Developing a legal framework for equity tokenization

ICOs – what exactly were investors investing in?

The hype around Initial Coin Offerings (ICOs) started with the raising of capital from protocol foundations such as the Ethereum Foundation, which raised almost USD 18.4 million over forty-two days in 2014[1]. The Ethereum ICO is one of the most successful ICOs to date, and one Ether (ETH) is worth more than USD 200 today, compared to USD 0.30 during the ICO!

With a native token such as ETH, it is clear what you are investing in – these tokens form part of the structure of a consensus protocol, and allow investors to participate in the upside of value creation as the protocol develops and grows. However, with the increasing number of successful ICOs, other projects developed creative models of financing through the issuance of tokens. These were no longer native tokens, but rather tokens tied to alleged promises of a share in revenue, profit, or some other form of gain.

On a contractual level, the obligations towards token holders were ambiguous in many of these cases, and during the ICO crash they were not able to lay any sort of claim towards the companies who had issued these tokens. This led to significant regulatory concern, and a clear take-away that a link between the issued tokens and its effective rights must be established so that investors are aware of what they have invested in.

Ensuring the rights of a token holder …

The tokenization of shares thus requires a robust legal framework that links the token exclusively to the shareholder position.

Analogous to Art. 965 of the Swiss Code of Obligations (CO), the shareholder position must be linked to the token in such a way that the shareholder position can neither be asserted without the token (the holder of the token must be considered legitimate vis-à-vis the company and payments to the holder must have a discharging effect) nor transferred to others (the transfer of the token must result in the transfer of the legal responsibility for the share).

With the adaptation of federal law to developments in the technology of distributed electronic registers, the statutory basis for the new ledger-based security will be created (Art. 973d et seq. CO (draft). In the meantime, the tokenization (linking the shareholder position to the token) must take place on a contractual basis. Tokenization cannot be used to circumvent any formal or other requirements applicable to shares (e.g. physical form requirement for the security or the problem of the written form requirement for the transfer of uncertificated securities).

The use of intermediated securities provides the most robust legal setup for the tokenization of shares currently. This is ensured through a combination of token terms and conditions, terms of issue and additional agreements between the issuer, shareholders and the custodian. This solution is reserved for custodians according to Art. 4 para. 2 BESA, which is why (in an unregulated environment) tokenization by means of uncertificated securities in the sense of Art. 973c CO is also used.

… And a regulated marketplace to transfer these rights

In addition to tokenization (primary market), a secondary market is needed where sellers and buyers of tokens can come together to process transactions efficiently, and in a way which ensures the legally binding nature of the transaction. This then raises questions regarding the required financial market infrastructure and associated regulation.

Solutions that are only used to publish purchase and sale interests ("bulletin boards") are not considered as a regulated trading system as the conclusion of the contract and settlement must take place outside of such a solution. This has a negative impact on the efficiency and legally binding nature of the performance of the transaction for both parties.

A preferred solution is an organised trading facility (OTF) that is governed by a standardised set of rules that are binding for participants. Contracts are concluded within the scope of application of these rules. Further, the inclusion of a stablecoin for the settlement of the transaction within this system enables an efficient solution for the "delivery vs. payment" model.

Legal framework must be implemented across the tokenization value chain

The legal framework for tokenization must consider the entire life cycle of the digital security – from issuance, to secondary trading and corporate actions. A piecemeal solution that addresses only one stage of the lifecycle will result in the value created being lost or diminished at other stages. In addition, differences in regulatory requirements based on geography will have to be accounted for. At Sygnum, we are building our tokenization solution with exactly this in mind. Our goal is an end-to-end solution that integrates the legal framework into technology and processes across the entire value chain – offering a seamless and compliant solution to issuers and investors which will transform the capital raising process going forward.

[1] https://coinnounce.com/ethereum-ico-2014/

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