The first month of 2021 has been full of initiatives and consultations on new technological tools and their use in the global market: from analyses of Artificial Intelligence systems to Reports on the opening of the market, financial and otherwise, to blockchain and DLT technology, with a particularly curious and careful look at the so-called “tokenization” of digital assets.
The OECD (Organization for Economic Co-operation and Development), in fact, again in January 2021, published a Report on Regulatory Approaches to the Tokenisation of Assets.
The Preface reads: «Asset tokenization, mostly theoretical only a few years ago, is now a reality with successful pilot projects around the world. Early uses were largely centred on ICOs, associated with non-compliant financial instruments, broken promises to investors and outright scams. But in the years since, tokenization has found a place in mainstream finance with use cases in tokenized stocks, bonds and commodities.» It continues: «DLT-based applications in the financial sector, are being developed and adopted to achieve benefits such as speed, efficiency and transparency, but there are also risks to market participants… This report identifies key regulatory issues, in tokenized activities and markets, that may merit further attention from policymakers to ensure that those activities … meet regulatory requirements and are consistent with stability, consumer and investor financial protection, market integrity and competition considerations.»
Regulators in most jurisdictions, with active markets, have adopted a technology-neutral approach to policies relating to tokenized assets and their markets, with the same rules applying to the same types of assets and risks, regardless of the technological means through which the product/service or asset is delivered. As such, the use of DLT or other technologies does not affect how these regulators assess whether the resulting financial product/service, or activity, falls within the regulatory perimeter and, consequently, whether it is regulated or unregulated! To address potential ambiguity, policymakers have provided guidance and clarification around (pre-existing) regulatory and supervisory frameworks as applied to tokenized activities and markets, protecting financial consumers, investors, and other market participants, while promoting market integrity.
This report focuses, in general, on Blockchain-based tokenized assets that qualify as financial instruments and regulated tokens issued directly on the blockchain.
Some jurisdictions, it says, have opted for ad hoc rules in this area precisely because it was thought that the combination of DLT technologies and the financial market could give rise to new types of risks by adapting existing schemes or introducing holistic frameworks or “Blockchain Acts” covering DLT activity in markets (e.g. France, Luxembourg, Switzerland and legislative proposals by the European Commission).
It is true that current legal and regulatory frameworks require intermediaries/operators to act as in securities settlement systems, which could exclude the use of decentralised/public blockchain networks.
Nodal passage, this below: “Custody in DLT-based networks, of tokenized resources, is conceptually and operationally different, compared to traditional financial security markets and enforcement of existing financial security policies may be difficult in many jurisdictions. Indicatively, custodians of tokenized assets do not physically hold the asset itself, cannot prove sole ownership and may have difficulty proving the existence of the tokenized financial asset for the purposes of their regulatory books and records. A number of legal and regulatory challenges also arise, relating to property rights and possession (e.g. restitution of ownership, forced transfers).”
The first chapter is devoted to a brief overview of what tokens are and the spread of distributed ledger systems in financial markets, where, more than in others, the related risks are many.
The second chapter, on the other hand, focuses on the kind of technology-neutral approach that is applied in this sector, extending already existing regulatory frameworks, behind the belief that tokenization, in these jurisdictions, could be seen as a simple replacement of one digital technology with another, where the requirements are set, without having any specific technology in mind. It is mentioned, in this regard, that, in 2019, the EMA (European Banking Authority) and ESMA (European Securities Market Authority) published a report for the European Parliament, in which appears a comprehensive assessment of the applicability of the EU rules on financial securities, to crypto assets. The European Council clarifies the circumstances under which a given crypto-asset may qualify as a MiFID financial instrument, using a number of practical examples, pointing out that some crypto-assets, such as those with attached profit rights, may qualify as MiFID financial instruments, in which case they and companies engaging in activities involving these instruments must comply with the full set of EU securities rules. Others, which represent a large portion of those crypto-assets in circulation, risk falling outside the regulated space.
The third chapter is devoted, as the title itself highlights, to the adoption of dedicated and tailor-made frameworks for tokenized assets. Several jurisdictions have moved towards this trend, and significant examples are given in the tables included in the Report, especially in France and Germany, or even in the small state of Liechtenstein.
Regarding, for example, the latter, it is stated: “through its Law on TT tokens and service providers, also known as the Liechtenstein Blockchain Act, which entered into force on 1 January 2020, it is interesting to note that policymakers here have introduced the term Trustworthy Technologies (TT Trustworthy), to describe DLT or other technologies that do not require trusted central parties as a basis for trust.” The figure of the so-called “physical validator” is introduced, which will be discussed at length later on.
On 24 September 2020, the European Commission announced a comprehensive package of legislative proposals to regulate crypto-assets, updating certain financial rules for crypto-assets and creating a legal framework for a pilot regime for the use of DLTs in securities trading and settlement. The Commission’s legislative proposal reiterated that tokenized shares and bonds are already subject to EU securities market legislation, as they qualify as financial instruments, under MiFID. However, recognizing that MiFID predated the emergence of crypto-assets and DLT, “the EC has proposed a new regulatory framework, the Markets in Crypto-assets Regulation (MiCA), which will replace all EU and national rules, relating to the issuance, exchange, and storage of such crypto-assets. The proposed regulation covers issuers, service providers, wallet operators, and cryptocurrency exchanges. The proposed framework provides for three categories of crypto-asset issuers:
(i) asset-referenced token issuers (cryptocurrencies that claim to maintain a stable value by referencing the value of fiat currencies/commodities/or a combination of such assets, e.g. stablecoin);
(ii) issuers of e-money tokens (cryptocurrencies for use as a medium of exchange and which purport to maintain a stable value by reference to the value of a fiat currency that is legal tender); and
(iii) issuers of crypto-assets that do not fall into the above categories (e.g., utility tokens).”
In France, for example, a tailor-made framework has been introduced, regulating the activities of secondary market crypto-asset intermediaries, called Digital Asset Providers or DASPs, with an optional license, issued by the AMF French Markets Authority, a license which, however, becomes mandatory, if the intermediary provides digital asset custody services and/or buys or sells digital assets for legal tender services in France. In these cases, DASPs are required to register with the AMF, with the consent of the Autorité de Contrôle Prudentiel et de Résolution (ACPR).
Earlier we mentioned, for Liechtenstein, the figure of the physical validator.
The Liechtenstein Blockchain Act introduced a third-party intermediary of such trust, called the Physical Validator, recognizing the need to bridge the gap between the offline and online worlds and to provide assurance that the underlying right, embodied in the token, truly exists. The new framework describes as a physical validator, a professional, whose function is to ensure the existence and contractual enforcement of property rights, represented in tokens, on TT systems, i.e., that the party tokenizing the right attached to something represented online, is indeed the party owning that right offline, allowing for a valid transfer on a TT system such as the blockchain.
The fourth chapter, focuses on “Policies on other risks arising from the innovative nature of DLTs”: sandbox-based projects and proof-of-concept settlements, have used tokenised forms of central bank currency (CBDC), as in the case of the French Central Bank and Société Générale SFH , which, in May last year, issued €40 million of covered bonds as security tokens registered directly on a public blockchain, using a digital form of euros, issued by the Banque de France, via a blockchain platform. This transaction followed an initial issuance of €100 million in security tokens by Société Générale SFH in April 2019, settled in a traditional fiat currency manner.
A series of practical cases and applications in some jurisdictions, which are outlined in the remainder of the chapter, help not only to better understand the financial mechanisms that may be emerging on the horizon, but also the “regulatory gaps” that need to be properly regulated. Real-time transfer solutions are also hypothesized, or as they are called here DvP, Delivery versus Payment, which could take advantage of new systems such as the so-called “atomic swap,” i.e., the exchange from wallet to wallet of two digital assets simultaneously, in a single operation.
Chapter five, in my opinion the most interesting, is devoted to how policymaking on asset tokenization presents a number of potential challenges, including:
– lack of common language around tokens;
– the probabilistic nature of transaction finalization in decentralised networks (“Public blockchains cannot, by default, guarantee the certainty of payment,” unless confirmed by a number of blocks, for example six in the Bitcoin network);
– asset location issues, for tokens representing physical assets (it may be difficult to enforce legal and regulatory requirements on trading activities, on nodes of a tokenization platform or intermediary facilitating the issuance or operation of the chain, when such parties are based in jurisdictions that do not have cooperation agreements with the originating regulator/supervisor. What happens when a participating party, e.g. node, is out of reach of the regulator?);
– Applicability of participant regulation to decentralised DLTs;
– legal considerations, including on the enforceability of smart contracts (“According to some legal practitioners, a contract between two parties that cannot identify each other cannot be legally binding.”);
– governance and liability issues related to the absence of a single central authority in public DLT networks;
– vulnerabilities related to data protection (e.g. ‘wash trading’) and privacy in particular, including in the use of digital IDs;
– operational problems (cyber-risk, hacking).
In a box, in this same chapter, reference is made to the EC Digital Operational Resilience Proposal (DORA), presented in September 2020, which aims to establish a clear basis, so that EU financial regulators and supervisors can go beyond financial resilience and also focus on strengthening their operational resilience.
Chapter six, which is the concluding chapter, hopes that international collaboration efforts and dialogue will become increasingly important, given the global and cross-border nature of DLT-based transactions and securities.
For those wishing to gain an overview of the current status of various jurisdictions in this area, the Appendix to this paper is of interest: Appendix A. Selection of regulatory approaches to tokenization initiatives.
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Raffaella Aghemo, Lawyer