Tokens and Regulations
Classifying security tokens as financial instruments brings in a range of legal provisions. It gives regulators a better handle to manage issues regarding trading and custody of security tokens.
The significant challenge for infrastructure development and construction is access to infrastructure project financing. The advent of ICOs (Initial Coin Offering) enhanced crowdfunding performance. While the startup industry found a new way of raising capital for their businesses, investors also had multiple options to fund the companies of their choices. While ICOs paved the method more efficient alternate fundraising mechanisms, the STOs brought ease to infrafintech through ICOs mechanism combined with the traditional market structures. Since STO bothers extensively on security, STOs must abide by regulatory provisions for the issuing jurisdiction. Some jurisdictions have their framework to regulate STOs. Sample below:
The United States of America
The Securities and Exchange Commission (SEC) in the United States is the most vocal on the issue of how a security token is defined and whether specific utility tokens are, in fact, security tokens that should be regulated. In their Decentralized Autonomous Organization (DOA) report in July 2017, the SEC concluded that the DAO ICO was, in fact, a security offering under the qualification of an investment contract. Tokenized assets fall within the regulatory framework as per Howey’s Test.
"STOs brought ease to infrafintech through ICOs mechanism combined with the traditional market structures."
Under the Howey Test, an investment contract exists if there is an "investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.
The regulations in the US are considered stringent. However, there are specific provisions in the rules conducive to STOs. For example, Regulation CF (Crowd Funding) can be used by any issuer to sell up to $1.07M of their offering in 12 months to non-accredited investors. However, the tokens issued under this category cannot be traded in the secondary market for 12 months. Another option could be to apply for an STO under Regulation D. In this case, an STO can be generally advertised and sold to accredited investors only. There is no limitation on the amount that can be raised. So far, this is the most used SEC exemption for security tokens.
"While ICOs paved the method more efficient alternate fundraising mechanisms, the STOs brought the ease of fundraising through ICOs mechanism in combination with the traditional market structure."
Canadian regulators took a proactive stance toward crypto in Canada. It became the first country to approve a Bitcoin exchange-traded fund (ETF) in February 2021. Additionally, the Canadian Securities Administrators (CSA) and the Investment Industry Regulatory Organization of Canada (IIROC) have clarified that crypto trading platforms and dealers must register with provincial regulators.
ICOs and STOs Regulations
Initial Coin Offerings (ICOs) or Security Token Offerings (STOs) are deemed to b security; registration and prospectus requirements are necessary. Securities in the jurisdiction of Canada are overseen by the Canadian Securities Administrators (CSA).
Regulations of Exchanges
Exchanges are termed ‘crypto-asset trading platforms’ or ‘CTPs.’ Firms dealing in virtual currencies must register with FINTRAC as Money Services Businesses (MSB). FINTRAC’s definition of a Money Service Business that deals in virtual currency includes those that exchange and transfer cryptoassets. This includes exchanging fiat to and from crypto-assets and from one crypto-asset to a different crypto asset. Cryptoasset transfer services include transferring assets on clients' requests or receiving a transfer of assets for remittance to a beneficiary. MSBs must follow FINTRAC’s compliance requirements of KYC, AML/CFT, EDD and institute a succinct Risk-Based Approach. Firms that deal with clients in Canada or solicit them must also comply with the law.
Tax Treatment of Assets
Cryptocurrency use is allowed in Canada but is not considered legal tender. The Canadian Revenue Agency (CRA) identifies cryptoassets as commodities, and transactions exchanged for goods and services are deemed barter transactions. The Income Tax Act covers cryptocurrencies.
The United Kingdom
In January 2019, the United Kingdom’s Financial Conduct Authority (FCA) distinguished between three types of tokens:
Exchange tokens — “These are not issued or backed by any central authority and are intended and designed to be used as a means of exchange. “They fall outside the regulator’s governing perimeter.
Utility tokens — “These 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.” They may be within perimeter if they meet the definition of “e-money.”
Security tokens — “These are tokens with specific characteristics that mean they meet the definition of a Specified Investment like a share or a debt instrument.” They are entirely under the scope of the FCA’s regulations if they meet the definition of a “Specified Investment.”
Nigeria's Securities and Exchange Commission officially defined digital assets under its regulatory umbrella. SEC stated that these digital assets, which provide “alternative investment opportunities,” would be classified into four distinct categories for regulatory oversight. (Chizotam Akwiwu, 2021)
Cryptoassets: The SEC has adopted a description of cryptoassets that describes them as a digital representation of value that can be digitally traded and functions as: a medium of exchange; and a unit of account; and a store of value, but which does not have legal tender status in any jurisdiction.
Utility tokens or 'non-security tokens': Utility tokens provide users with a product or service (e.g., virtual tokens). They are treated as commodities. However, spot trading and transactions in utility tokens do not fall under the SEC's purview unless conducted on a recognized investment exchange.
Security tokens: SEC describes security tokens as virtual tokens with the features and characteristics of security representing assets such as participation in actual physical underlying, companies or earnings streams, or an entitlement to dividends or interest payments.
iv Derivatives and collective investment funds of cryptoassets, security tokens, and utility tokens
"While the tokens provide an innovative and specialized avenue for investment, the evolution of the regulation will bolster investor confidence and redefine how these structures and applications can help develop new models for business and infrastructure financing."
FINMA, the regulatory authority of Switzerland, uses the term “asset token” in place of the security token. The asset token is classified as similar to security under the Swiss financial market law by FINMA. The regulation mandates the maintenance of records of tokens, including all transactions, adherence to anti-money laundering, and publishing prospectus for an STO.
Singapore’s central bank, the Monetary Authority of Singapore, has issued guidelines for digital tokens. As per these guidelines, the digital tokens constitute capital market products as defined in the Securities and Futures Act (SFA) (i.e., securities, derivatives contracts and so on). In these cases, the existing relevant licenses apply, based on the activities performed by the businesses: whether as a token issuer, exchange platform, advisor or otherwise. In fact, in 2019, the MAS had warned an issuer not to proceed with its securities token offering in Singapore until it can fully comply with regulatory requirements under the SFA.
Japanese regulators have also rolled out changes to their existing securities regulation to include the impact of security tokens to protect customer interest and streamline the tokenization process. ISSA paper on Crypto Assets raises the following aspects from the regulatory perspective:
When a tokenization platform for Crypto Asset holdings and transactions spans multiple jurisdictions, the need to take a different view of the legal status of the same asset or transaction arises.
CSDs might also find their Crypto Asset settlement and custody services regulated under the national regulations of their home country. They will need to assess whether they can provide new digital wallets under their existing licenses.
The paper highlights that new roles and services like smart contract verification, which are an opportunity for digital wallet service providers, are likely to emerge because of tokenization. Regulators and policymakers will need to consider defining and regulating such novel roles.
Classifying security tokens as financial instruments brings in a range of legal provisions. It gives regulators a better handle to manage issues regarding trading and custody of security tokens. (Anjana, 2021) While the tokens provide an innovative and specialized avenue for investment, the evolution of the regulation will bolster investor confidence and redefine how these structures and applications can help develop new models for business and infrastructure financing.
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