Let’s start settling our base ground defining “What falls under the definition of a Crypto-asset?” According to the official definition given by the European Union (EU):

“Crypto-Assets are digital representations of value or rights that have the potential to bring significant benefits to both market participants and consumers. By streamlining capital-raising processes and enhancing competition, issuances of crypto-assets can allow for a cheaper, less burdensome and more inclusive way of financing small and medium- sized enterprises (SMEs). When used as a means of payment, payment tokens can present opportunities in terms of cheaper, faster and more efficient payments, in particular on a cross-border basis, by limiting the number of intermediaries”

In line with this definition, the tokenization process can be understood in general terms as one through which a crypto-asset is created — in this concrete case a token — which attributes an underlying value to its digital representation.

It is very important to note that this representation of value may vary depending on the specific use of the token in question:

  • Tokens that represent a real physical asset on a distributed ledger: In this case, the economic value and rights derived from pre-existing real assets is embedded on a blockchain– based token: the token exists “on-chain” while the asset that backs the token exists “off-chain”
  • The issuance of a traditional asset in a newly tokenized form: In contrast to the first example, the asset tokenization in question requires the minting of a trading instrument via the native tokens of a live blockchain that were built on-chain and exclusively exist in that distributed ledger.

It is also important to note that a token can represent both a physical asset (e.g a real estate asset, a piece of art or even a diamond or gold) and an non-material asset (e.g a creditor or a property right).

Tokenization should then be understood as a process that allows the creation of digital manifestations for a variety of underlying assets that do not always have a physical form.

We can find projects all around the world already taking advantage of this brand new and powerful tool: from the tokenization of the official Georgian and Swedish Land Registry and its underlying property rights to a blockchain, to Real Estate tokenization of entire buildings in New York, to the tokenization of a specific collector item.

What kind of tokens could I create within my project?

Given that there is no statutory definition and no case law, currently the best approach is to rely on the token categories introduced by FINMA. Based on this classification, which is also referenced and used by the Swiss Federal Council in the Dispatch, the following three categories of tokens can be distinguished:

  • Payment tokens: (which are, according to FINMA, synonymous with “pure cryptocurrencies”; referred to herein as “cryptocurrencies”) are tokens that are intended to be used, now or in the future, as a means of payment for acquiring goods or services or as a means of money or value transfer. Pure “cryptocurrencies” do not give rise to any claims towards an issuer or a third party. Consequently, according to the prevailing view, these tokens are “purely factual intangible assets”. Examples of such cryptocurrencies are Bitcoin (including numerous cryptocurrencies resulting from forks or variations of Bitcoin, such as Bitcoin Cash, Bitcoin Gold and Litecoin) and Ether (from Ethereum).
  • Utility tokens: are intended to provide access digitally to an application or service by means of a DLT-based infrastructure. They are usually created within a concrete ecosystem to work as a payment or reward method inside of it.
  • Asset/ Security tokens: represent assets such as a debt or an equity claim against the issuer. Asset tokens promise, for example, a share in future company earnings or future capital flows. In terms of their economic function, therefore, such tokens are analogous to equities, bonds or derivatives. Tokens, which enable physical assets to be traded on a blockchain infrastructure, according to FINMA, also fall into this category.

Is relevant to point out that tokens may also fall into more than one of these three basic categories. Such hybrid tokens are, for example, asset tokens or utility tokens, which at the same time also qualify as payment tokens.

For a better understanding, see a visual categorization of the proposed taxonomy of crypto-assets introduced by the EU’s Proposal for a Regulation on Markets in Crypto-assets (MiCa)”

 
Could a token or crypto asset be categorized as legal tender?

The majority of crypto-friendly countries do not accept “crypto” as legal tender. El Salvador is the only country in the world to accept bitcoin as “money” in a narrow sense; in June 2021, the country’s Congress approved a proposal by President Nayib Bukele to formally adopt bitcoin through law as a form of payment and accept all tax contributions to be paid in bitcoin and Salvadorans to also pay their debts in bitcoins. Even the debt that existed before the approval of this law.

Additionally, there is currently no form of “state-backed” cryptocurrency available in most countries. Initiatives such as the “digital euro” are starting to be shaped in the heart of the Central European Bank that aims to complement the euro (€), but is not set to work as a substitute in any sense.

It is clear then that a key concept emerges: territoriality for a project should be understood as key in determining the applicable law to that project — if there is a law that exists and is applicable. Understanding these laws also helps clarify the full scope of legal requirements applicable to the issuing of a token or crypto-asset.

From a legal point of view, what stage are we currently at in the Crypto-Verse?

Blockchain and Distributed Ledger Technology (DLT’s) based solutions and their application in finance are increasing significantly in present times.

The fast-evolving FinTech industry is creating a variety of new applications every day, while also providing a wide range of tools at our reach: Payments with digital currencies and fiat-backed stablecoins; unregulated crypto-assets more and more integrated with markets such as bitcoin or ethereum and, of course, the crown jewel: the tokenization of assets. These are just some concrete examples of the different financial manifestations of cryptocurrencies today.

Asset tokenization, now positioned in a prominent place in crypto only surfaced a few years ago and was originally understood to be a theoretical and utopian possibility. As you may have experienced first-hand, this new exciting tool is now capable of fueling a wide variety of projects and applications: like the ones that are being born every day inside of the NEAR ecosystem.

In recent years, tokenization has found a place in modern finance with use-case in tokenized assets, leaving behind the first days of the Initial Coin Offerings (ICO’s) and showing us a new direction to go. Take as an indicator the launch of the SIX Digital Exchange platform by the Swiss Stock Exchange that is already working towards building the world’s first regulated digital market infrastructure.

But, sadly, we are not yet at the stage where we can rely on a single legal body to apply and regulate the legal issues that arise when using these technologies. Regulatory approaches are aiming to be created in many different jurisdictions: from the recent news from the Central European Bank passing of a bill to create a Digital Euro to the impossibility in the U.S to impose regulation under existing financial laws (this is because the existing U.S legislation requires the presence and regulation of intermediaries).

This means that due to the lack of applicable regimes to crypto-assets, every use-case aiming to apply to Blockchain-based tokens or DLT’s technologies will have to be analyzed individually to better identify Its concrete needs from a legal perspective. We are just not there yet.

As a consequence, many service providers and project managers are being forced to familiarize themselves with multiple legislations issued by different countries, to obtain multiple national authorizations or registrations, or to comply with divergent national rules.

This results in high costs, legal complexity, and uncertainty for actors operating in the crypto-assets space — and in many cases limiting the growth of their activities.

Are there any clearly defined legal areas that I should be focusing on?

The geographic location of the asset and regulatory/supervisory enforcement on trading activities: It may be challenging to enforce legal and regulatory requirements on trading activities to nodes of a tokenization platform or intermediaries facilitating the issuance or the operation of the chain when such parties are based in jurisdictions that do not have cooperation agreements with the home regulator/supervisor. What happens when a participating party (e.g. node) is beyond the reach of the regulator?

Governance risks are particularly relevant to fully decentralized ledgers, related to the difficulty in identifying a sole owner or node accountable for the full network or any derived responsibilities. The absence of a single accountable point of control is a very important challenge to regulating DLT networks and assigning responsibility for the failure or malfunction in the network.

The legal status of smart contracts still remains to be defined in many jurisdictions, and the potential lack of enforceability of such contracts gives rise to important financial consumer protection concerns. The audibility of the code of smart contracts and relevant permissions to change the code are other areas of concern.

Data protection and privacy (including relative to digital IDs), storage of data, and regulation applicable to the usage, sharing, and storage of data is another legal concern that in many cases fails to be completely resolved. This is especially the case since the publication and enforceability of the EU’s General Data Protection Regulation (GDPR) in 2018 and the U.S California Privacy Consumer Act (CCPA). Both of these regulations introduced heavy privacy compliance requirements in general terms for all data processing and storage with a special focus on the difficult relationship existing between blockchain-based solutions and these laws.

Risks related to Anti Money Laundering (AML), Know Your Customer (KYC) and Combating Financial Terrorism (CFT) are prominent in DLT-based systems and are particularly high in tokenized markets that are based on public permissionless networks.

As cryptocurrencies are still an emerging financial instrument, regulation is constantly evolving. Therefore, it is recommended to consult the requirements needed by your appropriate jurisdiction for updated regulation before starting a blockchain or cryptocurrency project.

Globally, there has been a spectrum of responses to crypto-assets in general. Some legislations have even gotten to the point of banning cryptocurrencies entirely (China, Russia, Vietnam, Bolivia, or Ecuador have essentially said NO to instruments such as bitcoin), while others are adopting novel models such as sandboxes to better understand the technology and how it can be regulated.

Conclusion

It is clear that a ‘case by case approach is needed when issuing a token asset and, subsequently, legally qualified crypto-assets. Some crypto-assets, e.g those with attached profit rights, are likely to qualify as MIFID (EU’s Market in Financial Instruments Directive) financial instruments.

Others may be categorized as a pure crypto-asset or as an e-money token and, therefore, fall outside of a concrete territorial regulation (U.S , EU, Switzerland, etc…)

In issuances, the law may introduce additional detailed requirements including the provision of a whitepaper, disclosure requirements to investors and an obligation for a dedicated information system that should be included in the register of the Central Bank and which should encompass access to asset functionality; continuity of operations; integrity and reliability of the information on the register, among other things.

At the Legal Guild we aim to help you, in the first instance, to be able to understand these legal complexities, and, at a later stage, we want to empower and direct NEAR communities and projects in the right direction to solve any recognized issues more sharply.

This document was created by
SANTIAGO CHAMAT 
Executive Director