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I Introduction
Due to advanced technological innovation, there has been a global disruption in the financial services industry allowing new players in the industry to be in direct contact with individual retail clients, overriding the dominant positions of traditional banks, brokers and central depositories. This push has had a positive impact, but also raises significant concern from a regulatory perspective. The development of distributed ledger technology (DLT) has made a noteworthy contribution to the advancement of various types of digital and virtual assets for facilitating economic transactions. This chapter discusses these developments in two different jurisdictions.
One country, Switzerland, saw a need to regulate DLTs themselves and revamped previous laws surrounding negotiable securities and infrastructure to incorporate ledger-based securities, making it the leading jurisdiction in the area of DLTs.
Another country, the UAE – more specifically the Abu Dhabi Global Market (ADGM) – saw that the advancement of technology like DLTs creates the foundation of exchange platforms for dealing in digital assets and created a framework that regulates the digital assets themselves. The hope is that our readers will take away the point that the infancy of DLT in the global financial realm leaves much to understand and regulate according to how this advanced technology is used within its jurisdiction.
II DLT in relation to the finance industry
DLT has changed the infrastructure and protocols for finance exchanges among users. It has gained recognition from its 'decentralised' feature based on a completely digital database.
DLT's infrastructure allows for the simultaneous access, validation and record-updating across a network between multiple 'users' in multiple locations. Essentially, DLT gets rid of the middleman, namely a bank, and allows users to complete exchanges directly between themselves. This network eliminates the need for a central authority to consistently update transaction records, or a central depository to hold physical securities.
This elimination of the middleman is what has been the catalyst behind various legislative updates in the financial sector.
III Regulatory context
While global regulators have been highly vocal in their concerns around cryptoassets, they have shown encouragement and enthusiasm for the underlying DLT infrastructure. In fact, many regulators have been working with industry stakeholders to develop pilot projects and sandbox initiatives to test and trial the technology.
i Switzerland
At the emergence of DLT technology, it was clear that the Swiss law had a real need to be updated in order to increase legal certainty in the transfer of ledger-based security by means of electronic registers.² There was a broad consensus that the potential for increased innovation and efficiency offered by blockchain technology can only be fully operated when the legal framework is optimal.
Therefore, a DLT Lex Revision took place on 1 August 2021. A number of Laws were edited to provide a secure legal basis for the trading of rights through electronic registers. The main amendments proposed by the DLT Lex Revision Act cover approximately 10 federal Laws relating to the Swiss Code of Obligations (CO), in particular on negotiable securities, and include the Federal Intermediated Securities Act (LTI), the Debt Enforcement and Bankruptcy Act (LP) and the Private International Law Act (LDIP).³
Moreover, the segregation of crypto-based assets in the event of bankruptcy has been clarified, and a new licence category for DLT trading systems has been established in the financial market infrastructure law, thereby creating a flexible legal framework for new forms of financial market infrastructure.
These adaptations of the federal law aim at modernising Swiss law by paving the way for more dematerialisation of transferable securities through registered ledger-based security.
From this revision, Switzerland became one of the first countries in the world to enact legal regulations for blockchain technology.
For example, in September 2021, SIX Digital Exchange (SDX), a Swiss Company that acts in particular as a central depository, became the first entity to be granted with a regulatory approval delivered by the Swiss Financial Market Authority (FINMA). This authorisation enabled the latter to fully operate an infrastructure based on DLT for digital securities.
The applicable rules on tokens
The rules surrounding the tokens must be determined according to their nature or categorisation.
In Switzerland, the categorisation of the token will ultimately remain subject to case-by-case assessments by FINMA.
Should the token exhibit the features and characteristics of a security, FINMA may deem the token to be categorised as shares, bonds or derivatives.⁴
From a regulatory standpoint, the issuance of 'digital securities' will bear no difference in their treatment as compared to conventional securities.
FINMA bases its own approach to categorisation on the underlying economic function of the token as follows:
Tokens will be considered securities if: (1) they are standardised and likely to be widely distributed in the market; and (2) they take the form of securities, rights, derivatives or intermediated securities. The first condition depends on whether the tokens are structured and split in the same way, and offered to the public or sold to more than 20 customers.⁵
In practice, once a token qualifies as asset tokens, it is classified as a security under Swiss financial market law by FINMA.
If a token is qualified as a security, it means that it can then be issued on a DLT and become a DLT security.
The applicable rules on DLT exchanges
Framework
The registered ledger-based security (the DLT Technology) is a further step towards the dematerialisation of transferable securities, in addition to the possibilities already offered by the simple ledger-security and the intermediated securities. Nevertheless, the registered ledger-based security differs from the intermediated security as it does not require the use of a depository, either for its creation or for its transfer. This is a manifestation of one of the characteristic criteria of the DLT, namely 'disintermediation'.
Paper securities were usually traded on the financial markets in an intermediated form, held by professional custodians – typically banks or securities firms – who in turn deposit them with central depositories. It was the era of retail-to-retail exchanges.
The use of DLT allows new exchanges without having to go through depositories.
Tokenisation, and the use of DLT technology, challenges central depositories mainly because:
The main benefit of the digitisation of securities is, therefore, not to simplify the operation of market infrastructure. This is a secondary benefit. The real progress lies in the ability of issuers to access the capital markets without being dependent on the risk appetite of third parties. The first benefit is, therefore, disintermediation and the resulting reduction in costs.
It then opens up a brand new customer-to-customer dimension.
The keystone of the ledger-based securities technology remains the register (the DLT) in which it is registered. This register serves as a support for the transactions involving the registered security right.
A uniform definition is, therefore, mandatory and is given by the Swiss law. It is a way to define the minimum qualities that the register must have to be considered as such. This ensures the security of such records, an essential quality. The securities ledger:
In 2018, the Swiss Federal Council admitted that the blockchain could fulfil the function of a DLT.¹²
The CO licensing conditions
A proper DLT system has to respect the rules fixed by the CO.
The FINMA licensing conditions
If the DLT is a trading facility for DLT securities, it will have to match the FinMIA conditions.
According to the Federal Act on Financial Market Infrastructures and Market Conduct in Securities and Derivatives Trading (FinMIA, often referred to as 'the Financial Market Infrastructure Act'), a trading facility for DLT securities is a Financial market infrastructure.¹³
Any financial market infrastructures require authorisation from FINMA.¹⁴
In addition, the requirements for financial market infrastructure associated with licensing and prudential supervision, such as those relating to organisation, guarantors, ancillary services and business continuity, also apply to DLT trading facilities.
DLT trading facilities providing custody settlement or clearing services are also subject to the requirements applicable to central securities depositories. These include, for example, requirements for the custody, booking and transfer of securities, as well as requirements relating to collateral, capital adequacy, liquidity, procedures in the event of participant's default and segregation.
However, in order to take into account the different risks associated with business models, a distinction is made between large and small DLT trading facilities. Small DLT trading facilities must meet reduced licensing requirements.¹⁵
Each DLT must be a legal entity under Swiss law and have its registered office and head office in Switzerland,¹⁶ and the persons responsible for its administration and management must provide the guarantee of irreproachable business conduct.¹⁷
A DLT must ensure fair and open access to its services¹⁸ and respect some rules of organisation such as:
A DLT trading facility shall be a commercially operated institution, which means it shall have independent economic activity pursued on a permanent and on a for-profit basis.²² About its organisation, the DLT shall also establish under FINMA supervision its own regulatory and supervisory functions appropriate for its activity.²³
Securities firms, other parties supervised by FINMA, the Swiss national bank, the Bank for International Settlements and other natural persons and legal entities, provided that they declare that they are participating in their own name and for their own account may be admitted as participants in a DLT trading facility.²⁴
The minimum capital of the DLT must be fully paid up,²⁵ as follows:
A DLT trading facility is considered small if the following cumulative criteria are met:
The lighter regulatory regime for small DLT trading facilities relates in particular to the organisational and governance structure of the trading facility as well as to lower capital requirements:
The FINMA authorisation process
In order to carry out its ruling correctly (and to check in particular if the CO and FinMIA conditions are reached), the FINMA will require in particular the following information and documents:
As explained above, Switzerland revamped its laws to regulate the underlying blockchain technology. However, as noted below, the ADGM sought to create a legal framework regulating the various digital assets that would potentially be traded using this technology instead.
ii Abu Dhabi (UAE)
The Abu Dhabi Global Market (ADGM) is an international financial centre free zone located in Abu Dhabi, United Arab Emirates. Since its opening, it has gained global recognition for its progressive and responsive business-friendly approach. Its three authorities are the Financial Services Regulatory Authority (FSRA or the Regulator), the Registration Authority and the ADGM courts. The Financial Services and Markets Regulations (FSMR) are modelled on the UK's Financial Services and Markets Act and details the powers and functions of the FSRA. The FSMR is supplemented by the FSRA's rulebooks and guidances (further explained below under 'The applicable rules on DLT exchanges'), which detail various requirements for authorisation by the Regulator to conduct certain activity within the ADGM.
The applicable rules on tokens
The FSRA regulates, and allows to operate within the ADGM, the following tokens (also defined as 'digital assets' in the various guidances discussed below).
Digital securities
Digital securities are digital or virtual tokens that have the features of a security (as defined by the FSMR) such as shares. All financial services related to digital securities (including dealing, trading and managing) are subject to the regulatory requirements under the FSMR. Intermediaries dealing with digital securities, such as multilateral trading facilities (MTFs) would need to be licensed under the FSRA.
Virtual assets
Virtual assets are non-fiat currencies (i.e., cryptocurrencies) and are treated as commodities under the FSMR. They are construed under the FSMR as being 'a digital representation of value that can be digitally traded and functions as a medium of exchange and/or a unit of account and/or a store of value, but does not have legal tender status in any jurisdiction and a virtual asset is neither issued nor guaranteed by any jurisdiction, and fulfils the above functions only by agreement within the community of users of the virtual asset and distinguished from fiat currency and e-money'.
Financial services in connection with virtual assets that have been 'accepted' by the FSRA are subject to the relevant regulatory requirements of the FSMR.
Fiat tokens
Fiat tokens are treated as digital representations of fiat currency. When used as a payment instruments, they will be treated as money services under the FSMR.
Other tokens or utility tokens
Other tokens or utility tokens are construed as digital assets that can be redeemed for access to specific products or services that do not exhibit the features and characteristics of a regulated investment or instrument under the FSMR. They are treated as commodities under the FSMR and, unless falling under the scope of specifically accepted virtual assets by the FSRA (as further explained below), they are not regulated by the same.
The applicable rules on DLT exchanges
Framework
The ADGM made its first debut in cryptoasset regulation in October 2017 when the FSRA under the regulating authority of the FSMR, issued its guidance on the regulation of initial coin offerings (ICOs), token offerings and virtual currencies (the October 2017 Guidance). A few months later in June 2018, the FSRA then issued another guidance on conducting cryptoasset activities in the ADGM that is to be read in conjunction with the October 2017 Guidance. At the time, no other UAE free zone had yet breached the topic, and UAE mainland authorities were issuing warnings, via the Central Bank and Securities and Commodities Authority, that it did not mandate or regulate cryptocurrencies and highlighted risks associated with investing in them.
As it was, the ADGM was the leading authority on the topic and, since then, has created an elaborate and detailed framework using a risk-based approach to protect investors and to guide those wishing to take part in the crypto world. Today, the FSRA regulations surrounding digital assets include the following guidances: (1) Regulation of Digital Security Offerings and Virtual Assets under the FSRA (the ICO Guidance);³¹ (2) Regulation of Virtual Asset Activities in the ADGM (the Virtual Asset Guidance, or VAG);³² and (3) Regulation of Digital Securities Activities in the ADGM (the Digital Securities Guidance, or DAG).³³ Together, these will be referred to as the 'Framework'.
For the purposes of this chapter, this ADGM section focus will only be on the Virtual Asset Guidance and the Digital Securities Guidance to give a high-level view of how the ADGM regulates these areas. Unlike the Swiss law explained above, the ADGM does not regulate DLTs specifically. Instead, the Framework considers the fact that DLTs are being used as the underlying platform for those who wish to trade or deal with digital assets using exchanges such as MTFs, and is provides guidance on how to categorise a digital asset and become licensed to deal with it within the ADGM.
Licensing conditions
Virtual assets
Under the VAG, the FSRA will consider the following when determining whether a virtual asset will be an 'accepted virtual asset' that meets the FSRA's requirements,³⁴ and therefore fall under the regulations of the VAG.
To clarify, the VAG does not apply to virtual assets that are: (1) not deemed 'Accepted Virtual Assets'; (2) ICOs or other capital-raising functions; (3) software that is used to mine or create virtual assets; (4) loyalty points schemes denominated in virtual assets; or (5) other activities deemed by the FSRA Regulator to be excluded as such.
In order to use a virtual asset in the ADGM, an authorised person³⁶ must first submit an application for a financial services permission (FSP) with the FSRA. Each application must explain, in detail, how the virtual asset will meet the above criteria. If a virtual asset application is accepted by the FSRA, it is only authorised for use by the applicant. If additional authorised persons want to use the virtual asset, they must submit separate applications for the same. This is to ensure that each authorised person is able to safely use and control the virtual asset, for example by proving that is has the relevant technological safeguards to monitor the identity or transaction of a certain DLT.
By the same token, an authorised person who has already received the FSRA's blessing for using a certain virtual asset cannot apply this approval to another virtual asset before offering it to its clients or customers; another application for this new virtual asset must first be made before the authorised person can take any action on it.
Because the FSRA's case-by-case review of each application, there is no public register of all virtual assets that it has approved for use. This kind of control ensures the clients' or customers' safety and interests come first.
Digital securities
The DAG defines digital securities as types of digital assets that possess the same features and characteristics of a security, which includes shares, instruments giving entitlements to investments, instruments creating acknowledgement of debt, etc.³⁷ Digital securities also include tokenised offerings of securities. In order for the FSRA to assess whether or not an offering of a digital token is regulated under the FSMR, similar to the assessment of an accepted virtual asset, the FSRA considers this on a case-by-case basis. However, unlike virtual assets, the FSRA maintains an official list of securities and can add to this list as it deems appropriate.³⁸
If a digital token exhibits the same economic and legal features and characteristics of a security, then the FSRA will deem it a digital security. The FSRA looks to information provided by an issuer³⁹ via either an approved prospectus,⁴⁰ or in the case of an exempt offer,⁴¹ the documentation associated with the offer, in order to determine if a proposed digital security meets the requirements of a security. In all cases, an offer for digital securities, whether by digital platforms, DLTs, or otherwise will be subject to consistent regulatory treatment by the FSRA.
An offer of securities to the public is a 'communication to any person in any form or by any means presenting information on the Offer and the Securities offered so as to enable an investor to decide to buy or subscribe to those Securities'.⁴² For ease, and because of the risks involved with the digital security industry, the FSRA expects that an issuer that intends to make an offer should be incorporated in the ADGM.
All requirements for an offer of securities are laid out in Sections 58–71 of the FSMR and Chapter 4 of the MKT. The language should be easy to read and comprehensible to investors by using defined terms and proper market terminology that is true, accurate and non-misleading.
In relation to a prospectus, the following information should be disclosed before submitting it for approval by the FSRA:
Cases where a prospectus is not required are detailed in MKT 4.3.1 and are defined as exempt offers. These types of offers can include for example, any offer where the total consideration to buy the security is US$100,000 or greater; of if the offer is made to fewer than 50 persons, natural or body corporate, in any 12-month period.
Additionally, an issuer making an offer of digital securities in or from the ADGM is expected to seek admission of their securities to trading on a recognised investment exchange or MTF operating within the ADGM as well.
Although the use of DLTs is growing considerably in the industry, the FSRA has indicated that it does not seek to regulate such specific technologies.⁴³ Instead, it expects the users of such technology to meet particular requirements in terms of their systems and controls.⁴⁴ The FSRA further expects that DLT will have implications for how digital securities are managed. For example, offers would be linked to a MTF, and therefore where there is control of the access to distributed ledger, there may be a limit on an investor transferring digital securities to another investor. Alternatively, access to a DLT may be controlled by the issuer itself. In any event, the FSRA expects any cost for the transfer of a digital security would be disclosed and dealt with on a reasonable commercial basis.
An offer digital security should be priced in fiat currency. However, it is known that payments for the offer of digital security can be made in both fiat currency and by way of accepted virtual assets. In the case of the latter, the subscription amounts collected will be calculated according to the exchange rate between the fiat currency and the relevant accepted virtual asset at the time of payment.
Non-fungible tokens
In October 2022, the FSRA amended the Virtual Asset Guidance to include a section on non-fungible tokens (NFTs),⁴⁵ given their increasing popularity; people are literally spending millions on digital pictures of apes.⁴⁶ NFTs are cryptographic assets on a DLT with unique digital codes that distinguish them from each other. No NFT can be replicated and, therefore, cannot be exchanged or traded for an equivalent value. They are exclusive in their design and are used as a digital collector's item.
While the FSRA does not seek to establish a regulatory framework for NFTs at the moment, it will allow NFT activities to take place within the ADGM under certain circumstances, once of which is that such activity must be undertaken by the NFT's regulated, active MTF which is also authorised to provide custody services in relation to virtual assets. Additionally, firms conducting investments in NFTs are allowed to do so within the ADGM.
The following is a breakdown of how the FSRA foresees NFT activity taking place within the ADGM:
There are additional requirements from an anti-money laundering perspective, as it is applicable to the entire Framework discussed here, and further requirements for certain funds holding NFTs, but for purposes of this chapter, the discussion is kept to a high-level view of NFTs within the ADGM.
It should be noted that NFTs themselves are outside the scope of the FSRA regulatory oversight, and the MTF/virtual asset custodian would need to satisfy the FSRA approval process before beginning any NFT activity within the ADGM.
IV Conclusion
As is clear from the above, the introduction of technologies such as DLT has rocked the financial field globally. Each country has interpreted this advance in a way that would allow it to regulate DLT activities within its jurisdiction. However, it is clear that the regulation of these digital activities is geared towards its safe use by investors with proper monitoring controls in place to regulate it.
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