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What is a Securitized Token?

Ray Luckiram
0 Comments|January 25, 2019

With the recent push towards regulation compliant securitized tokens, BAX Securities Law will be publishing a series on all aspects of the new digital financial instrument. 
 
By Ray Luckiram
BAX Securities Law
Rluckiram@baxsexuritieslaw.com  
January 22, 2019
 
Securitized tokens are a new wave of securities backed digital financial instrument which aims to unite traditional financial markets with the modern technologies of token offerings, cryptocurrency and blockchain. A securitized token will not only use advance technology to reduce inefficiencies in the transaction process of buying securities but it will also comply with securities regulations and will be traded through a regulated market. The potential of securitized tokens has created a major buzz in the financial districts around the world, though the execution of this concept is still in its infancy phase.
 
A security token is the next evolution in digital financial instruments. Prior to the ‘token phase,’ the main digital instrument was ‘coins’ and ‘initial coin offerings’ (ICOs). Coins were defined by their decentralized model and ability to trade anywhere around the world. However, the coins lacked regulation, were subject to price volatility and have almost entirely disappeared. The ICO process, a reflection of an initial public offering (IPO), was the first phase of selling where many investors invested in the initial release of coins.[1]
 
If regulators are willing to invest in cultivating a culture of digital financial instruments, it could fundamentally change the capital markets. Specifically, regulators must pre-empt the change in technology as opposed to merely react to the changes as they occur.
 
When is a token a security?    
 
A ‘token’ is a generic term used to describe units of a digital financial instrument. The underlying technology behind tokens is blockchain. In its most basic form, blockchain is a complex computer process which acts as a digital ledger where the transactions of a specific token are encrypted and recorded.[2] The impact of blockchain may go far beyond issuing digital tokens.     
 
Not all tokens will qualify as securities. The classification of a token and applicable regulations is highly dependent on the purpose and characteristics of the token. Regulators are taking an individualistic approach to classifying tokens.[3] The Canadian Securities Association endorses a “purposive interpretation that includes considering the objective of investor protection.”[4] When determining if a token qualifies as a security, the substantive characteristics of the investment contract of the token must be considered in relation to:
 
1. An investment of money;
2. In a common enterprise;
3. With the expectation of profit; and
4. To come significantly from the efforts of others.[5] 
 
Essentially, if a token operates like equities, bonds or derivatives, then it should be regulated and maintained as such.       
 
The Swiss Financial Market Supervisory Authority FINMA (FINMA), a leading regulatory body in the area of tokens, has divided tokens into three main categories: payment tokens or cryptocurrency, utility tokens, and asset or securitized tokens. [6]  Tokens do not always fall solely into one category. As a result, there is another category of hybrid tokens where the classifications overlap and the requirements are cumulative.[7]  
 
Payment Tokens
 
A payment token, also known as a cryptocurrency, is used as digital currency that can be exchanged for the provision of goods or services. The token may be used immediately or in the future. This form of token will not give rise to claims against the issuer.[8] This form of token is popular in Asia and Africa, such as M-PESA, because it allows for the easy distribution of tokens (representing fiat currency) through a person’s cell phone.
 
The debate on the classification of payment tokens as a cryptocurrency is not settled. Certain legal opinions believe that all tokens should be classified as securities. Conversely, FINMA states that payment tokens do not qualify as securities if they are solely used “as a means of payment and are not analogous in their function to traditional securities.”[9]   
 
Utility Tokens
 
Utility tokens are tokens which allow the owner to digitally access an application or service through a blockchain infrastructure.  If a utility token simply confers a right of digital access, then it will not qualify as security under FINMA guidelines. However, in certain instances, utility tokens may allow access to the capital markets or may be used as an investment vehicle. In these cases, the token will be a hybrid token and would be subject to securities regulation.  
 
Security Tokens
 
Security tokens are also called asset tokens because they represent assets such as debt or an equity claim against the issuer. For example, a security token may represent a share in future company earnings or future capital flows. These forms of tokens are related to equities bonds and derivatives based on their economic function. Security tokens may also represent physical assets or commodities traded on the blockchain.
 
Expectantly, under both Swiss and Canadian legislation, securitized tokens qualify as securities. These tokens are created with the expectation of standardized mass trading on some form of capital market. [10] In Canada, security tokens would be subject to both a prospectus and registration requirement unless applicable exemptions are available.[11]      
 
Qualification as a Security
 
The impact of qualifying a security token as a security under Canadian legislation has several advantages and disadvantages.  The main advantage is that the confidence of investors will raise substantially if an independent government agency oversees these digital financial instrument. Greater confidence will lead to greater investment, and will ultimately legitimize the concept of security tokens.
 
Conversely, subjecting security tokens to domestic legislation will remove the decentralized model employed by the previous regime (the coin regime). However, removing the decentralized model may be a necessary evolution in the process to legitimacy.
 
One advantage of the prior regime was the ability to raise funds worldwide without abiding by any domestic regulation. Once security tokens are properly registered, the sale will be regulated by local authorities. However, cross-jurisdictional investment may still be available. For instance, if a security token is correctly registered in Canada, it may be sold in the US under Regulation S.
 
Once regulation is installed, the cost of doing business will also increase. Satisfying government requirements, insurance and other business costs will greatly increase expenditure. The higher costs will directly affect the sales price of securitized tokens and it will make the barriers of entry far greater. Initial coin offerings were tremendously popular because it allowed unsophisticated investors access to capital markets. It will be much more difficult for unsophisticated investors to access a securitized token market.
 
Crowd Funding and Financing
 
Security tokens may be used as a method fundraising or crowdfunding. For example, investors may be offered a security token which is designed to generate initial funding for a specific project, such as the development of a self-driving car.  Under a prescribed formula, the initial security token may be convertible for another set of security tokens once a specific event occurs or a specified amount of time has passed. In this case, the initial security token would be convertible on approval of the car by the US Patent and Trademark Office. The initial security token is now redeemable for a new token which represents a claim on future earnings of the car. The token holder is now free to sell the security token in a secondary market.
 
The great potential in this scenario is based on the technological efficiencies in the ability to process millions of transactions. The issuer does not have to set a minimum investment limit and has a potential client base in the millions. A person could essentially buy one security token for one dollar through a relatively simple web procedure. Smart contracts would allow the processing and identification to happen almost instantly. 
 
Publication is not intended to constitute legal advice. No one should act on it or refrain from acting on it without consulting with a lawyer. BAX does not warrant or guarantee the accuracy or currency or completeness of the publication. No part of this publication may be reproduced without the prior written permission of BAX Securities Law.
 
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Keywords
Cryptocurrency
Securitized tokens
Security tokens
Blockchain


[1] See United States of America House Representatives,  The 2018 Joint Economic Report, Union Calendar No. 453, Report 115-596, Chapter 9 Building a Secure Future, One Blockchain at a Time, available at https://www.congress.gov/115/crpt/hrpt596/CRPT-115hrpt596.pdf
[2] Blockchains: The great chain of being sure about things, The Economist, 31 October 2015, available at https://www.economist.com/briefing/2015/10/31/the-great-chain-of-being-sure-about-things.
[3] Canadian Securities Administrators Staff Notice – 46-308 Securities Law Implications for Offering Tokens; See B. Hendrickson, Canadian Securities Administrators Issue Warning Regarding Cryptocurrency Exchanges, available at https://baxsecuritieslaw.com/canadian-securities-administrators-issue-warning-regarding-cryptocurrency-exchanges/
[4] Ibid, at p 2.
[5] Ibid.
[6] Guidelines for enquires regarding the regulatory framework for initial coin offerings (ICOs), FINMA, 16 February 2018.
[7] Ibid, , at para 3.1.
[8] Ibid.
[9] Ibid, at para 3.2.1.
[10] Ibid, supra note 6.  
[11] Ibid, supra note 3. 

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