The Magical World of Digital Security Tokens and Why You Shouldn’t Characterize Traditional Finance As a Dark Art — Part I of 2

Introduction

One of the fallouts of the COVID-19 crisis is a renewed focus on the benefits of digitization across industries- As an international lawyer [1]who has burnt the midnight oil for 15+ years on cross-border traditional finance deals, I am all too-familiar with the limitations of the traditional finance world-from general issues around its lack of flexibility, lack of access and indeed cost and process inefficiencies entrenched into its eco-system. Those limitations are the subject of another article (if not a thesis) as indeed is the story of how a formerly “traditionalist” and fairly “tech-phobic” lawyer like me has chosen to embrace the digital finance world, lived to tell the tale and indeed thoroughly enjoyed the journey!

For the purpose of this article, suffice to say that this journey into digital token advisory in its various forms has included several adventures of the legal kind- including advising on some funky STOs and generally unique blockchain-projects[2])] — This has left me fully in agreement with the proposition that the concept of “security tokens” will bring about a game-changing disruption to the world of traditional finance.

However, I believe that the security token industry suffers from a “perception” problem in relation to traditional finance- I will go on to explain what I mean by this and why, in my view, this seemingly small problem has more serious implications than what one may initially think.

The Perception Problem of Traditional Finance and Why It Matters

The “perception” problem of traditional finance that I’m referring to is the extreme negative perception of traditional finance that many security token enthusiasts have: painting everything to do with security tokens as “good” and everything to do with traditional securities products as “bad”.

Many digital token proponents do not just believe that security tokens will disrupt traditional finance but also that the digital economy will make all aspects of the traditional finance world completely and totally irrelevant.

My point is that this “binary”, “either or” line of thinking is simply not correct and is also counter-productive from an efficiency standpoint: And efficiency is a particularly important point underlying any discussion on digitisation generally and for security tokens in particular given that their associated cost and process efficiencies are touted as one of the key advantages over the traditional finance world.

I will go on to explain why…[And go on, you know you want that mug of coffee ]

There are two good reasons why traditional finance isn’t a Dark Art to be rejected outright. First, this is stating the obvious but just to get it out of the way: The traditional finance framework simply cannot be ignored because whether we like it or not, security tokens are an investment product and therefore the traditional laws governing investment products apply. Security tokens do not and cannot exist in a parallel, “lawless” universe. So, as an example, the oft-cited proposition that securities law restrictions don’t apply to security tokens (enabling “democratization of the capital markets”) is simply incorrect.

Secondly, and even more importantly, there are many tools, tips and tricks from the world of traditional finance world that can be very usefully deployed in the world of security tokens. A lot of the ground work has already been done in the traditional finance world across trillions of deals over the years that can be extrapolated to and leveraged for the digital token ecosystem — be it the crafting of well-established “documentation architecture” or indeed innovation in capital-raising structures (one easy example is the use of securitization techniques for structuring an asset-linked STO, something I experienced firsthand while doing an art-linked STO back in 2018).

What is also often missed is that several of the challenges faced while structuring a security token are not as novel as we think. Issues of traditional investment products in emerging markets in particular often require bespoke legal structuring and document drafting and the formulation of an effective strategy to manage regulatory risk in a multi-jurisdictional context (through creation or adaptation of a “best practices” framework)-exactly the same challenge faced on structuring an STO.

The challenges that one faces while structuring an STO are also similar to the challenges that one faces while structuring any first-of-its-kind traditional investment product- the same “whiteboard” brainstorming is required to anticipate different kinds of impediments that could impact deal closing. One common challenge on the legal front is how to put in place a strategy to manage the often intangible and seemingly unquantifiableand risk of operating in jurisdictions or business verticals where the regulations are less than clear or where the regulators may not be experienced in applying old-school laws to new age products. In addition, there is the all-important but oft-ignored process issues [1] in launching a new product — granular questions relating to clearing, settlement and how commercial terms relating to payments, amendments and the impact of corporate action events will play out in practice.

But SO What? I don’t Care About Armchair Theorizing…

You may be wondering if the purpose of my writing this piece was to engage in some boredom-driven armchair theorizing. You may also be wondering if I actually wrote this piece sitting on that chic armchair. The answer to both those questions is no.

The purpose of this piece is to set the stage for a series of articles that I propose to write on structuring digital tokens which will leverage both my traditional finance and my digital token advisory experience- In Part II of this piece , I will support the proposition that I’m setting out in this piece through a real-life example from the traditional securities world -principally, certain best practices and learnings on disclosure and marketing practices for traditional securities that can be very usefully deployed for security tokens as well. And the armchair photo is simply to keep your attention- Thank you pixabay!

But Wait: What is the Harry Potter Connection?

In simple terms, to draw an analogy from the Harry Potter series: Enthusiasts of the digital economy tend to characterize traditional finance as a Dark Art. My proposition in this article is that this gives traditional finance unnecessary and disproportionate bad press — and ignores the fact that even critics of the “Dark Arts” recognize the need to master it and then selectively deploy it for the greater good!

In Part II of this piece , I will also apply some traditional finance “magic” to metaphorically pull out of a hat something that will help STO issuers deal with one of their key challenges in structuring the issue of a security token- Understanding what managing their securities law risk exposure means from a practical perspective.

As icing on the cake- the “something” will be in an easy-to-use checklist form — and will thereby also address, in one fell swoop, the common criticism of securities lawyers being unable to convey information in an “easily-digestible” form!

If you want to make sure you don’t miss Part II of my piece when its published, watch out for my updates on LinkedIn (https://sg.linkedin.com/in/pooja-sinha-singapore).

[1] The views expressed herein are in my individual capacity and do not represent the views of my firm. The contents herein are purely informational and should not be construed as legal advice or opinion. Please contact me or another lawyer for advice on the specific risks that may apply to your fact situation.

[2] In addition to ICOs, STOs and IEOs, I’ve provided general structuring advice and documentation support to a range of clients in the blockchain-enabled economy including:

· blockchain-enabled start-ups offering a single product or service on overall risk mitigation, commercial terms and licensing strategy;

· “traditional” start-ups leveraging blockchain technology for the implementation of their business model;

· tokenized fund formation vehicles;

· bespoke structures for investing in digital assets including both traditional funds and more complex, leveraged structures; and

· different kinds of exchange or quasi-exchange platforms that effectively connect buyers and sellers of digital assets.

[3] In my experience, one aspect that is often ignored in structuring a security token is how the operational limitations of the token issuance platform can affect the commercial terms of the token.