ICO Wednesdays: the Security Token Trinity

It's our latest installment of ICO Wednesdays...but on a Thursday. Initial Coin Offerings are still a "thing" according to several leading regulators, and mostly these regulators are classifying ICO's as a security. However, some domiciles are carving out special rules for tokens versus other types of securities, or defining certain types of tokens as commodities or digital assets that are not securities. In Part 3, we explore (appropriately enough) the Trinity of the UK, Canada, and Australia.

This is our third installment of our ongoing series of articles around the token economy and Initial Coin Offerings and “Security Tokens.” Whether or not you believe in or care about blockchain, Initial Coin Offerings, Securities Tokens, etc., it's instructive to see emerging regulatory policy in response to technology and financial innovation. It has implications more broadly for any kind of new activity in financial services.

Part 1: Plus Ca Change

Part 2: When Everything is a Security

Part 3: Security Token Trinity (this installment)

Part 4: Welcome to the Token Islands (next week)

Part 5: Tokenomics, Exchanges and Derivatives, Oh My!

It has been great to see the comments and I encourage more participation from readers. I should mention that I am applying a healthy dose of skepticism in my writing and comments, not because I’m “not a believer” but because there is so much breathless hyperbole and inflation on the other side, I need to counterbalance with a bit of a sanity check. Three years ago I wrote about blockchain ideology, and the conceptual model holds true. I also assert that most of these instruments ultimately will be classified as “securities” across most domiciles.

So…swimming the token waters…

UK, Canada, and Australia represent interesting models to examine for engagement with token offerings that is less conservative than the US model but moderated from some of the more extreme examples we have seen extant. (I note in July 2019 the US SEC greenlit token offerings formally under Reg A+, consistent with their efforts to adapt tokens to existing securities regulations rather than invent or develop new token-specific regs. The sacrosanct Howey Test is satisfied but in a manner that is less burdensome than a full offering).

Taking the Security Token Trinity one at a time:

UK

The United Kingdom has been a fintech powerhouse and blockchain enjoys a comfortable home in London. On the asset management side some of the most progressive pilots by large financial institutions have emerged out of Moorgate and Canary Wharf. The Bank of England and numerous other UK governmental bodies have embraced and extended thought leadership in financial innovation (from the Department of Trade on out). 

The U.K.’s Financial Conduct Authority has been publishing white papers, running tech sprints, and engaging actively with the technology and finance communities to navigate fintech broadly and tokens specifically. Their formal policy guidance just issued yesterday outlines three different categories of digital assets under the token banner. 

Quoting the FCA:

• Security tokens: this category does not change materially from the Guidance that we consulted on and refers to those tokens that provide rights and obligations akin to specified investments as set out in the RAO, excluding e-money. We have now specifically removed e-money from the definition of a security token, to create a separate category. These remain within the regulatory perimeter.
• E-money tokens: this category refers to any token that reaches the definition of e-money. These tokens are subject to the EMRs and firms must ensure they have the correct permissions and follow the relevant rules and regulations. This category formerly sat within the utility tokens category. These tokens fall within regulation.
• Unregulated tokens: this category refers to any token that does not meet the definition of e-money, or provide the same rights as other specified investments under the RAO. This includes tokens referred to as utility tokens, and exchange tokens. These tokens can, for example, be issued centrally or be decentralised, give access to a current or prospective good or service in one or multiple networks and ecosystems, or be used as a means of exchange. They can be fully transferable or have restricted transferability. These tokens fall outside the regulatory perimeter.

(the “perimeter” means the FCA perimeter i.e., which firms require authorization from the FCA, and is distinct from the FCA's oversight role with respect to anti-money laundering, AML, where the FCA has formally stated it will be issuing further guidance for tokens).

This nuanced approach taken by the FCA is characteristically clever. It offers regulatory clarity to potential token issuers, buyers, and exchanges, while taking into account different use cases, thus avoiding overconstraint of innovation. 

Security Tokens are, ipso facto, transferrable securities. The equity and debt issuance models used in the UK can be adapted to these instruments. As a Specified Investment, there are disclosure, oversight, and reporting requirements just as there are for equity securities.

e-money Tokens may form a good analogy in the securities world, as the FCA notes, to e-money in the banking world. The UK has been able to promote financial innovation and competition, to the benefit of consumers, through providing two tiers of licenses for UK financial institutions that handle payments and current accounts, as well as lending and such: the less-onerous e-money license (used today by someone like Revolut) and the more stringent full banking license (e.g., how Barclays is regulated). (for completeness, I mention that the Prudential Regulation Authority or PRA is also part of regulating banking in the UK, in addition to the FCA) 

In fact, the FCA in its PS19/22 guidance has highlighted that it will separate out and create a new category to classify and manage "e-money Tokens". Previously they had spoken of Utility Tokens and only alluded to e-money.

It could be argued exchange tokens are analogous to loyalty programs or airline miles – therefore, not an FCA issue, but one worth noting to help differentiate them from other types of tokens. Bitcoin and close analogues are classified by the FCA as Exchange Tokens and treated more like a private currency than like a security, notwithstanding the speculation that occurs with such coins. The FCA puts them outside the regulatory perimeter.

Thus, a company can begin figuring out business model and product (in certain domains) before incurring the expense, complexity, and delay of full-on regulated activities, but still be “in market” unlike a sandbox project. By providing a spectrum of regulatory oversight and compliance impact for startups, depending on the nature of token they would like to issue, the UK’s coordinated effort enables a wider range of companies and encourages more experimentation while still protecting consumers and managing financial stability of the overall system.

Canada

Canada already has some experience with progressive financing structures for smaller companies, with issuances on the Toronto exchange and early acceptance of cannabis financing vehicles. The tech clusters in Vancouver and Toronto (and Quebec! Cheap hydro power!) have propelled a healthy fintech ecosystem including blockchain innovators.

The Canadian regimen is perhaps unsurprisingly a hybrid of the US and UK models. There is a variant on the Howey Test known as the four prong test based in court precedent, which can be reduced to a formulation that examines if the activity consists of:

1.         Investing money...

2.         ...into a common endeavor...

3.         ...with the belief of profit...

4.         that’s mostly from the effort of others.

If you answer yes to these, substantively (“mostly or entirely”), then you have a security on your hands, and you’re doing a securities token offering. See: Pacific Coast Coin Exchange v. Ontario (Securities Commission).

You’re also able to take advantage of the Canadian Securities Administrators (CSA) regulatory sandbox including relief from certain constraints. And the CSA gave explicit guidance for token offerings in the summer of 2018...putting them a year ahead of their US counterparts.

Australia

Australia has been vigorously exploring the token world for years and continues to evolve its thinking. Recently the Australian Securities and Investments Commission (ASIC) updated guidance on token offerings (using the “Initial Coin Offering” or ICO terminology). They offer excruciatingly clear flow charts and mapping to understand if you are offering an investment product and which regs you are subject to. The approach is even more nuanced in a sense than Canadian or UK approaches but clearly draws from a similar heritage. 

Other Australian bodies have been in active and relatively coordinated dialog around these topics eg, the Australian Treasury’s 2019 issues paper.

What next?

We’re explored some of the larger domiciles and their approaches to tokens. 

It is worth noting that Bermuda is a British Overseas Territory, not a sovereign nation, and yet has carved an interesting path on the rocky shores of fintech. And, indeed, the island nations have been quite progressive in exploring blockchain and tokens. In our next installment of the series, we will discuss Bermuda, Singapore, Hong Kong, Mauritius, Malta, and more.

Journey to the Token Islands with us next week...

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Opinions expressed herein are my own, and may not represent those of the University of Oxford or any other institutions with which I am affiliated. My disclosures can be found on the Visionary Future website.