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Asset Tokenization – Part II: Regulations and Risks

LEGAL ASPECTS OF TOKENIZATION – PART II

 

The increasing popularity and efficiency of asset tokenization and token issuance are revolutionizing the ways to raise funds and access specific services. However, the legal regulations and structure of tokens vary based on jurisdiction and token type.

It is imperative for token issuers and traders to comprehend and mitigate the associated risks of token issuance and trading. Critical aspects like intellectual property, personal data protection, and contractual liability must be accounted for.

Furthermore, token issuers and traders must adhere to the applicable laws and regulations in each relevant jurisdiction. It is advised to seek legal and financial counsel to ensure the legality and sustainability of token issuance and trading.

Technological solutions, such as Bimount’s BM-Truck, are also available to help mitigate the risks associated with tokenization.

 

TOKEN STRUCTURE

 

A token is a digital unit that represents value or an asset, and its form and structure can vary based on its purpose and function. Tokens can be issued on a blockchain or a specialized token platform. Some tokens represent physical or financial assets, like currency or stocks, while others serve specific functions, such as voting or accessing a service.

Tokens can be classified based on technical and legal characteristics. Common classifications include security tokens, utility tokens, governance tokens, and hybrid tokens.

 

Security Tokens (Equity Tokens)

These tokens are issued as securities and are subject to specific securities market regulations. They represent ownership or a stake in a company or project and usually have a financial value that can fluctuate based on the company’s or project’s performance.

Utility Tokens

These tokens are issued for use within a platform or service, serving as a form of payment or providing access to additional features. They are not considered securities and are not subject to securities regulations.

Governance Tokens

These tokens are issued to enable democratic decision-making within an organization or project, such as voting on protocol changes or new product development.

Hybrid Tokens

These tokens exhibit characteristics of both security and utility or governance tokens. Their classification may depend on the interpretation of applicable laws and regulations.

 

Tokenization projects generally favor security tokens due to their advantages and benefits. Security tokens represent ownership or a stake in a company or project and are issued as securities. As such, they are subject to specific securities market regulations, making them appealing to institutional investors and those seeking regulated and secure investments.

 

TOKEN REGULATION

 

Token regulations can vary significantly depending on jurisdiction and token type. Token issuers must comply with laws and regulations in each jurisdiction where they issue and sell their tokens. Key regulations affecting token issuance include:

 

Securities Regulations

Security tokens are considered securities and are subject to securities regulations. Issuers must comply with applicable securities laws and regulations in the jurisdiction where tokens are sold. In the United States, the Securities and Exchange Commission (SEC) has provided guidelines for issuing security tokens, including the requirement for securities registration under certain circumstances.

Consumer Protection Regulations

Token issuers must adhere to applicable consumer protection laws and regulations, which may cover misleading advertising, unfair business practices, and anticompetitive practices.

Data Protection Regulations

Token issuers processing personal data must comply with relevant data protection laws and regulations, including obtaining explicit consent for personal data processing.

Tax Regulations

Token issuers must comply with applicable tax laws and regulations in the jurisdiction where tokens are issued. This may involve capital gains taxes, income taxes, and other applicable taxes.

 

INTELLECTUAL PROPERTY

 

Intellectual property is another crucial legal aspect to consider in token issuance and trading. Tokens can be backed by digital assets such as patents, trademarks, copyrights, or trade secrets.

It’s important for token issuers and traders to understand the legal implications of using intellectual property-backed digital assets and ensure they possess the necessary rights to do so.

 

PERSONAL DATA PROTECTION

 

Token issuers and traders must comply with relevant data protection laws, such as the General Data Protection Regulation (GDPR) in Europe, to ensure the privacy and security of personal data belonging to token holders.

 

CONTRACTUAL LIABILITY

 

The terms and conditions of contracts governing token issuance and trading must be clear and precise to prevent confusion and conflicts. Among the obligations that token issuers and traders may have towards token holders are maintaining accurate and up-to-date records of issued tokens and transactions, promptly notifying any changes to contractual terms and conditions.

 

Additionally, they must implement appropriate security and privacy measures for personal data of token holders and comply with applicable laws and regulations. Token issuers and traders should also consider dispute resolution mechanisms in case of contractual breaches.

 

LEGAL AND REGULATORY FRAMEWORK OF THE JURISDICTION WHERE TOKENS ARE ISSUED AND TRADED

 

Laws and regulations vary significantly between countries and jurisdictions, which can have significant implications for token issuance and trading. Token issuers and traders must consider and comply with applicable laws and regulations in each relevant jurisdiction to ensure the legality and sustainability of token issuance and trading.

 

RISKS ASSOCIATED WITH TOKEN ISSUANCE AND TRADING

 

The risks associated with tokenization are similar to those related to any security, whether paper-based or digital. This means that investors should take the same precautions as in traditional businesses. The main risks are outlined below:

 

Regulatory Risk

Lack of clear regulation in many jurisdictions can lead to sanctions from regulatory authorities.

Contractual Non-Compliance Risk

Unclear terms and conditions of contracts governing token issuance and trading can lead to confusion and conflicts. It’s preferable to have tokens representing real rights, as personal or credit rights can be harder to enforce.

Investment Loss Risk

Tokens are highly volatile assets, and investing in them can be risky, resulting in significant losses.

Security Risk

Digital platforms and wallets used for storing and trading tokens can be vulnerable to cyberattacks, leading to token and personal data loss.

Fraud Risk

Lack of clear regulation and the anonymous nature of blockchain technology can enable fraudulent activities in token issuance and trading.

Competition Risk

Tokenization allows the creation of competitors that might threaten the market position of holders of underlying assets.

 

It’s essential for token issuers and traders to consider and mitigate these risks by seeking advice from legal and financial advisors.

 

RISK MITIGATION

 

The most critical risks in tokenization are counterparty, fraud, and insolvency risks. These risks can be mitigated through contracts considering the aspects mentioned in this article, but technological solutions also exist to mitigate such risks. A major concern for an investor, donor, or lender is not knowing if funds will be used efficiently for the agreed-upon purposes.

 

Having certainty that funds will not be diverted for other purposes would eliminate a substantial portion of the mentioned risks. For this, a tool that enables real-time, immutable fund tracking with ubiquitous reporting to all parties is needed. Bimount has developed such a tool that can integrate with tokenization platforms. For more information, refer to the following link: BM-Truck.

 

CONCLUSION

 

Asset tokenization is becoming a popular and efficient way to raise funds and enable access to specific services. However, token structure, legal and regulatory framework, as well as associated risks, vary based on jurisdiction and token type. It’s important for token issuers and traders to understand and mitigate risks associated with token issuance and trading and to comply with applicable laws and regulations in each relevant jurisdiction.

 

Moreover, intellectual property, personal data protection, and contractual liability are key aspects that must be considered. As the industry continues to evolve, it’s expected that new technological solutions and regulations will be developed to address risks and enhance the security and efficiency of asset tokenization.

 

Author: Rodolfo José Monsberger, CEO and Founder of Bimount, March 2023

 

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