The (Somewhat) Confusing World of Cryptocurrencies
This article provides an overview of the broad categories of cryptocurrencies, namely Virtual Currencies, Security Tokens, Utility Tokens and Asset Backed Tokens. Each category and its associated characteristics is considered in turn.
When people speak of cryptocurrencies, the first thing that probably comes to mind is Bitcoin or possibly Ether. This is not surprising given that these cryptocurrencies have frequently been in the news, especially over the course of the last year; grabbing headlines with their incredible swings in market price. A common misconception amongst the public at large is that all cryptocurrencies are essentially the same, usually linked to the expectation that cryptocurrencies will certainly appreciate in value given the extraordinary performance of Bitcoin and Ether — from January 2011 until the peak in December 2017, Bitcoin prices increased at a compound annual growth rate of approximately 375%; Ether was initially allocated for the equivalent to US$0.30 in July 2017, but had a peak market price in January 2018 of about US$1,350.
The actual world of cryptocurrencies is far more nuanced. While “cryptocurrency” is not a term of art, it is used to describe a wide variety of digital tokens, all secured using cryptography and blockchain technology, but which otherwise have wildly differing characteristics and which are usable for different functions. From a legal perspective, it is critical to distinguish cryptocurrencies as different token characteristics, functions and token-holder’s rights, and the underlying business model pursuant to which the tokens may be utilised, may trigger different regulatory considerations. At last count, there appears to be broadly four categories of cryptocurrencies — (a) Virtual Currencies, (b) Security Tokens, (c) Asset Backed Tokens and (d) Utility Tokens. This article considers each category in turn below.
On 21 November 2017, the Monetary Authority of Singapore (MAS) launched a second consultation on its proposed payments regulatory framework. Specifically, MAS issued its Consultation Paper on the Proposed Payment Services Bill (the Bill). The Bill is meant to streamline the regulation of payment services under a single legislation, expand the scope of regulated payment activities to include Virtual Currency services and other innovations and calibrate regulation according to the risks posed by these activities.
Under the Bill, virtual currency may be said to be, “any digital representation of value that is not denominated in any fiat currency and is accepted by the public as a medium of exchange, to pay for goods or services, or discharge a debt”. Bitcoin and Ether are examples of Virtual Currency.
Where one deals in Virtual Currency, one could potentially be construed as “providing virtual currency services” under the Bill, triggering licensing requirements.
There are two definitions of the term “securities” under the Securities and Futures Act of Singapore (SFA). Under Section 2 of the SFA, the term “securities” means:
- Debentures or stocks issued or proposed to be issued by a government;
- Debentures (includes any debenture stock, bond, note and any other debt securities issued by a corporation or any other entity, whether constituting a charge or not, on the assets of the issuer), bonds (includes notes, bonds and Treasury Bills, as well as options in respect of these instruments and convertible bonds), stocks or shares issued or proposed to be issued by a corporation or body unincorporate;
- Any right, option or derivative in respect of any such debentures, stocks or shares;
- Any right under a contract for differences or under any other contract the purpose or pretended purpose of which is to secure a profit or avoid a loss by reference to fluctuations in (i) the value or price of any such debentures, stocks or shares, (ii) the value or price of any group of any such debentures, stocks or shares, or (iii) an index of any such debentures, stocks or shares;
- Any unit in a collective investment scheme;
- Any unit in a business trust;
- Any derivative of a unit in a business trust; or
- Such other product or class of products as MAS may prescribe.
The term “securities” excludes futures contracts, bills of exchange, promissory notes, and certificates of deposit issued by a bank or finance company.
Under Section 239 of the SFA, the term “securities” means:
- Shares or units of shares of a corporation;
- Debentures (includes debenture stock, bonds, notes and any other debt securities issued by a corporation or any other entity, whether or not constituting a charge on the assets of the issuer but does not include (i) a cheque, letter of credit, order for the payment of money or bill of exchange, (ii) a promissory note having a face value of not less than S$100,000 and having a maturity period of not more than 12 months) or units of debentures of an entity;
- Interests in a limited partnership or limited liability partnership formed in Singapore or elsewhere; or
- Such other product or class of products as MAS may prescribe.
Collapsing these definitions, where cryptocurrencies fall neatly within the described instruments (eg, pursuant to the terms under which such cryptocurrencies are sold to purchasers), they will be considered securities for the purposes of the SFA. Where cryptocurrencies display characteristics that are typically associated with such financial instruments, there is a risk that they may be construed as securities under the SFA. The implication of such characterisation is significant — a person that deals in cryptocurrencies (or their derivatives) that are securities may be seen as undertaking a regulated activity (such as “dealing in securities”) with the result that licensing requirements are triggered under the SFA. Other regulated activities may also be triggered, depending on the manner in which a person is handling such cryptocurrencies. By way of example, where a person offers a service in which he manages a basket of cryptocurrencies that are securities for customers, such person may well be construed as providing fund management services under the SFA, triggering licensing requirements. For completeness, where such cryptocurrencies are offered to persons in Singapore, prospectus requirements under the SFA will prima facie, be triggered and should a full prospectus not be feasible, one would need to consider applicable prospectus registration exemptions.
Asset Backed Tokens
One of the benefits of the blockchain is the ability to tokenise virtually any asset. From a layperson’s perspective, this appears to be extremely beneficial as the technology seemingly allows ownership of an asset to be shared between multiple persons and bought and sold across national boundaries with ease. However, the broad scope of the assets that can be the subject of tokenisation also brings about a broad range of legal considerations, depending on the specific asset that is tokenised and the rights attached to each cryptocurrency token.
One of the commonly tokenised assets belongs to the category of precious metals. In effect, what typically transpires is that the issuer of the token (or a related corporation) has a store of the precious metal. The issuer wishes to provide the general public with the ability to gain exposure to the price of the precious metal. It may be the case that tokenisation of the ownership in the precious metal allows for each token to be priced in such a manner that the average person can afford to purchase ownership in the precious metal (via ownership in the token). This is possible as there is no limit to the number of tokens that can be representative of a specific amount of precious metal. There is also the added advantage of the token holder being able to transact in the tokens online, without having to deal with the physical aspects of the precious metal but with the ability to withdraw the actual precious metal at any time.
Where one is advising on tokens that represent ownership in precious metals, one should consider whether this triggers any regulatory implications. By way of example, the buying and selling of the tokens, may be construed as undertaking “spot commodity trading” under the Commodity Trading Act, Chapter 48A of Singapore (CTA). The CTA defines a “spot commodity broker” as “a person whether as principal or agent who carries on the business of soliciting or accepting orders, for the purchase or sale of any commodity by way of spot commodity trading, whether or not the business is part of, or is carried on in conjunction with, any other business“. “Spot commodity trading” is in turn defined as “the purchase or sale of a commodity at its current market or spot price, where it is intended that such transaction results in the physical delivery of the commodity”.
Another common business model for such category of cryptocurrency relates to the tokenisation of real estate. An example is where an issuer collects monies (Fiat) from purchasers of the cryptocurrency token, and with such monies purchases real estate. Each token represents beneficial interests in a trust that holds the real estate (and rights to some form of return on the real estate). There is a manager that manages the real estate with a view to generating a return for the token holders. Depending on the exact scope of the business model, there may be a number of regulatory issues that are triggered under such a scheme. It is possible that such an arrangement may be considered a “collective investment scheme” under the SFA and the offering of the tokens may be seen as the regulated activity of “marketing collective investment schemes” under the Financial Advisers Act, Chapter 110 of Singapore. Again, depending on the exact business model, it is possible that the manager may be construed to be providing fund management services under the SFA, triggering licensing requirements (unless exempt).
Cryptocurrencies which are properly referred to as “utility” tokens typically arise in the context of an initial token offering or an initial coin offering (ICO). An ICO is a method of raising funds through crowdfunding. At a basic level, an issuer offers new cryptocurrency tokens to participants, using blockchain technology. Participants will typically transfer more established cryptocurrencies, such as Bitcoin, Ether or XRP (by Ripple) to the issuer, in exchange for the new tokens at a pre-determined exchange rate. The new tokens issued are sometimes designed to be usable to pay for the products/services of the issuer (or its related corporation).
Conceptually, such an ICO is different from an initial public offering (IPO) in that in an IPO, funds are raised by an issuer through the issuance of its shares to investors. In an ICO, new tokens are issued to the consumers of the products and services provided by the issuer (or its related corporation). In a sense, the focus of a participant in an ICO may be on the quality of the products and services provided by the issuer (or its related corporation) while for an IPO, the focus of an investor may be on the quality of the products and services provided by the issuer and how that translates to the overall future value of the company (ie, the share value of the company).
The new tokens may also have other rights attached to them. In many jurisdictions around the world, there are financial regulatory concerns surrounding ICOs. These generally revolve around the proper legal categorisation of the new tokens issued pursuant to an ICO. The issue is likely to be determined based on whether such new tokens are effectively “securities” (or their equivalent in each jurisdiction) and the follow-on applicability of prospectus registration, financial regulatory, and other relevant laws. From a policy perspective, such laws are generally geared towards protecting consumers by ensuring that they are provided with a prescribed level of information on the offering to enable them to better understand their purchase. In addition, such laws seek to ensure that the entity that deals in such “securities” keeps to a prescribed level of operating standards, both in relation to its internal operations and vis-à-vis its dealings with customers/clients. Where new tokens are taken not to be “securities”, consumers may end up bereft of the protections afforded by such laws. In view of the above, new token issuers should have their new tokens subject to relevant review in each applicable jurisdiction.
A fundamental consideration of such new token issuers is often to ensure that their new tokens are not characterised as securities and do not display such security-type characteristics (ie, the tokens are not Security Tokens). As mentioned above, dealing in and/or offering Security Tokens may trigger both licensing and prospectus requirements and it is often the case that such requirements run counter to the considerations underpinning an ICO. One would also do well to ensure that the underlying business mode, product or service that the new token holder is able to access is not in itself regulated.
While the terms under which a cryptocurrency are sold to a purchaser, and any other undertakings made by the issuer of that cryptocurrency, are always relevant in the proper characterisation of the cryptocurrency, the relevant terms and undertakings may be most important when considering the purchase of cryptocurrencies properly referred to as “utility” tokens; especially when the cryptocurrency is not immediately distributed upon purchase.
The take-away from the above discussion may be summarised in two parts:
- If you are looking to purchase cryptocurrencies, make sure you know what specific cryptocurrency you are investing in and bear in mind that not all cryptocurrencies are the same. The market may view the pricing of different cryptocurrencies differently and not all cryptocurrencies may maintain a sustained increase in price. You may also wish to carefully consider the terms of purchase, which as a matter of market practice are usually highly in favour of the issuer.
- If you are looking to provide advice on legal matters relating to cryptocurrencies, it is crucial to pin-down the exact characteristics associated with the cryptocurrency in question and to look into possible regulatory and other legal issues that may arise from the specific cryptocurrency that you are considering.