where the concept of decentralization is idealized. However, the forced transfer feature will enable some real-world securities use cases. For instance, if a shareholder passes away, the forced transfer function can transfer securities from the deceased shareholder to his family members or other delegated recipients. Forced transfers also allow compliance with court orders that require shares to be transferred.
The issuer can assign a 3rd party delegate (e.g. a legal delegate) to access this feature. Issuers also have the option to permanently disable the forced transfer feature.
Tax Withholding and Address Exclusion for Dividends
While v1.3.0 already had modules to distribute dividends in ETH or ERC-20 tokens, v2.0.0 adds two complementary features:
- Tax withholding: issuers can control how much ETH/tokens they want to withhold from investors. The withheld balance is forward to the relevant tax agency. This feature could be useful in future if more tax agencies start accepting tax payments in cryptocurrencies – Overstock.com has already reportedly paid Ohio State business taxes using Bitcoin.
- Address exclusion: issuers can exclude certain wallet addresses from receiving dividends (e.g. the issuer’s own token reserve wallet).
Polymath has laid the groundwork for allowing smart contracts to be upgraded with new features without redeploying these contracts or migrating old data.
The SecurityTokenRegistry and ModuleRegistry smart contracts now support in-place upgradeability, with hopefully more to follow. Upgrades now provide new functions by replacing the smart contract that holds the logic while not changing the smart contract that holds the data.
New competitors are streaming into the security token issuance and trading space, which could lead to a ‘survival of the fittest’ situation in future.
On the other hand, more people developing legally compliant security tokenization platforms could create synergies as these firms find ways to collaborate and build a vibrant ecosystem that fuels adoption. In fact, the real competition comes from the traditional method of registering a security with the SEC, which is quite onerous.
Some blockchain startups in Polymath’s niche are:
Harbor offers a legally compliant platform to tokenizing private securities. To fully automate compliance with securities laws, Harbor created its own ERC-20 compliant R-Token which allows embedding KYC, AML, and other compliance features at the token-level.
Neufund is a blockchain platform focused in allowing its users to create and issue legally-compliant security tokens in the form of “equity tokens.” With the use of smart contracts, Neufund hopes to create a more secure relationship among issuers and investors.
Swarm Fund is a decentralized investment platform. Its helps investors of all sizes to potentially participate in private equity investments. They recently partnered with Stellar to support Swarm’s underlying blockchain.
Securitize allows funds, companies and other asset holders to tokenize their assets. Their Digital Securities (DS) protocol provides compliance solutions for issuers, investors and exchanges throughout the entire lifecycle of a given digital security.
tZero is building an Alternative Trading System (ATS). tZero aims to enable securities trading on the blockchain by cutting out middlemen and make the entire process faster and cheaper by easing trade settlement, improving recordkeeping and giving traders an easy-to-use front-end system. tZero is not a direct competitor to Polymath and Polymath actually advised tZERO on the design, economic model, and distribution of tZero’s own security token.
Polymath boasts numerous partnerships, perhaps in the belief that they will propel growth and provide users with essential features.
OpenFinance Network (OFN)
OFN a US-based security token trading platform. Their partnership with Polymath will allow Polymath-powered security tokens to concurrently list on OFN, thereby offering the tokens more trading opportunities in secondary markets.
Partnered with Polymath to verify issuers, their escrow services and accounts. Trustroot offers company profile verification through extensive background checks, confirmation of legal registration, and wallet ownership, among others.
Partnered with Polymath to streamline KYC and AML processes. IdentityMind is a blockchain platform offering KYC, AML and fraud prevention services for clients such as banks and payment service providers.
Partnered with Polymath to provide KYC services for accredited investors. SelfKey is a blockchain-based identity management system that verifies users and eases the KYC process.
Token Contracts Created on Polymath
At the time of writing, over 75 security token contracts have been created on Polymath, according to the Polymath Network Telegram group.
Corl Financial Technologies, SeriesX, and Ethereum Capital all plan to launch their security tokens on the Polymath platform. They will join companies like Minthealth, 7Pass, IPwe and BlockEstate, among others.
Risks and Challenges
The security token landscape is still evolving. Tokenization platforms such as Polymath will face both industry-specific and company-specific challenges as they try to get more issuers and investors on-board.
POLY Token Necessity
Is the POLY token really required for the network to function? Can’t the more prevalent ETH power transactions instead?
Competitors such as Harbor don’t even require a native token on their platform. One can argue that requiring users to pay in POLY as opposed to ETH (or even low-volatility stablecoins) creates extra friction that could discourage some from using the platform.
Unless people are willing and eager to use POLY, demand for the token could decrease, which further disincentivizes developers and service providers from participating in the network.
Who Accepts Liability?
Polymath, through its partnerships described above, is very dependent on third-party providers for KYC/AML, compliance, security and other services. While partnering with specialists makes good business sense, it creates ambiguity around which party is legally liable if something goes wrong.
If a security token is found to trade illegally, who should be punished? The third-party that verified the investors, or Polymath? How should each party be penalized? How will these legal matters be enforced across jurisdictions and borders?
Security tokenization is still young and it is hard to predict the legal issues that will invariably appear over time. However, it is possible that companies like Polymath may face multiple legal challenges if issues do appear, which will divert the team’s energies from growing the platform.
The global regulatory response to blockchain, cryptocurrencies and digital assets is fragmented and evolving slowly. Regulators still have to amend traditional securities laws to incorporate security tokens.
A full analysis of regulations related to security tokens is beyond the scope of this article. However, the Security Token Academy maintains a timeline of what different countries are doing in terms of cryptocurrency regulation.
At this stage, it is hard to predict how Polymath will be impacted by changing regulations and laws. In a worst-case scenario, regulators’ future hostility towards security tokens, or a significant security breach, could threaten core aspects of Polymath’s business model. That said, Polymath’s management team likely enjoys some credibility with the US SEC, since their own ICO was registered and compliant with SEC regulations. Therefore, Polymath’s management appears to show the willingness and ability to comply with (changing) regulations.
The potential is there, the industry is nascent, and the technology has been (mostly) built. Issuing companies don’t have to be blockchain experts to issue tokens on Polymath and can leverage a network of developers and service providers to build and customize their token.
However, Polymath, like any other blockchain startup must prove itself through adoption. They must attract promising companies as token issuers and enough developers and service providers.
Finally, and perhaps most importantly, will retail investors ever be allowed to invest in security tokens backed by private equity, venture capital and other complex financial instruments? Or will these opportunities remain limited to professional and accredited investors, like in today’s capital markets?
Current regulation prohibits retail investors from investing in most of these asset classes, and it will likely remain this way for the foreseeable future. There are exceptions that allow private companies to raise money from retail investors, such as an early-stage private company filing with the SEC under Regulation A+, but these exceptions are few in number.
If (a big ‘if’) future regulations do allow retail investors to participate in asset classes limited to accredited investors, security tokens could become very popular indeed.
This article first appeared on BitPR.
Disclaimer: Investing in token offerings, cryptocurrencies, and digital tokens is highly risky and speculative. The material presented in this article is meant for information purposes only. It is not intended to provide any sort of investment advice, nor does it recommend any company, token offering, or digital token and should not be taken as the basis for any investment decision or strategy.