An extract from The Virtual Currency Regulation Review - 2nd edition

Introduction to the legal and regulatory framework

While there is a wide variety of cryptocurrencies and digital tokens with differing characteristics, most cryptocurrencies are a cryptographically secured representation of a token holder's rights to receive a benefit or to perform specified functions. However, from a legal perspective, it is critical to distinguish between these digital tokens, as the offering of different types of digital tokens may trigger different regulatory considerations. At last count, there appear to be broadly four categories of digital tokens: digital payment tokens, security tokens, utility tokens and asset-backed tokens.

i Digital payment tokens

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 Payment Services Bill (the Bill) was intended to streamline the regulation of payment services under a single piece of legislation, expand the scope of regulated payment activities to include digital payment token services and other innovations, and calibrate regulation according to the risks posed by these activities. The Bill was passed by Parliament on 14 January 2019 and became the Payment Services Act 2019 (the PS Act). The PS Act is expected to come into force once the regulations supporting the PS Act have been consulted on and finalised.

Under the PS Act, a digital payment token is defined to mean 'any digital representation of value that (1) is expressed as a unit (2) is not denominated in any fiat currency and is not pegged by its issuer to any fiat currency (3) is or is intended to be accepted by the public or a section of the public as a medium of exchange, to pay for goods or services, or discharge a debt (4) can be transferred, stored or traded electronically and (5) satisfies any other characteristic that MAS may prescribe'. Bitcoin and Ether are examples of digital payment tokens.

Digital payment tokens are not currently regulated, as they are not considered securities or currency. MAS has now proposed that where someone deals in digital payment tokens, that person could potentially be construed as providing a digital payment token service under the PS Act, triggering licensing requirements.

ii Security tokens

On 1 August 2017, MAS released the following statement:

the offer or issue of digital tokens in Singapore will be regulated by MAS if the digital tokens constitute products regulated under the Securities and Futures Act [Chapter 289] (SFA) . . . MAS has observed that the function of digital tokens has evolved beyond just being a virtual currency. For example, digital tokens may represent ownership or a security interest over an issuer's assets or property. Such tokens may therefore be considered an offer of shares or units in a collective investment scheme under the SFA. Digital tokens may also represent a debt owed by an issuer and be considered a debenture under the SFA.

The Securities and Futures Act is the primary piece of legislation that governs securities and investment in Singapore. Where digital tokens are construed as securities under the SFA, such digital tokens would be subject to the various requirements of the SFA. Most commonly, these include licensing requirements for the regulated activity of dealing in capital markets products (the definition of which includes securities) and prospectus registration requirements for offering securities or securities-based derivatives contracts to persons in Singapore.

The term capital markets products includes any securities, units in a collective investment scheme and derivatives contracts. The term securities, in turn, includes shares, units in a business trust or any instrument conferring or representing a legal or beneficial ownership interest in a corporation, partnership or limited liability partnership and debentures (i.e., bonds or notes). The term securities-based derivatives contracts means any derivatives contract of which the underlying thing or any of the underlying things is a security or a securities index, but does not include certain derivatives contracts prescribed by regulations.

There is a risk that a digital token falling within the described instruments above would be a capital markets product, and for the purposes of this chapter will be referred to as a security token. However, it would be prudent to go further and say that if a digital token displays characteristics that the various financial products that form the definition of capital markets products are typically associated with, there is a risk that they may be construed as a security token and trigger licensing requirements for dealing in capital markets products and prospectus registration requirements under the SFA. This is discussed in further detail in Section II.

iii Utility tokens

Utility tokens typically arise in the context of an initial token offering or an initial coin offering (ICO). At a basic level, an issuer offers digital tokens to participants through blockchain and cryptocurrency technology. Participants typically transfer digital payment tokens (such as Bitcoin or Ether) to the issuer in exchange for digital tokens at a predetermined exchange rate. The digital tokens issued are often designed to be usable to pay for the products or 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, digital 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 (i.e., the share value of the company).

Digital tokens may also have other rights attached to them. In many jurisdictions, there are financial regulatory concerns surrounding ICOs, generally revolving around the proper legal categorisation of the digital tokens issued pursuant to an ICO. The issue is likely to be determined based on whether such digital tokens are effectively capital markets products (or their equivalent in each jurisdiction), and the follow-on applicability of prospectus registration and financial regulatory licensing 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 capital markets products keeps to a prescribed level of operating standards, both in relation to its internal operations and its dealings with customers and clients. Where digital tokens are taken not to be capital markets products, consumers may end up bereft of the protections afforded by such laws.

Notwithstanding the above, it is by no means clear how a digital token will be categorised in different jurisdictions.

When dealing with utility tokens, a fundamental consideration is often to ensure that the utility tokens are not characterised as capital markets products and do not display such characteristics (i.e., the tokens are not security tokens). As mentioned above, dealing in capital markets products 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. It is also advisable to ensure that the underlying product or service that the utility token holder is able to access is not in itself regulated.

iv Asset-backed tokens

One of the benefits of blockchain technology is the ability to tokenise virtually any asset. The technology 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 token.

One commonly tokenised asset belongs to the category of precious metals. In effect, what typically transpires is that the issuer of a token (or a related corporation) has a store of precious metal and 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 of the token). This is possible as there is no limit on 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 advising on tokens that represent ownership in precious metals, consideration should be given to whether this triggers any regulatory implications. By way of example, the buying and selling of tokens may be construed as undertaking spot commodity trading under the Commodity Trading Act (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 digital tokens relates to the tokenisation of real estate. One example is where an issuer collects monies (fiat) from purchasers of a 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 dealing in capital markets products under the SFA. 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, thus triggering licensing requirements therefor, unless exempt. A unit in a collective investment scheme falls under the definition of a capital markets product under the SFA.

Looking ahead

As discussed in Section I.i, the PS Act will streamline the regulation of payment services under a single piece of legislation, expand the scope of regulated payment activities to include digital payment token services and other innovations, and calibrate regulation according to the risks posed by these activities.

When the PS Act comes into force, payment firms will only need to hold one licence under a single regulatory framework to conduct any or all of the specified payment activities. Only payment activities where payment firms face customers or merchants, process funds or acquire transactions, and pose relevant regulatory concerns will need to be licensed. The new framework will expand the scope of regulation to include domestic money transfers (e.g., transferring money through payment kiosks), merchant acquisitions (e.g., acquiring transactions through a point-of-sale terminal or online payment gateway), and the purchase and sale of digital payment tokens.

To help ensure that the expanded scope of regulation is not onerous, the PS Act will differentiate regulatory requirements according to the risks that specific payment activities pose rather than apply a uniform set of regulations on all payment service providers. This can be seen from the calibrated approach that MAS has taken in the AML Consultation.

The PS Act will empower MAS to regulate payment services for money laundering and terrorism financing risks, strengthen safeguards for funds belonging to consumers and merchants, set standards on technology risk management, and enhance the interoperability of payment solutions across a wider range of payment activities.