An overview of the principal token models and analysis of the potential regulatory implications.
A while ago, Cambridge Centre for Alternative Finance published an interesting study examining the global cryptoasset regulatory landscape. While crypto regulation has evolved since the publication of the report, it is a very interesting read and a good resource for most of the regulatory actions that have been issued by authorities around the globe.
One of its key findings was that the first step towards regulating cryptoassets taken by regulators has typically been to distinguish cryptoassets which are deemed to be securities from other types of cryptoassets. This means a legal and regulatory classification of a cryptoasset should be based on an in-depth assessment of several factors on a case-by-case basis. These factors usually are the kind of rights attached, access to the tokens, its economic function, and transferability, to name a few. The result in many case is that cryptoasset-related activities carried out by intermediaries have strong similarities to existing financial activities found in traditional markets, e.g. cryptoexchanges are nothing else then marketplaces for other financial instruments that allow for trading. So, it suggests itself to regulate the activities related to crypto tokens in the same way.
Know Your Token Models
It is fascinating though that this initial step is puzzling for many people even in the cryptoworld, i.e. the differentiation of the different kind of tokens. For example, for a long time issuers of Initial Coin Offerings claimed that their token was a utility token and as such would not be covered by securities laws. Securities laws are particularly burdensome and have some severe consequences in the case of wrongdoing, so it is quite understandable. We have learned though that these statements did not stand the tests of the watchdogs and in more than in one example the story ended in tears (literally).
Thus, let us go through the principal token models and explain what the potential implications are. Even though there are a number of different token models out there including different names for the same thing, we can basically group them into three main categories: Payment, Utility and Security Tokens.
Payment Tokens are used an alternative means of payment and exchange. Unlike fiat currencies like the US Dollar, the Euro or the Japanese Yen, payment tokens like Bitcoin are not legal tender and not backed by a government. Instead, their main objective is to be a decentralised tool for buying and selling goods and services without traditional intermediaries and have no other function (or only limited functions).
What does this mean in regulatory terms though?
For instance, in a consultation paper published in January 2019, the UK’s FCA has confirmed that Payment or Exchange tokens – as the FCA calls them – “currently fall outside the regulatory perimeter. This means that the transferring, buying and selling of these tokens, including the commercial operation of cryptoasset exchanges for exchange tokens, are activities not currently regulated by the FCA”.
The German financial regulator BaFin (Bundesanstalt für Finanzdienstleistungsaufsicht, i.e. Federal Financial Supervisory Authority) published an assessment in 2014 on Bitcoin and an overview of the risks to which users of this and other cybercurrencies may be exposed and as a result Bitcoin was classified with legally binding effect as financial instruments in accordance with the German Banking Act (Kreditwesengesetz – “KWG”).Since then it has changed direction somewhat but in a recent advisory letter the financial watchdog confirmed that payment tokens do not represent securities within the meaning of the WpPG or assets as defined by the VermAnlG, but they are regularly financial instruments under the KWG.
The Swiss regulator FINMA equally does not treat payment tokens as securities but highlighted that if they were to be classified as securities through new case law or legislation, FINMA would accordingly revise its practice.
It is also important that this approach taken by the majority of regulators does not mean that related services would not fall under the regulatory remit of existing legislation, but would require authorization, for example, such as in the case of token exchanges.
Furthermore, it is worth noting that with the upcoming revision of the EU’s money laundering directive (“AMLD 5”) that needs to be implemented in each member state by 10 January 2020 stricter AML rules will become applicable to entities carrying out activities like the exchange between cryptoassets and fiat currencies, between one or more other forms of cryptoassets, the transfer of cryptoassets, the safekeeping or administration of cryptoassets or instruments enabling control over cryptoassets, the participation in and provision of financial services related to an issuer’s offer, or the sale of a cryptoasset.
Utility Tokens grant holders access to a current or prospective product or service but do not grant holders rights that are the same as those granted by specified investments.
In regulatory terms, this is a little bit more tricky as regulators potentially treat them differently. On one hand, using again the example of the German BaFin, “Utility tokens are not e-money if there is no third-party acceptance or they are only issued in exchange for other payment tokens (such as Bitcoin or Ether). With respect to pure usage tokens, there is also much to suggest that their issue does not induce any authorisation requirements under the Banking Act, the Payment Services Supervision Act or the Investment Code. Moreover, the possibility of classifying such tokens as a financial instruments pursuant to the Banking Act is also often ruled out, meaning that any trade-based services performed exclusively with these tokens on the secondary market do not require authorisation.”
The FCA, on the other hand, recently published a Policy Statement entitled Guidance on Cryptoassets. Therein, the London based authority pointed out that while “utility tokens are not specified investments, they might meet the definition of e-money in some circumstances (as could other tokens). In this case, activities involving them may be regulated”.
If that is the case EU law such as the E-Money Directive (“EMD2”) or the Payment Services Directive (“PSD2”) and respective national regulation would be applicable. However, as the European Banking Authority’s report with advice for the European Commission on crypto-assets shows, examples can differ significantly and as a result the regulatory treatment of a utility token as well.
And now for the category most ICOs would like to avoid: Securities aka Asset, Equity, or Investment Tokens. So: A Security Token provides rights and obligations similar to securities or investment like share or debt instruments.
So far so good. The trick is to determine whether a token falls within this scope though.
The European Securities and Markets Authority (ESMA) undertook a survey among the national competent authorities of the EU member states in order to determine the legal status of crypto-assets and determine possible applicability of EU financial regulation ESMA.
The survey questions were designed to determine the way in which a given Member State had transposed MiFID II into its national law and, based on that transposition, whether a sample set of six crypto-assets issued in an ICO qualified as transferable securities and/or other types of financial instruments as defined under MiFID II.
“Transferable securities” under Article 4(1)(44) of MiFID II, means those “classes of securities which are negotiable on the capital market, with the exception of instruments of payment, such as:
– shares in companies and other securities equivalent to shares in companies, partnerships or other entities, and depositary receipts in respect of shares;
– bonds or other forms of securitised debt, including depositary receipts in respect of such securities;
– any other securities giving the right to acquire or sell any such transferable securities or giving rise to a cash settlement determined by reference to transferable securities, currencies, interest rates or yields, commodities or other indices or measures”.
– From the ESMA Advice on Initial Coin Offerings and Crypto-Assets
While, there was broad agreement among NCAs that the crypto-assets that meet the necessary conditions to qualify as a financial instruments should be regulated as such, the report also highlighted the difficulties to clearly define a said token under the existing rules. A basic line can be established yet, as outlined by the German regulator, in the sense that tokens of this type represent a security class of their own because they have been converted into investments which can be traded on the financial market by tokenization and they must therefore be classified as securities. The “substance over form” approach, developed by ESMA, clarifies this and the material components, rather than the formal name of a financial instrument, are always the decisive factors.
BaFin suggests therefore that “the general rule for classification of a financial instrument as a security within the meaning of section 2 no. 1 WpPG is that it be transferable, negotiable on the financial market and encompasses rights comparable to securities. A securitisation in the form of a certificate, which ensures the marketability of financial instruments in the case of traditional securities, is not required for a token to be classified as a security.
The term “securities” is to be interpreted uniformly due to the desired EU-wide supervisory convergence; both the WpHG and the WpPG use the term „securities“ as defined by MiFID II, thus transposing this legal definition into national law. If rights comparable to those associated with securities are attached to a token, then the token facilitates increased marketability through simplified transferability and greater negotiability”. Negotiability in that sense means that a token needs to be sufficiently standardised and homogeneously designed. On the other hand, the aspect of transferability does not seem to be overly burdensome, since most tokens are designed that way, but the recent FATF Guidance on Virtual Assets and Virtual Asset Service Providers stressed the point of flexibility: “Flexibility is particularly relevant in the context of VAs and VA activities, which involve a range of products and services in a rapidly-evolving space. Some items—or tokens—that on their face do not appear to constitute VAs may in fact be VAs that enable the transfer or exchange of value or facilitate ML/TF. Some ICOs, for example, relate to or involve “gaming tokens,” and other “gaming tokens” can be used to obfuscate transaction flows between an in-game token and its exchange for or transfer to a VA. Secondary markets also exist in both the securities and commodities sectors for “goods and services” that are fungible and transferable. For example, users can develop and purchase certainvirtual items that act as a store of value and in fact accrue value or worth and that can be sold for value in the VA space.
Naturally, this is not the end of token models. Innovators will continue to strive to find different models and already a number of existing tokens combine the different categories. FINMA points out that “asset and utility tokens can also be classified as payment tokens, in which case, the requirements are cumulative, or in other words, the tokens are deemed to be both securities and means of payment. In particular, many providers intend the use of their utility tokens at future point in time as means of payment and thus virtual currency. Here regulators concur again as the general approach in such cases is to define the focus in terms of functions of the respective token lies and that the concrete circumstances of the individual case would be decisive.
The Bottom Line
Eventually, the regulatory consequences need to be determined on a case by case basis. Any discussion regarding crypto assets and their regulatory implications is pointless though where the basic elements are not determined first and the nature of a token is the starting point of any such analysis.
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