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Blockchain and digital assets

By Victor Buju

The Token: an introduction to an uncertain concept

Originally, the word “token” comes from West Proto-Germanic, taken up in Old English, meaning a “sign, symbol or proof” or “something that serves as an expression for something else”. Another use of this term was attributed to “pieces of engraved metal or plastic, used as substitutes for money” [1].

Recently, Token is a term that has rapidly populated modern vocabulary, being used in connection with the new technology generically referred to as blockchain sau DLT (Distributed Ledger Technology).

Around it a landscape is being created that promises a new economic revolution by eliminating the forces that until now exercised vast influence over the economy: governments, banks, financial institutions, intermediaries, etc. But what exactly is a token and what is its role in the new technological revolution?

In order to begin understanding what a token is in modern language, we consider it beneficial to approach the notion from a technical, economic and legal perspective.

The technical perspective

The token is a central element of blockchain technology, which gives it practical applicability in everyday life. From a technical point of view, the token does not exist physically, but represents a record, that is, a code written in a database. It encompasses both the notion of cryptocurrencies (cryptocoins) and the notion of digital assets (cryptoassets).

Although technically Ether is, for example, a token, the term is commonly used to describe crypto-assets that run on top of the blockchain of other cryptocurrencies[2]. These tokens do not exist independently but are generated on the blockchain of other native cryptocurrencies, the most widely used blockchain being Ethereum, whose native currency is Ether.

Tokens as cryptocurrencies (Bitcoin, Ether, etc.) are implemented through a protocol. protocols. Protocols represent a set of basic rules that allow data sharing between computers. For cryptocurrencies, they establish the blockchain structure - the distributed database that allows them to be exchanged safely over the internet[3].

Tokens as digital assets are implemented on the blockchain through “smart contracts”. Smart contracts, in turn, represent lines of code that reflect a series of rules for using the token, such as how they are distributed, how they can be used, to whom they belong and in what context, etc. The possibilities for adaptation are endless, just as with a real contract, the difference being that the text is replaced by lines of code. These offer a number of advantages because they automate the entire process of implementing and enforcing a contract, eliminating the need for an intermediary[4].

Therefore, from a technical standpoint, the token represents a product, a record in a programming language. By comparison, the token represents an application of blockchain technology, just as Google or Facebook represent an implementation of World Wide Web technology (www)[5].

The economic perspective

The token generally serves three functions: (i ) “a means of exchange”; (ii ) “a unit of account” or (iii ) “a store of value”[6].

Tokens may or may not be linked to an external, objective value. The most common example of a token linked to an objective value is the cryptocurrency USDT, whose value is pegged to the dollar: therefore, one unit of USDT will always be worth 1 dollar. Another method of linking a token to an objective external value is the process of “tokenization”.

Tokenization is a method that converts rights over an asset into a token. Interested parties can issue tokens on a platform that supports smart contracts, which will allow this token to be bought and sold on platforms that function like an exchange. The tokenization process can encompass any good or asset, such as shares, securities, property rights and intangible assets (such as intellectual property rights).

There is currently a real trend of tokenizing assets, as the technology promises to lift bureaucratic and financial barriers and provide access to such markets without intermediaries and without the costs associated with intermediation services. Of course, this technological revolution brings with it extremely interesting legal implications, which are set to be settled in the coming years through the various legislative approaches that states are currently working on.

The best-known example and the first application of this technology was the revolutionizing of payments, (peer-to-peer payments. For the first time, it made it possible for a payment to be made without the intervention of a bank or a financial institution.

Countries such as Estonia already use blockchain technology to provide digital identity cards. Based on these identity cards, residents have access to all digital services, such as paying taxes and duties, eliminating the need for the physical existence of counters[7].

The technology is also starting to be adopted in fields such as accounting and auditing, as it significantly reduces the possibility of human error and ensures the integrity of records, and the list can continue with various fields, from supply chain management.

When the token is not linked to an objective external value, its value is given by its utility and practical application, usually reflected by the number of people who choose to use and hold it. In reality, their value is extremely volatile and subject to manipulation.

In most jurisdictions, the token does not enjoy a legal definition, and its regulation and definition has proven and continues to prove to be a difficult mission for legislators.

Part of the reason a legislative framework has been slow to emerge is a lack of understanding of the underlying technology. As with any technological innovation, the process of acceptance and understanding of its impact on society is slow and arduous. It is important, in this respect, not to forget that until recently the internet itself lacked any rules regarding the holding, storage, processing and protection of users' data.

Another obstacle in framing a legal definition of the token lies precisely in its versatility, which, as shown above, can take the form of a means of exchange, an artistic work, or a title of ownership, some having mixed features. This versatility makes it extremely difficult to draft a general legal definition, requiring an individual analysis of each type of token in order to observe its nature, its characteristics, and the legal relationships it creates.

Given the anonymity inherent to blockchain technology, namely the fact that users can hide their identity behind a “digital wallet”[8], the main legislative directions focus both on combating money laundering and terrorist financing, as well as on protecting consumers and the public from potential fraud, which can be committed with much greater ease in this environment.

Naturally, in the European Union, the first step towards a coherent legislative framework was taken in the area of preventing and combating money laundering, through the adoption of Directive 2018/843 (AMLD 5)[9]. The Directive provided, for the first time, a definition of cryptocurrencies as “a digital representation of value that is not issued or guaranteed by a central bank or a public authority, is not necessarily attached to a legally established currency and does not possess the legal status of currency or money, but is accepted by natural or legal persons as a means of exchange and which can be transferred, stored and traded electronically.”.

The legislative challenge stems from the classification of tokens as financial instruments or securities. Such a classification would entail stricter legislation intended to offer real protection to investors against potential fraud.

In order to better understand in what context tokens might be considered financial instruments, the European Securities and Markets Authority[10] (ESMA) analysed, in 2018, a series of projects of this kind carried out in the Member States.

The sample of tokens analysed were available for purchase by various private investors. They reflected different characteristics, ranging from investment type, to utility type, and hybrids of investment-utility type. Tokens constituting a purely payment-type instrument were intentionally not included in the set sample, as they are unlikely to qualify as financial instruments[11].

The result of the survey highlighted the fact that some types of tokens representing crypto assets (for example those with attached profit rights) may qualify as securities or other types of financial instruments. The actual classification of a token as a financial instrument will fall to the competent authorities in each Member State and will depend on the specific manner in which each state develops its own legislative framework.

In practice, many companies and start-ups operating in this field present a project, build a website, and then proceed to a private sale (a mechanism similar to crowdfunding) of the new token created/to be created, using ICO-type mechanisms (Initial coin offering) or SAFT (Sales Agreement for Future Tokens. Under the promise of the project's success, these companies in most cases manage to raise significant funds, in the range of millions of euros.

Because these token transactions come with expectations of profit and, in some cases, even voting rights in the project (in DAO-type projects - Decentralized autonomous organization) they function in practice like an initial share offering. Tokens sold in this way as part of private sales play the role of shares that will finance the subsequent development of the business. It should be mentioned that, at present, investors who choose to invest in such projects do not enjoy legal protection and often fall prey to projects lacking economic substance, which sound good “only on paper” or which seduce through their description in the Whitepaper.

Globally, United States legislation has one of the strictest approaches to the legal status of this type of token, treating in practice the majority of tokens as securities (security tokens. In the US, the government body responsible for overseeing digital assets is the SEC (Securities and Exchange Commission. Although there is no specific regulation at federal level, the SEC will analyse projects and the tokens they create by applying the principle of “substance over form”.

In order to avoid being characterised as securities or financial instruments, many companies describe their own token as a “utility token”. Such a token fulfils only a certain function within the ecosystem in which it was created, for example allowing users to carry out certain actions on the network, having no value outside the ecosystem in which it was created.

Since, in the United States, case law plays an essential role in how financial regulations should be applied, the most important case for establishing the rules for classifying a token as a security is the SEC v. Howey.

That case led to a test, known as the Howey, test, to determine whether a financial instrument qualifies as a security: “a contract, transaction or scheme whereby a person invests money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party”[12].

Consequently, in this case, the Supreme Court established four criteria to determine whether the transaction could be considered an investment contract falling under the SEC's authority:

  • it is an investment of money;
  • there is an expectation of profits from the investment;
  • the investment of money is in a common enterprise;
  • any profit is derived from the efforts of a promoter or a third party.

Based on these criteria, almost all tokens offered in a private sale to investors are considered securities. Although project creators claim that the tokens created are strictly “utility tokens”, merely naming them as such or structuring them to provide a certain utility does not prevent their classification as securities. A similar approach is found in other Member States such as Germany[13] or France[14].

In essence, without going into the specific details of each legislative system, a token will be considered a financial instrument or security if it has the following general characteristics:

  1. the issuer offers, sells and issues tokens that are not fully functional at the time of issuance in order to raise funds for the purpose of developing the platform on which they are to be used in the future, and
  2. in connection with making such offers and sales, the issuer of that token makes promises or statements which, viewed objectively, would lead prospective purchasers to expect profits resulting from the increase in the value of the tokens attributable to the managerial or entrepreneurial efforts of the issuer.

By the end of 2022, in the European Union, the Regulamentul Uniunii Europene privind piețele de active criptografice (Regulation of the European Union on markets in crypto-assets) (“MiCA”)[15], is to be adopted, which will, for the first time, confer on the token a framework and a legal status, transforming it from a digital fiction into a legal reality.

In addition to the proposed rules and measures regarding the issuance, sale and trading of crypto-assets, the package includes a proposal for a pilot regime for market infrastructures based on distributed ledger technology (DLT)[16], a proposal on digital operational resilience[17] and a proposal to clarify or amend certain related EU rules on financial services[18].

The Regulation identifies three categories of tokens:

  • asset reference token, defined as a type of crypto-asset that purports to maintain a stable value by referring to the value of several fiat currencies that are legal tender, one or more commodities, one or more crypto-assets, or a combination of such assets;
  • e-money token, defined as a type of crypto-asset whose main purpose is to be used as a means of exchange and which purports to maintain a stable value by referring to the value of a fiat currency that is legal tender; and
  • utility token defined as a type of crypto-asset which is intended to provide digital access to a good or service, available on blockchain, and is only accepted by the issuer of that token.

In the Regulation, the token issuer is defined as “the legal person who offers to the public any type of crypto-assets or seeks the admission of such crypto-assets to trading on a crypto-asset trading platform” while the offer of tokens to the public is defined as an “offer to third parties to purchase a crypto-asset in exchange for fiat currency or other crypto-assets”.

It should be noted that the Regulation does not specifically indicate which tokens fall within which category, leaving the details of future regulations in the hands of the competent national authorities of the Member States. The Regulation merely provides the basic structure on which Member States can build and develop their own legal framework, and it represents an important step towards better protection of consumers and investors in these emerging markets.

 

Preliminary conclusions

As can be seen, the token is a central element of blockchain, as adaptable and changeable as the world in which it was created. It can be both a fungible and a non-fungible asset, it can be a means of exchange as well as a work of art or a title of ownership.

As mentioned at the beginning of this material, tokens appear to come as a technological revolution that could eliminate the coercive forces that hold economic hegemony - banks, governments, financial institutions, etc. Some specialists argue that exactly those forces that provided stability and security in the economy are being eliminated. Therefore, the struggle between the technological freedom promised by blockchain technology and the protection of individual rights and freedoms will, as usual, be fought in the legal arena, with the legislator tasked with striking the balance between individual freedom and social security.

While other states have already taken the lead in legislating in this field, Romania lacks a legal framework. Although at first glance this may seem positive and appealing, in reality, the absence of any legislative framework may attract speculative projects while deterring serious and complex projects that require the legal protection of a predictable and solid legislative framework.

Romania has before it a great opportunity to become a genuine hub for such projects and to attract extremely valuable investments by creating a transparent, friendly and flexible legislative framework which, at the same time, contains effective mechanisms to combat market abuse. We believe that the great winners of this technological revolution will be the states that understand its importance and its ramifications and that make efforts to integrate it as effectively as possible into society.

[1] https://www.etymonline.com/word/token

[2] https://www.coinbase.com/learn/crypto-basics/what-is-a-token

[3] https://www.coinbase.com/learn/crypto-basics/what-is-a-protocol#:~:text=Protocols%20are%20basic%20sets%20of,securely%20exchanged%20on%20the%20internet.

[4] https://codozasady.pl/en/p/smart-contracts-approaching-legal-revolution

[5] Blockchain-For-Beginners-Study-Guide-1 - Blockchain Council. Page 14.

[6] Anti-Money Laundering Regulation of Cryptocurrency: U.S. and Global Approaches, page 2.

[7] https://www.pwc.com/gx/en/services/legal/tech/assets/estonia-the-digital-republic-secured-by-blockchain.pdf

[8] https://en.wikipedia.org/wiki/Digital_wallet: A digital wallet is an electronic device, an online service or a software program that allows a party to carry out electronic transactions with another party by exchanging digital monetary units for goods and services.

[9] Directive (EU) 2018/843 of the European Parliament and of the Council of 30 May 2018 amending Directive (EU) 2015/849 on the prevention of the use of the financial system for the purposes of money laundering or terrorist financing, and amending Directives 2009/138/EC and 2013/36/EU.

[10] The European Securities and Markets Authority is an independent EU authority which protects the stability of the EU's financial system.

[11] https://www.esma.europa.eu/sites/default/files/library/esma50-157-1391_crypto_advice.pdf

[12] https://www.sec.gov/corpfin/framework-investment-contract-analysis-digital-assets

[13] https://www.winheller.com/en/banking-finance-and-insurance-law/bitcoin-trading/initial-coin-offering-ico-germany/security-tokens.html

[14] https://cms.law/en/int/expert-guides/cms-expert-guide-to-security-token-offerings/france#:~:text=Security%20Tokens%20are%20qualified%20as,211%2D1%20et%20seq.

[15] https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX%3A52020PC0593

[16] Proposal for a Regulation of the European Parliament and of the Council on a pilot regime for market infrastructures based on distributed ledger technology - COM(2020) 594

[17] Proposal for a Regulation of the European Parliament and of the Council on digital operational resilience for the financial sector and amending Regulation (EC) No 1060/2009, Regulation (EU) No 648/2012, Regulation (EU) No 600/2014 and Regulation (EU) No 909/2014 - COM(2020) 595.

[18] Proposal for a Directive of the European Parliament and of the Council amending Directives 2006/43/EC, 2009/65/EC, 2009/138/EU, 2011/61/EU, EU/2013/36, 2014/65/EU, (EU) 2015/2366 and EU/2016/2341 - COM(2020) 596.