The laws of tokenisation
Tokenisation is a difficult concept to untangle from a legal perspective. It generally refers to the issuance of a digital asset (usually, a cryptographic token) that purports to represent a real-world asset; however, this is just a limited view. Representation of an asset in the form of a token can mean one of three things: first, that the token enables its holder to exercise a right over the asset; second, that the token has the same value as the corresponding asset; and third, that the token is an instrument connected to the fate of a real-world asset, like a security.
Is tokenisation legal? It depends on what is being tokenised, in what manner, and for what purpose. For example, if a credit is tokenised and put on a trading platform, the operation is similar to the securitisation of a bond, and therefore securities law should apply. If a token represents the value of a fruit in the supermarket, there is at best a contractual agreement on this representation between the issuer and the buyer of the token. A contractual agreement will always exist between the issuer of a token representing a right of access to a house and the holder of that token.
A token can thus represent a claim on someone, an existing value, or a new form of value or instrument connected with an existing asset. It is important to understand what type of token is being dealt with to ensure that the applicable legal requirements are well defined, providing security to market actors.
Types of tokens
There are various types of crypto tokens available on the market today, each with their unique specifications and purpose. Therefore, it is crucial for investors to understand the differences between types of tokens to make informed investment decisions and to obtain the benefits derived from the existence of various types of tokens.
The most known types of tokens are (i) utility tokens –tokens that can be used to purchase a good or service offered by the issuer of the cryptocurrency; (ii) security tokens –digital assets that represent transferred ownership rights or asset value to a blockchain token (corresponding to the digital form of traditional investments like stocks, bonds or other securitised assets); (iii) NFTs or non-fungible tokens –representing unique assets such as digital art, digital content, or media; and (iv) governance tokens –tokens that allow holders to participate in the on-chain governance for a crypto project.
Hence, based on their interests and goals, investors may consider the various opportunities arising from the diverse range of crypto tokens available in the market. Investing in NFTs presents an opportunity to invest in collectibles, while security tokens and governance tokens are more closely linked to investments in companies and blockchain projects.
Furthermore, each type of token typically has distinct technical features and offers varying levels of decentralisation, liquidity, and control. By becoming informed about these differences, investors can select the tokens that best align with their investment objectives, risk tolerance, and overall investment strategy, promoting a more diverse and inclusive investment ecosystem and unlocking new capital flows.
Regulation of tokenisation in Europe
Europe has been taking steps to enhance its legal framework around tokens and tokenisation, although further development is still necessary. It is thus essential to consider several legal documents carefully, including MiFID (Markets in Financial Instruments Directive), DLT Pilot Regime, MiCA (Markets in Crypto-Assets), and contract law and general rules:
– MiFID was first enacted in 2004 and replaced in 2018 (MiFID II) with the aim of increasing transparency, standardising regulatory disclosures, and regulating the financial markets in the EU. This framework applies to tokens representing securities, providing guidance on trading in financial instruments within the EU;
-The DLT Pilot Regime, applicable from 23 March 2023, introduces a legal framework for testing the trading and settlement of transactions in crypto-assets that qualify as financial instruments under MiFID II. Its objectives include developing crypto-assets that meet the definition of financial instruments, building the distributed ledger technology (DLT) infrastructure, and maintaining a high level of investor protection, market integrity, financial stability, and transparency, while also preventing regulatory arbitrage and loopholes;
-In September 2020, the European Commission proposed the MiCA regulation as part of the broader Digital Finance Package that entered into force in June 2023. It covers all types of non-security tokens, including payment tokens, currency tokens, and utility tokens, aiming to protect investors and support innovation within the growing cryptocurrency market.
Understanding the specifications and objectives of these legal regulations is crucial for businesses and investors engaging in tokenisation in Europe and seeking to navigate a rapidly changing regulatory environment. Legal compliance is a prerequisite for successful operation in the tokenisation industry, and therefore businesses should be well-versed in the applicable regulations and requirements. Businesses and investors must comply with the regulatory framework to avoid possible fines or legal trouble.
Infrastructure assets: what type of tokenisation?
When considering tokens for infrastructure projects, the type of token needed will depend on the project requirements and the characteristics of the investors involved. Many infrastructure initiatives result from the Public-Private Partnerships (PPPs) framework, involving external financing and Special Purpose Vehicle (SPV) structures.
Security tokens appear to be the most relevant type of token for this purpose since they offer many advantages when it comes to infrastructure projects.
First, infrastructure projects require significant capital investments, and security tokens make fundraising rounds more accessible to a broader range of investors, increasing liquidity and allowing infrastructure developers to expand their investor base beyond traditional institutional and retail investors.
Second, security tokens are generally listed on regulated exchanges, in accordance with the evolution of the fintech legal framework, allowing investors to trade them more easily and securely. Security token offerings thus provide greater investor protection. As security tokens are compliant with securities laws, they come with greater disclosure obligations, investor protections, and investor rights than other token types. These provisions give investors greater peace of mind and security in what can be high-value, long-term, and complex investments.
Looking ahead, while security tokens are not yet available to retail investors, many entities are working to get them approved by regulators for broad deployment. The European Union’s robust legal framework on securities trading and compliance will help ensure the continued development of the regulatory framework for security tokens, making them an ideal tool for promoting infrastructure investments in the future.
However, one should not underestimate the potential of other types of tokens – such as NFTs, payment tokens or utility tokens – which, despite not being securities, also have interesting characteristics as a product to be used in a financing operation. Crypto-assets’ technological infrastructure allows for greater flexibility and effectiveness in transferring value between different parties, which in turn may promote the development of better managed operations for infrastructure financing.
Challenges and question
As the fintech market continues to expand and advance, a crucial question arises regarding the financing of infrastructure projects through tokenisation, particularly security tokens: Can a bridge be built between the fintech market and the traditional financial market?
One way to connect the fintech market with the traditional financial market is by developing platforms that facilitate the issuance, trading, and settlement of security tokens on the traditional financial markets. Doing so would enable both markets to take advantage of the technology’s unique benefits, such as transparency, 24/7 trading, low transaction costs, and fast settlement. This, in turn, would provide infrastructure projects with the opportunity to raise capital from a global pool of investors more efficiently.
The tokenisation of infrastructure assets would allow traditional investors to explore alternative investment opportunities. With the expansion of the investor base, investors can select options with different returns and risk profiles, resulting in a more efficient price discovery mechanism. This mechanism could provide better, more accessible, and less costly capital to finance infrastructure projects.
Therefore, establishing a connection between the fintech and traditional financial markets would offer a new approach to infrastructure financing. This approach would create opportunities to maximise investor participation and establish a tokenisation framework that merges traditional and potential investors in a new market. This new market would offer faster, more efficient, and less costly transactions, leading to a cheaper capital cost and broader infrastructure funding for both the fintech and traditional markets.
However, while bridging the fintech and traditional financial markets can bring many benefits, there are several challenges that need consideration. Tokenisation’s technological and legal complexities can present businesses with substantial operational and process problems. Additionally, ensuring transparency, legitimacy, and security is crucial for building trust in the system and its underlying technology. Investors must know and trust that the system will protect them amidst the complexity of digital assets and intermediaries.
To overcome these challenges and enable the advantages of this bridge, legal documents need to be further developed to provide clarity and to streamline the tokenisation process. Tokenisation requires compliance with securities laws and regulations that vary across jurisdictions, demanding up-to-date knowledge of the legal and regulatory landscape. Ultimately, establishing trust through transparency and security measures and ensuring that businesses and investors comply with regulatory requirements will be essential in promoting the wider adoption and success of tokenisation in infrastructure financing.
