By partner Nick Moore and trainee Miles Higgins in London at global law firm Morgan Lewis
Cryptoassets continue to attract significant and growing attention from consumers, markets, governments and regulators globally. Whilst often controversial, it is beyond doubt that the underlying blockchain technology provides great opportunities across sectors from financial services to consumers.
Initial Coin Offerings (ICOs) are an increasingly popular way for start-up and scale-up companies to raise capital. Investors participate in the fundraising by transferring fiat currency or crypto-currencies such as Bitcoin or Litecoin in exchange for the issue of digital tokens.
The benefits of an ICO include immediate access to a decentralised funding market without the need for custodians, intermediaries and, potentially, a low level of regulatory interference. However, this only works to the extent that the tokens that are issued themselves fall outside the regulatory “perimeter”. Needless to say, the crypto world does not operate in a legal vacuum.
Token – main classifications
There are three main types of token, with many variants of each type and hybrids which take certain characteristics of each. Broadly, the main categories are:
- Exchange token: crypto-currency, which allow goods and services to be bought and sold without the need for a central issuing authority or settlement via a bank
- Utility token: which provides users with access to a current or future product or service
- Security token: these tokens are similar to traditional securities such as shares, derivatives or debentures
|Security …||Exchange …||Utility …|
|Crypto||Digital representation of an underlying security||Bitcoin||Tokenised access to an online gaming platform|
|Share certificate||US$||Arcade token|
Whilst regulators globally are focussed on all categories of token, from the point of view of issuance, it is the security token (and a particular sub-category of security token, the “equity token”) which have drawn the most regulatory attention. So, what is a security token and how does it differ from other types of coin or token?
Broadly a security token is a digital representation of an underlying security. It has one or more of the characteristics generally associated with a share, derivate or debt instrument. A coin or token with some or all of the following features may well constitute a security token:
- Voting rights (but see below)
- Access to a fixed or fluctuating income stream derived from profit (but see below)
- Entitlement to a distribution of capital upon liquidation
- Other features of ownership or control (e.g. a right to direct the board of directors)
- A right representing indebtedness (i.e. to be repaid money lent)
- A right to subscribe for a token with the above characteristics in the future
- An ability to derive profit or other value from the movements in an underlying security
From a regulatory point of view, sensitivity begins if the rights above cause the token in question to be a financial instrument which is within the relevant regulator’s remit. Using EU regulation as an example, the above rights might cause the token to be a “transferable security” under the Markets in Financial Instruments Directive II (i.e. “MIFID II”).
Comparison with Bitcoin
Global regulators are taking a pragmatic view (at least as to issuance) in relation to exchange tokens. Taking Bitcoin and the UK as an example. Bitcoin is not considered as legal tender due to its limited similarities with fiat currencies. Further, Bitcoin does not provide any rights which are enforceable against a third party – there is no entitlement to profit (other than as derived from the implicit movements in the value of the coin), no entitlement to the repayment of capital and no right to direct, control or enforce against any third party.
Security tokens – limits
The general consensus among regulators is that Bitcoin is not a security. This is, for example, the position in the UK and of the current chairman of the SEC in the USA, although some members of Congress have voiced disagreement. That is not to say of course that a host of other regulations including in relation to consumer protection, money laundering and restrictions on advising or arranging transactions do not apply.
Equally, it is not true to say that a token with some of the features described in the list above will always constitute a security token. For example, a narrow right to vote on a very specific matter affecting the underlying corporate (such as the timing of a follow-on ICO) does not imply either ownership or the right to direct the board of directors which one traditionally associates with a share. Similarly, a contractual right to receive a particular payment does not necessarily amount to a dividend, distribution or other return of capital which conventionally form part of the package of rights which comprise a share.
Equally, it is not true to say that a token with some of the features described in the list above will always constitute a security token.
An equity token is a sub-category of security token which has some or all of the features of a “share” in the sense that the term is used in company law. Indeed, the key (and often the only) significant difference between an equity token and a traditional security is the method of recording ownership. A traditional stock is recorded on a members’ register and can be accompanied by a paper certificate. An equity token records corporate ownership on a blockchain. An equity token does constitute a share; it is simply taking an existing model and evolving it one-step forward – it is, simply put, a digital representation of a share.
Advantages of equity tokens
Equity tokens bring the flexibility of the blockchain and the democratic nature of digital currency to the (otherwise illiquid) “market” in unlisted securities. They enable companies to raise equity using blockchain technology without locking-up investors. They also (potentially) enable issuers of securities to access the large pool of institutional money that has not yet penetrated the cryptocurrency market.
So why has the market for equity tokens not taken off as expected?
There has been some press comment about how security tokens, including equity tokens, have failed to deliver the expected results. Globally, there have been only a handful of equity token issuances in the last year. Commentators have pointed to various problems:
- In some jurisdictions, it is not possible for a share to be electronically represented. Whether that is possible depends on the local law applicable to the particular type of company looking to make the issuance. What may be possible in Switzerland might not be possible in Germany, for example
- Large investors need to know that all key laws and regulations have been followed
- Many investors want privacy. They do not trust blockchains that allow outsiders to see their investments and transaction values
- Some investors do not want their shares being controlled by a private key on the blockchain
- The regulatory burden on issue for the issuer
The regulatory impediment
There is one problem above all others for issuers of equity tokens. This is the need to create and file public documents when issuing securities to the public. Taking the UK and the EU as an example, the requirements are strict and the penalties for non-compliance are material. There are exemptions, but these tend to be focussed around smaller deals or those with no public element.
Taking the UK and the EU as an example, the requirements are strict and the penalties for non-compliance are material.
In particular, the historical financial information requirements can be burdensome for the largest international corporates, let alone a start-up. There is, therefore a very clear sense in which this regime sits awkwardly with the decentralised, democratic nature of cryptoassets and associated fund raisings.
A hard truth
The hard truth is that many security tokens and, by definition, all equity tokens will, at the point of issue, invariably be subject to demanding disclosure and filing rules, at least for issuances of any material size or with any material public element. There is no indication that the leading global regulators are preparing a lighter touch regime for security tokens than for traditional shares and, it must be said, it is difficult to argue that they ought to. Despite the emergence recently of new platforms to facilitate the issue of equity tokens, it is a market in which growth is perhaps unlikely to explode any time soon.