Digital tokens – a regulatory perspective


Loosely we are using the word ‘tokens’ to provide a neutral definition for this technology. The key distinction from a regulatory point of view is whether the token is a digital currency which will not necessarily attract regulation in its present form (bitcoin as a digital currency is only prohibited in a few jurisdictions see for more details), or a digital financial instrument/security which would engage absolute regulation/compliance before being issued.

Digital Currencies
These come in two main forms, either mined or pre-mined.

Mining is the involvement of network participants in creating the currencies and securing the network; this forms a way to distribute the token.

Mining, in itself, generally involves little or no regulatory issues in most countries, so is the safest way to launch a new coin. Bitcoin is the quintessential mining-based digital currency.

When the tokens are pre-mined then they are either distributed by means of selling them, ‘burning’ them or via loyalty schemes.

Where the distribution of the pre-mined currency involves a sale to the public then this is the most riskiest strategy for distribution of the coins and we will explore the regulatory issues that arise below.

Burning tokens is where an investor’s funds are burnt to give value to the tokens and to distribute the coins. Example would be Counterparty.

Distribution via loyalty scheme is the use of the Airmiles or other company loyalty schemes as a template and then replicating that system using digital tokens.

Things in common
All of the above tokens are valuable in their own right and do not reference an external source of value. This is in contrast to digital fiat/commodities or financial instruments discussed below.

Below, we will explore the regulatory risks involved with investing in digital currencies and, in the second part, look at a digital fiat/commodities and more innovative tokens that are closer to financial instruments. At the end, we will do a case study of an area that could be explored where the regulatory risks are slightly lower but may be able to achieve the crowdfunding of projects; which is the main reason for pre-mining and selling the digital currency.

Buyer Beware
As an investor you should know fundamentally what you are investing in. So you need to conduct your due diligence on the digital currency itself. If you are mining the currency then you need to assess the ROI on the machinery. If you are dealing with a digital currency that has been pre-mined then you need to assess the trustworthiness, credibility of the Issuer.

Bear in mind that none of these digital currencies in themselves are or can be, at this stage, regulated. If Russia bans bitcoin then bitcoin still exists, as it is purely mining based currency; there is no issuer of bitcoin.

That said, where the digital currency has been pre-mined then it is likely that the entity behind the currency might fall into the purview of regulation.

An example of that would be Ripple, the issuer of the XRP digital tokens, recently who was fined by FinCEN $700k for regulatory breaches. Ripple communicated with FinCEN regarding their currency and suggested changes to the actual protocol itself to be more AML compliant.

This, I suggest, is the beginning of digital currency issuer falling into the grasps of regulators (this is however potentially an opportunity for new digital currency issuers).

Regulatory Overview
Look at for a breakdown per country of where digital currencies are permissible or banned. Only countries at present where a ban is in force are Equador, Iceland, Bolivia and soon Russia. These bans are usually not against digital currencies themselves but have the effect of banning them; this would be where a country has strict capital controls with loose definitions or prohibits surrogate forms of money.

With that in mind it is much like the Wild West of finance out there; you need to absolutely do your due diligence on the digital currency itself and who is behind the digital currency.

Some digital currency projects are trying to be as transparent as possible and even inviting independent audits of any claims made in relation to the projects, but it is incumbent on you as a buyer to find these things out on your own.

Numerous warnings have been sent out round the world to clarify that digital currencies sit outside of the regulated financial system and that there are essentially no protections for buyers.

See statement from the Secretary for Financial Services in Hong Kong, Professor Chan:

“ The Investor Education Centre and the Consumer Council have reminded the public from time to time that trading bitcoins may result in monetary losses, and that holders may not be able to obtain a refund of their monies should a virtual commodity collapseor those who deal in it cease to operate. We have been discouraging people from engaging in such speculative activities or transactions without considering the risks involved.”

The importance of this if you are interested in buying digital currencies is to understand and appreciate that these digital currencies, for the large part, sit outside of the regulated financial system for now.

What may change as we move forward with this industry is to see more intermediaries involved in dealing with digital currencies regulated and the same with some Issuers of digital currencies such as Ripple.

Digital promissory notes – digital fiat/commodities

The promissory note is a fascinating legal concept and has been a part of the world of commerce and still is for years.

The letter of credit is used in trade finance and is an example of this type of arrangement. These instruments are generally not defined as financial instruments/ securities.

A basic example of a note of this sort could be that I sign a deed creating a note promising to pay the bearer the face value of the note whatever that face value is, which could be a commodity or otherwise. These instruments, however, are generally used in the world of commerce not finance and there are conventions surrounding their creation.

Where the note is being used for investment purposes rather than commercial purposes then it is likely closer to the concept of a security/financial instrument.This will be a common distinction to make and the distinction will have fundamentally different regulatory consequences.

An example of currency based promissory notes being used in the world of bitcoin world is with ‘digital fiat’ and ‘digital gold’. These tokens have a face value stated on the digital token; x amount of USD or gold.

Now if you are buying digital fiat or gold you have to consider whether there are any capital controls or licensing that affects you from being able to purchase these promissory notes. In certain countries bear in mind that brokering gold would require licensing and in certain countries there are capital controls on bringing fiat currencies into a country, for example, see Venezuela. Also, issuers/ brokers of digital gold may in future be considered to fall within electronic money laws or straightforward MSB laws.

Then there is the trust factor. As a purchaser of digital commodities/fiat you need to be sure that you trust the issuer first that they will redeem the face value.

So the above are essentially currencies/commodities, but the next set of tokens could fall into the definition of a regulated financial instrument/ security.

Digital shares

Shares are regulated financial instruments in most countries in the world. Buying and selling advising on is a regulated activity.

Let’s remember why all these regulations exist in the first place? This is because it is too easy to hype a story and sell shares (remember the Wolf of Wall St) and who gets burnt it is usually the retail guys not the savvy VCs.

From a marketing perspective, in most countries in the world there is an exemption for marketing securities to sophisticated/ professional investors, as they can usually see past the hype to the hard numbers and have the resources to do due diligence before putting their money down.

Regulations were originally designed to protect consumers not prevent innovation.

Now there is an interesting trend in blockchain technology to digitise regulated shares. This is literally turning the share into a permanent and almost ‘tangible’ digital token (as opposed to an entry into a private register that can be easily manipulated). The founder of Overstock Patrick Byrne’s is looking into this (see Medici project) and Nasdaq is even considering using blockchain technology for its Private Exchange.

Other projects are mixing the notion of a share with other elements, thereby, creating creating revenue share or equity investment opportunities that bear similar characteristics to shares but are issued as digital tokens.

Let’s just remember that if you make something digital it doesn’t mean that it stops being regulated.  So issuing (in certain countries) dealing, advising or providing a marketplace for regulated shares would require licensing.

Software or a Security/Share
A number of issuers of digital token play with the notion of ‘software’ and the intention of the legal entity backing the project. The usual combination for these new tokens is to say we are selling software plus we are a non-profit association.

Do not be tricked into thinking that semantics or playing with definitions will give an issuer blanket amnesty from regulatory action.

Regulators will look at substance over form. For example the FCA in the UK in its definition of what a share is references ‘equivalent to shares’. In the US the definition of security is pretty much all encompassing:

Securities Act 1933

(1) The term ‘‘security’’ means any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered
into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a ‘‘security’’, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.

So a lot will come down to evidence.

If a regulator takes action then the onus is usually placed on the accused to prove that they did not issue a security/financial instrument and did not breach any laws.

Remember in the US there is a requirement for securities to be registered with the SEC. This is not necessarily the case in all countries, but you have to consider this dimension when your coin is accessible to most parts of the world.

So approaching the SEC would be a clear way to protect the viability of your project. They would normally be able to issue you a no-action letter for your project. Thus why any sensible project would have had a strong legal team supporting the project and would seek clearance from some of the more sensitive regulators before proceeding.

Digital mining contracts
These contracts deliver to the holder a revenue stream. This could be a mining contract in the form of a digital token. The bearer of the asset gets the yield from the mining revenue generated. This is not dissimilar to a bond or other debt based instrument. Also, if it is a debt based instrument then it will look like a bearer bond due to its decentralised nature; note that bearer bonds/shares are slowly being phased out due to the money laundering risks involved with their usage in society.

If it is structured as a genuine contract for services then you have to be able to segregate the machines; if you aren’t receiving a lease on identifiable machines then you are really investing in a collective investment scheme (see below). The key concept here is whether the machines are divisible or not.

Digital Collective Investment schemes
These are digital assets that may represent a part of a whole. This could be where an item has been tokenised digitally, so if we take the example of a piece of property, but rather than the token representing the whole property, it represents a pro rata amount of the property. This is typically used for mining contracts where you share the hashing power on a pro rata basis. From a regulatory perspective this is no different to a fund. Whether the fund is a regulated fund or not will depend on the type of property that is being broken down. If you take a house and tokenise it then this would be deemed an unregulated collective investment scheme which, in most countries should not be available for retail investors nor marketed to the same. If the target property is a bundle of non-divisible securities then breaking down the asset into unit-tokens would be normally classified as a regulated open-ended collective investment scheme – a regulated structure in most countries.

All of the above would not be freely accessible for consumers and in a lot of countries to issue such assets without proper authorisation from local regulators and an approved structure might even be a criminal offence.

Also, remember if you create a decentralised token representing legal title to a piece of property for example, then note that in certain jurisdictions there may be formalities surrounding the transfer of that property such as that the transfer needs to be witnessed by a notary.

In summary, mined digital currencies are the safest bet from a regulatory perspective. Pre-mined issued/distributed via loyalty or burning is next down the list. After that the regulatory risks mount up with digital fiat/commodities and then selling pre-mined currencies and/or innovate revenue based or investment tokens.

Remember if it is a security/financial instrument then you need to go through a regulated broker, crowdfunding platform or exchange. The US Jobs Act will from June allow more access to investors but registration of the securities will still be a requirement. So if you are issuing digital securities then you may need to register with your local jurisdiction and in other jurisdictions. For investors, you should understand that digital currencies pre-mined or mined sit outside the financial system, so you should understand the risks. If you are buying unregistered securities then the issuer may be subject to regulatory sanction meaning your investment will be compromised.

Ideas to explore – Case Study
Kickstarter is the original crowdfunding platform. Where new ideas are tested. Usually the backers of project only receive the product when ready. So the ‘investment’ is linked to a tangible good and the delivery of the same. This is usually an acceptable form of non-equity crowdfunding and does not necessitate any regulation in most jurisdictions, so this is a great place to start.

Think of non-equity crowdfunding as pre-paying the good that you will receive; but there are no guarantees of delivery as the good is novel, has never been made before.

Now with Kickstarter the premise is to encourage startups to pursue fanciful ideas. This could be the same but with a digital token. You get given a token to represent your right to the product and then present the token once the product is ready.

In this instance the token would be linked 1-1 with the item.

Where things start to differ is that the use of digital tokens technology permits the token to be transferrable and used as a medium of exchange. Even an interesting secondary market could emerge where people exchange tokens at different prices depending on whether they think that the product development is successful. The exchange of these tokens could operate in a totally decentralised way without needing an intermediary.

Now if the token represents on a one-to-one basis a definable and indivisible piece of property then what you have is a second market on top of Kickstarter. Now there are of course risks with this strategy as in some jurisdictions it may be deemed a transferable security. But the basis of the principle is sound in that we are looking at encouraging investment in startup ideas but providing a liquid market for people to exit if they wanted.

Of course before launch you would have the system approved by a regulator but this is some low hanging fruit ripe for the picking.

Here is a new Kickstarter project to put up solar sails in space. An ambitious project.

You can see below the different tiers available for backers of the project. Each one of those tiers could be a digital token.