If I buy a token in an asset-based security token offering, will I own a piece of the property? Am I tokenizing the asset?

No. Let’s take real estate as an example. Tokenising the underlying real estate would require tokenization of the Land Registry. This is not what happens. You will most likely own an interest in a share in a company that is the owner of the property. This is an indirect interest in the share, and the share, in turn, represents an indirect interest in the property. The token is an asset-backed security.

That’s an indirect interest. Isn’t that a structured product or a derivative?

If the token could be considered an instrument or agreement under which the return is determined by reference to the change in the price, value or level of property (or a basket of property), then that is a structured product.

This interpretation will influence the regulatory regime that will apply to the offering.

If the token is an indirect interest in shares, are we tokenizing shares then?

Usually, shares or the share register are not being directly tokenized. It may be possible to do so in some locations. It would need the laws of that legal system to accommodate digitization of each step of the share issuance and share transfer process.

Some questions to consider include:

–      Can shares be issued and transferred on an uncertificated or dematerialized basis?

–      If share certificates are needed, then can they be digitally signed in a way that can be hashed?

–      What filings with government registers are needed, and can e-filing be automated?

–      Are digital register of members permitted?

–      Are automated updates to the digital register of members permitted?

–      Can stamp duty processes on share transfers be automated, and handled digitally?

These and other related questions will be answered in different ways in different places. Sometimes solutions can be found; sometimes not. If a solution cannot be found, then the issuer can choose another location, wait for laws to be updated, conduct a traditional security issuance, or find an alternative tokenized approach.

What kind of alternative tokenized approach?

The alternative that is presently used more frequently is for the company to issue shares to a custodian. The role of the custodian is to hold the shares (and hence the share register) static. Sometimes a trustee is used instead of or in addition to a custodian. This depends on the structure and the token rights. Then, the company declares that a digital token represents a right that is derived from and linked to the shares. This is typically a right to an earnings stream such as dividends, but can also include voting rights and other rights associated with shares. This is a structure similar to depositary rights.

Sounds complicated.

It is an additional layer to the legal structure used for the investment arrangement. So, it is an added level of complexity.

This is an offering to the public. Is the asset-owning company a public company?

Public companies could be used. But it doesn’t have to be a public company, and usually will not be. It will normally be a private company.

A private company is a company that, by its Articles of Association, limits the number of its members to fifty, is prohibited from offering its shares to the public, and contains restrictions on the transfer of its shares. A share is the share in the capital of the company. The company only has regard to the person entered in the Register of Members as the owner of that share. This person is the legal owner of share.

Even though it is private company, an indirect interest in its shares is being offered more widely.

Isn’t that contradictory?

It is possible to separate legal ownership to shares from equitable interests in or rights to the shares. Only indirect rights linked to shares are being offered widely in the token offering. When that token is traded in the secondary market, then only the indirect interest is being traded, not the legal interest in the share itself. The legal interest in the share remains static, and that legal interest will have restrictions on transfer prescribed by the Articles of Association.

So it is not contradictory, but it may seem counter-intuitive.

Can a Hong Kong private company limited by shares be used for this purpose?

Theoretically, yes, but unlikely in practice. Stamp duty is assessed on the transfer of a beneficial interest in shares under Hong Kong tax law. Even though security tokens are not shares, they may represent an interest in shares, and stamp duty may be assessable on transfers of security tokens. A better location might be a location that does not impose stamp duty on share transfers, or has an electronically enabled system for submission and payment of stamp duty.

Is this likely to change?

Perhaps with maturity of the ecosystem. So watch this space, but don’t hold your breath.