DLT: regulation, applications and token sales 101

DLT: regulation, applications and token sales 101

by Joey Garcia ISOLAS LLP

Most people will have, by now, heard of the proposal to introduce a regulatory framework that is intended to capture and regulate firms that use distributed ledger technology (DLT) for the transfer or storage value belonging to other people. The response to this principles based approach to regulation of the emerging, but very quickly developing, space has been fantastic.

“Operators…crave a regulated framework”

Many operators in this area crave a regulated framework for their businesses and operations. Creating a distinguishing layer between a professionally run business and a ‘garage operator’ in this space is critically important for the development of the industry. The security of knowing that you are dealing with a regulated business cannot be underestimated. While regulation may always remain technology neutral, and while Gibraltar is not seeking to somehow attempt to regulate any form of fully decentralised protocol, it is the operators in this space, the ones that are providing intermediary functions that invariably have touch points to the technology, and the underpinning value of the information ‘stored’ on a distributed ledger, that need to be professionally run.

Regulation will bring with it a level of consumer protection that has not necessarily existed in this space before but that is not to say that regulation will protect any person or individual from the underlying risk of exposure to, say, any particular crypto asset but it will ensure that the entry and exit points or ramps are regulated, and that those who are building the infrastructure and businesses using the underlying technology (for certain purposes relating to transfer and storage of value) are well run operations.

I must admit that when we commenced an initiative to provide a framework for this activity around 3 years ago, it was very much virtual currency focused. Today, the proposed framework is thankfully much wider. The speed of evolution in the use and application of this technology is quite incredible and this is why I personally feel that the approach we are taking in Gibraltar is correct and intentionally wide.

Token Sales…what’s a token?

One of the use cases of the technology has been the recent explosion of ‘token sales’ or ‘Initial Coin offerings’ (ICO’s). In ultra-simple terms, let’s consider the recent Uber licensing issue in London.

Let’s consider a case where I want to create a new business to fill this gap in the UK market. I want to call this the SKuber service. For the purposes of the example I will disregard any IP/copyright issues, or licensing issues around the activity. Essentially I believe that the SKuber service is going to be better, faster, more reliable than Uber or actually any other taxi service in London. One of the reasons for this is that it will be cheaper for both the passenger and more profitable for the driver because I will be ‘disintermediating’ the need to the centralised company ‘Uber’ and allowing the driver to receive more of the revenue, while allowing the customer to also pay less by way of fees. People will be able to use the service and interact directly between themselves in a secure way without the need for me to be involved.

To support the Skuber service I am going to create a new ‘token’. This token is basically the internal Skuber currency. You can use the service and pay the driver but only with this new SKU token. To build the Skuber service and infrastructure I am going to pre-sell SKU tokens, initially only to professional investors who are taking more of the enterprise risk, but ultimately to the public who want to use the service and in that way create a network of interested users in my service. People can choose to buy the token now at a set price during a public sale of that token (essentially the ICO) or further down the line through a number of potential
mechanisms or even secondary markets that will develop for the SKU (and which are not necessarily controlled in any way by Skuber).

What I am aiming to do is to build supply and demand for the new alternative taxi service and then use the proceeds of this sale to build the Skuber network (build technical infrastructure, develop the application, incentivise drivers, subsidise car purchases, obtain licenses etc etc). This is of course a very very simple case scenario and there are a multitude of issues that would need to be considered in the above kind of set up, but at a high level this is the principle behind the creation of these new tokens. There are of course platforms that are also infinitely more complex than the taxi service example. Decentralised computer storage, news, prediction market platforms, credit scoring, copy trading or portfolio management, location services, web browsers, identity systems etc etc . The token can have almost any functionality (and well beyond the function of being a simple exchange of value like bitcoin for example). This ‘smart contract’ functionality can allow for logic to be coded into the blockchain creating the ability to replicate many (automatically executing) business processes and the token can represent any functionality desired by the developer

Security vs Utility – regulated or not?

The opportunity for a ‘DLT Firm’ to raise funds in this way is a relatively new phenomenon. However, in the last year more funds have been raised through this crowdfunding mechanism than have been allocated by the entire venture capital investment community. This is not without its complications though, and there are a multitude of risks relating to this activity, in particular, the treatment of the token by different regulatory authorities around the world. Selling something that may be treated as a form of equity, debt, a derivative, option, a form of e-money or an arrangement that may constitute a collective investment scheme arrangement will bring the token within the existing ‘legacy’ legal and regulatory frameworks that exist around the world (and which are by no means consistent). In essence, ‘form will be disregarded over substance.’ Similarly the tax treatment and in particular VAT implications for delivery of a token into another jurisdiction can also be complex.