Classifying Cryptosecurities

Introduction

Distributed Ledger Law recently published an article in the Belgian legal journal Tijdschrift voor Rechtspersoon en Vennootschap – Revue pratique des sociétés (TRV-RPS).[1] The article discussed, among others, some of the legislative initiatives that were taken so far by jurisdictions in the US and Europe to enable the issuance of “cryptosecurities”: securities (such as shares or bonds) that are held, transferred and/or issued by means of distributed ledger technology.

One of the article’s takeaways is a proposed classification of cryptosecurities.

Classification matrix

Cryptosecurities exist in many variations, depending on the extent to which distributed ledger technology (DLT) is used, and the extent to which the cryptosecurities receive legal recognition.[2] A distinction can be made between (i) the recording (i.e., keeping the securities ledger up to date), (ii) the transfer and (iii) the issuance of cryptosecurities. In this matrix, we propose a descriptive classification of cryptosecurities based on these three elements.

Use of DLT and legal recognition are essential parameters of a cryptosecurity. It can therefore be useful to compare initiatives relating to cryptosecurities with one another on the basis of these parameters. This helps in quickly getting to the essence of an initiative, and facilitates the communication around the initiative. The classification matrix is intended to provide a framework for this.

Examples

Let’s apply the proposed classification to some real-world examples.

1. Example of a cryptosecurity of category A1: Borsa Italiana has launched an initiative to allow non-listed SME’s to keep track of their stock ledger by using a DLT platform.[3] The platform will only be used to keep track of the cap table, not to transfer shares. Hence, there is only a weak use of DLT (i.e., category A). The project will stay within the boundaries of the existing legal framework; there is no explicit legal recognition of the DLT principles used (i.e., category 1).

2. Example of a cryptosecurity of category B1: In December 2016, Overstock.com Inc., a North-American online retailer listed on Nasdaq, completed the first-ever issuance of cryptoshares.[4] The cryptoshares were issued in the form of book entry shares (for which no share certificates were issued) registered in the stock ledger of the issuer in the name of the shareholders.[5] The shares are exclusively traded on a multilateral trade facility that is operated by a subsidiary of Overstock. com Inc. Transactions in the cryptoshares are settled almost immediately (t+0). The platform comes with some quite radical transfer restrictions built in: the cryptoshares cannot be sold short nor pledged.

In summary, a transaction would unfold as follows.[6] First, the transaction is recorded in the internal ledger of the multilateral trade facility. The updated ledger is then automatically published on the internet (on an anonymised basis). Finally, a cryptographic hash of the updated ledger is registered on the Bitcoin blockchain. This cryptographic hash serves as a digital fingerprint that can be used to verify the accuracy of the internal ledger.

Taking this structure into account, the Overstock cryptoshares can be classified as category B1: there is a moderate use of DLT (category B), but no explicit legal recognition (category 1).

Category C3 cryptosecurities

Several jurisdictions (such as Delaware, France and Wyoming) have been industriously enacting legislation to enable the issuance of cryptosecurities by companies that are governed by their respective laws. If one follows the proposed classification matrix, this makes them the first “category 3 jurisdictions”. Undoubtedly, the first category C3 cryptosecurities will soon be issued.


Footnotes:

[1] M. Van de Looverbosch, “Crypto-effecten: tussen droom en daad”, TRV-RPS, 2018(3), pp. 193-207.

[2] For a classification of cryptosecurities according to legal recognition, see Direction Générale du Trésor (France), “Consultation publique sur le projet de réformes législative et réglementaire”, 24 March 2017, pp. 4-5, https://www.tresor.economie.gouv.fr/Ressources/File/434688. For a discussion of degrees of integration of DLT with the current intermediated structure of listed securities, see P. Paech, “Securities, Intermediation and the Blockchain: An Inevitable Choice between Liquidity and Legal Certainty”, LSE Law, Society and Economy Working Paper 20/2015, 26-28. For a reflection on degrees of technological support, see K. Werbach, “Trust, But Verify: Why the Blockchain Needs the Law”, pp. 43-48, https://ssrn.com/abstract=2844409.

[3] See https://www.reuters.com/article/us-lse-blockchain/london-stock-exchange-group-tests-blockchain-for-private-company-shares-idUSKBN1A40ME.

[4] Zie http://investors.overstock.com/phoenix.zhtml?c=131091&p=irol-newsArticle&ID=2230245 (bezocht 30 december 2017).

[5] This is remarkable, because in the US almost all shares of listed companies are registered in the stock ledger of the issuer in the name of Cede & Co., a nominee of Depository Trust Company.

[6] See the prospectus dated 9 December 2015, pp. 34-36, in particular p. 36, and the prospectus supplement dated 14 November 2016, pp. S-52 – S-57, both available via the EDGAR database of the US Securities and Exchange Commission, at https://www.sec.gov/edgar.

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