Utility tokens, in their purest form, provide a means of access to a technology platform or service. Utility tokens derive their value from the demand for that access, rather than from the value of any underlying asset or share in the profits of the venture.
In contrast, the value of a security token is derived from the underlying asset. The nature of that asset is limited only to its ability to be tied to a token, but could include equity, fractional entitlements to a pool of investments, profit shares, bonds and other debts, real estate, commodities and even collectible assets such as art or fine wines. By attributing a digital token to an otherwise illiquid asset, the token can give the asset a tradable quality, an irrefutable record of transfer, the possibility of rapid and 24-hour transaction settlement and the removal of costly middlemen.
Unlike other offshore jurisdictions, the Cayman Islands has not yet expressed an interest in implementing an overarching framework to govern digital assets. Instead, the primary legislation governing securities in Cayman is the Securities and Investment Business Law (SIBL). In this fast-moving sector where the technology is always running ahead of the law, this “watch-and-wait” approach helps the Cayman Islands adapt quickly.
SIBL sets out an exhaustive list of financial instruments that constitute “securities” and requires those who carry on, or hold themselves out as carrying on, a “securities investment business” to obtain a licence from the Cayman Islands Monetary Authority (CIMA) subject to certain safe harbors. While every token is different and requires a full regulatory review, pure utility tokens would not, generally, be deemed to be securities and therefore would not trigger licensing requirements under SIBL. Consequently, issuers, dealers and custodians of pure utility tokens do not generally require licensing in Cayman.
Conversely, most security tokens would be expected to fall within SIBL’s definition of securities. However, as a result of SIBL’s more prescriptive approach to defining securities, certain tokens deemed generally as security tokens may, in fact, not fall within SIBL’s ambit. Moreover, whilst tokenized equities, debt and—where interpreted as a debt to holders—profit shares would be securities under SIBL, their issuers would likely benefit from the safe harbors that SIBL provides thereby avoiding the need to be licensed under SIBL.
As the bear market for ICOs continues, many digital asset businesses have reverted to traditional debt and equity raises. Cayman’s company legislation and the wide choice of corporate vehicles available allows for a great deal of commercial flexibility and lends itself well to tokenized equity and debt issuances. Where Cayman issuers are looking to attract a wide range of investors through equity, we anticipate the tokenization of depository receipts, rather than the equity securities themselves. In such cases, the issuer would issue the equity securities to a licensed depository which in turn would issue tokenized depository receipts, representing those equity securities, to investors. The depository will hold the underlying equity securities on trust for token holders on the terms set out in the depository agreements.
For smaller enterprises looking to attract fewer investors, direct tokenisation of equity interests is possible. Cayman’s Companies Law provides flexibility for Cayman companies to determine the manner for passing shareholder resolutions and the process for transferring their equity securities, both of which can be conducted electronically, with the instruments of transfer completed digitally. Under Cayman law, legal title to a share is transferred when the name of the transferee is entered into the company’s register of members. For a Cayman-exempted company that register may be held electronically, provided the company can produce legible evidence of its contents and, consequently, could be held encrypted on a private blockchain and accessed when required.
Smart contracts built into the tokens can govern those transfers once any pre-set conditions have been satisfied and also ensure that the register of members is updated simultaneously with any transfer. Regulatory concerns over AML, KYC and jurisdictional restrictions can be alleviated in the same way. Digital verification of identities, the receipt of electronic copies of documents instead of traditional “wet ink” paper-based processes and the use of third party providers will, over time, provide even greater flexibility in satisfying increasingly robust AML compliance obligations.
The Cayman Islands has also seen increased interest in the formation of tokenized funds, where an investor’s interest is represented by a cryptographic token, as opposed to shares or other interests or units offered to investors in a more traditional fund structure.
The primary piece of legislation in the Cayman Islands relating to open-ended investment funds is the Mutual Funds Law. A “mutual fund” is defined as a common investment vehicle which issues equity interests (such as tokens in a tokenized fund structure) that allows participation amongst a pool of investors in the profits or gains of such vehicle’s investments and which is redeemable at the option of the investor.
A tokenized fund will typically appoint a board (depending on the legal structure of the tokenized fund), an investment manager, an administrator, a custodian and legal advisers. In addition, a tokenized fund is likely to appoint a smart contract auditor and/or a third party KYC service provider to assist with the KYC process for subscribers. All registered mutual funds must have their audited financial statements prepared or signed off by an approved Cayman Islands auditor and filed with CIMA within six months of their financial year end.
Depending on the redemption rights, token holders may redeem their tokens for cash and/or payments in-kind (or a combination thereof) or transfer their tokens with the written consent of the board. The attraction for holders of these tokens is that they also have the potential to offer liquidity through an exchange.
Notwithstanding their increasing popularity, liquidity remains elusive for security tokens. Few security token exchanges have commenced operations and those that have remain in their infancy.
The tokenization of assets represents the next shift in the blockchain journey. As this latest fund raising model develops and grows in popularity, Cayman’s flexible corporate and regulatory regimes will ensure that Cayman stays at the forefront of this revolution and continue to provide a welcome home for businesses looking to launch the next generation of digital assets.
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