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TOKENISATION Are tokens the future of entrepreneurial finance?
The future of entrepreneurial finance
TOKENISATION IS AN INNOVATIVE NEW FINANCING AND CAPITAL-RAISING MODEL FOR ENTREPRENEURS
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BY DR IYANDRA SMITH BRYAN
F
rom as early as the 2000s, entrepreneurs have sought innovative and dynamic methods of raising capital from the public. This is evident in the surge of crowdfunding platforms attracting professional and retail investors that have been at the centre of digital transformation.
Having a significant impact on entrepreneurship financing, tokens have emerged allowing entrepreneurs to receive capital easily, quickly and efficiently. Entrepreneurs can raise capital by issuing tokens to token holders in a similar way as a company would issue shares to its investors, in exchange for consideration (the token price). While tokens customarily are not representative of actual ownership in a company, token holders often seek to acquire tokens in anticipation of such tokens increasing in value following their acquisition and later being sold on a secondary market.
BENEFITS TO ENTREPRENEURS
In modern times, in order to take advantage of the heightened process efficiency and greater ability to access global liquidity pools, we have seen new alternative assets formulated as a result of isolating specific economic functions, such as tokenised cash flows from real estate projects or royalty cash flows from works of art. For the purposes of this article, we will focus on security tokens (see the box on page 33 for definitions).
Security tokens introduce a myriad of benefits to entrepreneurs: first, they protocol of various cryptocurrencies is instituted by the company issuing the tokens, and thereafter, the tokens issued by the company are sent directly to the token holder’s digital wallet address or through a crypto‑exchange. Blockchain is a shared, distributed ledger that facilitates the process of recording transactions or tracking assets in a business network. Thus, blockchain is a distributed database for recording transactions.
The word ‘distributed’ means that there is no centralised storage location, such as a central server or a cloud computing platform; instead, the information and technical transactions are spread across a wide network of computers. The blockchain concept was first discussed in a bitcoin white paper, written by Satoshi Nakamoto, in which he referred to the distributed ledger as ‘a chain of blocks’. In this white paper, Nakamoto suggested a peer‑to‑peer distributed ledger platform for the processing of financial transactions without relying on trusted third parties for their execution.
The network is founded on a peer‑to‑peer distributed architecture, which necessitates consensus calculations and/or algorithms to ensure that the transactions across the blockchain network are duplicated so that the ledger maintains its integrity. What this means is that anyone with access to the blockchain network will be able to see the same information. Blockchain networks can be public and accessible by anyone, such as bitcoin and ethereum, or private and permissioned, such as a corporate network for asset tracking. Beneficially, trust is incorporated into the structure of the network.
In some jurisdictions, tokens continue to be unregulated, while in others, regulatory guidance has been issued or a regulatory framework has been put in place to govern token offerings. In the past, some token issuers took the position that, so long as the token being offered was not a security under the laws of the jurisdiction of its issuance, there was no need to consider whether the token constituted a security in any of the jurisdictions in which the token may ultimately be purchased or resold. It is clear that this reasoning is faulty.
create an innovative new financing and capital‑raising model that leverages scalable efficiencies. They provide enhanced and easily accessible liquidity. Moreover, by removing third‑party intermediaries traditionally involved in the post‑trading process, tokenisation offers significant cost‑efficiency benefits. A study by Ghent University concluded that tokenisation could offer total cost savings of up to EUR4.6 billion by 2030, provided adoption rates were high.
Further, tokens provide customisable opportunities and bridge legacy finance with the new world of digitisation, gleaning benefits from each. Customising and designing security tokens carefully can equip entrepreneurs with heightened abilities to raise more capital easily and quickly. In addition, a data flow free of friction, provided that there is a regulatory framework and adequate policies are in place, permits greater transparency.
THE BLOCKCHAIN
Tokenisation takes place when a new blockchain monopolising an underlying
IS A TOKEN OFFERING A SECURITY OFFERING?
Before issuing tokens, companies should ensure the requisite regulatory and legal analysis is undertaken to determine whether regulation would apply and their tokens could be considered tokens, and the steps that must be taken to ensure adequate compliance. If the primary goal is to raise money, rather than, for example, to build a network, legal and commercial issues are likely to arise that require consideration before conducting a token sale.
For example, in the US, the Chairman of the Securities and Exchange Commission (the SEC) has provided guidance to the effect that the SEC will apply the tests and standards that have been laid down by the Supreme Court of the United States (the Supreme Court) in the well‑established case Securities and Exchange Commission v WJ Howey Co (Howey). In Howey, the Supreme Court held that the offering of a token constituted a security offering subject to the Securities Act of 1933 (the Act).
When determining whether a token offering constitutes a security offering that is subject to the Act, the Supreme Court laid down a four‑prong test. Is there: 1. an investment of money 2. in a common enterprise 3. with the expectation of profit 4. from the managerial efforts of others?
Factors that are relevant to this four‑prong inquiry centre on the manner in which the token is offered and/or distributed. If a token offering is considered to be a security offering, then it must adhere to all securities law requirements, which include requirements to register, cybersecurity requirements, anti‑money laundering and market manipulation requirements, among other regulatory requirements. Further, firms that are handling the token offering, including any exchange or intermediary trading, are also subject to such securities law requirements.
In applying the Howey four‑prong test, the SEC has pursued a number of avenues for regulation. In 2017, the SEC applied the Howey test to digital assets for the first time, when it found that the sale of Decentralized Autonomous Organization (DAO) digital tokens was
What is a token?
A token is a digital representation of a right (or rights) to any tangible (financial or otherwise) or intangible assets, stored and recorded on a blockchain.
There are different concepts of tokens: tokenised securities, security tokens, utility tokens and payment tokens. Utility tokens are primarily focused on supporting and developing a community-based ecosystem by awarding consumptive rights to token holders, while payment tokens are a means of payment in a blockchain-based ecosystem.
Tokenised securities are customarily considered to be a traditional, regulated security type with a digital wrapper; that is, where the proof of ownership in the company is recorded on a distributed ledger.
On the other hand, security tokens tend to have a much more expansive scope and inherent characteristics that are formulated to constitute or represent assets typically of an underlying financial type, such as participation in a company’s earnings streams, or an entitlement to dividends or interest payments, or a combination thereof packaged together. Such tokens may be classified as equities, bonds, collective investment schemes or derivatives, dependent upon their economic functions and terms.
an unregistered securities offering. The DAO offering was issued via a Swiss foundation, and the SEC’s report on the token offering confirmed that the existing US securities law framework applies to token offerings and must be considered even in the case of token offerings occurring primarily outside of the US.
The SEC has also issued further regulatory guidance clarifying its view that the vast majority of token offerings are often structured as offerings of securities, for the primary reason that token holders acquired tokens very likely for the exclusive purpose to later profit from an increase in the value of the token, emanating from the company’s business model and strategies.
THE DARE ACT
In The Bahamas, the sale or redemption of a digital token in exchange for fiat currency or another digital asset is expressly regulated by the Digital Assets and Registered Exchanges Act, 2020 (the DARE Act). The DARE Act defines what triggers registration of an initial token offering under the legislation. An issuer that intends to offer digital tokens for sale in or from within The Bahamas through a token offering shall prepare an offering memorandum and shall comply with the regulations, rules and guidelines to be promulgated under the DARE Act.
The DARE Act applies to: (a) any person who as organiser, issuer, founder, purchaser or investor participates in the formation, promotion, maintenance, organisation, sale or redemption of an initial token offering; and (b) any legal entity carrying on a digital asset business irrespective of the physical location from which the activity is carried out.
Importantly, the DARE Act expressly excludes tokenised securities, non‑fungible tokens, electronic representations of fiat currencies, virtual currencies and certain other types of token.
It is important that entrepreneurs, as they seek to raise financing through token offerings, remain cognisant of the trend of financial regulators to scrutinise and review token offerings, whether in the jurisdiction of issuance or the jurisdictions in which the tokens are marketed or resold. Tokenisation creates new opportunities for raising capital, heightens access to liquidity in a cost‑effective manner and boosts access to new markets in an efficient and more readily accessible way.
Dr Iyandra Smith Bryan is General Manager at Quantfury Trading
