Towards acceleration of security tokens and decentralisation

Oliver Völkel (OV): My business partner Arthur Stadler and I started the company back in 2016, so it’s seven years now, and from the beginning, we had a strong focus on crypto and blockchain, primarily bitcoin in the beginning. We were four people back then; today we are almost forty.

Back then, no one talked about tokens and tokenization yet. But Ethereum was already a thing, and in 2017, when the ICO boom took off, we got involved in advising companies who wanted to issue tokens. We advised the first Austrian initial coin offering by a company called Herosphere. It was an economic success for the issuer, compared to some other Austrian projects. And it also was a success for us in terms of the legal structure. The Herosphere token, Hero, was a token you could use to interact with the Herosphere smart contracts.

MJR: A true utility token?

OV: Yes, exactly. And then, after a while, everybody started to talk about the next big thing, security tokens, and a couple of security token offerings were being conducted - although, in the beginning, not legally compliant. But we understood early on that a security token offering is basically an offering of securities. I am still very proud that our law firm advised the very first security token offering in the European Union that got a capital markets prospectus approved for its offering. I still remember trying to push the regulator a bit to make them answer faster so Austria would be the first country with an approved STO. Only a couple of weeks later, Germany followed.

MJR: So there was a race between Austria and Germany?

OV: Yes, and fortunately, we won that race. And since 2018, our company has advised around 50 companies about STOs of all sizes.

MJR: Wow, that’s a lot. But they were not all from Austria, right?

OV: No, not at all. The nice thing is that Austria’s property law is very favourable to using tokens as a carrier medium for securities. In Germany, for example, and several other jurisdictions, that’s impossible because they require or used to require a tangible asset to be the carrying medium for a security, such as paper. But that’s not and was not the case in Austria. And in the terms and conditions of a security, you can choose Austria as the relevant jurisdiction and have Austrian property law apply to the tokens. So even though most projects were not based in Austria, they could still use Austrian law for that purpose.

MJR: So many of these companies came from neighbouring countries?

OV: Not just neighbouring countries. It was also companies from places like South America and Australia.

MJR: What are the latest important developments in the security token space as you see it?

OV: Since 2020, tokens are increasingly becoming an instrument for communication between someone possessing assets and others owning those assets. For instance, in Austria, projects regarding gold coins, gemstones, and rare bottles of wine have been popular. The idea has been that a custodian possesses the assets, and the asset owners trade the assets using tokens. So, what happens from a legal point of view is that the custodian interprets any transfer of the tokens on the blockchain as an instruction to change possession of the asset from the transferor to the transferee of the token.

Demand for advice regarding STOs has remained constant. We have yet to see exponential growth. Currently, people are becoming more interested in tokenizing assets the way I just described it by using tokens as an indicator of who you, as a custodian, possess certain assets for. Using tokens this way, you can transfer real ownership in most assets. That’s the next big thing…

MJR: When talking about the development of tokenization and the security token industry, what is your view on the EU’s DLT Pilot Regime, which has just come into force? Do you expect the pilot regime to accelerate the number of STOs in Europe?

OV: Well, I’m not that big of a fan of the Pilot Regime. It enables certain already existing market players like the Central Securities Depositories (CSDs) to experiment using DLT technology. Still, not many of these incumbent players would even be interested in doing that. So the law was made basically for a handful of people, and it has no practical use for most of the crypto community that would like to see, for example, security token exchanges emerging. So, I’m not that optimistic in terms of the Pilot Regime giving a boost to the crypto economy.

I’ve seen other projects that try to circumvent some of the restrictions regarding the requirements to operate multilateral trading facilities for securities. They seem promising, but it is more of a struggle against current regulation, and the Pilot Regime doesn’t bring much of a benefit, to be honest.

MJR: Okay, interesting; that’s a fairly bold statement! I believe the EU Commission thinks it’s being innovative here…

OV: Yeah, but the biggest problem is that the capital and financial markets regulations were developed around a system that emerged organically over decades. Out of necessity that system distinguished certain functions so that some intermediaries, for instance, were coupled to exchanges. And the reason was that you just couldn’t handle everyone who wanted to trade directly. To have everyone directly access an exchange was just not possible technology-wise just thirty years ago. So you needed intermediaries because the technology was limiting what you could do.

And now we’ve put limitations, for example, market participants needing intermediaries to access an exchange, into law. This separation of functions goes through all financial regulation. It’s not just the intermediaries to an exchange; it’s also the security depositories or central counterparties. And all those functions are separated by law because they developed that way in a time where it wasn’t possible to do otherwise.

Now we have this rather limiting legal system that stipulates requirements where our technology has moved on. So that’s really the basic problem.

MJR: What should be done instead of the DLT Pilot Regime or in addition?

OV: That’s the question, what to do about it? It’s a first step for the EU to introduce the Pilot Regime, but I don’t think it’s going to change a lot. Deregulation is probably the way forward, but that will not happen anytime soon.

Anybody interested should look very closely at what the law stipulates regarding reception and transmission of orders, execution of orders on behalf of clients and dealing on own account under MiFID II because it’s actually possible to emulate what an exchange does without having to be an exchange.

There is a project in Austria, Assetera, which also takes part in the Austrian regulatory sandbox hosted by the Austrian FMA. They aim to establish something like a securities tokens exchange without being an MTF or OTF. There are a few other projects like this one. At the moment it is rather a struggle to find loopholes to build something useful that doesn’t violate the laws.

So I am not that confident that we will see secondary markets for security tokens emerge in 2023 or 2024. I believe it’s going to take a bit longer. And I don’t think the Pilot Regime will bring about a significant change.

Another major discussion currently in Austria revolves around DeFi. When is a DeFi project truly decentralized? In the sense that you cannot view a smart contract as a part or mere tool of a company offering a service.

Why do I bring this up? Because decentralized systems, decentralized exchanges, and decentralized protocols for services that otherwise would be considered to require a license can indeed be built without requiring licenses or being supervised.

An example is one of our clients, an Austrian company with U.S. roots called Morpher. They have created a set of smart contracts and are operating an oracle. The data fed to the smart contracts can be anything like price data for underlyings, and you can use their token to interact with the smart contracts and create what they call a virtual future. This virtual future accepts your bets on price developments, and whenever you close the future and you are correct in your bet, the virtual future creates new tokens. But if you are not correct, it destroys your tokens. We have advised on how to build this system to be truly decentralized, and it’s now built in a way that the Austrian regulator also accepts it as a truly decentralized system that is not subject to regulation.

MJR: Have the Austrian regulators tried to come up with a definition of ’truly decentralized’?

OV: No, not yet. But I think the regulator will eventually state that true decentralization means you do not have legal relationships between the participants who are using a protocol. If you look at how lending is often done in practice, there’s an intermediary; you provide liquidity, which is then managed or passed on. And you can easily pinpoint entities that form legal relationships in many of those setups.

The key to true decentralization is to eliminate all these legal relationships. But you need a lot of legal and technical engineering to make this work. However, there are solutions, and we know that the Austrian regulator also sees it this way.

MJR: Returning to what you said about the secondary market. You doubt that it will take off in 2023, right?

OV: Yes, I doubt that. We need people to find clever ways to circumvent existing regulations because it’s simply unsuitable. Or we find innovative ways of utilizing regulation that can easily be followed, such as a limited MiFID license involving reception and transmission of orders as I said before. That’s not that big of a deal compared to operating an MTF or OTF which is possilble only under the Pilot Regime anyway.

It will either be those smart guys or others that come up with usable, decentralized secondary market structures which are genuinely decentralized in the previously discussed sense. I don’t think it will have anything to do with the DLT Pilot Regime or MiCA [Markets in Crypto-Assets Regulation], which doesn’t cover it anyway.

MJR: But you still do believe that, eventually, the secondary market will open up and accelerate, right?

OV: Eventually, it will. I’ve been a bit overly optimistic in the past ever since we got crypto in the form of virtual currencies. Back in 2016 I expected Austrian banks to offer accounts denominated in bitcoin by 2021. Things take time. Now I try to stay a bit pessimistic and be happily surprised if it all develops quicker.

To speed things up, we need a general shift in thinking, and we probably need a younger generation in CEO positions who have grown up with the technology and understand that we need to focus on it and invest in it. Unless this happens, progress will not be made at the pace actually possible.

MJR: And you most likely find no young CEOs in the current landscape of European CSDs…

OV: Because of the Pilot Regime? No, I wouldn’t know of any, but if there is one out there who is reading this interview by any means, please contact me.