Regulation of Digital Assets - An Evolving Topic

Introduction

The regulatory considerations surrounding tokenised issues are complex, the emerging opinion across most regulatory regimes appears to be, that as tokenisation does not introduce a fundamental structural change to the origination and distribution of securitised assets, the regulation and supervisory structures currently in place will apply as equally to tokenised issues as they do to securitisation issues.  

This means that that current compliance regulatory environment relating to MiFID, anti-money laundering, know your customer and related will apply equally to the tokenisation as they do to securitisation.  

It will be the case however, that as distributed ledgers introduce near-instantaneous and irreversible transaction characteristics, issuance operational measures will need to be adapted to demonstrate regulatory compliance.

United States & "Digital Assets"

In the United States, whether a transaction results in the issue of a a “security” is a matter of Federal law, with the term “security” being regarded by the SEC as a “flexible rather than a static principle”.

Within this framework the SEC has determined that a “digital assets” is “any asset that is issued and transferred using distributed ledger or blockchain technology”

Whether a “digital asset” becomes a “security” pivots on the form and terms of the issue, as well as the manner by which the issue is offered and sold.  

As tokenisation issues are “digital assets” directly linked to an underlying pool of physical securities, tokenised issues will fall within the supervisory remit of the SEC, requiring issues to either be SEC registered or to qualify for an exemption.

White House Executive Orders / Biden Administration 9th March 2022 and White House Fact Sheet 16th September 2022 Responsible Development of Digital Assets reinforces this view.   

The current position of the US legislature and the US regulator is that existing securities laws are appropriate for regulating digital assets.

Europe & "Asset Referenced Tokens"

There are eight jurisdictions in Europe, including France, Italy, Germany, The Netherlands, Spain and UK that have elected to regulate “Security Token Offerings” using existing domestic securities law.  Luxembourg has adopted a similar approach but has recently implemented new requirements specifically designed to facilitate the issue and transacting of asset backed security tokens using distributed ledger technology.

At the EU-wide level, the European Parliament as recently as 20th April 2023 approved new crypto-currency regulations following its Markets in Crypto-Assets, or MiCA, consultation process.

This introduces a unified EU-wide framework to facilitate the issue of crypto-assets across the Union, including the tokenisation of conventional financial receivables.

The legislation defines a crypto-asset as being a

“digital representation of value or rights that may be transferrable or stored electronically using distributed ledger or similar technology”

Asset Referenced Tokens, being those that determine value by reference to a pool of underlying assets, are separately defined from Electronic Money Tokens being those that maintain value by reference to a single fiat currency and from Non Fungible Tokens that reference an object of high value, high scarcity or of itself, is unique.

The legislation also modifies the definition of a “financial instrument” to include assets able to be traded using distributed ledger technology enabling these assets to be brought with the auspices of the MiFID II Directive.

By so doing crypto-asset service providers will be required to meet minimum capital thresholds, as well as demonstrating compliance functions that address the MiFID II criteria relating to payments for order flow, transaction execution fairness, identifying front running activities and pre- and post transaction transparency.  

Further service providers will need to demonstrate operational resilience, will need to have a registered office within a member state, will need to demonstrate “Effective Management” within the Union and will only be permitted to issue promotional material more closely aligned to an investment prospectus, providing a detailed and carefully considered assessments of investment risk.

The legislation as it relates to Asset Referenced Token issues, will apply 12 months from the date the new regulations come into force, expected to be in the 2023 European summer.  

The balance of the new regulatory environment is expected to be introduced in 2025.

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Japan & “Security Token Offerings”

Japan has been at the vanguard in modifying its regulatory regime to accommodate the digitalisation of asset backed security issues.

In March 2020 Japan’s Financial Instruments and Exchange Act or FIEA, was amended to enable “digital tokens” to be classified as “securities”.  This created a new class of securities known as “Security Tokens” and a new type of security offering known as “Security Token Offerings” or STO’s.  

STO issuance, distribution and trading in turn falls within the auspices of the Japanese Financial Services Agency which has supervisory authority over securities trading.

The first STO issue was led by Sumitomo Mitsui Trust Bank in March 2021: a short dated private placement, underpinned by credit card receivables.  

When considering an STO, Japanese bankruptcy laws need to be taken into consideration.  These laws specify that unless there is a clear separation of the financial interest in the asset pool from the Originator in the event of an insolvency, there may be a right to recovery against the pool.  That is, the Originator needs to demonstrate a “true sale” of the assets. 

This may present an additional layer of complexity if considering an “evergreen” trust to underpin an STO.  The ability to cycle out underperforming assets, replacing these with assets of higher quality, may result in an inability to demonstrate the“true sale” test has been met.   

This does not preclude the use of trust structures.  Rather than the conventional approach of establishing a special purpose vehicle with the additional establishment, maintenance and reporting overheads this involves, a trust may be used to hold the pooled assets.  

Sumitomo elected to use this approach with its March 2021 issue.  

In this structure the trust was established to enable the transfer of beneficial, fractional interest within the trust to alway coincide with the recording of the change of ownership on the distributed ledger.  This enabled fractional interests to be transferred without the need to deliver a physical instrument or to manually maintain book entries of transferred holdings.

This also enabled the Sumitomo issue to be classified as a “Paragraph 2 Security”.  This refers back to the FIEA that classifies securities as “Paragraph 1 Securities” being conventional issues such as bonds and shares, typically having high levels of liquidity and are thus subject to stringent licensing, reporting and registration requirements, and “Paragraph 2 Securities” such as collective investment schemes, that are less liquid and are thus subject to significantly looser controls.

As a Japanese secondary market for STO’s does not yet exist, it is too early to determine whether STO’s will be categorised as “Paragraph 1” or “Paragraph 2” securities.  It is anticipated this question will be addressed in 2024, following careful consideration by the FSA of all the regulatory and legal issues surrounding the possible introduction of STO peer-to-peer electronic trading platforms. 

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Australia & “Crypto Tokens” 

The Australian regulatory framework relies on two concepts: the first being the “function” of a transaction or scheme, the second being whether a “facility” is provided being an arrangement through which “financial functions” may be performed.  These are defined in  the Corporations Act as being:

Unlike other countries, Australia does not have specific “securitisation” legislation.  In Australia, digital assets issued against a pool of receivables are regulated according to the“function” provided and whether that function provides a “facility”.  If both these criteria are met, the digital asset will be regulated as a “financial product”.  

Complexity arises as the definition of a “financial product” in the Corporations Act differs from the definition of a “financial products and services” in the Australian Securities and Investments Commission Act.  This Act in turn concerns itself with both “financial products” as understood by the Corporations Act as well as credit card and other consumer finance related considerations.  This results in an overlap across the ASIC Act with the regulatory regime created by the National Consumer Credit Protect Act.

The Anti Money Laundering and Counter Terrorism Financing Act is also of relevance as this Act provides a money laundering and prevention of terrorism financing activities registration, compliance and reporting regime covering all financial services and products 

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This above may be summarised in the following table:

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Against this background in August 2022 the Australian government announced a review of the current regulatory environment, with the intention of reforming the Australian regulatory environment to accommodate the introduction of crypto-asset issuance and trading. 

In February 2023 the Australian Treasury implemented its Token Mapping consultation process with industry, as a “foundation step” to enable digitalised assets to be issued.  

The purpose of this consultation was to map tokenisation systems against the existing regulatory framework in order to identify areas where legislative and regulatory change would be required. 

In order to frame the consultation process Treasury introduced a set of definitions to the nomenclature, the principle ones being:

Diagrammatically Treasury represented the mapping of token issuance against the existing regulatory regime in the following manner: 

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Once a Token system has been identified as delivering a “function” the next step is to identify if the benefit being delivered is a “financial function” as defined by the Corporations Act.  If a “financial function” is being delivered, the Token System will become regulated as a “financial product”.

Treasury Conclusions and Next Steps 

Treasury concluded that a Token System will provide record keeping functionality analogous to existing Registry / book-entry ownership record keeping, a review of existing Registry and Custodial regulatory arrangements will be required.

Further Treasury concluded that existing AML, CTF and KYC compliance and reporting functions will need to be reviewed to accommodate the use of Smart Contracts to ensure continuing compliance with AML, CTF and KYC legislative requirements 

Finally as Smart Contracts may be used to automate intermediary-less transacting of Crypto-Tokens consideration needs to be given to the regulation of emerging “automated market-maker” platforms.

The first step in this review process will be the issue by Government of a proposed framework for new for Registry and Custodial licensing arrangements.  This is expected to be released for public comment in mid-2023.

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