This Focusing on Funds article looks at the evolving hot topic of artificial intelligence (AI) and technology for the funds sector. Crypto-assets, particularly “security tokens” and distributed ledger technology (DLT), create many opportunities for issuers. However, the EU and other regulators are responding to this revolution and looking at how it fits in with existing regulations. Some of these are explored further below.
Tokenisation and DLT create the opportunity for new products, streamlining administration and broadening the investor base through platforms.
Crypto-assets use DLT, such as Blockchain, to enable the synchronisation, digital sharing and updating of records in a distributed and decentralised way. When a crypto-asset is recorded on DLT, it is tokenised.
Crypto-assets can be categorised into different forms of ‘tokens’ as follows:
- Exchange tokens, which are used for exchange and buying goods and services, including coins such as Bitcoin.
- Security tokens, which represent a form of security interest, including shares or units in a collective investment scheme, and which are likely to be the most relevant for ‘tokenising’ fund products.
- Utility tokens, which are used for giving rights to products or services.
Notwithstanding the above, crypto-assets can present risks of market manipulation and insider trading, financial crime and, most notably, risks to consumers (including fraud, cyber-attacks and money laundering). For this very reason, individual international regulators are adopting or exploring new approaches to crypto-assets and related products with a view to addressing risks.
Further UK regulatory news on this taxonomy and marketing of crypto-derivatives is included below.
In January this year, the European Banking Authority (EBA) and the European Securities and Markets Authority (ESMA) released reports on crypto-assets.
The reports note the wide range of crypto-assets being issued and the ESMA report notes that specific security tokens may be classified as financial instruments for the purposes of the Markets in Financial Instruments Directive (MiFID).
Where a security token qualifies as a financial instrument under MiFID, a full set of EU financial rules are likely to apply to their issuer and/or firms providing investment services/activities relating to those instruments, including the Prospectus Directive 2003/71/EC (as amended), the Transparency Directive 2013/50/EU and the MiFID framework. Where the token relates to a fund, the Alternative Investment Fund Managers Directive (AIFMD) may apply and consequently the obligation to comply with AIFMD rules may also arise. Many typical funds could therefore be within this remit if the issued security tokens fall within the relevant EU regulatory regimes; it will ultimately depend on the specific jurisdiction and offering.
ESMA also hints at the need for EU policymakers to consider implementing a bespoke regime for specific types of crypto-assets that do not qualify as financial instruments.
The UK Government launched the Cryptoassets Taskforce in March 2018, consisting of HM Treasury, the Financial Conduct Authority (FCA) and the Bank of England. It subsequently reported on the risks and benefits of crypto-assets and the actions that will be taken forward by HM Treasury, the FCA and the Bank of England.
The FCA published a consultation paper earlier this year providing guidance on crypto-assets and their application generally (CP19/3). It noted that the use of new technology alone does not alter how it considers crypto-assets to fit within the regulatory sector. Crypto-assets were broadly categorised into the three types of token mentioned above and guidance provided on the degree of each token’s regulation in the market. The FCA indicated that security tokens are likely to be specified investments (like shares or debentures) falling within the FCA’s regulatory perimeter.
In July 2019, the FCA published a policy statement Guidance on Crypto-assets (PS19/22)summarising the feedback received to CP 19/3, the FCA’s responses and its Final Guidance. The FCA has made some clarification changes to CP19/3 and reframes its taxonomy by referring to security tokens, e-money tokens (both being subject to regulation) and unregulated tokens (which include utility tokens and exchange tokens). The FCA’s Perimeter Guidance gives an overview of the regulatory perimeter and where tokens are likely to be regulated as specified investments under the Regulated Activities Order, financial instruments under MiFIDII, E-Money under the E-Money Regulations 2011 or fall within the Payment Services Regulations 2017. Firms need to obtain permission from the FCA, if a token activity is regulated, to perform those activities and an issuer will be required to comply with the relevant rules.
In July 2019, a further consultation paper was released by the FCA, in which it proposes to ban the sale, marketing and distribution of derivatives (ie contracts for difference, options and futures) and exchange traded notes that reference unregulated transferable crypto-assets by firms acting in, or from, the UK (CP19/22) (the FCA Crypto-derivatives Prohibition Paper).
The FCA will also be working with international regulators to monitor the risks of firms seeking to move UK clients to entities outside of the EU.
Comments on the FCA Crypto-derivatives Prohibition Paper are welcomed by the FCA prior to 3rd October 2019 with a final policy statement and final Handbook rules due in early 2020.
Amongst other developments, Luxembourg has taken steps to recognise the growing trend towards use of DLT and security tokens.
By the law of 1st March 2019, Luxembourg amended its existing legal framework relating to the circulation of securities by inserting specific provisions for securities issued over DLT (such as Blockchain), giving transactions done via this new technology the same legal status and protection as those done through traditional means.
This law, by enabling the holding and circulation in DLT to be organised via security tokens under a clear legal framework, will certainly promote the use of new technologies in the circulation of securities, in line with technological innovation and the digitalization of the financial sector.
The Dutch regulators also acknowledge the potential of specific functional crypto-applications and the underlying technology. They believe that security token offerings (STOs) may open up opportunities for the funding of small and medium-sized enterprises, provided that investors receive clear and enforceable rights in return, as is the case with for example shares and bonds.
It should be assessed if a token qualifies as a security. An important consideration from a Dutch regulatory perspective is whether the holders of a token participate in the company's capital and receive a payment for this. This payment must correspond to the return achieved with the invested capital. In this respect any controlling rights are not decisive.
Switzerland has been a hub for blockchain/ cryptocurrency companies since the very early days. In line with that, the Swiss authorities have launched numerous initiatives to accommodate those companies, including companies planning to organise security token offerings in Switzerland. The most important documents, evidencing the initiatives, are the following:
- Guidelines of the Swiss Financial Market Supervisory Authority (FINMA) for enquiries regarding the regulatory framework for initial coin offerings (ICOs) of 16 February 2018. These guidelines address the financial market law treatment of ICOs, including offerings of asset tokens, respectively security tokens.
- Report of the Swiss Federal Council on a legal basis for distributed ledger technology and blockchain in Switzerland of 14 December 2018. This report addresses the legal treatment of blockchain technologies, including ICOs respectively STOs under current Swiss private, insolvency and financial market law.
- Consultation papers related to new laws improving the framework conditions for distributed ledger technology and blockchain of 22 March 2019. The proposed new laws will allow a more secure transfer of uncertificated securities by way of an entry in decentralized registers, including blockchains. Furthermore, a new license category for cryptocurrency-exchanges shall be established.