Plumbing for the future of security tokens: Implementing KYC in bank transaction processes.

Decentralized finance is flourishing. With no central parties involved and few regulations in place, tokens are springing up all over. But what about regulations and how are they affecting this new industry?

Practitioner Perspective with Dr. Lewin Boehnke of the Crypto Finance Group

Most commonly, a public blockchain is also the medium of choice when multiple financial intermediaries cooperate to issue a tokenized product. Public smart contract platforms are becoming a sweet spot for a whole class of centrally issued securities. However, tokenized real-world assets offered by centralized and regulated issuers require Anti-money Laundering and Know Your Customer policies, and this form of centralization opposes the decentralized nature of the network.

The precise obligations, which regulated financial institutions have, heavily depend on the details of the token. What is the role of the institution? Is it the issuer of a product? Is it a custodian or co-custodian? In addition, the regulatory situation of the asset itself, as well as the jurisdiction in question, factors in.

Standardizing asset types and the corresponding token functionality will ease the handling significantly, but for the time being, these are mostly customized considerations. Given these inconsistent obligations, it is difficult to build processes that integrate neatly with client wallets, have a familiar user experience for the holder, and enable well-established processes for banks.

Consider the traditional operations when a client initiates a transaction, for example. Some checks are executed immediately and automatically, but if a transaction is flagged, it may be stalled, and may or not be executed after the pending checks.
Although such operations could be mimicked by a token smart contract, there are two drawbacks.

  • First, many of the automated checks cannot be completed with a smart contract because e.g. they require confidential internal information. This can limit the approvable transactions immediately to very few cases — e.g., transferring small amounts between users who are both asset holders already.
  • The ideal solution is doing checks during the transaction. This process of going from an on-chain & off-chain (hyphen use consistency in entire text) checks brings us to the second drawback: the user’s experience with the wallet will likely break completely. User wallets expect a transaction to either make it to the chain, in which case the balances should be changed to reflect that, or to fail, in which case, this is clearly indicated to the user. If a transaction check is pending off chain, the intermediate on chain state cannot be interpreted by the user’s wallet. The balances in the users’ wallets only change once a bank’s approval has been published on chain.

In other words, the blockchain simply cannot reach out to the bank, so the bank has to make an entry on the blockchain.
Besides such post-checks, two more options exist:

1. Pre-checks improve the situation by feeding information about the transaction or addresses into the contract before the holder attempts the operation.

2. and finally, (2) there is the ideal solution of doing all checks during the transaction. When the holder includes the countersigning by the institution in the operation, the contract can check this and act accordingly. Despite being the best option, in our view, this does require some additional plumbing. An ERC-20 contract, for example, does not allow additional data to be provided. ERC-223 and ERC-777 do allow this, but they have very limited support from wallet software. The additional pre-check between the contract and the bank would ideally be included in the wallet as well.

There are still many challenges to solve before the plumbing is in place for blockchain technology to fully disrupt the financial industry, but we are on it.

Find out more about tokenization in the finance sector from the Crypto Finance Group:

This article spoke about ERC-20 contracts as well as ERC-223 and ERC-777 contracts, but what is the technological meaning behind these terms and are there more forms of contracts that can be used when issuing a Security Token? Next weeks article will deal with this question.

This article is an extract from the 90+ page Security Token Report 2021 co-published by the Crypto Research Report and Cointelegraph Consulting, written by thirteen authors and supported by Crypto Finance, Blocklabs Capital Management, HyperTrader, Ten31 Bank, Stadler Völkel Attorneys at Law, Riddle&Code, Coinfinity, Bitpanda Pro, Tokeny Solutions, AlgoTrader, and Elevated Returns.