This document provides a qualitative legal analysis of securitization on blockchain in the Capital Markets Union. The combination of securitization and DLT is relatively new, making legal documents scarce to consult.
INTRODUCTION
Title 5, on the other hand, examines various legal documents related to the issuance, trading, settlement and custody of signed financial instruments. It summarizes the most important observations regarding the implementation, the impact and the legal questions surrounding securitization on blockchain.
THE SECURITISATION OF ASSETS
- I NTRODUCTION TO S ECURITISATION
- T HE L IFE C YCLE OF S ECURITISED I NSTRUMENTS
- The Process of Securitisation
- Legal Provisions for Offering and Trading
- The Settlement of Asset-Backed Securities
- T HE B ENEFITS OF S ECURITISATION
- T HE R ISKS OF S ECURITISATION
- E UROPEAN S ECURITISATION L EGISLATION
Therefore, the owner of the security receives a periodic payment equal to principal plus interest. In the issuer-pays model, the originator of the security pays the rating agency rather than the investor.
THE TOKENISATION OF ASSETS
D ISTRIBUTED L EDGER T ECHNOLOGY AND B LOCKCHAIN
- A Brief Introduction
- The Mechanisms of Distributed Ledger Technology
- Types of Blockchains
- Smart Contracts
- Legal Taxonomy of Tokens
Whoever owns the private key is § the legitimate owner of the wallet and its contents. Also, loss of the private key, most of the time, results in loss of tokens.
S ECURITISATION ON B LOCKCHAIN
- Deployment and Maintenance of Tokenised Asset-Backed Securities
- Offering Document and DLT Risks
Thus, the Securitization Regulation 2017/2402 would apply to all tokenized asset-backed securities falling within the scope of the Regulation. First, the service is responsible for the smooth installation and continuation of the smart contract. Second, as the blockchain operator, the DLT servicer initiates the functions mentioned in section 3.1.4., i.e.
The issuer, which does not benefit from the necessary infrastructure, hires a DLT servicer to perform investor onboarding, install and maintain the trading platform, and implement smart contract functions. Originators of tokenized securities must draw up an offer document that describes the conditions of the offer and the risks associated with it (ALJB, 2020). Permissionless blockchains like Ethereum are public and decentralized, meaning that after adding data, most of the network would be required to reverse a transaction called a soft fork7.
A DVANTAGES AND C HALLENGES OF T OKENISATION
- Advantages of Implementation
- Technical Challenges and Solutions
As mentioned in section 2.2.3., they check that the necessary funds are available to initiate the clearing and settlement of the transaction (Wandmacher & Wegmann, 2020). In addition, DLT could offer new ways to store information, which could improve the quality and accessibility of the securitization data. In addition, smart contracts could enable the automatic payment of dividends at maturity, which would have to be done by the manager of the securitization company (McDonald & Bosco, 2021).
Automating the securitization process is no longer theoretical because companies such as Intain already provide these services (Travers, 2022). An interesting detail about the development of Intain smart contracts is their source of inspiration. Fractionalization increases liquidity and financial inclusion, transparency and accountability strengthen confidence in investment quality, and programmability allows automation of clearing, settlement, structuring and even dividend distribution.
THE SECURITISATION REGULATION
T HE D EFINITION OF S ECURITISATION
The first thing to verify is whether blockchain technology is compatible with the definition of securitization. According to article 2, securitization is a "transaction or scheme, whereby the credit risk associated with an exposure, or a pool of exposures, is divided, with all the following characteristics: a) payments in the transaction or scheme are dependent on the performance of the exposure or of the pool of exposure;. The definition itself does not appear to impede the use of blockchain for securitization purposes.
The Regulation of Security of smart contracts and their legal applicability has not yet led to any clear answer from the European regulators. Therefore, every smart contract is preceded by a legal document which gives the structure of the tranches and how the smart contracts will enable this tranche. It can be concluded that a contract defines installments and that smart contracts constitute the means to execute the contract.
S ELLING OF S ECURITISATIONS TO R ETAIL C LIENTS
However, the discussion may be simpler for securitization because any issuance of asset-backed securities requires the drafting of an offer document which must specify, among other things, the priority of payments for each tranche.
D ISCLOSURE R EQUIREMENTS
- Transparency Requirements
- STS Notification
Therefore, adequate and enforceable transparency requirements are paramount as many SECR articles depend on the influx of information. The SECR has inaugurated that securitization registries will “collect and maintain details of the securitization” and “provide direct and immediate access” to competent authorities and investors (Regulation 2017/2402 Art.17(1)). Article 27 of the SECR introduces the STS notification for this purpose, which states that originators must inform the European Securities Markets Authority (ESMA) when their securitized product meets the requirements and how it meets these requirements (Regulation 2017/2402).
The Securitization Regulation requires institutional investors and competent authorities to carry out a due diligence assessment in accordance with Article 5 of the SECR (Regulation 2017/2402). Another exciting feature for DLT is the use of a waterfall structure in case of default values. 8 “A condition that fully matures the performance owed by the party upon breach of contract” (Swinney, 2016).
GENERAL LEGISLATION FOR SECURITY TOKENS
T HE I SSUANCE OF S ECURITY T OKENS
- Definition and History of AML/CFT
- European Framework
- Legal Challenges of AML/KYC Implementation
- Possible Implementation
In the European Union, the fight against money laundering and the financing of terrorism is combated by means of the 5th Anti-Money Laundering Directive (AMLD5). The DLT Pilot Regime and MiFID II define security tokens as financial instruments and, like all financial instruments, they are subject to the 5th Anti-Money Laundering Directive (5AMLD). The first ambiguity to be discussed is the definition of depository receipt providers in the 5th Anti-Money Laundering Directive.
The definition limits the scope of anti-money laundering provisions to virtual currencies, thereby excluding security tokens. Another debate is how they will combat money laundering and terrorist financing in countries that do not treat security tokens as financial instruments. Since security tokens are not recognized as financial instruments, an institution providing services such as issuance or custody may refuse to perform AML/CFT.
C USTODY OF T OKENS
- Non-Custodial Wallet
- Custodial Wallet
- Losses and Liability
The DLT pilot regime introduces two new market infrastructures that are licensed to provide custodial wallet services, viz. the DLT Settlement System (DLT SS) and the DLT Trading and Settlement System (TSS) (Regulation 2022/858). The trading and settlement regime is of particular interest as it was not included in the first draft of the pilot regime and reflects a pragmatic approach to blockchain. Finally, a holder can send their tokens to an custodial wallet on a crypto exchange that does not support the send token standard.
In this case, Coinbase must provide the user with the private key of the custodial wallet to import it into a non-custodial wallet that supports the BEP-20 standard. Unfortunately, this most of the time leads to the loss of tokens, as custodial wallet providers are reluctant to provide this service (Binance Academy, 2021). This assumption can be made from article 54, paragraph 3 of the Commission's delegated Regulation, which clarifies that investment firms providing services to a professional client may assume that he has "the experience and knowledge necessary to understand the risks involved in the transaction or in the management of his portfolio".
FINDINGS AND OBSERVATIONS
I MPLEMENTATION
A practical illustration of a personal liability scheme can be found in the prospectus issued by Bitbond (Bitbond, 2019, section 2.2.13.). Additionally, they clarify that the investors are solely responsible for protecting the private key and that its loss ultimately results in the loss of funds (Bitbond, 2019, Section 2.2.13.). The paper identifies several challenges, such as anti-money laundering provisions, remittance rules and jurisdictional issues.
Specific to securitization and its conditional access for retail investors, permissible tokens can provide the necessary infrastructure to comply with regulatory requirements. Second, the paper highlights several features that smart contracts will provide to meet regulatory requests or correct issues such as lost or stolen tokens. It can be assumed that issuers of tokenized securities will most likely need to contract a DLT servicer.
L EGAL D IMENSION
The execution of these functions leads to the crucial question of who is responsible for the installation and maintenance of the platform. In 2019, ESMA also confirmed in a Q&A that it is outside their mandate to determine the operational mode of reporting for private insurance and that reporting entities can use any arrangement (ESMA, 2019b, Answer A5.1.4.) The condition of the only thing that applies to both types of assurance is that the data must be wrapped in XML templates. Regardless of the type of insurance, investors should be aware of the tokenization process and the risks it brings (ALJB, 2020).
The entire transaction, from issuance to placement of tokens, must be explained in the offering document. It is essential that a lawyer and a coding expert verify the adequate transposition of the offer document into the smart contract. After analyzing SECR's ability to accommodate DLT, the paper focuses on general questions arising from the issuance and storage of security tokens.
I MPACT A SSESSMENT
Accordingly, other trading venues such as organized trading facilities (OTF) or regulated markets (RM) are not subject to liability provisions. This is not theoretical because companies like Intain are actively building this infrastructure (Travers, 2022). The integration of this information into smart contracts brings standardization to the industry, which was previously impossible.
The standardization of an opaque and overly complex market, such as the securitization industry, must be sufficiently stimulated to prevent any repetition of 2007 practices. There are also limitations to the use of smart contracts for securitization, where the technology cannot be implemented or offers no advantage compared to traditional software. DLT and smart contracts can improve the integration of contractual elements, such as the payment sequence of the installments, but these benefits are reduced when the back-end infrastructure is inefficient (Gaffney, 2022).
CONCLUSION
Retrieved August 15, 2022, from https://www.coinbase.com/de/learn/crypto-basics/what-is-proof-of-work-or-proof-of-stake. Retrieved August 17, 2022, from https://www.outlookindia.com/business/demystified-the-difference- between-crypto-coins-and-crypto-tokens-read-here-for-details-news-197683 Surname, E .
