Digital Asset Working Group Report June 2019 Contents

Executive Summary...... 1 Level-setting...... 4 Market Context...... 4 Survey Results...... 5 First Survey - November 2018...... 5 Second Survey - February 2019...... 7 Drivers for adoption across the digital asset value chain... 12 Token Definitions & Taxonomy...... 14 Defining Tokens...... 16 Token Data Structures...... 17 Specific implications for tokens in financial markets...... 19 Key Regulatory Considerations for Tokenizing Assets in the EU and UK...... 19 Tokenomics & governance sub-group input...... 22 One specific area this group is taking forward...... 25 Projects going forward...... 25 Decentralised Finance...... 25 Why is DeFi important for financial institutions to watch? ...... 25 How is DeFi different from what came before it? 25. What are some of the larger projects? ...... 26 Next Steps...... 26 About R3...... 27 opportunities and hurdles for Taxonomy & Definitions,” “Legal Executive the market. Surveys showed the and Regulatory Considerations,” following: “Digital Asset Network summary Governance,” and “Go-Forward • Blockchain-enabled digital Projects.” The digital asset ecosystem assets are primarily a revenue is the most exciting area for opportunity, held back The DAWG put forward a blockchain technology, and it somewhat by regulatory taxonomy and definition of digital has massive implications for uncertainty. assets, to help participants use the way businesses interact and custody assets from both • The most significant in every industry. This is most a technical and business sense. impact will be in digital immediately relevant in capital This taxonomy is purposefully representations of real assets markets, where the ability to and digitally native securities. aligned to the many digital represent assets and transact asset taxonomies taking shape over digital rails with new models • Most organizations plan in the market, in which R3 and of trust is changing the way that to have products in the other DAWG participants are capital acquirers and allocators market in these areas in the actively involved. The purpose interact. next 1-5 years. The most of this effort was to go further powerful forces for market than a simple taxonomy and advancement are digital-first Innovation in digital assets provide a reference model exchanges and new models has always been oriented to for how digital assets can be for custody of digital assets, connecting issuers and investors which fits with a broader represented in code and how in more efficient and valuable market theme of an evolving they are recognized by existing ways. The financial crisis of and expanding role for both laws and regulations. The Legal 2008 provided a moment of exchanges and custodians in & Regulatory group shared opportunity, which bitcoin and the digital asset space. implications from an EU and UK blockchain technology seized legal perspectives, including in the following years. The • The distributed nature of MiFID and CSD-R applications. blockchain business networks Ethereum ecosystem presented a This assessment highlighted offers advantages (verifiable new world of digital assets, which the importance of regulated provenance) and challenges (if culminated in a bubble itself in one is using PoS). Security Settlement Systems 2017, when capital was allocated and the role of custodians in a to projects with weak business There is little doubt that the ability market where participants can cases. The market is moving to to create smart contracts and manage or delegate ownership take advantage of blockchain put more automation into digital of digital assets and private infrastructure, but is focusing assets directly adds significant keys. The Governance group on real enterprise use cases value through the capital examined considerations of and institutional scale. It was markets lifecycle and may make network governance, which in this environment that R3 - a middle and back office functions changes based on the consensus blockchain software technology more efficient. For all of this to be mechanism, the stakeholders company - brought together a possible, the market needs clear in the network, and the way the group of 50 organizations and standards on asset issuance, network participants execute 100 participants, all of whom are exchange, settlement, and changes to the network. active in the digital asset market. management. The primary product of the The working group was framed The DAWG produced multiple DAWG as a whole was the by two sets of surveys intended sub-working groups, which identification and assessment to establish market readiness addressed different aspects of the market drivers for digital and the outlook for digital assets, of the digital asset ecosystem. asset market adoption. Those as well as identify the major These included “Digital Asset drivers are framed within the

© 2019 R3. All Rights Reserved 1 digital asset value chain, which transaction finality, flexible trend is producing interesting includes issuance, registration, custody models, and a solution projects and innovations in exchange, settlement, and to include verifiable identity. financial markets. management. The general Finally, this paper addresses a requirements for market scale few opportunities for projects The Digital Asset Working Group and institutional adoption of going forward. For example, the included participants from the digital assets are clear standards, Decentralized Finance (DeFi) following organizations:

Allen & Overy CLS ING PIMCO

Alliance Commerzbank Intel Capital R3 Bernstein

ATB CU Ledger Itau SBI

Deutsche Latham & B3 SocGen Bank Watkins

Deutsche BAML Linklaters State Street Boerse

Barclays DLA Piper LSEG Trowe Price

Blackrock DTCC Mizuho UBS

BNC Euroclear NatWest US Bank

BNP Paribas Fidelity Nomura Westpac

BNY Mellon Fintertech Northern Trust WSGR

Cambridge Judge Goldman Sachs Numerate Business School

Citi ICICI Perkins Coie

© 2019 R3. All Rights Reserved 2 APAC READOUT HIGHLIGHTS DIGITAL ASSET 74% IMPACT of participants pointed to “tokenized assets” as having the most important On May 22nd 2019, over two hundred impact on their organization as and fifty participants joined R3 at Singapore Management University to opposed to “cryptocurrency” (19%) or hear takeaways from the Digital Asset “neither” (17%). Working Group (DAWG) and to discuss the findings in the context of the Asian market.

Live surveys of the participants further validated initial DAWG responses. Network fees (specifically “gas” to use Ether) was a significant impediment for the use of the cryptocurrencies that underlie public blockchains.

1-5 Years Similar to DAWG findings, respondents said it would take their organizations one to five years to roll out products and services around digital assets.

© 2019 R3. All Rights Reserved 3 As complexity increased, the additional costs incurred. Level-setting trusted custodians picked This is causing pain for financial up another critical market institutions and dissatisfaction Market context function: reconciliation of asset among the most important parts composition and ownership. of the value chain: issuers and investors of assets. Across use cases, issuers and investors have always existed 2008 as the two primary parties to a Bitcoin transaction. An issuer is a party The financial crisis had many who makes a promise to the proximate causes, but the With one whitepaper that built marketplace and an investor market’s structural weakness on decades of cryptographic buys that promise by spending was the origin. Financial markets research and development, money or deploying capital. That did not accurately value assets Satoshi Nakamoto proposed promise could be a commitment and their risk profiles. Further, a system for anonymous, to deliver a good, provide a asset holders did not understand independent parties to transact service, or build a business. The the relationships between with assurances against double- investor is buying that good, assets, which was largely due spends. Bitcoin began as an service, or share of profits. We to the complexity enabled by interesting solution to preventing can call that promise an asset. technology in capital markets. double-spends (fraud) and Complex securitization made it showed how distrusting parties As markets developed, banks difficult to assess and manage could reach consensus about the were employed as trusted safe- risk. When one segment of an state of a global ledger through keepers of assets. They evolved asset class - retail mortgages cryptographic proofs. It was most to provide access to markets. - underperformed, a potentially interesting to institutions and In fact, financial institutions limited weakness destroyed enterprises not as a medium of provided expanded roles across significantly more value, with exchange or store of value, but the transaction value chain, wide-ranging negative results. as a new model for creating becoming the infrastructure trusted transactions between that connects issuers and The financial crisis caused distrusting parties. This took off investors in all types of markets. us to re-think intermediaries, as blockchain technology. This expansion of roles includes market structures, and the risk-taking functions, marketing, basis of the promises issued. Ethereum broking, and the original New regulation was introduced, intermediary function: custody. which fundamentally changed The public blockchain market structure and the role community took this innovation Custodians began to represent of participants in the financial forward, using the underlying assets in digital form in the asset value chain. In the recovery technology of Bitcoin to create 1960s. Computers provided a and associated market structure new applications and networks. fundamentally better way to record changes, trusted intermediaries Blockchain technology was assets, track movements, and and custodians were limited from quickly applied to reconciliation maintain accounts. The way revenue opportunities and picked use cases across industries, but issuers and investors interacted is up additional risk controls which especially in capital markets. always changing. From face-to- added cost and process. This was Tokens - native representations face arrangements, to mail, to paramount. of promises on a distributed voice trading, to electronic markets. network - were shown to be a Technology is always being In the ten years since the new and different way to connect applied to make this process easier. recovery began, major markets issuers with investors. The public have been on an extended bull blockchain community took this Technology also allows for run, and financial intermediaries forward with massive fundraising increasing complexity in assets have been asked to deliver operations in which investors and how they are created. better financial results despite bought tokens representing

© 2019 R3. All Rights Reserved 4 securities or “utility” value for Out of this market downturn, continents to form the Digital future use in the platform. This enterprises realized there could Asset Working Group (DAWG). market brought forward important be a better way to issue and The participants came from innovations in both the ability to invest in digital assets. Between financial institutions, traditional represent assets digitally and digital representations of assets, financial market infrastructure, direct custody of digital assets. direct custody, and peer to peer fund managers, and law transactions, the advantages firms. The primary goal of However, many of the businesses of blockchain technology the DAWG was to determine that raised money through demonstrated real promise. the market requirements and the public blockchain markets Issuers, investors, and market capabilities that would drive lacked robust business plans or infrastructure providers are real market adoption of digital solid governance practices. The investing in blockchain technology assets in capital markets. The retail nature of many exchanges with real business plans and participants held discussions encouraged speculation and a regulated securities markets. about various aspects of the “greater fool” theory of investing. digital asset ecosystem, and This correlated to a significant drop It was in this context that R3, also heard presentations from in public blockchain token prices. an enterprise blockchain solution providers such as company already working digital asset issuance platforms, Enterprise Opportunities with financial institutions and digital custodians, settlement and Requirements corporates, brought together asset issuers, and digital asset 48 organizations across three exchanges.

Survey results Respondents were given a First Survey - working definition for digital November 2018 The Digital Asset Working Group assets as follows: sought feedback from members All respondents were then via two surveys, the first was at the For the purposes of this survey, asked their views on positive outset of the group, and the second we define digital assets as a and negative aspects of digital came approximately halfway ledger-based asset, either: assets. Approximately half of through the six-month project. those responding viewed the • Assets native to Distributed main positive benefit as revenue Ledger (“DL”), in which the The first survey covered the opportunities, with a further third ledger is the account of record goals of the working group, and seeing cost reduction as the (including cryptocurrencies), or respondents’ views on digital main benefit. assets. The first survey had 18 • Assets immobilized, respondents from across the dematerialized, and/or held off financial industry, and related chain, but represented on DL. professional services firms.

Revenue opportunities The most important positive 33.3% Cost reduction Regulatory treatment impact of digital assets on Capital/balance sheet reduction our business will be: All 18 responses 50% Unclear at this time Revenue is only part of it. Industry growth is another

© 2019 R3. All Rights Reserved 5 Revenue loss Cost increase The most important negative Regulatory burden impact of digital assets on Capital/balance sheet increase Cost and risk of implementation our business will be: 44.4% Business rentention 18 responses 16.7% Dual costs and complexity in the ad ... Unkown

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When asked about which whether as representation of impactful for their businesses. categories of digital assets other more traditional assets, Cryptocurrencies and utility respondents saw as potentially or natively issued (e.g., bonds tokens received a slightly more having the greatest impact, they issued tokens), would be more mixed reception. suggested that the tokenization,

Rate the impact that the following types of digital assets will have on your organization (medium to long-term):

8 0 - Insignificant 1 2 3 4 5 - Very significant

4 Number of responses 2

0 Virtual/Crypto currencies Digital representations Digitally native securities Utility or access tokens of real assets

Scale from lowest to highest

Further to this, respondents were • Digital Cash products and solutions for asked specifically which types of digital assets, with one-third • Asset backed tokens digital asset products they saw of respondents indicating that as having the most impact on • Securities tokens/tokenized they currently have an offer or their businesses. More common securities see their organization bringing responses included: an offering within a year. A • Lending/financing tokens further 61% indicated that their • Legally recognized smart organization would bring an offer contracts Respondents were also fairly in less than five years. confident about the prospect • FMI functions (depository, of their organizations offering settlement, registry)

© 2019 R3. All Rights Reserved 6 <1 Year What is the timeline for your 16.7% 1-5 Years organization to offer products 5-10 Years 61.1% >10 Years or services on digital assets? 16.7% Our organization currently as a 18 responses digital asset offereing

Second Survey - market appetite for digital assets, and exchanges played, and how as well as particular issues and they would be critical in fostering February 2019 opportunities discussed amongst adoption of digital assets. the members. Respondents to the survey largely A second survey, taking place welcomed the notion of these approximately three months One issue of discussion which entities adopting a digitally native after the working group with arose as part of the working approach, which could lead to largely the same base of group was the role that financial the support of these new asset respondents, provides an update market infrastructures (FMIs) types. on respondents’ views on the

New exchanges and market infrastructure built from a “digital-first” perspective would be an advantage to my business: 17 responses

6 6 (35.3%)

4 4 (23.5%) 4 (23.5%)

3 (17.6%) 2

Number of responses 0 (0%) 0 (0%) 0 (0%)

0 1 2 3 4 5 6 7

Scale from lowest to highest

© 2019 R3. All Rights Reserved 7 Another aspect related to digital exists. Many respondents viewed custody services saw this as less assets was the ability for a flatter this positively. Presumably entities desirable, which was reflected in custody structure than currently currently involved in offering at least some responses.

The ability to directly custody assets is appealing to my business: 17 responses

5 (29.4%) 5 (29.4%) 5 (29.4%) 4

Number of responses 0 (0%) 0 (0%) 1 (5.9%) 1 (5.9%) 0 1 2 3 4 5 6 7

Scale from lowest to highest

Another point of discussion participants were concerned providers and their clients. This was how digital assets are about loss of private keys. Even if aspect should be considered secured. Looking at the method it were possible to recover keys, if offering such a solution to utilized in cryptocurrencies and this could still create issues for institutional markets. tokens, public-private key pairs,

The risk of key loss (even if recoverable) is of significant concern: 17 responses

10 11 (64.7%)

5 Number of responses 0 (0%) 0 (0%) 0 (0%) 1 (5.9%) 3 (17.6%) 2 (11.8%) 0 1 2 3 4 5 6 7

Scale from lowest to highest

© 2019 R3. All Rights Reserved 8 The need to pay for transaction consequences that slow and controls across large fees for using a cryptocurrency adoption of digital assets on institutions. Some respondents (e.g., ETH) is a unique aspect these types of networks. Some did not see this as a major to the operation of tokens on participants noted the difficulty hurdle, while just over half stated permissionless blockchains. in acquiring cryptocurrencies for that it would be a considerable While this may be something experimental purposes. Scaling impediment for adoption of that requires education or applications on permissionless digital assets. more mature infrastructure, it blockchains to product may could also have unintended require changes in processes

The requirement to use a cryptocurrency (e.g. Ether) to pay network transaction fees is a significant impediment for adopting digital assets: 17 responses

7 (41.2%) 6

4 4 (23.5%)

Number of responses 2 2 (11.8%) 2 (11.8%) 0 (0%) 1 (5.9%) 1 (5.9%) 0 1 2 3 4 5 6 7 Scale from lowest to highest

Respondents also looked at how positive, seeing benefits for noted that this could pose issues a distributed ledger could lend compliance and cost reduction, related to banking secrecy rules, itself to providing a full history of however some respondents and frontrunning. an asset. Responses were overall

Having the ability to identify the history of where an asset has been, back to its creation is appealing my business: 17 responses

7 (41.2%) 6

4 3 (17.6%)

3 (17.6%) Number of responses 2 2 (11.8%) 0 (0%) 1 (5.9%) 1 (5.9%) 0 1 2 3 4 5 6 7

Scale from lowest to highest

© 2019 R3. All Rights Reserved 9 Another area which factored owing to their full histories being require each entity to store in the compliance and cost available, tie data permanently considerable amounts of static reduction discussion was how to the asset. Contrast this data themselves, which is often data could be referenced. with current methods which reconciled with other entities. Digital assets in some forms,

Attaching data to the asset itself, as opposed to each owner recording data in their own systems, would add value: 17 responses

5 (29.4%) 5 (29.4%) 4

Number of responses 3 (17.6%) 3 (17.6%) 2

0 (0%) 0 (0%) 1 (5.9%) 0 1 2 3 4 5 6 7

Scale from lowest to highest

One potential benefit cited for the reasons for inefficiencies in the others. When asked specifically use of digital assets was greater current system were not related about shortening the settlement efficiency of the life cycle of a to technology, but rather factors cycle (regulation and market trade. Responses tended positive such as regulations, compliance convention) results were also but were mixed on this aspect. and market conventions, among largely similar. Discussions suggested that many

The live cycle of a trade that current exists is inefficent for technology reasons: 17 responses

5 (29.4%) 4 4 (23.5%)

3 (17.6%) 3 (17.6%)

Number of responses 2

0 (0%) 1 (5.9%) 1 (5.9%) 0 1 2 3 4 5 6 7

Scale from lowest to highest

6 6 (35.3%)

4 4 (23.5%) 4 (25.5%)

2 Number of responses 2 (11.8%) 0 (0%) 0 (0%) 1 (5.9%) 0 1 2 3 4 5 6 7

Scale from lowest to highest

Respondents were positive Members noted that while some may view such statements towards the notion of smart automation is generally positive, as defensive, repeated histories contracts and distributed overly automating could have of flash crashes and strict ledgers acting to automate and adverse side effects which could adherence to codified policies enforce some aspects related negatively impact the orderly have resulted in the need to roll to the functioning of assets. operation of markets. Though back or alter trades.

Codifying, and digitally enforcing certain behaviors of assets would improve my buisness: 17 responses

7 (41.2%) 6

4 4 (23.5%) 4 (23.5%)

Number of responses 2 2 (11.8%) 0 (0%) 0 (0%) 0 (0%)

0 1 2 3 4 5 6 7

Scale from lowest to highest

Though members have noted operations costs are considered. investments to realize the gain. numerous benefits of tokens Respondents of the survey This is a key aspect that solution and distributed ledgers, they mirrored this sentiment, noting providers should factor into their noted that many proposed that they had only seen a few proposals that leverage radically use-cases came up short when potential avenues which could new operations methods. upfront investments and all-in truly propel them to make the

8 8 (47.1%)

5 (29.4%) 4

Number of responses 2 2 (11.8%) 0 (0%) 0 (0%) 1 (5.9%) 1 (5.9%) 0 1 2 3 4 5 6 7

Scale from lowest to highest

This section walks through asset lifecycle can be broken Drivers for the lifecycle of digital assets, up into five major categories: providing an overview on the issuance, registration, exchange, adoption work required for digital assets settlement and management. to exist within regulated capital Within each of these stages, across the markets. For tokens to be used as adoption of tokens will vary financial instruments, the entire based on customer base, digital asset lifecycle of the assets will need functionality, definition, and to reflect, or at least account for classification under law. value chain features of traditional assets. The

Digital Asset Value Chain

ISSUER ISSUANCE REGISTRATION EXCHANGE SETTLEMENT MANAGEMENT INVESTOR

• List assets available to trade • Host markets of various • Digitally represent asset structures • Custody assets and keys on behalf as a token • Facilitate price discovery of beneficial owners • Connect token to backing • Facilitate asset trades • Manage corporate actions asset(s) • Send trade data & confirmation • (Much of the active work can be • Issue token to market to system of record automated at the asset level)

• Register the asset with the • Allow participants to agree relevant regulator and/or CCP to settlement method and • Ensure tokenized asset is parameter fungible with otherwise • Provide network for settlement identical non-tokenized assets asset transfer

© 2019 R3. All Rights Reserved 12 Issuance registration process of existing instrument. Settlement off- assets is a critical step. blockchain can occur through One of the first questions token existing networks, where issuers face is how to initially Exchange transactions are simply mapped offer assets on blockchain to the payment process platforms. These are operational One of the most obvious concerns, focused on how the determinants of any asset’s Additionally, blockchain asset is modeled, defined, and longevity is its demand by based settlement can serve how the features of a digital investors. Since tokens are additional benefits aside from asset work. For example, tokens a new way of representing allowing tokens to be traded must represent assets and an investment, usage rests with a guarantee of payment. agreements in digital form. confidence in both the asset’s In some scenarios, settling on One feature of tokens is that value and the infrastructure blockchains provide benefits data is contained in the asset through which it is traded. This simply for payments, as they can itself. Additionally, in order to be value must be tangible and shorten the post-trade process. understood, they must fall under convertible into other assets Regardless, any assets settling a clear taxonomy of assets and or trusted sources of value. on- or off- blockchain must market-accepted definitions of Counterparties must be able to confer a sufficient degree of asset characteristics and abilities. agree on prices and transact on finality. existing markets with liquidity and Registration systems integrated to OMS tools. Management Additionally, due to the regulated Tokens must also integrate within nature of financial services, these Tokenization provides an existing financial infrastructure. trading parties need to exist opportunity to improve the This means that the assets must within a perimeter of KYC checks. management of financial assets both integrate technically, and Finally, the parties will require full by encoding features into the the bookkeeping techniques knowledge of - and confidence in asset. There has been much must account for these new - the settlement process. research on specific areas where assets that firms hold. For tokenized assets provide unique example, currently securities Settlement value - for example, reflecting must be registered with multiple facts from external sources. bodies. Tokens must follow Settlement is frequently Tokenized assets decouple the this path, and gain recognition discussed in conjunction with responsibility from proving single- with relevant authorities such blockchain, but the role of spend and services – providing as CSD, SEC, IRS, etc., Moving blockchain in settlement is potential for users to have more forward, tokens could either often confused – as there are control. With tokens, custodians reflect registered status in the multiple possibilities. Blockchain can either provide private keys asset itself as a data field or can either serve as the delivery or assets themselves (or both). characteristic of the asset itself. leg for assets settled elsewhere. However, custodians must still This instruction could come Alternatively, blockchain can integrate with OMS tools and from almost any participant: be used for payments to settle represent asset characteristics to Issuer directly, issuance platform, assets directly. As a result, tokens relevant registration authorities. exchange, custodian. will need to have a mechanism for settling transactions either General Additionally, assets issued on on- or off- blockchain platforms. a blockchain platform must be Settling on-blockchain platforms There are many network level fungible with assets previously may require settlement assets improvements that need to occur registered without blockchain to exist on ledger, such as before financial assets existing applications. Mirroring the a stablecoin or other cash on these blockchain platforms

© 2019 R3. All Rights Reserved 13 can become mainstream. relevant across certain stages of 2. Financial Asset Tokens: These surround scalability, this value chain. Tokens whose intrinsic features privacy, interoperability and are designed to serve as or identity. First, each step in the represent financial assets such value chain must support scale as financial instruments and Token “securities”. demands of market as-is. This is especially true in integrations Definitions & 3. Consumer Tokens: Tokens that to exchanges Second, each are inherently consumptive in transaction must be confirmable Taxonomy nature, because their intrinsic without broadcasting data to features are designed to every participant in the network. Many have attempted token serve as, or provide access Third, applications addressing taxonomies. In the interest of to, a particular set of goods, one or more steps in the value standardization, the DAWG services or content. chain must integrate with legacy decided against creating systems. And fourth, network competing standards. They further note that, these participants must be able to categories are designed in find trading parties. Network Rather, the DAWG uses Global reference to a token’s “intrinsic” participants must be able to Digital Finance’s (GDF) taxonomy. features – i.e. the actual functions share their verified identify The GDF taxonomy contains that are coded into the tokens and verify the identities of their the following three top-level and the networks and platforms trading counterparts. label categories, which are not on which they operate. However, necessarilymutually exclusive: price volatility, transaction cost The following section will abstract acceptance, tax treatment, 1. Payment Tokens: Tokens away from the digital asset value cybersecurity are among the whose intrinsic features chain, focusing on the types of hurdles faced by these and tokens, and how they can be are designed to serve as a general-purpose store of payment tokens achieving more best classified and understood. widespread acceptance as a Later sections will elaborate on value, medium of exchange, and/or unit of account. store of value or medium of governance and legal questions exchange.

© 2019 R3. All Rights Reserved 14 Loan ISDA CDM ISDA CDM ISDA CDM ISDA CDM ISDA CDM ISDA CDM ISDA CDM Obligation Represented Fungible Token / NonFungible Fungible Token / NonFungible Fungible Token / NonFungible Fungible Token / NonFungible Fungible Token / NonFungible Fungible Token / NonFungible Fungible Token / NonFungible Fungible Token / NonFungible No No No No No No Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes type? Fungible be mutually Can the token others of the same interchangable with Yes Yes Yes Yes Yes Yes Yes Yes N/a N/a When issued as a depository receipt Depend on contract Depend on contract Depend on contract Depend on contract Depend on contract Depend on contract Depend on contract Redeembable form of consideration? No No Yes Yes Yes Yes Yes N/a N/a N/a native token Can the token be redeemed for some When issued as a Depend on contract Depend on contract Depend on contract Depend on contract Depend on contract Depend on contract Depend on contract N/a N/a N/a N/a Token issuer Token issuer Token issuer Token issuer Issuing company receipt (depository Issuing organization Depends on fair value Depends on fair value Depends on fair value Depends on fair value Depends on fair value Depends on fair value Depends on fair value always has a liability) When issued as a depository Liability of financial obligation? Which party holds the ultimate N/a N/a N/a N/a N/a N/a No-one When issued Central bank as a native token Issuing company Issuing organization Depends on fair value Depends on fair value Depends on fair value Depends on fair value Depends on fair value Depends on fair value Depends on fair value Lender Obliger Asset of Token holder Token holder Token holder Token holder Token holder Token holder Token holder Token holder and rewards? Which party is entitled to the risks Depends on fair value Depends on fair value Depends on fair value Depends on fair value Depends on fair value Depends on fair value Depends on fair value TOKEN TAXONOMY Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes the thing on ledger? Depositary receipt The asset exists off ledger but can a No (Assumption is ledger native only) No (Assumption is ledger native only) depository issue a receipt representing No No No No Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes be issued the ledger? directly on to Can the asset Yes (in theory) Native tocken Gold, oil, etc. Things (Art etc.) Real estate Equity Bond OTC Option Exchange traded option Exchange traded future Forward OTC Swap Exchange traded swap Repo Obligation Loan CBD Cryptocurrency E-money Physical stuff Obligations Currency Commodity Equity Fixed Income Derivative Depository receipts issued in respect of real-world things can be as fractions the single thing. Hence pre tty much everything fungible. For depository receipts, the token issuer always has ledger liability. However, party iwth ultimate liability is li kely a different entitiy, as table alludes to. With ledger native tokens, the party with on liability and ultimate is same party. Cyrpto-curriencies have no issuer (e.g. a Bitcoin confers rights). Asset-like things Contract- like things 1. 2. 3. 4.

© 2019 R3. All Rights Reserved 15 The group also recognized that Digital tokens function differently newer, which is typified by a within each type of token, and in from dematerialized assets, in that cryptocurrency (e.g., Bitcoin, Ether). particular Financial Asset Tokens, they are individually identifiable, the underlying asset can alter and can only be affected by the The group decided to focus on how a token is used or viewed holders of the cryptographic proofs the latter, as the former was for those unique digital tokens. by an owner, as well as from a widely understood as something variety of legal lenses. The team different. Digital tokens are not themselves at R3 has previously designed valuable but are valued based on a model to categories a variety the context given to them, either In the initial definitions above, of asset and agreement types. their usage, or as an exchange cryptography was part of the It demarcates assets as having for an otherwise valuable asset solution, but it was noted that a relationship with an issuer (tangible, such as goods and most electronic money is already and owner, whereas contracts services, or intangible such as secured by cryptography in one are rights between two or more ownership in a company). way or another. Therefore the counterparties. heart of the second portion of Participants noted that this the difference, that instructions definition, whilst potentially are fully self-contained, meaning Defining tokens helpful on certain aspects, could once an instruction (e.g., to be too restrictive, advocating for move an asset) are sent there One debate that the working a wider approach. aren’t any further external points group received a lot of interest in on which one needed to rely. was how to define digital assets, This led the group down a path Contrast this with e-money in a and specifically crystallise what of looking at the use of the term PayPal, which requires the user to defines tokens. While the goal “token” before cryptocurrencies log into their account and send a was not to derive a concise when “token” was used for valid instruction to PayPal who in- definition, favoring an approach data structures where “tokens” turn sends an instruction to their that yielded insight to what were commonly used for banking partners (after netting), classification or exclusion from cryptographic techniques who in turn make movements at that category could mean. where the token itself was a the central bank (after netting). “stand-in” for shared secrets Perhaps a title for these types of An initial approach, looked at but had no value in itself. It assets are “cryptographically- tokens in the context of physical was acknowledged that this secured assets”. It was also noted security devices: would be an incorrect way to that, while one can conduct a look at the assets participants Building on the concept of security fully self-contained transaction, tokens—physical devices, like were concerned with as losing they can also opt to delegate RSA’s SecurID, which allow the private keys would result in the this function to a custodian, holder to access an electronically complete loss (in the case of in full (fully hosted) or in part restricted resource through Bitcoin) or temporary loss, until (multi-sig accounts). Participants cryptographic methods—digital an administrator can re-issue also asked the question of tokens, or ‘crypto assets’ allow the (still theoretical or limited to whether the “digital” element is holder of a cryptographic proof prototypes). a necessity, one could (at great to make changes to identifiable physical expense) manually units registered on a distributed So, returning to the notion of recreate a Bitcoin network (and ledger (which could include a “digital assets”, one could quickly therefore its tokens) using only blockchain). separate two major types of paper and a pen. They can also digital assets. Firstly, those By virtue of their construction and print out paper wallets and move placement on a distributed ledger, which resemble balances held Bitcoin/Ether, those this requires the entire history of digital tokens purely in digital formats (e.g., trusting the party which provided can be traced back to the moment e-money, central bank deposits). the paper wallet to not create a they were created or issued. The second is something competing transaction.

© 2019 R3. All Rights Reserved 16 The other thing aspect that token design and compliance • Creator (entity initially issuing was considered was the with existing financial regulations. the token) difference between the legal Those specifically looking to effect of making a transaction. A Permissionless smart contract create a financial instrument, cryptocurrency or rematerialized platforms, such as Ethereum, have focused primarily on security becomes the binding have gained relatively significant adapting simplified token part of the transaction, traction amongst projects looking standards, such as the ERC20, to which could be akin to the to create tokens which can be include additional functions and “cryptographic” equivalent transferred amongst participants. information that offer the ability of moving physical allocated The most notable format being to give certain entities the power gold. One can individually and Ethereum’s ERC20 token standard. to approve only certain transfers, uniquely identify the asset and Whilst not designed to exclusively the creation/redemption of manipulate that asset. There facilitate financial instruments, tokens to adjust the total supply, is probably another term for some projects have explored this as well as white/black listing. cryptographically-secured possibility, either intentionally or assets, which whilst being fully inadvertently due to regulatory Whilst such functionality was self-contained, rely more on advice that such projects may be certainly developed to meet trust in other types of structures viewed as financial instruments. regulatory requirements (usually legal claims) to derive perceived by projects, the the final transaction. This could The ERC20 token standard was working group noted that in doing look more like a depository purposely designed to offer so projects offering regulated receipt or claim on unallocated simplistic functionalities within the financial instruments may run gold, which whilst a claim on Ethereum platform. Holders can afoul of other rules embedded in something is otherwise not send programmatic instructions regulations. One such example directly 1:1 and pushes toward to the platform, which include: was the development of a so- the creditworthiness of the called “partially fungible token guaranteeing institution. • Transfers to another Ethereum address, standard”, which may violate rules governing the fungibility Token Data Structures • Checking the balance of tokens of certain classes of financial within an address, and instruments under MiFIDII. The working group also noted • Approval to another entity the numerous projects looking Taking the example of a German to build token standards to withdraw up to a certain amount of tokens. registered financial instrument, and designs. These projects which has the characteristics of a appeared in most permissionless sovereign/supranational/agency and permissioned DLT platforms In addition to these functions, (SSA) bond, issued as a token which allowed some form of the Ethereum platform keeps a would likely need to adhere to the tokenization, including Ethereum relatively small amount of data following rules when designing (ERC20, ERC777, etc.…), Stellar, about a specific issuance of the functioning of their token Fabric (FabToken), and Corda ERC20-type tokens, including: data structure: (Token SDK). While these standards, and proposals, • Total supply, • MiFiD II, ranged in functionality from highly simplistic to complex data • Name, • German Securities Trading Act structures, the working group (Wertpapierhandelsgesetz), • Ticker, identified potential areas of • German Securities further investigation with regard • Divisibility (level of precision Prospectus Act to how data is shared within the to which each token can be (Wertpapierprospektgesetz), distributed ledger vis-a-vis the broken down to), and

© 2019 R3. All Rights Reserved 17 • German Capital Investment Act Depending on where and how these tokens are (Vermögensanlagengesetz), issued, registered and traded, there may be additional rules which apply. This is also does not • German Banking Act (Kreditwesengesetz), account for other jurisdictional rules which may • German Capital Investment Code apply if the token is traded, cleared, settled, held, (Kapitalanlagegesetzbuch), etc... in other jurisdictions.

• German Payment Services Supervision Act Amongst the considerations, a token SSA bond falling under German jurisdiction would likely • (Zahlungsdiensteaufsichtsgesetz), need to meet the following criteria and have data • German Insurance Supervision Act stored in relation to its issuance, trading, clearing, (Versicherungsaufsichtsgesetz), and settlement and custody.

• German Civil Code (Bürgerliches Gesetzbuch)

SUP-TYPE DIMENSION PROPERTIES TYPE CHARACTERISTIC (EXAMPLE) Securitization of Legal Transparency e.g., information/ prospectus rights

Marketability e.g., mutual interchangeable Fungibility Tradability e.g., prim./ sec. market, OTC etc. (liquidity)

Identifier codes (e.g., Isin, German VKN)

Issuer (LEI)

IssuanceDate basic Total amount issued

Day-count convention

Maturity

MaturityDate

Coupon type (i.e. fixed, floating, indexed)

Coupon

Currency

SSA Bond Rating (Fitch) Static data Rating (Moody’s)

Technical Rating (S&P)

Coupon payment dates (each)

non-basic Coupon payment dates (first)

Disbursement amount

Status

Knowledge and experience

Financial situation with a focus on the ability to bear losses

Clients’ Objectives and Needs

Expected investment horizon

Risk-attitude

Distribution strategy

Beneficial Owner Dynamic Data Custodian

© 2019 R3. All Rights Reserved 18 In addition to these criteria and operation and sharing of data a in such transactions. Answer data, a financial intermediary mixture of approaches may be that question in the negative and issuer may also need to required. and the tokenized asset will fall consider how they match the outside the regulatory perimeter following dataset with regard to (although consumer protection trading activity: Specific legislation may continue to apply). • Off chain cash payment implications Financial instruments are defined addresses in the EU’s Markets in Financial Instruments Directive II (2014/65/ • Product category for tokens EU)(“MiFID II”) as: • Client category in financial • i) transferable securities (such While potentially daunting for as shares, bonds, depositary those creating offerings and markets receipts, etc.); services on new technology, the working group noted that Key Regulatory • ii) money-market instruments (i.e., treasury bills, certificates compliance with such rules are Considerations for of deposit and commercial the reality of operating regulated paper); financial functions. Tokenizing Assets in the EU and UK • iii) units in collective Working group participants investment undertakings (such highlighted that data linked to 1. Is the asset a financial as fund interests); instrument or other regulated tokens, and their secondary asset? • iv) emission allowances; and markets activity may not all need to be lodged within a distributed EU regulators have consistently • v) various kinds of derivatives. ledger. A view was that data reiterated that they take a linked to tokens can be held in technology neutral approach However, given that MiFID II three ways: to regulating innovation1. This is is an EU directive, it requires important because it clarifies that implementation into the national • Distributed ledger - at the the existing regulatory perimeter laws of each EU member state. lowest level, and attached to and definitions apply to tokenized Consequently, although MiFID the asset (e.g., ERC20 Token assets as they do to traditional II represents a harmonized EU name), asset classes. Accordingly, as level regulatory framework in relation to financial instruments, • Common service - data held for traditional asset classes, the it may have been implemented centrally and accessible most important gating question by participants (held at a under EU regulation relating to differently and/or subject registrar and accessible via API tokenized assets is whether the to different interpretations call), or tokenized asset is a “financial across member states. In the instrument” or other regulated UK, for example, whether or • Held individually - data held asset? Answer that question in not a tokenized asset will fall by participants requiring such the affirmative and the tokenized within the regulatory perimeter data and reconciled against generally depends on whether records held by other parties. asset will fall within the regulatory perimeter, resulting in licensing, the tokenized asset falls within Each method comes with organizational and conduct of the UK’s Financial Services and benefits and trade-offs, however business requirements on entities Markets Act (Regulated Activities) depending on what is being and intermediaries involved Order 2001 (2001/544) (the “RAO”). shared and rules governing the While the RAO is drafted to cover

1 See, for example, the European Securities and Markets Authority (ESMA) Advice to the European Union (EU) Institutions on Initial Coin Offerings and Crypto- Assets, dated 9 January 2019, and UK Financial Conduct Authority’s proposed Guidance Consultation on Crypto-Assets (CP19/3), dated 23 January 2019.

© 2019 R3. All Rights Reserved 19 the totality of MiFID financial • ii) what does it mean to take Furthermore, where transferable instruments, it is broader in custody of tokenized assets securities are transferred scope and covers a range of and what are some of the following a financial collateral UK-specific asset classes not challenges that must be arrangement as defined in point covered by MiFID. overcome? (a) of Article 2(1) of Directive 2. The need for a CSD 2002/47/EC, those securities shall It is, therefore, necessary to take be recorded in book-entry form in into account the characterization The Central Securities a CSD on or before the intended of a tokenized asset both in Depositories Regulation settlement date, unless they have the jurisdiction in which the (236/2012/EU) (“CSDR”) came already been so recorded. issuer is based, as well as the into force on 17 September jurisdiction in which investors are 2014 and was introduced to CSDR, therefore, distinguishes located because the regulatory harmonize the regulation of a between transferable securities characterization of the tokenized market that had settled over one actually traded on a trading asset in each may differ, resulting quadrillion (1,000 trillion) worth venue (where Article 3(2) will in different regulatory outcomes of transactions in the two years apply) and those which are across borders. before its introduction. CSDR is admitted to trading but not, in an EU regulation, meaning that fact, traded (where Article 3(1) In addition, EU regulation covers it is directly applicable in the will apply). Transferable securities a number of other types of laws of EU member states (in which are admitted to trading regulated asset which fall outside contrast to EU directives like MiFID on a trading venue (but not the definition of a financial II which must be incorporated traded) are not required to be instrument and which are subject into member state laws by the recorded in dematerialized form to different regulatory regimes, member states themselves). in a CSD. However, transferable for example electronic money, securities which are admitted to insurance contracts and pension One of the fundamental trading on a trading venue (but contracts. principles of CSDR is not traded) must be represented that securities should be in dematerialized form from 1 Given that the focus of this dematerialized – that is, recorded January 2023 in relation to new paper is on the tokenization electronically in book-entry issuances and from 1 January of transferable securities (the form through a CSD – from the 2025 in relation to existing type of financial instrument moment that they are traded on issuances, although this need not covering equity and transferable an EU trading venue. This principle necessarily be in a CSD (other debt instruments) and since is codified in Articles 3(1) and 3(2) entities, such as a registrar, the regulatory position relating of CSDR. Article 3(1) requires an may suffice). Conversely, where to licensing and conduct issuer established in the EU that transferable securities are of business requirements is issues or has issued transferable actually traded on a trading generally well understood, securities which are admitted to venue they must be recorded in the discussion in this paper is trading or traded on EU trading book-entry form in a CSD. limited to two other fundamental venues2 to arrange for such regulatory questions in relation securities to be represented in These rules apply equally to to financial instruments under EU book-entry form. Article 3(2) goes tokenized transferable securities. regulation: further by requiring that where Therefore, a distinction can a transaction in transferable be made between tokenized • i) is it necessary to involve a securities takes place on a transferable securities which central securities depository trading venue the relevant are either (i) not admitted to (“CSD”) in every tokenization securities shall be recorded trading on an EU trading venue project involving financial in book-entry form in a CSD. or admitted to trading but only instruments in the EU; and

2 Trading venue as defined in article 4(1)(24) of MiFID II, meaning this is limited to trading venues that are licensed to operate as (i) an organised trading facility (ii) a multilateral trading facility or (iii) a regulated market.

© 2019 R3. All Rights Reserved 20 traded on an OTC basis; and (ii) 3. Custody of tokenized assets: “held” in the digital wallet in which admitted to trading and traded some legal challenges that private key is stored. The on an EU trading venue. The private key is, therefore, similar to The core function of a custodian former will not be required to the historical physical certificate is to provide “safekeeping” be dematerialized on the books which demonstrated ownership services to investors. However, of a CSD, whereas the latter of securities prior to the advent of what safekeeping involves will. This is at present a crucial electronic book-entry systems. has changed dramatically distinction because while EU over time with the evolution CSDs are reportedly exploring There is no legal or regulatory of technology. Historically, a the possibility of servicing the requirement for a custodian custodian (normally a bank) tokenized security market, at to safekeep a private key and would hold its clients’ physical present we are not aware of owners of digital assets can paper securities safe in its vault any EU CSDs willing to provide choose to safekeep their own with clearing and settlement of depositary services in relation to private keys outside of any these paper securities effected tokenized assets. custody arrangements. However, by transfer of the physical paper as was historically the case for – messengers would be sent to The CSD’s settlement engine physical certificates, security deliver paper stock certificates by would also need to be concerns are creating demand hand. This was an inefficient and designated as a securities for new custody solutions to manual process and has now settlement system under the protect private keys. These largely evolved into a modern Settlement Finality Directive solutions range from fully- computerized book-entry (2009/44/EC) (“SFD”) in order hosted custody services (where custody chain in which custodian to ensure EU-wide settlement a customer pays a custodian banks hold beneficial title to finality for transactions. There to safekeep private keys on the securities on behalf of investors is some debate as to how customer’s behalf), self-custody through their accounts in CSDs, settlement finality should apply solutions (services which provide with a CSD’s books and records to a securities settlement system an additional security layer providing the highest root of title. utilizing distributed ledger around the customer’s private technology3. While it should be keys which are still held by the However, the conception of possible to design such a system customer), and hybrid models safekeeping is evolving once in a way that complies with the (for example, where two keys are more with the advent of stipulations of the SFD and which, needed to sign a transaction tokenized assets. This is because therefore, provides participants with one key being held by the tokenized assets are typically with the protections of settlement customer and another being held “held” in a digital wallet and finality, the requirement by a custodian). transfers of tokenized assets under the current rules for a are authenticated by the holder “system operator” would seem Safekeeping and administration of the wallet using a private to inherently disallow truly of financial instruments for the key which is stored in that decentralized “permissionless” account of clients is classified as wallet. Therefore, rather than a systems from designation under an ancillary activity under MiFID II, custodian authenticating the the SFD on the basis that such meaning that providers of those transaction based on its books systems are not operated by any services do not require a license and records showing ownership participant or controller. Note unless they also provide other of securities, with tokenized that CSDR provides that only a investment services under MiFID assets whoever holds the private CSD may operate a designated II. However, individual member key has the power to effect a securities settlement system. states may gold-plate MiFID II transfer of the tokenized assets

3 See ESMA Advice to the European Union (EU) Institutions on Initial Coin Offerings and Crypto-Assets, dated 9 January 2019 for a discussion of the key issues.

© 2019 R3. All Rights Reserved 21 and many have introduced a • Will these new custody technology providing additional separate licensing requirement providers also provide the functionality, and potentially a for the provision of custody vast range of security services third layer of companies working services. For example, in the UK provided by traditional together through a consortium. safeguarding and administration custodians, including These consortiums are forming managing payment flows of assets is a standalone in many industries to deal with (e.g. relating to dividends and regulated activity. However, the particular problems of those coupons), corporate actions, while the FCA has confirmed that administration services and industries. safeguarding and administration granting intraday credit on a of tokenized securities would global basis? If not, who will The governance of the major fall within the scope of the provide these services? public blockchains, Bitcoin and regulatory perimeter, it is not Ethereum, is ad hoc and difficult entirely clear what safeguarding • If new custody providers do to understand; it is run primarily and administration of tokenized manage payment flows, how by the relevant “core developers” will cash funds be held on securities comprises. The through BIP and EIP procedures. behalf of the customer? The better view appears to be that UK’s Client Assets rules require safeguarding and administering client money to be deposited A recent article in Decrypt private keys on behalf of the in accounts held with a central summarized the governance owners of the assets to which bank or third-party bank or issues in the context in the recent those private keys relate in qualifying money market debate over the adoption of would constitute the regulated funds. Compliance with ProgPoW as follows: “One of the activity of safeguarding and these requirements will place most interesting aspects of the administering assets in the UK. restrictions on the ability of a Ethereum platform is that has new custody provider to run no centralized decision-making However, even if that is the its custody services through a process. Like other improvement case, there are still a number single cash and assets wallet. proposals, ProgPoW was debated of open questions in relation to both online and via biweekly core the custody of tokenized assets Tokenomics & developer calls until a consensus which will need to be clarified by governance is deemed to be reached. How regulators and/or legislators: that happened, and whether sub-group input community members were given • The UK’s Client Assets rules enough of a voice, has been the Companies that are developing impose a number of ongoing subject of much debate. Now and distributing digital assets requirements on custodians, that this is subsiding, the absence (“Digital Asset Developers”) will including the requirement to of established mechanisms for rely on blockchain infrastructure perform daily internal and dealing with this sort of thing is external reconciliations of for sales, custody and ownership taking its place. Rettig, who is asset ownership. While these of such assets, and they need part of the project management concepts are well understood to carefully consider how such group known as the Ethereum in relation to traditional infrastructure is governed. Cat Herders, has been at the financial instruments, it is not Blockchain infrastructure is still center of the governance entirely clear what external evolving, and the governance of row. He had clearly reached reconciliations would involve such evolution will be critical to in the context of tokenized breaking point when he posted the success of the Digital Asset securities created on a DLT his weekend tweet, followed by Developer. infrastructure. For example, a stream of others to explain his would it be enough to ensure reasoning. “Essentially, developers The blockchain infrastructure that the custodian’s own are not keen to make decisions is likely to have several levels: records of asset ownership on non-technical issues, which match the DLT ledger or is the blockchain platform, in are political in nature and the something more required? some cases a second layer of

© 2019 R3. All Rights Reserved 22 Ethereum Foundation, will not is the set of decision processes or traditional for-profit companies. step up to the plate for decision systems that allow for a platform making, for fear of taking sides. It to adapt over time to changing The DA Asset Developer need is, in fact, trying to move further conditions or new information. to consider the following issues into the shadows.” The design of a governance the organization of a blockchain must be flexible enough to consortia or joining a blockchain Other blockchain platforms allow for adaptation under consortia should consider the have taken a more traditional unforeseen circumstances, which following key issues: approach. For example, the is when it will be most needed. Corda Network will be run by an However, rules, mechanisms, and 1. Identifying classes of independent foundation, which processes are typically put into stakeholders: The classes of will include a governing board, a place in order to ensure that the stakeholders in the blockchain technical advisory committee, a needs of particular stakeholders, projects need to be identified governance advisory committee, such as platform users, are in order to determine how such stakeholder classes and a changeable network served decisions that result will be represented and operator. Another example is the from a governance system. The how the authority to make Hedera Hashgraph ecosystem economic fields of social choice decisions will be allocated. will be run by a 39-member (the study of decision making These stakeholders may governing council through by groups) and contract theory include miners, software a Delaware limited liability (which covers decisions made developers, investors (in corporation, Hedera Hashgraph by representatives) both provide some cases), project users, LLC. frameworks for analyzing the companies involved in a quality of a governance system.” particular consortia, service The Digital Asset Developer also providers to companies needs to consider the incentives The Digital Asset Developer which are users (for example, and other economic issues in needs to consider how each level freight forwarders in logistics blockchain project consortia), the design of the blockchain of the blockchain ecosystem academic institutions and ecosystem which it intends to is governed, including the nonprofit foundations. These employ for its digital assets. stability and predictability of stakeholder classes may vary The Prysm Group, a leading such governance procedures over time. blockchain economic consulting and how the governance firm, summarizes these issues procedures will interact. Many 2. Processes for proposals for as follows: “Blockchain protocols of these governance decisions changes. The Digital Asset and apps are economic systems will be implemented in software, Developer should understand that provide participants with frequently software licensed how changes to the blockchain ecosystem can be proposed infrastructure that allows them under open source software and decided. These changes to coordinate their activities (“OSS”) licenses. And many should be planned with and create value. The design of the governance issues of consideration for iterative of that infrastructure needs the blockchain projects in the input and response, drafts, to facilitate value-producing ecosystem will be similar to and a definite commitment to transactions and incentivize the governance issues solved code. If the blockchain project beneficial behaviors in order for (and continuing to be solved) uses off chain governance the platform to be successful.” by OSS projects, such as Linux through an entity, the change They note that the design of and OpenStack. Although proposals can be made a token ecosystem has five the governance of for-profit through the board of directors elements: (i) contract design (ii) entities may also be helpful, the or similar governing body. market design (iii) information governance of collaborative 3. Decision making. Although systems (iv) token economics projects like OSS projects and many blockchain communities and design and (v) governance. blockchain projects are quite are eager to make use of They go on to note, “Governance different from governance of

© 2019 R3. All Rights Reserved 23 “on-chain” governance and On the other hand, the board held by a single entity or group of “virtual organizations” such needs to represent the major entities arising due to a merger or as decentralized autonomous stakeholders in the blockchain acquisition. organizations (DAO), these ecosystem. approaches are new and 1. Special voting rights for have many uncertainties. The terms of the board members critical issues. Although The Digital Asset Developer will depend on the blockchain board approval is generally should carefully consider the used for many decisions, the risks of such new procedures. project and the value of “institutional memory”. The classes of stakeholder may For example, the first major desire that some decisions quorum will depend on the decentralized autonomous require additional approval size of the board and the need organization, The DAO, was (such as the approval of the a failure due to errors in that sufficient stakeholders class of stakeholders). The the smart contracts that are present to give the board members could also require were supposed to run the decisions legitimacy. Frequently, special class votes for other organization. the majority of board members major issues in the blockchain who form a quorum will be the projects which could include requirement for routine decisions the software license for the The Digital Asset Developer (my experience is that most project, the policy for use of the should consider using off-chain board decisions in well run trademark for the project and governance through traditional projects are unanimous or near change in decision making on legal entities for its blockchain unanimous). However, certain determining future features of infrastructure. This system the blockchain project. decisions may require a higher generally means decision making percentage of votes to ensure through “representatives”. This 2. Off chain governance: entity their legitimacy; examples of approach has worked well in OSS selection. If the blockchain these type of decisions could project decides to use off projects: a non-profit foundation include changing the size chain governance through an with a board representing the of the board, changing the entity, the choices can range different stakeholder classes. allocation of board seats among from nonprofit foundations to the stakeholder membership more traditional entities. For The major issues relating to the classes, changes in consensus example, Delaware is widely board for blockchain projects are: recognized as having the procedures, changes to the number of members, method of most sophisticated corporate network protocol, a change in appointment or election for the law in the United States (and block or transaction validity rules members, term of the members the world) and many new and any change or addition that (frequently annual), quorum (the OSS projects are organized affects the interoperability of number of members needed to as nonprofit, nonstock applications using the blockchain transact business), percentage corporations. On the other project. hand, Hedera has decided to votes for approval of proposals use a Delaware limited liability (and any special percentages Many OSS projects ensure corporation. The selection of for certain proposals) and any that a single entity (or group the type and the jurisdiction limit on affiliated entity on the of affiliated entities) does not this entity will be driven by board (i.e., many projects limit obtain undue influence over the the location of the founding the number of members from members of the blockchain project by limiting the number “affiliated entities” such as project and prospective of board members who can subsidiaries and also deals with members as well as tax be from a particular entity or consolidation through mergers issues. On the other hand, group of affiliated entities. This or other corporate transactions). Switzerland is widely viewed limit is frequently referred to as The Digital Asset Developer needs as a “neutral” jurisdiction by a board diversity requirement to consider the risk that if a board many international companies and also applies to an increase and is the location of a number becomes too large, it can be in the number of board seats of the original blockchain difficult to operate effectively.

© 2019 R3. All Rights Reserved 24 foundations, such as the (income-generating) savings, Most of these projects are built Ethereum Foundation and the token exchange and prediction in a way that seeks to leverage Tezos Foundation. (betting) markets. Key to DeFi has the strengths of the decentralized been the ability to utilize Ether aspects of permissionless (ETH) as an underlying source of blockchains (i.e. censorship The Digital Asset Developer needs value upon which to build other resistance and plausible to monitor the governance of the financial products. As has been deniability). blockchain infrastructure that witnessed previously with token it intends to use for the sales, sales in 2016/2017, this is not Most DeFi projects try to abstract custody and ownership of such restricted to Ethereum, though the operation of their services assets. Blockchain governance this is where more of the projects away from anything in the real is constantly evolving, and the have been built so far. world, by building all of the options will change over time. functionality in a peer-to-peer Why is DeFi important for network. Much of this is done at financial institutions to the “protocol layer”, which is then One specific watch? dependent on the crypto-asset network (e.g., Ethereum or EOS). area this While it is easy for a financial Other projects have leveraged institution to be dismissive other (non-blockchain) peer- group is of what is happening in to-peer networks which can cryptocurrencies and host and manage some of the taking forward permissionless blockchains, functionality for these services there is the potential for some of (e.g., 0x Relayer network), Projects going these projects to showcase the ultimately only interacting with a forward potential market demand for new blockchain for a portion of their products built in a technology operations. If successful, at scale, this architecture could potentially Decentralized Finance greenfield. However, many of these projects cannot be directly remove the ability for developers to control the ongoing operation Looking at trends beyond the copied due to their seemingly of their creation. Of course, all scope of digital assets alone, inability or unwillingness to work of this brings in a myriad of the group recognized trends within regulatory frameworks, legal and ethical questions, in the wider permissionless as well as often questionable which financial institutions must blockchain market, notably economics models. consider. those demonstrated by the Decentralized Finance or “DeFi” The vision of many of these Another feature of DeFi is their movement. projects ultimately boils down to a parallel “permissionless” and common utilization of the native cryptocurrencies of a DeFi, or Decentralized Finance, is global financial system based permissionless blockchain, a the moniker for the latest trend around cryptocurrencies and departure from the ~2013-2017 in the Ethereum ecosystem. tokens. trend of every project arguing the Sometimes branded “Open need for a native currency and Finance”, DeFi seeks to go beyond How is DeFi different from network. the original cryptocurrency what came before it? use cases of payments and One such example is borrowing, crowdfunding (i.e. ICOs) Unlike many areas of crypto- and lending based on using Ether to enable more complex assets which seek to innovate for collateral. This stems partially financial operations. At current, whilst remaining compliant with from the relative ease of use, and some of the focal points are regulations, DeFi seemingly seeks auditability, of using Ethereum decentralized lending, and to take the opposite approach. for this purpose (compared with

© 2019 R3. All Rights Reserved 25 Bitcoin, which would require developing and managing Next steps additional layers to custody the asset). It also has the advantage The DAWG will continue as of not needing to rebuild liquidity an organization to showcase for yet-another-coin. solutions, assess industry updates, and participate in real By using a common network and applications. As digital asset native cryptocurrency, these ecosystem solutions come to projects are able to build upon market, the DAWG will be an each other (e.g., Decentralized audience to offer validation exchanges allow leverage or correction in the launch afforded by a decentralized token process. These solutions will be lending platform). showcased to the participants as and when they are ready What are some of the larger for market input. Additionally, projects? the DAWG will assess industry events as they evolve. The Currently there are a handful of DAWG facilitators will provide a projects, some of the more well- periodic summary of the most known include:4 important market news. Finally, the DAWG will be a launchpad • Lending/Borrowing - for digital asset applications. The MakerDAO/DAI, Dharma membership will be opened to all Protocol, Compound active market participants, and R3 will continue to host the group • Token Exchange - 0x, Uniswap and provide market updates. • Prediction Markets - Augur

4 Note that this is not an endorsement of any project.

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This publication is intended for informational and educational purposes only and does not replace independent professional judgment or advice. No information contained in this publication is to be construed as legal advice. R3 does not assume any responsibility for the content, accuracy or completeness of the information presented or for any loss resulting from any action taken or reliance made on any information included in this publication.

About R3

R3 is an enterprise blockchain software firm working with a broad ecosystem of more than 300 participants across multiple industries from both the private and public sectors to develop on Corda, its open-source blockchain platform, and Corda Enterprise, a commercial version of Corda for enterprise usage.

The Corda platform is already being used in industries from financial services to healthcare, shipping, insurance and more. It records, manages and executes institutions’ financial agreements in perfect synchrony with their peers, creating a world of frictionless commerce. Learn more at r3.com.