Securities law has developed and formalized over decades, with technology enhancing and augmenting the way we engage with trading assets, money, and investments.
While we’re not trading by paper or phone call anymore, we’ve not experienced a technological leap in quite the same way as custody and transacting with blockchain, cryptocurrency, and digital assets.
And with that leap has come friction and in some cases pain for the investor and trader. This technology doesn’t just enhance the efficiency or speed of the process, but it empowers the individual, it promises increased security and agency, but does it deliver? Below I’ve outlined a few of the challenges of trading securities on most blockchains and why we built the Chia blockchain the way we did.
Maximal Extractable Value
What is it?
In blockchain technology, a concept known as MEV, or Maximal Extractable Value (formerly Miner Extractable Value), can play a significant yet often obfuscated role in how transactions are processed.
MEV is the maximum value a blockchain miner or validator may receive by including, excluding, or changing the order of transactions during the block production process. Many blockchains face issues with MEV due to the fact that a validator can choose to order transactions in a way optimal for them and to the detriment of investors.
Why does it matter?
Much to the chagrin of many industry participants, and despite the myriad claims of MEV “enabling liquidity,” we believe doing this to a known securities transaction is clearly market manipulation under Section 9(a)(2) of the 1934 Act.
Industry participants are even trying to redefine MEV as “Efficient Optimization Flows” or “EOF” to avoid the association with market manipulation and other activities that can be used to generate illicit profits.
Some blockchains also enable another source of MEV to occur, enabling third parties to bid for the right to sequence a block, a feature known as MEV-boost. This behavior can often lead to further perverse incentives and manipulation for illicit gain when done in the context of a known securities transaction.
Additionally, MEV exposes security flaws in many blockchains, such as Sandwich Attacks.
How do we address it?
By contrast, we designed the Chia blockchain to route all transactions in parallel within each block, and allow transactions to set rules about how they can be executed. Simply put, the order of transactions in a settling block on the Chia blockchain does not affect the price of any transaction in that block. Chia’s unique technology, including Chia Offers, combat MEV while increasing the security of each transaction.
Ex.
When a seller offers to sell 1 MSFT DC for $50.00 worth of USDC, the only price that that transaction can enter a block and settle is $50.
What are the current constraints?
The only practical MEV that exists on the Chia blockchain is that a farmer, who also tracked the original Offer file, can step into the shoes of the taker at the same terms and take a good deal for themselves without impacting the investor trading the asset.
However, unlike other blockchains, farmers-even in pools-sign their own blocks and due to both the highest node count of any smart contract blockchain and one of the highest Nakamoto Coefficients, it’s unlikely for farmers to have many opportunities for such trades.
It also paradoxically increases the total liquidity to the decentralized market on the Chia blockchain as the offeror still receives the price they intended in the funds they specified.
This issue is technology-neutral as blockchains could upgrade and re-architect to enable parallel transaction processing instead of sequencing. That would enable most or all of the most toxic forms of MEV to be eliminated, such as sandwich attacks and payment for order flow. But fixing this would also limit opportunity for a validator income stream, which we believe will catch the ire of regulators and legislators soon.
Market and Limit orders: Only possible with a 3rd-Gen Blockchain
In the future, this can be extended to explicitly designate one or a trusted group of price oracles and assert that the offeror will take anything plus or minus the mean of the oracles. Each oracle can only announce one price per block and the announcement or ordering of other oracles has no effect on any other oracle or trade that doesn’t specifically reference it.
Centralized Smart Contracts vs. Coins
What is it?
On Ethereum Virtual Machine (“EVM”) (like Ethereum) and EVM-like chains (like Solana), assets are not actually, nor directly, issued to individual wallets. Instead, they are issued within a centralized smart contract under control of the securities issuer.
Why does it matter?
While the simplified structure may make development easier, it exposes security flaws and significantly reduces decentralization. This is effectively a single ledger of which public key pair owns how much of a given asset. This creates risk versus other designs as it leaves a single point of failure where, if, for example, a nation-state is able to find a backdoor or a weakness, it can drain the entire contents of the issuance from that contract into their control.
Though it is feasible for developers to actually cede control of an Ethereum smart contract (for example, as Tornado Cash has done), most developers and project teams keep the ability to upgrade the smart contract with a set of required multi-signature keys (for example, as many versions of Uniswap have done).
The power to upgrade is the power to do anything with the then state of the contract. To the extent that a security is being traded or pledged in such a centralized or controlled smart contract, the developers would almost certainly need licensure as one or more of a broker-dealer, exchange, or ATS. This is because they actually have full and final custody of any assets under the control of any smart contract that possesses securities on behalf of investors.
While such developers have labeled autonomous transactions using smart contracts as “Peer-to-Peer” or even “decentralized finance,” these are misnomers at best and deliberately misleading at worst. Most transactions are Peer to (Controlled and/or Centralized) smart contract (which serves as an intermediary) to Peer.
How do we address it?
The Chia blockchain places each issued asset (a Coin) in a wallet controlled by the investor. To compromise every coin, barring some fundamental flaw in the Chia Asset Token standard (which has been audited twice with only one severe issue identified and fixed), an attacker must compromise each investor’s individual holdings across all investors – to reach the same attack success.
Smart contracts on the Chia blockchain can be more aptly described as Smart Coins because each Coin contains a puzzle, a set of programmable instructions, with a narrower attack surface.
Who has control of smart contracts?
Peer-to-Peer trading with Chia Offers on the Chia blockchain does not have a third party involved. Assets remain in the custody of the maker and the taker until a valid settlement is reached on the Chia blockchain when those assets are atomically swapped into the other’s self custody possession. At no point does anyone have the ability to redirect assets to anyone other than the maker and taker.
Caveat
The only two exceptions are:
- A farmer could attempt to step into the role of one side; or
- Could decide not to include a transaction in the block they are making
In either case, one side of the trade will get exactly what they want, and the other will lose nothing but the opportunity cost.
The decentralized nature of farmers on the Chia blockchain also make it quite difficult to predict when a farmer will make the next block and severely limit the likelihood that any censored transaction will not be able to easily get into the next transaction block–a major disincentive to a farmer not including the transaction for the transaction fees in the first place.
Why is it hard to trade securities on blockchain? Because most blockchains weren’t built for it. The last thing investors want to introduce to their trades is risk from the tools that were meant to facilitate it.
We built the Chia blockchain to be secure from the ground up, it’s meant to support, augment, enhance the work done in high-compliance environments.