Regulatory problems with DLT/blockchain
Practical applications of blockchain technology are currently being developed in such areas as organization and functioning of company governing bodies, accounting, controlling, auditing, as well as voting at general meetings. Digitization and the growing role of software in company management put new interesting questions on the agenda. Since the technology already allows management to be taken over by systems based on algorithms and artificial intelligence, many questions arise, such as: is this variant legally permissible, can algorithms assume the role of company governing bodies, and how does this affect the issue of liability, which was previously legally assumed by people and governing bodies?
Delaware General Corporation Law allows the use of distributed ledger technology (blockchain) to store shares and communicate with shareholders. Therefore, it authorizes private entities to construct and subsequently introduce changes to the blockchain. From this perspective, the regulation is quite permissive. Foundations are being created for an ecosystem aimed at removing all uncertainty about the authenticity of shares issued and stored in blockchain-based databases. In the longer term, regulatory development is aimed at creating a more flexible, dynamic digital economy in which blockchain technology and intelligent contracts play a major role.
The economic purpose of business models based on ICO (Initial Coin Offerings) tokenization, in particular STO (Security Token Offerings), consists in the use of network effects. Most ICO projects are focused on creating positive network effects and, thus, on increasing value for token owners. ICOs associated with the development of innovative Open Source Software have an especially high potential for growth, as exemplified by Ethereum. In the case of tokens, it is very important to create a network of users who will be rewarded for their contributions to the network as well as another, more remote group, that will be willing to purchase tokens to benefit from the network in this manner. Therefore, the first group is stimulated with the tokens to contribute, e.g. provide services for the network. The second group of stakeholders is incentivized to buy the tokens to benefit from them. The network effects created as a result of ICO may be groundbreaking for a given market, intensifying competition and even pushing some rivals out of the market.
ICO projects are subject to significant information asymmetry. Unlike venture capital projects, where there may be several rounds or phases of funding, in the case of ICO project initiators want to quickly raise a significant amount of capital and pay less attention to network development. This is apparently in the interest of token holders, as the value of tokens increases when their number is limited. Unfortunately, there is also room for manipulation and fraud. Thanks to ICO, instead of using initial public offering (IPO), companies can acquire small initial funding without due diligence, compliance with regulatory requirements, time, or fiduciary mechanisms that a traditional IPO would require. In the case of small companies dealing with unproven or unknown technologies, this alternative offers financing opportunities to those who otherwise would not qualify for traditional financing methods. This approach, however, may create opportunities for fraud.
Book building mechanisms do not apply here. Prices are determined by the project initiators based on the “take it or leave it” principle, with the first investors usually getting discounts – sometimes up to 40-50%. Investors who come later do not really know whether the sale of the first tranche resulted from high demand for tokens, the quality of the project, or erroneous pricing decisions made earlier by the initiators. People who negatively evaluate the project have no impact on prices.
The emergence of DLT/blockchain as a groundbreaking innovation makes it necessary to review the existing law in terms of its applicability. This applies to many regulatory areas. In the USA it is under consideration whether and how Article 8 of the Uniform Commercial Code applies to securities based on blockchain (“uncertificated securities”). It can be concluded that the law regarding the storage, transfer, or pledging of securities is sufficiently flexible to also cover the problems of assets constructed on the basis of blockchain.
It is suggested that the regulators take advantage of the already considerable experience with crowdinvesting, e.g. in terms of investor protection or inclusion of professional entities as intermediaries in the ICO procedure, similar to investment banks in the preparation and running of IPOs. In the USA the efforts of ICO investors are directed at loosening the limitations imposed by the SEC in the case of DAOs – treating all tokens as securities under US capital market law (Howey test). The simplified procedure was defined as the SAFT concept (Simple Agreement for Future Tokens). Not only the USA, but also the ESMA adopted a conditional definition of a token, whose nature depends on the examination of individual cases.
Many countries have been recently preparing regulations for DLT/blockchain systems. South Korea, China, and the USA are focusing on regulating the ICO market. This is due to the growing popularity of ICOs, involving more and more capital. This requires clarification of the legal nature of ICOs, e.g. whether a given case is about currencies, investments, or goods (services). The most favorable jurisdictions for cryptocurrencies and ICOs are currently Singapore, Hong Kong, Switzerland, the United States, Estonia, Malta, and Scotland.
The possibility of fraudulent use of ICOs to deceive investors is the main reason why some countries prohibit ICOs. The US Securities and Exchange Commission (SEC) issued a warning that public companies may become involved in ICO systems to manipulate market prices. Many countries are working on policy changes to codify compliance with anti-money laundering/know your customer (AML/KYC) regulations and introduce the requirement of additional supervision, such as registrations and disclosure statements. In addition, if an ICO is related to transfers of property rights or currencies, this ICO may be subject to securities law.
The recent explosion of ICO sales could mean the beginning of a wider change on public capital markets, similar to the change in media distribution that started a few decades ago. Blockchain significantly reduces the cost of exchanging value and allows everyone to transfer digital assets around the world in a highly reliable way, fueling the dreams of truly global capital markets that leverage the power of blockchain and the Internet to help create and multiply capital. High liquidity, efficiency, and low transaction costs of ICOs are, however, accompanied by concerns about security and lack of trust.
Malta is an interesting example of regulating the market of cryptoassets. Malta adopted three laws enabling business operations based on blockchain (Virtual Financial Assets, Innovative Technology Arrangements and Services, Malta Digital Innovation Authority). These acts constitute the legal framework for a digital economy based on DLT/blockchain, cryptocurrencies, and tokenization. This legislation also includes intelligent contracts and decentralized autonomous organizations (DAOs), also to protect traders utilizing innovations on the financial market.
There are many examples of practical applications of DLT/blockchain (e.g. e-voting), one of them being the implementation of the so-called durable medium. Information contained on a durable medium cannot be controlled by any of the parties involved – neither the customer nor the company. This means that a message sent to a bank account is not a durable medium, because it is located in the bank’s system. If a piece of information is beyond the control of either party, nobody can delete or change it on their own. The customer must be actively informed about its existence, e.g. by a push notification in an application. The idea of a durable medium is, therefore, to strengthen the position of the customer. Theoretically, an institution could send a link to their system, which the customer could access after authorization. But in such a case we cannot be sure that the information is not changed to the detriment of the customer later on. Blockchain perfectly meets the requirements of a durable medium.
Due to the fact that some banks have opted for WORM technology (“Write Once, Read Many”), several remarks are in order. It seems that this is not a matter of hierarchy – DLT/blockchain and WORM can complement each other. Whether the requirements of a durable medium are met depends on the method of implementation. One can get the impression that the judgment of the Court of Justice of the EU (BAWAG) as well as the doubts of the Polish Office of Competition and Consumer Protection on whether a solution based on DLT/blockchain meets the criteria of a durable medium became an opportunity for some technology companies to promote their own WORM-based products, without taking into account the best interests of the market. It should be emphasized that the requirements for a durable medium can be met in various ways: using blockchain, WORM, a trusted third party, or centralized solutions (e.g. instant payments).
Prof. dr hab. Włodzimierz Szpringer
Collegium of Business Administration, Warsaw School of Economics.
Faculty of Management, University of Warsaw
Last Updated on February 1, 2021 by Karolina Ampulska