A common pattern of innovation in technology is to carve out a piece of infrastructure present in a big number of companies, specialise on it, productize it and turn it into a service.
This is what Amazon did with AWS in the computing space. But many other companies are trying to apply the same playbook to several other segments. For example, two years ago I presented Credix, which is trying to replicate this playbook in the Capital market space.
TAU Finance is another example of the same playbook.
They are trying to simplify the extremely tedious and onerous activity of legal structuring in financial instruments and want to become a legal operative system that financial services can use to create financial instruments in a faster, cheaper and fully compliant way.
The goal of this post – written together with Torben Leowald, one of TAU Finance’s co-founders – is to dig deeper into the tokenisation regulation around the globe, present TAU’s solution and assess its potential for the wider crypto space.
Tokenization regulation around the globe
One of the biggest hurdles to crypto mass adoption so far has been the lack of clarity whether the legal claims represented by the tokens were actually equivalent to traditional financial instruments. In simple terms, right now, a clear connection between blockchains and the legal system doesn’t exist. And, without clarity on this front, institutional investors can hardly adopt the new rails at scale.
The global legal systems are going in the direction of making on-chain tokens and public blockchain as genuine as traditional financial instruments and rails, but the journey is not trivial.
In this context, there are two crucial problems that legislation across the planet have to analyse and solve:
- Does the token represent effectively the stated claim?
- Does the transfer of such a token effectively transfer legal rights?
Does the token represent effectively the stated claim?
The concept of token – intended as the possession of control of one thing that conveys certain rights in something else – is not new, and in fact has been around for centuries. A piece of paper is not very different in this sense from a digital token.
In the US this is included in the Uniform Commercial Code (UCC), and the proposed new Article 12 would expand the concept to “controllable electronic records”.
In the UK, the consultation paper on Digital Asset proposes the explicit recognition of a “third category” of personal property according to the English Law.
In the EU, MiCA is a comprehensive regulation that governs certain aspects of the crypto space – starting with stablecoins – but the commercial law aspects have not been addressed bloc-wide. Certain EU jurisdictions have adopted their own regulations to recognise the ability to use tokens for the representation and transfer of unlisted securities.
| France 🇫🇷 | French Financial Code (Code monetaire et financier) |
| Luxembourg 🇱🇺 | Luxembourg supported a framework in which issuance conversion or transfer of dematerialised securities can be affected by registering them through a DLT |
| Germany 🇩🇪 | In the German electronic securities act (Gesezt uber elektronische Wertpapiere – eWpG) dematerialised securities can be issued through entry of those securities into an electronic securities register, maintained on DLT by a crypto registrar |
| Switzerland 🇨🇭 | DLT Act |
| Italy 🇮🇹 | Decreto sulla tokenizzazione |
Does the transfer of such a token effectively transfer legal rights?
While the ability to represent a security onchain is addressed and supported in multiple jurisdictions, transferability is subject to a number of limitations and it has emerged as the biggest hurdle.
Most restrictions are on the ability to list natively-issued securities on regulated exchanges.
In particular in France, Germany and Luxembourg, security tokens frameworks are not applicable to listed securities handled through a central securities depository because it would violate Article 3(2) of EU CSDR.
In the US, the secondary trading of listed securities requires intermediaries, including a registered broker/dealer licence. Reconcile DLT operations with broker/dealer licence is not trivial (for example, on DLT it is not straightforward to demonstrate possession and control of customer securities).
Tau Finance’s solution
“A cleverly designed exchange for magic beans will never get around the basic problem that the magic beans don’t work, and people might stop believing in them. If crypto is going to work in the long run, it will need to prove its real usefulness outside of finance. Finding new ways to trade the tokens is fun, but it is not enough—the tokens have to mean something too.”
Matt Levine
TAU Finance aims to be the communication and orchestration layer that enables the integration of smart contracts into real-world law in a trust-minimising and decentralised manner. This allows DeFi and crypto tokens to be connected to contracts and cash flows in the real world.
Through Tau, financial services will be able to create tokenised financial instruments with legal standing equivalent to traditional financial instruments – fully compliant in the jurisdiction of their choice – in a more affordable and streamlined way, using an off-the-shelf solution, or simply by issuing securities on-chain. The assets are issued natively on-chain, with the primary source of truth being the information stored in the smart contract’s code on-chain.
TAU Finance is built on the premise that crypto today faces two significant hurdles in becoming valuable in the real economy.
First, tokens on-chain are unable to carry legal recourse within them (the “magic beans” problem). Second, financial instruments represented by a token cannot be exchanged on-chain without violating securities regulations globally (trading “magic beans” is not enough utility for a technology in the long run).
TAU, functioning as a legal protocol across different chains, tries to address this gap. The protocol operates at a high level as a clearing, trading, and settlement system for financial and legal instruments, enabling the use of public blockchains in capital markets without breaching securities market rules.
TAU Finance’s architecture
The protocol comprises five key components:
- Legal Contracts
Client protocols and applications implement a legal contract, which conceptually serves as a rulebook for the defined financial instrument. The contract outlines the properties the financial instrument and corresponding transactions must adhere to in order to be processed and settled. It is represented by a token on a public blockchain. - Operators
A set of decentralized node operators responsible for verifying that transactions comply with the destination protocol’s policy. These operators are reputationally and economically incentivized through Tau’s consensus mechanism. - Rules
The rules are immutable scripts and information stored in IPFS, which express the jurisdiction-specific requirements specified in the legal contract. These rules are executed by the Operators. - Legal Engine
The legal engine monitors on-chain objects to ensure adherence to pre-specified rules and the emission of events in the case of transactions and creation events. Client protocols engage the legal engine to authenticate validator signatures. - Tau Aggregator
The Tau Aggregator ensures that all actions within the protocol are synchronised and connected. It acts as the bridge between off-chain agencies, the on-chain legal engine, off-chain IPFS, and the client protocol.
A novel feature of the Tau Protocol is the introduction of “Regulatory Hooks”, which serve as checkpoints within a transaction workflow to assess and enforce legal and regulatory compliance, integrating on-chain transactions with off-chain legal systems. A Regulatory Hook brings legal enforceability to on-chain agreements through a combination of Tau Protocol licences, the legal smart contract structure, and off-chain validation and communication with legal systems.
Core use cases
Tau wants to provide a global, licensed settlement system for transactions involving on chain financial instruments.
Tau is designed as the comprehensive legal layer for any financial and non-financial agreements on-chain that benefit from legal enforceability and recognition in real-world jurisdictions and economies. On top of Tau, applications ranging from institutional-grade decentralised credit protocols, securities exchanges, native tokenisation of off-chain collateral, and advanced crypto-dollar concepts can be built, expanding the DeFi application space into the realm of traditional finance.
The first use case for the Tau Protocol will be a global system of state-of-the-art SPVs (Special Purpose Vehicles) that can be used for the collateral management of any security that needs to be represented on-chain. The novelty of the solution lies in the decentralised governance of the SPVs through TAU’s consensus mechanism and the representation of the locked collateral as bearer instruments on-chain via TAU’s capabilities to issue enforceable contracts.
Conclusions
Tokenization is an extremely sexy word in today’s financial space: every financial expert will tell you that, in their opinion, “every financial instrument will end up onchain”; every major financial institution is evaluating the adoption of this technology and the forecasts of major consultancy firms are astronomically high numbers.
The brutal reality is that, right now, tokenization has not really taken off. It is true that more and more securities are being migrated or natively issued onchain, but most of these projects – developed by banks and incumbent financial institutions – are PoC or mere PR exercises with limited commercial impact. In particular, there isn’t a single segment or niche where tokenisation took off as the new standard to issue securities.
TAU Finance’s product could change that.
The problem that they are trying to solve is to facilitate the creation – at scale and for an affordable price – of legally sound tokens that have actual capacity to represent legal claims on the underlying. All, through the use of the existing regulatory frameworks and not new fancy and untested regulations.
The hurdles they are facing are not trivial: it is not guaranteed at all that Institutional Investors will trust a startup with such a critical piece of a financial instruments setup; and on top of it, tokenization will have to concretely demonstrate its potential in real world applications.
Nonetheless TAU Finance – and its future clones that I expect will emerge – could represent one of those foundational tools in the tokenisation space that will materially make it more efficient and cheaper to issue sound financial instruments onchain.
Only time will tell us if this will be a reality or just a founders’ dream.
Resources
TAU Finance
- Website – https://tau-finance.com/
- Investor Deck – https://docsend.com/view/2uyu9cvyiv4ryst7
- Litepaper – https://docsend.com/view/ymf42qmmhj2xreeu
- Case Study: https://docsend.com/view/8wb7gnz8ivph9qka
Tokenisation regulations
- https://www.statestreet.com/us/en/asset-owner/insights/tokenization-regulation
- https://www.bis.org/fsi/publ/insights49.pdf
SPV
Market forecast
