The race to regulate: Jurisdictions embracing the blockchain economy
Over the last 12 months various jurisdictions around the world have introduced regulatory clarifications around distributed ledger technology (DLT) and the various forms of cryptoassets and activities that use this versatile technology.
The recognition of the need to create a regulatory environment in this area is a response to two principal factors:
• the negative perception around the volatility, security and lack of investor protection associated with certain DLT based applications; and
• a desire for jurisdictions to be seen as champions of blockchain based ecosystems.
Despite concerns over the declining fortunes of ICOs, it's undeniable that there are huge benefits to DLT based technologies for many business, governmental and charitable activities. Its potential is only now starting to become clear. However, the risk of failure in the application of DLT, whether technological, legal or business related, could have a hugely negative impact on investors and on the credibility of blockchain systems themselves.
Regulators have therefore decided that its potential can only be harnessed if there is proper classification, licensing and monitoring of activities associated with it. This is precisely what forward-thinking financial services regulators across the globe are looking to achieve.
In Malta, for example, the Virtual Financial Assets Act (VFAA) 2018 creates a classification system for DLT assets and operates a cascade of definitions to separate out activity between security token, electronic money and utility token. Anything that doesn't fall within those categories defaults into being classified as a “virtual financial asset”. Different regulatory regimes apply for each category. Any security token, as commonly understood, is treated as a financial instrument, the regulation of which then becomes governed outside of VFAA by standard MIFID/prospectus regulations. The regime kicks out security tokens in a similar way to the Howey Test in the US.
The regime for other types of DLT asset is lighter and Malta gives guidance, for example, on the contents of whitepapers for ICOs. A licensing regime is set up for those engaged in activities around DLT assets (exchanges, key custodians, exchange traders, funds holders) with minimum financial liquidity for different activities and, crucially, a “VFA Agent” gatekeeper to ensure that companies raising funds do so in a professional manner adopting high standards of probity. Alongside this, Malta has created a separate piece of legislation, the Innovative Technology Arrangements and Services Act (ITAS) 2018, which sets up a technology audit and licensing regime to ensure that platforms operating behind any financial offering are robust and secure. It will be interesting to see how certain well-used technology platforms fare under this new regime as it has only recently started operation but has attracted a huge amount of interest.
The UK regulator has started down a similar path of classification. The Financial Conduct Authority has issued consultation papers confirming its intention that security tokens fall under current regulatory parameters, while looking to extend and implement regulations for cryptoassets that are comparable to its existing definition of “specified investments”. Central to their work is the creation of a new framework which secures investor protection.
Offshore centres are very keen to establish their credentials in this area, and Bermuda provides a good case in point. Last year it introduced the Digital Assets Business Act, which defines cryptocurrencies as digital assets. The regulations incorporate online exchanges of both fiat currency and digital assets and are very specific about the types of activity that can be included within the crypto business ecosystem. This includes business services such as wallet and key custodians, whose activities are to be regulated and licensed. The Companies and Limited Liability Company (Initial Coin Offering) Amendment Act 2018 has also been implemented in order to increase regulation and transparency around ICOs.
The United Arab Emirates has also taken steps in this direction, with the Abu Dhabi Global Market creating extensive guidance for ICOs and cryptocurrencies. It also differentiates between security tokens, backed by a tangible asset such as shares or bonds which are therefore regulated as a security, and cryptoassets which are treated as commodities requiring Financial Services Regulatory Authority permission in order to trade.
A common feature of these various jurisdictions is that security token offerings still attract “old fashioned” regulation as they are classified as financial instruments, whereas pure “coin” type cryptoassets or utility tokens are subject to lighter regimes. Regulators will be increasingly vigilant to ensure that security tokens are not cloaked as cryptoassets so as to attract a lighter burden. Those looking to fundraise need to be careful not to fall inadvertently on the wrong side of the line. Cases pursued by the SEC in the US are illustrating this. There'll also be an increased focus on how to classify and regulate emerging solutions which are hybrids of existing groupings. For example, certain types of stablecoins pose a classification challenge which may need to be resolved either through further regulation or clarification by the courts.
Scrutiny of the legal issues and the legal definition of claims around lost assets and insolvency protection in areas such as tokenised fundraising and equity ownership will also grow. Jurisdictions such as Switzerland are carrying out pioneering work in this area.
The successful curation of security token offerings for equity raising, and the potential to trade security tokens on emerging digital exchanges, will have a transformational effect on venture capital and private equity, which we will explore in future blogs.
One thing is certain: while originators, users and investors in cryptoassets aspire to operate in a regulation-lite, decentralised world, and while the technology offers major opportunities for peer to peer activity, regulators will insist on proper licensing to protect investors and users. Applied correctly, such regulation will not only bring much needed credibility to this area in the wake of multiple ICO failures, but will also allow jurisdictions to gain a strong foothold in the emerging DLT economy.