Sumary

Similar to how stable coins such as USDT are backed by USD, a Fungible Token (FT) can be backed by a share of a company. This would effectively allow zero non-network-fee transaction of stocks. With non-fungible tokens (NFT), this can be extended to derivatives as well.

Disclaimer

Securities trading is highly subject to regulation in most, if not all, jurisdictions. I’m not familiar with the majority of these regulations, nor am I familiar with any relevant rules and regulations outside of Canada and The United States. Because of this, some or all of this proposal may be difficult or impossible to do legally. Because the tokens are technically derivatives and anyone (to the best of my knowledge) can sell options and futures, which are also derivatives, my assumption is that at least the core premise (selling tokens backed by a security) is legal in both Canada and The United States, but obviously I don’t know for sure.

Problem

Stocks of public companies can’t be traded without using a trusted third party (such as Wealth Simple Trade, RBC Direct Investing, etc.) and those third parties often take high fees on transactions. It also makes it difficult to transfer/sell a share to a specific person, although this isn’t something that’s particularly useful to do, apart from gifts, which is also uncommon.

Implemntation Sumary

This system would be effectively the same as current stable coins: a trust company/bank receives the backing asset (in this case shares of a company, or similar security), and, in exchange, will issue a FT to the party that deposited the backing asset. The trust will then hold the backing asset until the owner of the FT backed by the backing asset (whether it be the original depositor or anyone else) requests to exchange the FT for the real company stock. When this happens, the trust will burn the FT (or verify the user has burned it), and transfer the backing asset to the requesting party.

This has two obvious problems:

  1. it is currently non-trivial to transfer stock to a specific third party. So, instead of the trust receiving the backing asset directly, it is better for the trust to receive a monetary deposit worth the same or more as the requested stock. Upon receipt of the deposit the trust would then purchase the requested share themselves, and issue the FT to the depositor.
  2. There is no way to support derivatives using only FTs. To support things like stock options, special NFTs must be used. These will necessarily have some limitations over traditional derivatives; most notably, as there is no way to enforce payment of debt on any major blockchain network (or any blockchain network of which I’m aware), any payout (including both money and stock) from the contract must be locked in the token until the contract is either expired or exercised.

Implementation

As both FTs and NFTs are required to achieve the full scope of this proposal, and multiple types of each are required, using a (very custom) ERC-1155 contract (or an equivalent on whichever network this system is being implemented on) will probably be ideal.

Implementation for Stocks

I believe the best implementation of this system for stocks is to simply receive money from users that is equal to the current price of the stock the user wants (optionally, plus a few), and then the user is issued an FT that they can return at any time to receive the money equal to the value of the stock at time of return (optionally, less a fee).

What is done with the users money between purchase and return is irrelevant to this section. Some options are described in the Potential Monetization section.

Implementation for Bonds

Bonds are effectively stocks with a par value that increases at a constant rate, or drops to zero instantaneously. For this reason, bonds can be implemented in exactly the same way as stocks.

Implementation for Options

NOTE: I will not explain what options are or how they work in this section, nor will I explain the different types of options, as that is not what this proposal is about and that information can be easily found on the internet.

One possible way to implement options is through special NFTs, as stated above. The contract must support advanced functionality for these NFTs, which will differ depending on the type of option.

Similarly to how Enjin and Xenum allow NFTs to be backed by ENJ and ETH respectively, these option NFTs should have a backing of tokens representing the assets the options are based on, as well as the money (likely in a stable coin) with which to buy the asset. This is to enforce a payout to both parties in the event the option is exercised. This has the added benefit of ensuring both parties agree to the terms, because they must both send an asset in order to create the NFT.

It should be noted that naked calls are impossible with this system, as it requires the assets to be held in escrow before the NFT can be created.

For the rest of this section “option” and “NFT” will be used interchangeably.

All NFTs will require a method to exercise them. What this does exactly will vary based on the type of NFT. For most options this function will only be callable by the buyer, however, in some cases, such as when the option specifies that it must be exercised (ex. oil futures), any party, including parties not involved in the transaction, may execute the method.

Any option that needs to expire (I’m unaware of any types of options that don’t fit this category) will also need to have a method to expire them. This method will burn the token and release the assets that the token was “holding” to the parties who have the rights to such tokens, based on the terms of the option. In most, if not all, cases it makes sense to let any party call the expire function, including parties not involved with the transaction. Of course, the expire function should check if the option has actually expired before doing anything.

In some cases the expire and exercise methods will do the exact same thing. This is fine. They should both still exist in order to maintain consistency within the smart contract.

Potential Monetization

The most obvious way to monetize this system is to sell the tokens for slightly more than the backing asset is worth, and sell them for slightly less. Technically this would be the same monetization method as current investment platforms (taking a fee), but in this case the fee is only paid when the token is exchanged for the underlying asset. In the case where this system is popular, most people will not do this. It will be much easier to sell the token to another user rather than go through the process of exchanging it for the underlying asset, which would likely require some KYC process.

I am not familiar with the way trust companies work, so I’m not sure this is possible/legal, but another potential to monetize is to sell the underlying asset in the open market, and simply buy it back when a user wants to exchange a token representing the asset for the asset itself. This would effectively be a short position, so this should not be done with every asset.

If the implementation of this system is such that the users never receive actual stock, just the money in exchange for the stock, one possible monetization method would be to never actually buy the stock, and simply pay out when requested. However, this would be a short position on every supported security, so it is also possible to lose money this way.

The need for a DEX

This concept in itself is very similar to base cryptocurrency: people can trade an asset without involvement of any third party. However, to simplify the process, and increase liquidity, a number of cryptocurrency exchanges have been created. These exchanges necessarily take a fee. They typically take the fee on withdraw, and not when purchasing the tokens, but they still take a fee. Decentralized Exchanges (DEX) do exist, but they are uncommon.

This proposed system, if successful, will also inevitably lead to the creation of exchanges, which would take a fee, thus not actually solving the problem. This would instead just create the same problem, but now it’s more difficult to get to the point where you have that problem. So people will just use regular investment platforms so they don’t have to take extra steps to then have the exact same problem.

Because of this, it will be necessary to create and popularize a DEX. It must also be very simple to use, otherwise people will just not use this solution for the reasons described in the above paragraph.