Blockchain Applications and Regulatory Matters
There are two current main applications of blockchain: one as a digital currency, the second one is used for crowdfunding.
Let’s look at the evolution of these applications.
Public blockchain application is digital currency and integrated payment system.
This innovation has completely removed the need for a trusted third party.
It allows peers in a network – whomever they may be – to send value to one another, globally and almost instantly.
Bitcoin demonstrated that a distributed community could share a payment system and store of value.
When something such as bitcoin, works in such a miraculous way, it is natural for others to want to replicate the success of that model.
As a result, enthusiasts wanted to create own version of bitcoin. This resulted in the altcoin explosion.
Many coins in the early 2000’s were similar in many ways, and thousands of coins were created.
These new cons often were:
- mining-based digital currencies
- or had a mix of mining and pre-mine.
Ripple – an alternative to bitcoin as a payments network – pre-mined its coin. Ripple’s XRP token is used as an anti-spam token for the network and a conversion token for forex transactions.
The pre-mine of a new protocol was used to raise funding for the protocol itself.
Then, a new trend emerged which was less about creating a new protocol, but rather leveraging the strength of the bitcoin network in other ways.
Different communities arose that were building on bitcoin.
There was the coloured coin protocol, Counterparty and also Mastercoin, now Omni.
All those layers allowed a user to simply create another token and use the existing basic functions of pay, receive and escrow, for the new token.
The tokens that were created by a project were often used as a tool to raise capital for the project.
Before a project was live, the founders would start a campaign to give the community the opportunity to purchase their coin.
This crowd sale campaign came to be known as the Initial Coin Offering (ICO).
MaidSafe on Mastercoin raised around USD5m with its ICO. Factom raised a few million.
With Maidsafe and Storj, their token is used to pay for the services.
Ethereum then announced that it was going to create a general framework for blockchain programming.
Its own crowdsale ICO in September 2014, raised nearly USD15m. Once Ethereum went live, it became evident that ICOs were going to breathe a new lease of life into the sector.
Even the Ethereum foundation refers to ‘trustless crowdsales’ on its homepage as a principle application of Ethereum.
So, the second major application of public blockchain is undisputedly crowdfunding.
The interesting effect of blockchain crowdfunding is that it removes the need for crowdfunding platforms themselves.
What we are seeing now, is that Ethereum has heralded a new generation of ICOs.
These ICOs raise typically between USD5 million to USD15 million at a time.
Let's look at some of the token sales projects and the type of instruments that were sold.
This is a type of token used to access software or services. This is generally regulated as a digital currency in most jurisdictions. However, even access tokens can provide incredible capital returns. Ethereum, Storj and Factoids are prime examples of access tokens.
Virtual Securities Token
This is more like a share in a company.
The issuer of the token promises one of the following or a combination of:
- a share of the profits of the company
- a portion of gross sales
- transaction fees in a network
- or a portion of assets.
These types of tokens may be subject to tighter regulations.
In particular, jurisdictions the sale of these tokens may be deemed to constitute an investment.
The founders often do not structure the tokens to be investments – but their interpretation by courts or authorities may lead to that finding.
This is a case where substance will often triumph over form.
One labelled ‘virtual’ stock market was created by Ethan Burnside in 2013.
On the website, it was possible to create what he referred to as ‘virtual’ shares and bonds to raise funding for your project.
They were labelled ‘virtual’ shares and bonds as the Issuers did not create genuine shares or even legal structures to support the issuance.
Mr Burnside was charged for breaching the Securities Act in the US.
This precedent from the Securities and Exchange Commission (SEC) states clearly that the formality of the instrument is immaterial in the US.
If it is not actually a share or a bond but an investment contract, then it will be defined as a ‘security’ under US law.
Enacting Virtual Securities Tokens on ICOs are therefore more complicated.
In the EU, there are restrictions on amounts raised by selling securities without a prospectus.
Reference: Article 3.
The Prospectus Directive applies to ‘transferrable securities’.
Transferable securities shall mean:
“— shares in companies and other securities equivalent to shares in companies
— bonds and other forms of securitized debt which are negotiable on the capital market and
— any other securities normally dealt in giving the right to acquire any such transferable securities by subscription or exchange or giving rise to a cash settlement excluding instruments of payment”
Reference: Article 1(4)
If a Virtual Security Token is deemed a transferable security then the Issuer should be mindful of the Prospectus Directive.
In addition, the standard token issued during an ICO is a fully transferable token. It acts in a similar manner as bitcoin, with the ability to transfer to anyone even if the recipient is not known to the issuer.
ERC20, which is the standard for Ethereum tokens, have, by default, full and unrestricted transferability.
This ‘bearer’ nature of Virtual Securities Tokens creates issues in certain jurisdictions.
In October 2014, the recommendation from Financial Action Task Force (FATF) states:
“[…] countries that have legal persons that are able to issue bearer shares or bearer share warrants, or which allow nominee shareholders or nominee directors, should take effective measures to ensure that they are not misused for money laundering or terrorist financing”.
This led to several countries abolishing bearer shares. In the UK, for example, bearer shares were abolished in 2015.
Consequently, Virtual Securities ICOs are likely to be affected by bearer share restrictions.
The type of limitations that may affect a virtual securities offering is as follows:
· limits on the amount of capital raised (Prospectus Directive)
· place registration requirements on the issuers – the US in particular, unless exemption applies
· limits on the number of investors
· limits on the type of people who can purchase
· limits on whether the ERC20 token will have transferability due to bearer share restrictions.
There have been many Virtual Securities Offerings. These are obviously some of the most appealing ICOs as they promise a better return on investment.
Virtual securities are instruments that are:
Model 1: Not defined as such by the Issuers but act like securities.
Model 2: Explicitly acknowledged as a security or investment contract by the Issuer – although an unconventional security. They could give access – similar to share warrants – to a real security or not be linked to a financial instrument at all and give a defined return to the investors in its own right.
Lykke and Blockchain Capital have issued the best Model 2 Virtual Securities so far. Lykke issued a right to a share in their company as a coloured coin. Blockchain Capital set up a fund with an ICO. They raised USD10m. However, there were certain restrictions: US investors had to be accredited, transfer of the token had limitations. Notable that the offering memorandum was extensive. The token will go live on 15 May 2017.
We have a third trend emerging which is the issuance of a traditional security on the blockchain. This third category is not a Virtual Security. It is a conventional security issued on the blockchain. These instruments are here referred to as Blockchain Securities.
Shares were typically issued in what is known as ‘certificated’ form.
In the context of a share transfer, this means that there would be a share register and a share certificate for the shareholder. The transfer of a share would involve a stock transfer form, updating of the share register, cancellation of the previous share certificate and issuance of a new certificate.
These numerous steps would be impractical in a trading environment on a stock market.
When electronic trading emerged on stock markets the system of trading typically involved the equitable ownership of the share moving hands on an electronic trading system then legal ownership being transferred after the event.
New regulations were introduced in the EU to streamline this process further, these were referred to as the ‘Uncertificated Securities Regulations 2001’ or ‘USR2001’.
These regulations allowed for the legal or equitable transfer of shares at the point of electronic settlement. This removed the necessity of a two-step process.
Importantly, USR2001 would only allow the electronic transfer on recognised settlement systems namely with ‘Operators’.
In the UK, operators are required to be approved by the UK Treasury. An example of a USR2001 Operator would be CREST, which is owned by Euroclear.
The CREST settlement system itself becomes the share register of the companies it supports. CREST holds the shares in an uncertificated form and the company usually has a duplicate of that record.
Operator authorisation is needed to ensure the continual reliability of the Operator’s systems. Any inaccuracy could lead to disorder in stock markets.
So, to have Uncertificated shares they must be held by a USR2001 Operator.
These are the requirements.
In contrast, we are finding that progress is being made to enable companies to issue and transfer shares directly onto a blockchain.
In Delaware, US, they are amending the law to have shares issued on the blockchain.
According to Cooley, the Delaware Blockchain Initiative has suggested amendments to permit the issue of “so-called "Distributed Ledger Shares” under Delaware Corporate law that could be authorised, issued, transferred, redeemed – living their entire life cycle – on a distributed ledger”.
The notion suggested is that, rather than maintaining a share register, the company maintain its list of shareholders on a distributed ledger.
For the EU, there would need to be policy changes to allow for the blockchain itself to become an Operator. This is unlikely, as parts of market infrastructure regulation are designed to have liability assigned to a legal entity. It would be a significant departure to remove that legal entity altogether.
A recent report from Euroclear made this point very clear.
The report said, “the use of DLT by a central securities depository (CSD5), for example, should not by itself trigger any specific regulatory approvals”.
The Central Securities Depository can use blockchain if it so wishes. But its own role cannot be dispensed with blockchain. Not least because its own role is entrenched in legislation.
Therefore, in the short term, we will start to see Euroclear or other USR2001 Operators offer essentially CREST on blockchain.
In parallel, other jurisdictions, which have a more nimble legislative process, may take a more flexible approach to Blockchain Securities.
With that in mind, it may take some time for Blockchain Securities to become commonplace.
For ‘public’ Blockchain Securities we need to add an identity layer to resolve the ‘bearer asset’ issue.
Let’s look at where we might be heading.
Countries may create a regulatory framework for a new type of company.
This company will be created as a smart contract on the blockchain. Its basic functions as a company will exist on the blockchain and it will issue shares on the blockchain.
It is commonplace for countries to prepare standard articles of association to be used when a company is incorporated. These are referred to as the ‘Model Articles’.
In the future, a blockchain friendly country will provide Model Smart Contracts.
These Model Smart Contracts will be written for example in Solidity and will cover several areas.
First, a Model Incorporation Contract will be provided – downloadable from the Company Registry’s office. Once published on-chain the company will be incorporated.
Secondly, there will be a Model Share Issue contract. This contract will be compatible with the Model Incorporation Contract. Publish the code and the shares will be issued.
Of course, underpinning such as system will be an identity layer – for accountability purposes.
This all sounds hugely ambitious but the ambition is not a technical one; it is a legal one.
Decentralised Autonomous Organisations (DAO) are, technically, already being created on Ethereum.
The only missing piece is complete harmony with the legal systems. Currently, the DAOs created are akin to informal partnerships or community associations, which are fairly unsophisticated legal forms.
Aragon – a new project that is carrying out an ICO this month – will ensure that creating a DAO is accessible for anyone. Finally, it will be the meshing of blockchain innovations with a legal system that will be the ultimate leap forward.