TOKENIZATION SERIES: BLOGPOST #2
THE REGULATORY FRAMEWORKS FOR TOKENIZED ASSETS: PAVING THE WAY TOWARDS A DECENTRALISED, TOKEN-BASED ECONOMY
As discussed in our previous blog post, the tokenization of assets has enabled the economy of everything and fundamentally changed the way we invest and raise funds. But there’s more to that. With tokenization, digital assets are becoming more similar to complex financial commodities and, as such, require a corresponding regulatory framework.
Dr. Karl Michael Henneking from Untitled INC, Distributed Economy Think Tank & Blockchain Venture LaunchPad states that regulatory frameworks can help the industry to unlock its full potential.
“If we focus on digital securities, only a modern regulatory framework will allow us to fully unfold their potential. Overall, regulation of such assets, if transparent and geared towards utilising the benefits of digital technology, will have a positive impact. In particular, already regulated financial institutions and larger institutional investors will benefit since a significant barrier to enter digital asset markets is removed.”
Artur van Lier, COO of LiteBit, the Netherlands-based crypto exchange, agrees.
“Crypto industry is no longer only for geeks and early adopters, but also for people who see the industry as an investment opportunity. But in order to become an equal part of a broad financial ecosystem, the crypto industry has to reach certain stability. And stability is something that an established regulatory framework could offer.”
However, despite efforts to establish broader regulatory guidelines, some critical questions remain open.
CAN WE APPLY WHAT IS ALREADY THERE?
Current regulations around financial assets exist for several justified reasons, including:
- to protect customers’ funds and keep markets efficient and transparent,
- to limit excessive risk-taking and oversee the functioning of markets, and
- to prevent fraudulent activities.
If we transfer to the digital assets arena, these reasons and risks are still present and justified. But how we deal with them might change. In other words, ensuring that laws and regulations are indeed technology agnostic is vital, but, at the same time, we should understand the underlying risks that need to be mitigated.
The problem is that the existing regulatory framework was designed with traditional securities in mind, and the reality is that we’ve created — unknowingly at the time — regulations that aren’t technology agnostic and remain unclear when it comes to new asset classes and their application.
Certain jurisdictions have already taken measures to deal with these issues. Some countries, such as Austria and Luxembourg, are conducting thorough assessments of projects and companies to ensure compliance with national and relevant EU regulations.
Others, including Germany, Malta and Liechtenstein, choose a different approach and are developing a holistic regulatory framework dedicated to the token economy. In January 2020, Liechtenstein became the first country with comprehensive regulatory guidelines, when the so-called Blockchain Act or Token and Trusted Technology Service Provider Act came into force.
And in September 2020, the German government has published a draft of the Electronic Securities Act, establishing a legal framework for issuing electronic securities (bearer bonds) on distributed ledger technologies and addressing the critical civil law issues surrounding tokenized securities.
Some countries have yet to define their regulatory approaches. For example, the Turkish government is still drafting a regulatory framework for tokenized assets, which is expected to be released this year. In addition to defining legislative controls, the framework might require operators to host infrastructure locally, which can add burden and complexity for new players and possibly slow down adoption.
Finally, some jurisdictions don’t have a defined approach yet and haven’t taken any steps to develop regulatory frameworks aimed at tokenized assets. And what’s the best step to start with? Undoubtedly, with a clear token taxonomy. Here’s why.
NOT ALL DIGITAL ASSETS ARE TREATED EQUALLY
The classification of digital assets is complex. How can we define, for example, Bitcoin? Does it represent money? A store of value? A payment means? An investment tool? Or something else? In the financial sense, there is no single definition possible, and it’s understandable why regulators have been struggling to put these assets into a bucket.
Yet, although complex, the proper taxonomy is crucial because different types of assets are treated differently from an operational and regulatory perspective. For instance, if we define a token as a financial instrument, the set of related regulatory rules should be applied accordingly. When the created assets are unlike any known existing asset, it has to be decided whether to regulate them in the same way as other assets or to put them in a completely new category. If policy makers choose to create a new asset category, regulation should be created based on an understanding of the technology, the asset, the risks it carries and its purpose.
The lack of an exact classification and taxonomy even led to conflicts within the boundaries of the same country. In September 2018, Berlin’s Superior Court of Justice (Kammergericht) overruled BaFin’s decision following criminal proceedings on operations conducted by the Bitcoin trading platform. The court ruled — in opposition to BaFin’s decision — that Bitcoin can’t be considered units of account and, therefore, the related activity and operations aren’t a licensable banking business or financial service. According to the decision, Bitcoin and similarly operating cryptocurrencies like Etherum or Ripple don’t represent a financial instrument regulated under the German Banking Act (Kreditwesengesetz).
Over the years, much work has gone into the classification of tokenized assets. The SEC in the USA and FINMA in Switzerland, amongst others, are taking measures to solve this problem. FINMA, for instance, divides tokens into the following categories:
- Payment/exchange/currency tokens (cryptocurrencies). These tokens are designed to enable purchases, sales and other financial transactions and are intended to provide many of the same functions as long-established currencies, such as the Euro or US dollar.
- Security/investment tokens. This category represents such assets as company equity, earning streams, dividends or interest payments. They are equivalent to equities or bonds. A security token is a tradeable digital asset that derives its value from an underlying asset in the real world. Therefore, these tokens are subject to federal laws that govern securities.
- Utility/consumption tokens. These tokens are usually issued to fund the development of the cryptocurrency, and they can be later used to purchase a good or service offered by the issuer. Utility tokens allow holders to exchange them for various services; as such, they aren’t created to be an investment.
- Other tokens. There is a wide spectrum of tokens that play a major role in the token economy. Several new asset classes or unidentified tokenization use cases of intangible assets like patents or usage rights are expected to foster innovation and growth of the ecosystem.
In the absence of a globally acknowledged classification, different regulatory bodies, financial institutions and jurisdictions have different viewpoints on how to address issues related to digital assets. As a result, one of the most significant regulatory challenges is uncertainty in different jurisdictions.
IS IT POSSIBLE TO TACKLE AML GLOBALLY?
The innovation behind tokenized assets promises, at minimum, to enable markets without borders. While that is technically possible, it remains hardly achievable from a practical, economic and regulatory perspective.
The European Union’s 5th Anti-Money Laundering Directive (AMLD5) that came into effect on January 10, 2020, tried to shed some light and provide certain legal clarity for investors and institutions trying to swim in these waters and regulatory bodies overseeing operations.
“The introduction of AMLD5 marks a significant development in the regulation of tokenized assets. Yet, a large number of legislative gaps, mostly due to the fast evolution of the industry, can still be found in this EU directive. DeFi, for example, is a glaring gap in AMLD5,” says Jacek Trzmiel, regulatory affairs advisor at Coinfirm, the industry leader in regtech for digital currencies and the blockchain-based financial ecosystem. “DeFi was a nascent sector at the time AMLD5 was drafted. So the lack of any clear regulation is a typical reflection of regulation and regulators playing catch-up. “Crypto forks are also uncovered by AMLD5,” he adds. “Forks have been ingrained with the industry since the Genesis Block — so it’s about time that this element became incorporated into legislation somewhere.”
Another issue with regulatory frameworks such as AML and KYC is that different countries have different approaches. In Europe, for instance, every country has its own legislation.
“Ideally, AML, CTF and tax evasion are tackled globally, but in the context of highly heterogeneous regulatory regimes for digital assets — or partially missing regimes and missing regulatory clarity — finding a common framework on a European level in our opinion would be a significant step forward,” says Dr. Henneking.
“European directive AMLD5 had a goal to ensure that European companies have the same line. Unfortunately, what we see in practice is that every country has its own regulations in place,” Artur van Lier states. “For example, if a crypto-related company is based in the Netherlands and provides services to customers from Germany, it needs to apply for a German licence with the BaFin and set up headquarters in Germany. This is very inefficient, expensive and represents an extreme pain for companies in the industry. And this is where Europe has a competitive disadvantage compared to the United States or Asia, where you have much larger markets but one regulatory framework. We need a solution that works on the European-level playing field,” he concluded.
Given that AML requirements vary so widely across the jurisdictions, it can be hard, complex and expensive to achieve compliance.
“Yes, but still, it’s better to be safe than sorry. The important thing to bear in mind is that in the past, when ICOs and blockchain-native business models launched, they would take the approach of innovate now and wait until the hammer of the regulator came down. Regulators have wised up and governments are tax revenue-hungry,” says Jacek Trzmiel. “Institutionalisation begets rules. Rules that shareholders and blockchain network stakers now expect. Stakeholders know that the ‘innovate now, wait for the laws to catch up’ approach does not work anymore. Now, not implementing basic KYC, AML and CFT makes business operations first hard, then complicated and lastly impossible. So, it’s better to be safe than sorry,” he added.
In June 2019, AMLD5 was reinforced with the ‘Travel Rule,’ which was introduced by the Financial Action Task Force (FATF). According to the directive, VASPs are obliged to disclose customer information, such as the sender’s and recipient’s names, geographical address and account details, when performing a transaction of $1,000 or higher. This might enhance security, but it also presents tremendous challenges to infrastructure and market players.
“It’s a complex topic. On the one hand, the crypto industry was invented by people who preferred anonymity. From the perspective of innovators, geeks and early adopters, anonymity is understandable,” says Artur van Lier. “However, in the last ten years, the industry has evolved, and it’s now becoming a part of the global financial system. This carries a major responsibility. And we, as an industry, should ensure that transactions related to fraudulent activities can’t be processed.”
“Is the ‘Travel Rule’ the best solution to address this problem? I’m not sure,” he continues. “But what I’m sure about is that the industry, with so many smart people in its trenches, can come up with something better than the ‘Travel rule.’ Crypto sector is, like no other sector in the world, capable of finding an appropriate solution to bridge this gap.”
HOW TO ADDRESS TAX POLICIES?
As shown above, tokenized assets pose several challenges for regulatory bodies. Tax policies are no exception, with several crucial questions still unanswered.
For example, if the asset is backed by a real estate property, should the stock of the digital asset be included in the country’s net wealth taxes or other capital taxes? Should VAT systems be applied to these assets? How can regulatory bodies detect and address the risks of tax evasion? How do digital assets fit within the existing taxation laws? Is the tax treatment of digital assets coherent with the broader regulatory framework?
The majority of jurisdictions have provided no guidance on the taxation, and the advice that has been issued isn’t extensive. In most cases, the income from digital assets falls within an existing income category, and they are taxed correspondingly.
For example, in Austria, tax treatment depends on whether the digital asset is treated as a business asset, investment asset or other asset. In Belgium, professional traders are taxed as professional income, with tax rates ranging from 25–50%. If the operations performed with digital assets falls outside of the professional activities, the tax treatment is defined on a case-by-case basis. Estonia taxes the income from trading as a business income, which is subject to personal income taxes.
To reach its full mainstream adoption, the token economy must achieve a stable and transparent market, as well as clear and consistent regulatory guidelines on an international level. Since we are dealing with technological innovation, it’s necessary to rethink what is regulated and why in order to leave room for a new how. This means that the industry itself needs to become more educated on regulation, market economics and their risks.
A regulatory framework is necessary to create a stable industry and reduce uncertainty for market players so that they are willing to invest, innovate and expand the market. Regulations exist for a reason, and while we have a new technological advancement, we still want to prevent the same issues and the same fraudulent activities.
Jacek Trzmiel agrees.
“Regulatory frameworks keep the integrity of markets intact. Without sets of common principles between counterparties to a transaction of any kind, the world would be a significantly more lawless place. Tokenization of assets indeed opens up other avenues of highly regulated industries. Real estate, for instance, is already tokenized. Selling off the rights of music is being tokenized. How long is it before healthcare, arguably the most regulated industry in the world, goes this same way?”
Various industries will start to tokenize a variety of assets. As such, existing regulation may need to apply to new assets, or new requirements may need to be added. Policy makers need to recognise when there’s an underlying asset that we already know how to regulate or when there is a completely new asset type that might, in some cases, require new rules or the direct application of existing regulation. Regulators should also understand the underlying technology so that tech agnostic regulation can be developed and enforced, while potential gaps in existing regulatory frameworks need to be identified and addressed.
The first steps toward a comprehensive regulatory framework are already underway. In September 2020, the European Commission adopted a Digital Finance Package that aims to increase the competitiveness of the Fintech sector in Europe.
Digital Finance Package also introduced an extensive new legislative proposal on crypto-assets, called Markets in Crypto-assets (MiCA). Once MiCA comes into force, will be directly applicable to all Member States without the need for national implementation. The proposal lays out an independent regulatory regime for the issuance and trading of various types of tokens. In addition, it presents rules on licensing requirements and supervisory powers concerning service providers, including exchanges, brokers and, of course, custodians.
As the industry grows, the role of custodians to safeguard the assets becomes more and more critical. Nevertheless, the regulatory response to the custody of tokenized assets is still evolving. And this leads us to the topic of our next blog post, in which we’ll provide an overview of digital asset custody and explore its unique challenges.