This paper is the first edition of a series called “Blockchain — Legal Snapshot Switzerland”. The aim of this series is to provide a hopefully helpful update related to hot topics in the current crypto scene. The author is an attorney-at-law and partner at a Swiss based law firm specialized in the area of distributed ledger technology / blockchain. He intends to provide content as interesting as possible, and to avoid unnecessary academical and sales language. The “Blockchain — Legal Snapshot Switzerland” series are not legal documents. They rather strive to provide insight in the blockchain / distributed ledger technology market, give a quick update about legal developments, and give an outlook of the potential quarterly developments. It is envisaged that the author publishes a “Blockchain — Legal Snapshot Switzerland” Paper regularly.
Classification of Token
The Swiss Financial Markets Supervisory Authority (FINMA) has published on 16 February 2018 a guidance paper clarifying how Initial Coin Offerings (ICOs) will be treated from a legal and regulatory point of view. At this time, Switzerland was the first country issuing a guidance related ICOs and with that shed some important light related to the novel blockchain industry. In its guidance, FINMA came up with a qualification of Token which was retrospective, but very pragmatic and pioneering at the same time. FINMA categorizes tokens into three types: Payment token, Utility token, and Asset token, and explicitly states that hybrid forms are possible.
What is a STO about?
As a Security Token Offering (STO) is based on Asset token respectively Security token (both terms are used synonymously in this article), it is worthwhile to have a quick look at the token definition:
As a first disappointment, at the beginning there is no unified or event translational definition related to Security token. However, at least a few jurisdictions provide some guidance what a Security Token consists of. In Switzerland, according to FINMA’s characteristic, an Asset token represent assets such as participations in real physical underlings, companies, or earnings streams, or an entitlement to dividends or interest payments. In terms of their economic function, these tokens are analogous to equities, bonds or derivatives.
Other jurisdictions, such as the US, have a rather broad understanding of Security Token: The SEC is making use of a US Supreme court decision which dates back more than 70 years. The scene at these times was sunny southern Florida, where the Howey Company was leasing part of their citrus farms to finance other ventures. This case, and in particular the created “Howey test” for finding out under which circumstances a security is considered as security, has influenced the SEC’s definition of “securities” forever. According to the Howey test a transaction will be considered a security if all of the following requirements are met: (i) There is an investment of money, (ii) there is an expectation of profits, (iii) the investment of money is in a common enterprise and (iv) any profit comes from the efforts of a promoter or third party
In a nutshell, if someone is investing money planning on profiting from someone else’s efforts, you’re buying a security.
Analysing further jurisdictions, a common denominator can be found: Security Tokens are Tokens which are linked to “something”. This “something” can be literally anything. Concluding from that, a Security Token needs to have an underlying. It is not a surprise that there is neither a unified nor a clear definition related to the relationship between a Token and its underlying. In particular, it is unclear whether the Token is for example backed or pegged by the underlying.
Legal and regulatory implications of STOs
From a Swiss perspective, the qualification of a token as a security comes with some challenges but does not mean the end of the world. In principle, two aspects need to be considered closely.
a) Synchronisation between the security token and its underlying
According to current Swiss securities law, it is not yet clear whether a security token represents all functions which are inherent to a security. This may sound misleading. It is. The reality is, that on the one hand FINMA has mentioned that tokens may qualify as securities. However, FINMA — as an authority — may not act as a lawmaker. On the other hand, current Swiss securities law requires a certain degree of physical characteristics for the qualification of a security.
As a (security) token as a “digital unit of value” does not have any physical characteristics, it is highly disputable whether a token can qualify as a security. From a Swiss perspective, it would be a great advantage when Swiss security law would be adapted by mentioning that also (security) token may qualify as securities. By such an amendment, it would be ensured that all functions inherent to a security could be legally embedded in a security token. There are several task forces busy proposing changes to the securities law. Nevertheless, this may require some time. Good new is that already today, we have efficient and solid legal concepts which ensure a full synchronisation between security token and its underlying.
b) Primary and Secondary market issues related to security token
Besides the above-mentioned synchronisation which is mainly an issue of civil law, primary and secondary market issues are related to financial market regulation. Before issuing a security token, primary market regulations need to be adhered to. In Switzerland, we follow a pragmatic approach in this regard and structure projects in a way that they are in line with the “Big 5”. Big 5 is representative for (i) Stock Exchange Regulation, (ii) Anti Money Laundering Regulation, (iii) Banking Regulation, (iv) Financial Market Infrastructure Regulation, and (v) Collective Investment Scheme Regulation. The good news is that in Switzerland the Big 5 can be applied to security tokens, and with that we are happy to have such a high degree of legal certainty.
Secondary market issues are related to trading of security tokens. Professional securities dealing requires a securities dealer license and needs to take place on a regulated exchange. There are currently a lot of interesting projects in the pipeline for establishing regulated marketplaces for security token in Switzerland. Probably the most prominent one is the one of Switzerland’s stock exchange — owned and managed by SIX — announced that it is building a fully integrated trading, settlement, and custody infrastructure for digital assets. Other projects are well advanced, and we will quite likely see a regulated exchange for security token in Switzerland soon.
Are STOs the next big thing?
Yes, definitely. After the rise of the protocols, such as the famous and very well-functioning Ethereum protocol, we have seen a lot of Token related to currencies — in a pure form or designed as stable coins. We can argue how many cryptocurrencies are really needed. The author tries to play the joker and does not intend to quote on that further. Followed by the currency Token there was a big rise related to the utility Token. A few were pretty good. However, others were just meaningless. Security Tokens are the opposite: they are a perfect mean to transport values! Shares, debts, etc. — purely all financial instruments can be tokenized. But Security Tokens are not only about linking financial instruments with a Token. Security Tokens can be linked to everything which has a value. Its fields of use are truly unlimited.
Is the future really that bright or is there a hidden trap somewhere? There isn’t. Nevertheless, it is important to mention that the issuance of Security Token (primary market implications) and trading of Security Token (secondary market implications) need to be analysed carefully.
STOs vs. IPOs
Traditional Initial Public Offerings (IPOs) are currently booming: By the end of the third quarter, 851 companies went public. This is a significant increase compared to 570 IPOs by the end of the third quarter in 2017. With USD 186.6 billion, the total issue volume was substantially higher — by 94 percent — than in the previous year (USD 96.2 billion).
What are the differences between IPOs and STOs? It is mainly about cost: An STO does not require a “facilitator” such as an investment bank as with an STO security tokens are directly offered to the public without any intermediary. This is directly reflected in lower transaction costs. As a rule of thumb, an IPO costs between 6–12% of the gross issuing proceeds. Compared to that, an STO devours a much lower share of the proceeds. An STO can be executed faster than an IPO as the lengthy and cumbersome roadshows related to ICOs can be done in an abbreviated procedure by online advertisement of the security token to be offered. What about regulation? In Switzerland, both, IPOs and STOs take place in a regulated environment and therefore provide for legal certainty. With a smartly designed onboarding / KYC process STOs can be arranged in a way that they surpass ICOs in this regard.
After the rise of payment and utility tokens it is expected that security tokens, respectively STOs, will have a tremendous impact on existing means for raising of capital.
What does it mean technologically?
On 17 September 2018, Tezos has reached mainnet status. This is an important landmark in Blockchain related technology. Tezos protocol is considered as a very well thought through and highly esteemed by the community. Nevertheless, compared to Ethereum, Tezos is still a modest undertaking yet: Most of the applications are currently based on the Ethereum protocol. Given that, it is possible that we will see in the nearby future at least two strong and powerful open protocols hopefully both offering smart contract and staking capabilities. This will have additional beneficial impact for the rise of STOs.
One of the most prominent security token projects in Switzerland is “blockimmo”. Blockimmo brings sellers and investors in real estate projects together by smartly using the advantages of the Ethereum blockchain. The project is in a very mature state, and the STO is expected soon. In addition, blockimmo has developed a unique AML / KYC process which enables fast and safe onboarding of token holders.
STX currently develops a decentralized exchange and launch platform. The underlying technology is promising as it focuses on transaction speed and has invested considerable efforts for the development of a user-friendly frontend.
And for sure we are all excited to see how Switzerland’s stock exchange is setting up its crypto exchange.
We are currently at the beginning of the STO age. A lot of interesting projects were initiated and will soon reach a high degree of maturity. It is expected that in Switzerland in the fourth quarter of 2018 the first and successful STOs will take place.