The public offering of security tokens on the crypto markets for financing purposes has become a viable alternative for innovative businesses since 2017. The options for funds-seeking companies range from the issuance of so-called utility tokens, which resemble a digital voucher usable exclusively within the business model of the token issuer to so-called security tokens, which grant their bearers participation, rate of return or repayment claims. While utility tokens regularly do not constitute regulated investment products, offerors of security tokens must observe the specifically applicable capital markets regulations, just as providers of traditional investment products. Specifically, providers of security tokens might have to create comprehensive prospectuses pursuant to the EU Prospectus Regulation, the German Investment Code or the Asset Investment Code, if they intend to offer their tokens to investors on a public market.
SECONDARY MARKET FOR SECURITY TOKENS STILL IN ITS INFANCY
The public offering of security tokens does not pose great difficulties from a technical or regulatory point of view anymore. Numerous providers that offer technical support for tokenization projects have emerged. From a legal point of view, it has to be noticed that the competent capital markets supervisory authorities in Germany and Europe have positioned themselves with adjusted administrative practices within the last two years, which allow for token offerings and which are in large parts congruent to the administrative practices that are applicable to the issuance of traditional investment products. That said, the remaining problem of token offerings is the lack of a development of secondary market for security tokens. Even internationally there are only few exchanges that allow for the trading of regulated security tokens. Some established exchanges are announcing for several years now that they intend to create trading segments for security tokens. The economic and legal implementation however is complex and seemingly requires a lot more time than estimated. Investors in security tokens are therefore often facing the problem that their tokens lack tradability, which should be the defining feature of tokenized investment products.
DECENTRALIZED LIQUIDITY POOLS AS A SOLUTION FOR THE SECONDARY-MARKET-PROBLEM OF SECURITY TOKENS?
An option that lately became popular within the crypto market to quickly establish tradability of newly issued tokens is the usage of so-called decentralized Liquidity Pools (LP). Token issuers themselves may create an LP via smart contract on a compatible blockchain, which they can equip with an initially freely choosable amount of their own tokens and with other common cryptocurrencies such as Bitcoin, Ether or e.g. USDC. LPs are Decentralized Exchanges (DEX), meaning that tokens and cryptocurrencies with which they are equipped can be purchased and sold by investors immediately after the launch of the LP via a direct interaction with the specific LP. Tokens of the provider are therefore immediately tradable with the other cryptocurrencies with which the LP is equipped. Even though the creation of Liquidity Pools requires that the provider ultimately commits a certain amount of his tokens and a suitable amount of units of other cryptocurrencies, the fact that he thereby creates an immediately accessible secondary market for his tokens may be worth it.
IS THE INITIATOR OF A LIQUIDITY POOL SUBJECTED TO REGULATORY OBLIGATIONS?
Valid legal arguments can be made that the equipment of a Liquidity Pool with one’s own security tokens in order to create a secondary market would constitute a public offering. That being said, issuers of security tokens will obviously not only distribute their tokens via LP´s and without return but also via traditional distribution channels for which they would be required to create and publish a corresponding prospectus respectively other required investor information and documentation anyways. The question arises, if the initiator of an LP can be considered its operator with regards to the trade activities of the LP which would maybe trigger the obligation to acquire authorization for the operation of a multilateral trading facility. The decisive factor to answer this question is the technical design of the specific LP. An operating quality of the initiator in the regulatory sense will regularly be hard to justify, should the initiator not have any technical influence over the LP after its launch and if he does not receive any trading fees or other contributions from the trading activities of the LP.
Attorney Lutz Auffenberg, LL.M. (London)
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