In their legal initiatives regarding trading platforms for DLT-based securities, Switzerland and the EEA are taking a very progressive approach. The Swiss DLT Law introduced a new type of financial market infrastructure license for trading platforms for DLT-based securities.

Entities without a pre-existing financial market license may apply for this new type of license. Applicants expecting a business volume below certain thresholds qualify for a sandbox solution and benefit from less strict requirements. In contrast, the European Commission proposes a pilot regime to test the waters before introducing wide-ranging changes to the EEA financial market regulation. Under this pilot regime MiFID II investment firms, market operators or CSDs may apply for a permission to operate a DLT financial market infrastructure. Experiences gathered during this pilot regime will be analysed and reported to the EU Council and Parliament at the latest after a five-year period. Subsequently, more permanent and extensive legislative action will be taken.

Despite the different approaches, both legislative initiatives aim at grasping the opportunities brought by DLT related to activities traditionally reserved for CSDs and trading platform operators. Both Switzerland and the EEA introduce a possibility to combine these activities under one financial market infrastructure, that keeps DLT-based securities in central custody, enables multilateral trading, and settles transactions.

Switzerland

The new type of financial market infrastructure introduced by the Swiss DLT bill is named “DLT trading facility” (DLT-Handelssystem). A DLT trading facility is a commercially operated institution for multilateral trading of DLT securities. Its purpose is the simultaneous exchange of bids between several participants and the conclusion of contracts based on nondiscretionary rules. To clearly differentiate the DLT trading facility from the multilateral trading facility (MTF), one of the following requirements must be met in addition: (i) Admission of legal entities other than supervised financial institutions or private clients as participants; (ii) provision of central custody of DLT securities based on uniform rules and procedures; (iii) provision of clearing and settlement for transactions in DLT securities based on uniform rules and procedures.

In addition to multilateral trading of DLT securities, the DLT trading facility may also offer trading of instruments not qualifying as securities, such as cryptocurrencies. However, according to the draft DLT ordinance, derivatives in the form DLT securities, instruments which impede compliance with anti-money laundering provisions (e.g. privacy coins), or instruments that could impact the integrity or the stability of the financial system are not eligible for being admitted to trading.

Compared to a traditional stock exchange or MTF, a DLT trading facility has two major regulatory advantages:

First, a DLT trading facility will be allowed to admit not only regulated financial intermediaries as participants but also other legal entities and private clients. The latter two, however, can only be admitted, if they trade in their own name and on their own account. This is to facilitate the combat against money laundering and terrorist financing. To enable the Swiss Financial Markets Supervisor Authority (FINMA) to fulfil its duties, all participants, whether subject to FINMA supervision or not, will have to provide it with information or documentation upon request.

Second, a DLT trading facility will be allowed to provide central custody, clearing and settlement services for DLT securities, e.g. on a blockchain. This is a major innovation since MTFs and stock exchanges are currently dependent on a CSD to fulfil these functions. A DLT trading facility will, however, not be allowed to centrally clear DLT securities, to avoid a risk concentration. This activity remains reserved to central counterparties.

The requirements to obtain an authorisation as a DLT trading facility will be similar to the ones for obtaining authorisation as a stock exchange or MTF. Additional requirements, similar to the ones imposed on CSDs, apply if the DLT trading facility is not only enabling multilateral trading, but also keeps DLT securities in central custody or clears and settles transactions.

DLT trading facilities must be operated by a Swiss entity, save for the possibility to outsource certain services. In other words, a completely decentralised trading platform will not be licensed as a DLT trading facility in Switzerland. Other noteworthy requirements are for example the establishment of a self-regulation and supervisory organisation that is independent from the business functions. This organisation has to ensure, inter alia, fair and open access to the DLT trading facility as well as orderly and transparent trading. The minimum capital requirement is CHF 1 million.

DLT trading facilities providing central custody, clearing or settlement services on top of enabling multilateral trading are subject additional requirements. These include for example requirements related to the segregation of assets, establishing procedures for the case of a participant default, risk diversification, liquidity and collateral requirements. The minimum capital requirement for DLT trading facilities with such additional CSD functionalities is CHF 5 million.

To encourage start-ups and smaller institutions to advance innovation, the DLT bill includes a sandbox regime for small DLT trading facilities. According to the draft DLT ordinance, a DLT trading facility qualifies as small if its trading volume in DLT securities is less than CHF 250 Million p.a., the volume of DLT securities kept in custody is less than CHF 100 million, and the clearing and settlement volume is less than CHF 250 million p.a. Small DLT trading facilities can benefit from several eased requirements. These eased requirements namely aim at reducing the required headcount and organisational burden. The draft ordinance sets the minimum capital requirement for small DLT trading facilities at CHF 500’000 and for small DLT trading facilities providing custody, clearing and settlement services at 5 % of the DLT securities kept in custody, but at least CHF 500’000.

European Economic Area

The proposed PDMIR pilot regime for market infrastructures based on DLT aims at gathering evidence and experience before introducing wide-ranging and permanent changes to the existing financial services legislation. Thus, operators of DLT market infrastructures will need to provide the European Securities and Markets Authority (ESMA) and the national competent authority every six months with a report on their activity, including the difficulties and issues encountered. ESMA will fulfil a coordination role between the national competent authorities and evaluate the outcome of the pilot regime on a yearly basis. ESMA and the European Commission will report to the Council and the Parliament at the latest after a five-year period, whereupon further legislative action will be taken.

A DLT market infrastructure according to the PDMIR is either a DLT multilateral trading facility or a DLT securities settlement system. The permissions to operate either type of DLT market infrastructure are granted by the national competent authority, which is required to consult ESMA before deciding on an application. A permission is valid for no longer than six years. Only investment firms or market operators according to MiFID II are eligible to operate a DLT multilateral trading facility, while only CSDs according to the CSD Regulation can operate a DLT securities settlement system. In other words, for now the DLT market infrastructures are expected to be largely operated by incumbents, which are already licensed as investment firm, market operator, or CSD today.

The investment firms, market operators or CSDs applying for a permission to operate a DLT market infrastructure need to submit to their national competent authority, inter alia, a detailed business plan describing how they intend to carry out their services and activities, describe the use of DLT, describe their IT and cyber arrangements, and establish a transition strategy. The latter must describe the operator’s strategy to transition or wind down its business activity in case the DLT market infrastructure cannot operate as intended, for example if the permission is withdrawn.

As a matter of principle, the requirements for operating a traditional MTF or CSDs apply to operators of a DLT market infrastructures as well, but the national competent authorities can grant exemptions upon request. Such exemptions will enable operators of DLT market infrastructures to make use of the opportunities brought by DLT. Most notably the operator of a DLT multilateral trading facility may request an exemption from the requirement to record DLT transferable securities in book entry form, and to only admit to trading DLT transferable securities that are registered with a CSD. These exemptions may only be granted, if the DLT multilateral trading facility (i) ensures the recording of DLT transferable securities in a way that allows for a prompt segregation of assets, (ii) settles transactions in DLT transferable securities against payment, (iii) provides timely settlement information and transaction confirmations, and (iv) guarantees safekeeping of the DLT transferable securities, related payments and collateral. A CSD operating a DLT securities settlement system may apply for exemptions from requirements of the CSD Regulation, such as the requirement to enter dematerialised financial instruments in book entry form, maintain securities accounts, and segregate participant assets in the way set-out in the CSD Regulation. Exemptions will only be granted if the operator of the DLT securities settlement system will demonstrate that the distributed ledger used is able to compensate non-compliance with the CSD Regulation requirements. Moreover, the operator of a DLT securities settlement system may also apply for being allowed not only to admit regulated entities as participants, but all types of legal and natural persons. Such persons may, however, only be admitted, if they are fit and proper, of good repute, and understand post-trading and the functioning of DLT well enough.

The PDMIR proposal furthermore puts in place safeguards to ensure that the pilot regime does not pose a threat to the financial stability. Operators of DLT multilateral trading facilities can only admit to trading and operators of DLT securities settlement systems can only record DLT transferable securities that are either (i) shares of an issuer with a market capitalisation of less than EUR 200 million or (ii) bonds with an issuance size of less than EUR 500 million. Sovereign bonds may not be admitted to trading or recorded at all. Furthermore, the total market value of DLT transferable securities recorded on the DLT securities settlement system or the DLT multilateral trading facility must be lower than EUR 2.5 billion. Operators of DLT market infrastructures will need to submit a monthly report on the adherence to these restrictions to the national competent authority.

Conclusion

The Swiss DLT bill and the draft EEA PDMIR provide a remarkable opportunity to improve efficiency of multilateral trading, central custody, and transaction settlement.

The draft status and the pilot regime approach of the EEA PDMIR will for now deter some market participants from taking action to become a DLT market infrastructure. Moreover, incumbents have a substantial advantage over challengers under the EEA PDMIR, since they already passed the hurdle of being licensed as a MiFID II investment firm, market operator or CSD, which is a requirement to be eligible for applying for the permission to operate a DLT trading facility. Switzerland’s DLT bill, in contrast, is finalised and the complementing ordinance is well advanced. This already provides enough regulatory certainty to plan and execute the first steps to become a DLT trading facility. Moreover, the sandbox solution for small DLT trading facilities is a sensible approach to reduce entry barriers for challengers.

The introduction of ledger-based securities in Switzerland provides legal certainty and allows for more efficiency in recording and transferring securities. In the EEA issuers will need to assess whether securities may be validly issued using DLT based on the laws of the relevant member state.

Although regulatory initiatives provide the legal foundation for innovation using DLT, it remains to be seen which requirements will pose challenges in practice and whether market standards for the use of DLT in this area will be developed soon. In addition, it is currently uncertain whether the regulation of DLT-based securities and DLT trading platforms will eventually be coordinated internationally through international standards or regulatory guidance. In particular, the work of the International Organization of Securities Commissions (IOSCO) on this topic will need to be monitored.

This article is an extract from the 90+ page Security Token Report 2021 co-published by the Crypto Research Report and Cointelegraph Consulting, written by thirteen authors and supported by Crypto Finance, Blocklabs Capital Management, HyperTrader, Ten31 Bank, Stadler Völkel Attorneys at Law, Riddle&Code, Coinfinity, Bitpanda Pro, Tokeny Solutions, AlgoTrader, and Elevated Returns.

This contribution summarises the recent developments of the regulation with regards to the issuance of security tokens and trading platforms for security tokens in Switzerland and the European Economic Area (EEA), which includes in particular also Liechtenstein.

In September 2020, the Swiss Parliament adopted the Federal Act on the Adaptation of Federal Law to Developments in Distributed Ledger Technology (DLT bill). In the same month, the European Commission adopted several legislative proposals as part of its Digital Finance Strategy. Both regulatory initiatives aim at improving the framework conditions for DLT by increasing legal certainty whilst minimising risks for investors and the financial system.

The Swiss DLT bill will amend existing legislation. For the purpose of this contribution the amendments to securities law and to the regulation of trading platforms and post trading infrastructures are of interest. Switzerland will introduce ledger-based securities and DLT trading facilities. Whilst the provisions enabling the introduction of ledger-based securities entered into force on 1 February 2021, the ones introducing the DLT trading facility are expected to enter into force on 1 August 2021. The DLT bill will be complemented by the Blanket Ordinance in the Area of DLT (DLT ordinance), which will contain implementing provisions.

The European Commission adopted four proposals: The Market in Crypto-Assets Regulation (MiCA), the Pilot DLT Market Infrastructure Regulation (PDMIR), the Digital Operational Resilience Regulation (DORA), and a directive to amend existing financial services legislation. These proposals do not govern whether securities may be issued validly based on DLT but leave this to the national law of the EEA member states. For the purpose of this contribution namely the PDMIR is of relevance, which introduces a pilot regime for DLT market infrastructures. The proposed legislation still needs to pass the legislative process, which could take 12 to 24 months and may entail significant changes.

DLT-based securities

The Swiss DLT bill explicitly introduces the possibility to issue securities using DLT. This new form of securities is named “ledger-based security”. The legislation proposed by the European Commission does not include such a new type of DLT-based security.

It clarifies though that financial instruments, including transferable securities, issued using DLT will be subject to MiFID II and, as a consequence, other financial market regulations will apply as well, namely the Market Abuse Regulation, Prospectus Regulation, Transparency Directive, Short Selling Regulation, Settlement Finality Directive and the Central Securities Depository Regulation. Transferable securities based on the DLT will, however, not be in scope of MiCA. The proposed MiCA is largely intended to be a subsidiary regulation and carves out from its scope several types of crypto-assets that are already governed by other regulations, such as crypto-assets qualifying as transferable securities and other financial instruments.

Switzerland

The Swiss ledger-based security (Registerwertrecht) is a new type of uncertificated security, which can serve as an alternative to the existing intermediated securities (Bucheffekten). Both types are immaterialised securities, but the latter require, unlike the new ledger-based securities, a regulated institution such as a bank, securities firm, or a Central Securities Depository (CSD) for creation and transfer. To create ledger-based securities the parties involved must enter into a registration agreement or agree on a registration clause, and the securities ledger has to fulfil certain requirements.

The registration agreement or registration clause must set-out that the rights reflected by the securities are entered into a securities ledger (Wertrechteregister) and may only be claimed and transferred via this ledger.

The securities ledger must ensure (i) that creditors, but not the obligor, have the power of disposal over the rights ref lected on the register, (ii) its integrity by technical and organisational means, such as joint management by several independent participants, to protect it from unauthorised modification, (iii) recording of the content of the rights, the functioning of the ledger and the registration agreement, (iv) that creditors can view relevant information and ledger entries, and check the integrity of the ledger contents relating to themselves without intervention of a third party.

After being duly created, the ledger-based securities will have the same traits as traditional securities. The registered rights can be created and transferred on the ledger only, a party entered as creditor in the register is assumed to be entitled to the right, and third parties may rely on the ownership of right as reflected in the ledger.

The Swiss legislator also included a link between the traditional securities market and the new register uncertificated securities. The new type of securities can be used as a basis to create traditional intermediated securities. Thereby the rights reflected in the register uncertificated securities can be fed into the system of the traditional securities market. To this end, the ledger-based securities must be transferred to a traditional, regulated custodian, credited to a securities account, and immobilised on the securities ledger. This possibility could for example be useful to list the rights reflected on the securities ledger on a traditional stock exchange or to make the rights bankable and credit these to a traditional securities account.

If the entity’s articles of association foresee this possibility, shares may also be created as ledger-based securities. The issuing entity will be responsible for selecting the technology of the register on which its shares are created, its quality, and security. It must also ensure that conditions for certain types of shares are adhered to, e.g. for shares with limited transferability, the option to transfer should be limited by the securities ledger.

European Economic Area

The following paragraphs summarise some of the legislative initiatives in EEA member states to this regard.

France introduced a DLT ordinance and a DLT decree. The DLT ordinance allows for the issuance, registration and transfer of unlisted equity, debt securities and units in funds, using DLT instead of traditional securities accounts. The DLT decree sets out the technical conditions that must be met by the distributed ledger used to register the securities. The distributed ledger must (i) ensure the integrity of the recorded information, (ii) allow the identification of the owner of the securities as well as the nature and number of securities held, (iii) include a business continuity plan which includes an external data recording system, and (iv) enable the owner of securities to access their transaction statements. Securities within the scope of the DLT order and not traded on a trading venue according to MiFID II may already be issued and traded on a distributed ledger in France today.

On 6 May 2021, the German legislator adopted the Electronic Securities Act, which introduces, inter alia, the possibility to issue electronic bearer bonds. The electronic bearer bonds can be issued by using either a central electronic securities register or a cryptosecurities register. The act also addresses the most urgent civil law questions. Most notably by defining electronic securities as “goods” under German property law, existing civil law principles apply. Further legislative action is expected to introduce DLT-based shares and units in funds at a later stage.

In January 2021, the Luxembourg legislator adopted a law that allows for the issuance of dematerialised securities using DLT-based issuance accounts. This issuance account is used to record the type and amount of securities issued and are maintained by a “central account keeper”, which is subject to a financial market license requirement. Transferring DLT-based securities is already possible today, since licensed account keeping institutions may offer securities accounts operated on a distributed ledger.

The European Commission did not propose to introduce a new type of securities based on DLT. Instead, the form in which securities may be validly issued is governed by the laws of the relevant EEA member state.

1 Authors: Silvan Thoma ([email protected]) / Martin Liebi ([email protected]) both PwC Legal, Switzerland advise and have advised multiple digital assets operators in the legal aspects of the issuance of digital assets and the set-up and licensing process of the operation of multilateral trading facilities.

This article is an extract from the 90+ page Security Token Report 2021 co-published by the Crypto Research Report and Cointelegraph Consulting, written by thirteen authors and supported by Crypto Finance, Blocklabs Capital Management, HyperTrader, Ten31 Bank, Stadler Völkel Attorneys at Law, Riddle&Code, Coinfinity, Bitpanda Pro, Tokeny Solutions, AlgoTrader, and Elevated Returns.

Just about any asset can be tokenized. To offer an idea of the possibilities, we will give some concrete examples below. Practical cases exist for all of these examples.

According to our observation, profit participation rights are currently the most popular instrument that is tokenized. Participation rights are used for corporate financing. A company raises capital from investors and, in return, promises a share in the profit and loss of the company as well as in the company value. A profit participation right can be repayable or non-repayable. Persons subscribing to profit participation rights thus have a position similar to that of shareholders in the company, except for the right to a say in the company’s affairs.

Tokenized profit participation rights

Their position is similar to that of limited partners in a limited partnership. The payment of the profit participation can be made in euros or a digital currency, such as Ether. In such a case, the payment is made to those addresses on the Ethereum blockchain that are in possession of the tokens. Tokenization turns the capital participation right into a transferable security under EU law.

The profit participation right is very popular due to its flexibility. It can be used for a wide variety of purposes. The funds raised can be shown in the company’s balance sheet — depending on the structure — either as equity or debt. If the company opts for equity, this can strengthen its appearance vis-à-vis other potential providers of debt capital.

Tokenized revenue participation rights

Profit participation rights are not the only common instrument. Other types of participation rights are also popular, such as revenue participation rights. These are similar to profit participation rights insofar as they both involve a promise by a company to make payments that are dependent on a specific measure. Whereas this measure for profit participation rights is the profit or loss of the company, in the case of revenue participation rights, the reference point is specifically the revenue. Profit and loss can be influenced by the company to a certain extent, for example, by bringing forward investments. This is not the case with sales, which can be emphasized to potential investors.

The revenue participation rights can also be structured quite flexibly. It can be repayable or non-repayable. Certain minimum and maximum participation thresholds can be set, or the revenue share can be made dependent on other factors. Tokenization turns the revenue sharing into a transferable security under EU law.

Tokenized subordinated loans

The qualified subordinated loan is currently the most popular instrument in the crowdfunding sector. In a subordinated loan, the company raises funds and usually promises an interest rate commensurate with the risk and repayment at the end of a fixed term. Qualified subordination means that the lenders may only demand payment after all other non-subordinated creditors. If promised interest payments or repayments cannot be made, insolvency proceedings do not have to be initiated due to qualified subordination. The subordinated loan also becomes a transferable security under EU law through the process of tokenization.

Excursus: Opportunities for tokenizing debt instruments

The three tokenized instruments presented above have in common that they serve corporate financing and that they involve the issuance of debt instruments, i.e. ultimately promises by the capital-raising company. The main advantages of raising funds in this way are as follows:

• The possibility of adaptation to the needs of the company
• The possible externalization of corporate risks
• Greater flexibility in the use of the company’s assets.

Adaptation to requirements of the company When issuing tokenized debt instruments, capital is not lent by lenders, but the promised interest and repayments are sold as a product. Unlike a bank loan, the company determines the terms on which money is to be borrowed. This means that special financial and tax considerations can be taken into account when structuring the token terms and conditions.

First and foremost, the interest arrangements are of central importance. Interest can be fixed or variable; it can be paid on an ongoing basis or there can be no interest at all during the term of the instrument, with a higher repayment at the end of the term. In the case of variable interest, the interest rate can be linked to external parameters (EURIBOR, inflation index, commodity prices, exchange rates, etc.) or to internal indicators (EBIT, sales, internal indicators).

The repayment arrangement is equally flexible. Repayment can either be made in regular installments — e.g., per quarter or year — or there can be no repayment during the term. In this case, the instrument is usually repaid in full at the end of the term. If repayments are to be made during the term, the respective amount can also be structured differently. As explained above, instruments can also be issued that are not repayable at all.

Externalization of corporate risks

Because of the flexibility in the design of payments, tokenized instruments can also serve as a tool for (partial) risk hedging in addition to financing. In some cases, the potential is obvious; in other cases, it requires a detailed examination.

Example 1: Company A’s earnings are significantly dependent on the price of steel. The company bears the risk of rising raw material costs. The interest could be structured in such a way that the interest increases when steel prices fall and decrease when steel prices rise.

Example 2: A customer of Company B wants to conclude a major contract in Saudi riyal. The company thus bears the exchange rate risk. The repayment of the instrument could be structured in such a way that it can be made in riyal at a certain rate.

Example 3: Company C finances the construction of a residential building and would like to finance the construction and maintenance costs from the rental income. The company bears the long-term refinancing risk. The instrument could be designed for the long term, and the interest and repayment could be linked to the inflation index (also provided for in the rental agreements).

Flexibility in the use of assets

Since the stricter capital adequacy requirements came into force, banks generally require a high level of collateralization when granting loans. The granting of a lien on real estate and pledging of operating assets and receivables are common practice. This deprives companies of the freedom to manage these assets.

Borrowing with the above-discussed (and also other) instruments usually takes place without the provision of collateral. However, it is also possible to order collateral and, in this way, obtain a more favorable interest rate on the market.

Tokenized commitments to use

Tokenization of commitments to use is the latest development of tokenized instruments. Commitments to use are promises by a company to obtain performance from a third party. The company “uses” itself to get a third party to perform. Usage commitments are most often used when the company makes a promise that can only be fulfilled by someone else. In the context of corporate financing, commitments to use can be structured in various ways. Examples from practice include:

• Pledges regarding own shares in the business: If a company does not have authorized capital, only the owners of the company can make effective promises regarding their shares in the company. However, the company itself can, for example, make a promise of use that, if certain conditions are met, the token holder will participate in the company by way of a share transfer or capital increase.
• Commitments on the appropriation of profits: Just as only the owners of the company are entitled to the shares in the company, only they are entitled to the profits. However, by way of a promise of use, the company can promise to guarantee that the distributed profit will be used in a certain way by its owners. In this way, for example, the promise can be made that profits will be passed on to token holders.
• Agreements under company law: A large number of agreements can be replicated by way of a commitment to use, which could otherwise only be agreed between shareholders of the company. This includes co-sale rights, pre-emptive rights or co-determination rights. These usage commitments can also be used in combination with the other instruments presented above. For example, a tokenized profit participation right can also contain a commitment of use to acquire shares in the company under certain conditions.

Promises made at the expense of third parties cannot, of course, effectively bind these third parties. This always requires the consent of the obligated person. In order to give weight to the company’s promise, it must therefore ensure that the third party actually performs what has been promised, even if the third party may not wish to do so. In the examples presented above, the obligation of the company must therefore be transferred to its owner.

In practice, this is carried out in two different ways. Either the company’s articles of association are amended to include appropriate clauses ensuring that the company’s owners must fulfill these promises made by the company, or a trustee takes over the company shares and, in this way, ensures that the promises made are fulfilled after a corresponding request by the company (see Model 2.B above for tokenization).

Tokenization of a limited liability company (GmbH)

Shares in limited liability companies have been “immobilized” on purpose (at least in Austria). In order to transfer shares in a limited liability company, an assignment agreement must be concluded in the form of a notarial deed. Even the mere offer to transfer must already be made in the form of a notarial deed in order to be effective. If this formal requirement is not complied with, the offer or transfer is void.

Because of these formal requirements, the share in a GmbH cannot be tokenized directly. However, the above-mentioned instrument of a commitment of use can be used. A transfer commitment, together with a commitment to use the profit and, if necessary, a commitment to co-determination rights, can be effectively tokenized. These promises can be transferred without any formalities. Compliance with the pledges can be ensured by the company itself using the trust model B. In this way, the company can effectively make promises regarding its own shares, even if it does not have already authorized capital (as may be the case with stock corporations, for example).

Tokenization of a stock corporation

In Austria, only registered shares may be issued by unlisted stock corporations. The names of the shareholders are to be entered in a share register. Tokenization brings the share register onto the blockchain. Transfers of shares are made by notifying the company, which records the transfer in the share register on the blockchain.

Bearer shares may also be issued in the case of listed stock corporations. In this case, however, the shares may only be securitized in the form of a global certificate. This global certificate must be deposited with a central securities depository. In order to enable the tokenization of bearer shares, it is therefore still up to the legislator (at least in Austria). However, a stock corporation could also issue tokenized use commitments with regard to its own authorized capital. This would be comparable to the model presented above for the tokenization of use commitments with regard to GmbH shares, but in this case (provided authorized capital is available) the appointment of a trustee could be omitted.

Tokenization of real assets such as precious metals or apartment buildings

Not only promises (claims) or entire objects such as companies can be accessible to tokenization. In particular, interest in the tokenization of real goods such as precious metals, precious stones or even shares in apartment buildings has been growing recently. The focus is not on the idea of financing, but on the desire to transform these relatively illiquid resources into easily tradable goods.

The linking of the real world with the tokenized representation usually succeeds with trust variant A. A trustee is appointed to take custody of the tokenized real goods. The trustee initially warrants that the tokenized goods actually exist. The further relationship between trustee and token holder can be structured differently.

For example, the trustee can act as an intermediary for real (co-)ownership positions for the respective token holder, as is the case with securities deposits on the traditional capital market. However, it is also possible to grant the trustee only a succession claim under the law of obligations. Which variant is preferred depends on the circumstances of the individual case.

Tokenization of voucher entitlements

The so–called voucher model should not go unmentioned. This first established itself as a suitable instrument in the course of the ICO wave in 2017. And although the ICO boom is long over, the voucher model still has its justification in certain areas. In this instrument, the company promises to exchange a token for a certain service in the future. The funds collected are used to finance the company. Depending on how the voucher is structured, it can be used to manage accounting and tax consequences. The voucher property can be linked to the other instruments presented above, so that a token can simultaneously have aspects of, for example, a profit participation right, a commitment to use and a voucher.

The first step on the way to successful tokenization is always to consider which goals are to be achieved with it. The types of tokenization presented above can have very different tax effects and also effects on the company’s balance sheet, depending on the specific design.

This article is an extract from the 90+ page Security Token Report 2021 co-published by the Crypto Research Report and Cointelegraph Consulting, written by thirteen authors and supported by Crypto Finance, Blocklabs Capital Management, HyperTrader, Ten31 Bank, Stadler Völkel Attorneys at Law, Riddle&Code, Coinfinity, Bitpanda Pro, Tokeny Solutions, AlgoTrader, and Elevated Returns.

The buzzword “tokenization” has been circulating through the ether for several years now. It is not only the crypto community that has recognized that the use of blockchain-based tokens makes a digital representation of almost all assets at least within the realm of possibility.

In our legal practice, we have advised on a large number of such projects. With this article, we would like to provide an overview of which tokenization models are common in practice, which alternatives exist beyond that, and which legal as well as tax considerations need to be taken into account. (1)

What is tokenization?

At the risk of carrying owls to Athens, we would like to briefly summarize what tokenization actually means for those readers who may be looking into it for the first time. In general, tokenization is the process of creating a digital representation of certain real assets on the blockchain. Often these are securities, means of payment, company or project participations, loans, precious metals or even shares in real estate.

Tokenization generally fulfills two different functions. On the one hand, the need for certain intermediaries is eliminated, which helps to save transaction costs. On the other hand, illiquid assets can be made easily tradable in this way.

Functions of tokenization

1. Reduction of necessary intermediaries
2. Increased liquidity of assets

The first function of tokenization thus concerns the reduction of necessary intermediaries. This is a particularly important aspect in the issuance of tokenized securities. Unlike traditional issues on the capital market, neither a paying agent bank, nor a depository, nor other intermediaries are required. The company raising capital issues the tokenized securities (or ‘security tokens’) directly to the investor. The investor holds the tokens in their own wallet.

The second function of tokenization relates to the possibility of making illiquid assets liquid, i.e., preparing them for simple and rapid trading. A physical gold bar or shares in an apartment building are more difficult to trade than a token, for example.

The limits of what is possible in tokenization are essentially determined by economic, tax and accounting considerations. Once it has been determined which asset is to be tokenized and tax and accounting issues have also been clarified, there is generally nothing to prevent
implementation. Two things are required for this.

In a first step, the digital representation of the asset is created in technical terms: A smart contract is published on any blockchain, which produces and manages the desired number of tokens. In practice, the Ethereum blockchain is most frequently used for this purpose. The tokens created in this way will later digitally represent the desired asset.

The second step is to link this digital representation with the real asset. This second step — the interface between the digital and real worlds — is the real challenge. As a result, the holder of a token should be placed in such a position that they have a claim to the tokenized asset that can be enforced in the real world. The legal protection of the token holder must be given top priority in the structuring of the project if the current trend toward tokenization is to pave the way for long–term and sustainable development.

Steps to tokenization

1. Generation of the tokens on a blockchain
2. Linking with the asset

How is an asset linked to a token?

The legally secure link between a digital token and its real asset is, therefore, the core of tokenization. How this is implemented depends on the specific asset in question and the law under which the tokenization is carried out. So, it makes a difference whether the law of Austria, or, for example, Liechtenstein, Germany, Switzerland or another jurisdiction is chosen. Since our expertise is in Austrian law, we present the approaches under Austrian law.

Model 1: Direct link between right and token

If the right is a legal claim — as is the case with securities, means of payment or loans — the right can usually be directly linked to the token. The ownership of the token is then necessary for the exercise of the right. To transfer the legal claim, the token is transferred to another person on the blockchain. Whoever owns the token is the creditor of the security, payment or loan claim. This is achieved through corresponding clauses in the contractual agreement between the parties.

Whether existing debt can be tokenized depends on the prior agreement reached between the parties. If the debtor wishes to tokenize existing liabilities — i.e., its own debts — this generally requires the consent of all creditors. If, on the other hand, a creditor wishes to tokenize an existing claim, this may be possible under certain circumstances without the debtor’s involvement.

Model 2: Interposition of a trustee

If not only simple rights to receivables are to be tokenized, but a real ownership position, or if a stricter form is prescribed for the transfer of the right — e.g., if a written contract is required — then one must dig a little deeper into the legal bag of tricks. Tokenizing tangible objects such as stocks of goods, precious metals, shares in real estate or even participations in companies should be considered. In these cases, it may be necessary to choose a trustee structure, whereby two different variants can be considered here as well — depending on the requirements.

In the first option (Model 2.A), a trustee directly mediates the ownership position. The trustee owns, for example, physical gold bars for the token holders. In connection with an example of tokenization of real assets such as precious metals or apartment buildings, we will discuss this construction in more detail below.

In the second option (Model 2.B), the trustee only indirectly ensures that the company can actually keep its promise. This option is particularly relevant in the tokenization of usage promises (see also below). Indeed, as a rule, the participation of the owners is necessary for the fulfillment of this promise. In such cases, the trustee is appointed as a shareholder of the company. This is particularly interesting in the case of corporate forms that do not have authorized capital.

Caution:
Not every legal system is the same. While Austrian law, for example, is well equipped for the types of tokenization presented, and Liechtenstein has even created its own law on asset tokenization, the legal situation in other countries may differ. In many cases, however, Austrian or even Liechtenstein law can be made applicable with a choice of law clause in order to take advantage of these favorable legal systems for oneself, even if the company is not domiciled in Austria or Liechtenstein.

1 As Austrian lawyers, we deal in this article with the practice and the legal situation in Austria. The legal situation in other countries may differ. Fur-
thermore, this article is only intended to provide an initial overview. It cannot replace individual legal advice

This article is an extract from the 90+ page Security Token Report 2021 co-published by the Crypto Research Report and Cointelegraph Consulting, written by thirteen authors and supported by Crypto Finance, Blocklabs Capital Management, HyperTrader, Ten31 Bank, Stadler Völkel Attorneys at Law, Riddle&Code, Coinfinity, Bitpanda Pro, Tokeny Solutions, AlgoTrader, and Elevated Returns.

The establishment of a framework for security tokens in the U.S. is critical to the widespread adoption and further development of blockchain technology. For the moment, however, these new types of securities must continue to operate under policies that date back to a time long before the Internet.

The Securities Act of 1933, colloquially referred to as the “Securities Act” or the “33 Act,” regulates securities offerings in the US. All offerings must be registered under Section 5 of the Securities Act or meet a pre-established exemption from registration. Any issuer offering or selling security tokens in the US must abide by the requirements of the Securities Act.(1)

Practically speaking, registering an offering means a significant commitment of time and resources, including SEC approval and ongoing compliance obligations under the Securities Exchange Act of 1934, discussed next. A full public offering is done pursuant to a registration statement on Form S-1 (or Form F-1 for foreign issuers). There is also a form of limited public offering under Reg

ulation A (known colloquially as “A+” because Congress several years ago increased the maximum offering size), which has an offering circular requirement similar to, but less comprehensive than, a registration statement and that results in certain disclosure and filing requirements that resemble a lighter version of the public offering. To date, two companies have been allowed to utilize Regulation A+ for blockchain tokens, which requires an SEC declaration that the company’s offering circular is “qualified.”(2)

Exempt offerings(3) come in many flavors besides Regulation A, with security token issuers often relying on Regulation D (private offerings) and Regulation S (non-US offerings). A single offering may rely on both exemptions simultaneously, Reg D for US purchasers and Reg S for non-US investors.

Because they are exempt, these offering types do not have formal disclosure requirements imposed by statute or rule, but informal practices have arisen that vary with the type of security token, the target investors, and other factors.

When doing a series of offerings that rely on one or more exemptions, issuers need to be careful that their offerings are not collapsed into a single offering that might require registration. This is known as “integration” of the offerings and requires careful analysis.

A few other matters to keep in mind for offerings that rely on Reg D:

1. They are limited to sophisticated investors, which are subject to evolving standards but usually focus on the investor’s net worth or income (so-called “accredited investors”).
2. Reg D issuers can be disqualified under the “bad actor” provisions, which prohibit issuers from using Reg D if they or their officers, directors, or shareholders have engaged in wrongful conduct. (A waiver process is available through the SEC.)
3. The issuer must file a notice on Form D with the SEC and various states to provide information about the offering to regulators.
4. The securities sold will be subject to significant resale restrictions, often for at least one year.

Reg S offerings have various requirements to ensure that the offering is truly non-US in nature and that prevent securities sold offshore from being purchased by US investors. Issuers relying on this exemption need to pay careful attention to the detailed requirements. It is important to have sophisticated legal counsel to advise on either a public offering or an exempt offering.

In the next article, we will discuss the few projects that have used full registration or Regulation A offerings, and we will look at the ongoing requirements for a public company. Regulation D and Regulation S offerings were much more numerous and were used in a variety of circumstances.

1 Securities Act of 1933
2 Full registered token offering: INX registration statement; Regulation A+ token offerings: YouNow offering circular; Blockstack offering circular
3 SEC information on exempt offerings

This article is an extract from the 90+ page Security Token Report 2021 co-published by the Crypto Research Report and Cointelegraph Consulting, written by thirteen authors and supported by Crypto Finance, Blocklabs Capital Management, HyperTrader, Ten31 Bank, Stadler Völkel Attorneys at Law, Riddle&Code, Coinfinity, Bitpanda Pro, Tokeny Solutions, AlgoTrader, and Elevated Returns.