ERC-1400: Custodial Ownership
Placing the distribution, trading, governance and capital distribution of securities onto public blockchains provides opportunities to reduce costs, increase accessibility, improve transparency and integrate compliant financial products into open finance (aka DeFi). To help facilitate this transition to a world of securities on public blockchains, custody services from specialized service providers are widely recognised as an important plank in increasing adoption from institutions and individuals. Custody services can decrease risks around fraud and hacks, as well as streamline the customer experience and abstract away the underlying complexity of these novel technologies.
ERC-1400 is a library of security token standards that has seen great adoption amongst Ethereum protocol developers and service providers. The latest 3.0 release of our Polymath protocol for security tokens includes an upgrade to ensure that ST-20 tokens generated through the protocol are fully compliant with this library of standards. We have also seen adoption by a number of other projects and service providers operating in the space as well as continued discussion and feedback across a wide array of interested parties, developers, and thought leaders.
ERC-1400 evolved from a single monolithic standard into a library of interoperable standards with the intention of facilitating its adaptability and growth in a rapidly changing legal and regulatory landscape, allowing new functionality to be added without compromising existing compatible services and infrastructure.
Ownership vs Custodianship
One of the key advantages of security tokens is that they provide a transparent and reliable record of ownership of an asset. ERC-1400 inherits from ERC-20 (or similar token standards) the concept of ownership as a balance associated with a specific Ethereum address which represents the asset owner.
However there are many use-cases for security tokens that require a more sophisticated and granular concept of ownership, specifically differentiating beneficial asset ownership from custodial ownership of those assets. In this case the token owner remains the beneficial owner of the security with respect to capital distribution and governance, whilst the custodian has exclusive rights over changing the beneficial owner.
Example 1:
- a DeFi protocol requires you to provide security tokens as collateral. The DeFi smart contract must be able to transfer away your tokens if there is a liquidation event, which requires custodial ownership. The investor who is posting her tokens as collateral should continue to receive any dividends and be able to vote in any corporate actions.
Example 2:
- the investor nominates a custodian to safe-guard their tokens. They transfer custodial ownership to the custodian, and retain capital distribution and governance rights. This means that their assets are secured (via the custodian in cold storage) whilst the investor can still use a hot wallet to interact with governance and capital distribution.
Within ERC-20, the `approve` and `transferFrom` functions provide a kind of limited custodial ownership, but the security token owner still retains full rights to decrease the allowance or transfer tokens away entirely to a different address. As a result, custodians (whether organisations or smart contracts) must take full ownership of the token in order to guarantee their unilateral right to transfer the token so as to ensure that they are fully responsible for any changes in beneficial ownership of the asset. Typically the custodian then maintains (either on-chain or off-chain) a separate ownership record which maps their aggregated balance held in custody back to each individual beneficial owner.
This has a number of unfortunate consequences:
- the on-chain cap table of the asset is no longer an accurate reflection of beneficial ownership and instead mixes custodial ownership and beneficial ownership
- beneficial owners lose the ability to directly benefit from capital distribution such as dividends or coupon payments and must rely on custodians to facilitate these transactions
- beneficial owners can no longer participate in corporate governance directly and instead must rely on custodians to pass through their votes, or vote on their behalf
ERC-2258: Custodial Ownership Standard
ERC-2258 aims to standardise an approach towards the custodial ownership of assets represented through security tokens, cleanly differentiating between custodial and beneficial ownership in order to solve the above issues.
With this ERC, a token holder can now choose to nominate a custodian for a fixed number of tokens. The token holder cannot transfer away any tokens which have been put into custody, giving the custodian the expected guarantee that they retain full control over any changes to the underlying beneficial owner of those tokens.
At the same time, since the security token still records the beneficial owner in the usual expected way, issuers and investors get a clean and accurate cap table, and direct capital distribution and governance which can now operate independently of custodial ownership.
Full details of this ERC can be found as a proposal here and we would love the community to review and comment on this approach — we think it represents a simple, but powerful evolution of the traditional approach to token ownership which is both relatively simple to implement, backwards compatible and interoperable with the full set of ERC-1400 token standards.
Joining Polymath
Do you want to join the security token revolution? We are growing rapidly and always looking for high quality talent. Check out our careers page at https://polymath.bamboohr.com/jobs/ to apply!
About Polymath
Polymath Network (Polymath) is a decentralized platform that makes it easy to create security tokens. The platform simplifies the complex technical challenges of creating a security token and aims to bring the multi-trillion dollar financial securities market to the blockchain.
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