Can the EU still win the tokenization race?

Just one year ago — at the top of the ICO mania — the EU was well positioned in the race towards crypto use and blockchain/DLTs adoption. When regulators around the world, led by the US, started cracking down on ICOs and crypto markets, the EU took a bit of a “laissez faire” attitude. In hindsight this was good since — despite the initial worries — the damages were very much contained and there was a substantial growth of new businesses and investments in the sector.

And whether this was due to the slow reaction of EU regulators to new developments or — rather — a voluntary policy stance, is anyone´s guess. The result was however positive, specially when compared with blatantly wrong and highly damaging regulatory interventions — such as the NY BitLicense.

Anyways, that was last year in cryptoworld — which is more like 10 years in a traditional sector. Today we face a radically new situation.

I mean, if with ICOs the issuers have profited from a regulatory loophole to issue — in most cases — securities´ tokens disguised as utility tokens (see here for the best token classification framework), now that the sector is turning to securities´ tokens, there will be no more loopholes to exploit. From now on everyone will have to comply with applicable securities´ regulations.

Therefore what will make a difference in the future — in order for the sector to prosper and to grow — are a set of key policy decisions which need to be taken — urgently and decisively — by EU regulators and legislators. This, if we do not want to be left behind by countries which are either more reactive and agile in issuing ad hoc legislation for the sector, or rather have in force a more flexible set of legislation to benefit the securities´ markets. The time for “laissez faire” is over. The EU must act.

Indeed, the competition for the EU is strong. Above all the US, which has the strongest infrastructure and a favourable and flexible set of laws and regulations when dealing with securities and capital markets. Then the UK, which no doubt may take advantage from the Brexit to launch new, flexible and attractive regulatory packages for that sector, while also benefiting from a top notch financial infrastructure which is second to none. Then of course the Asian countries — such as China with Hong Kong — ahead of all. And do not forget Switzerland which — with a great tradition in banking — has all the good cards to play the game and become a very attractive tokenization-hub for EU businesses. In fact they already are a very crypto friendly jurisdiction.

And finally, in case the EU will not act as a whole, there will be more agile, policy flexible and fast thinking countries within the EU, which will carve themselves out a privileged position in the sector. This is in fact already happening with Malta and Gibraltar (depending on where exactly Gibraltar will stand after Brexit), which are able to attract substantial crypto business from all the EU and beyond.

This is however not a net positive for the EU, since it only enforces the trend — which is already under way — of intra-EU jurisdiction shopping.

Let me then articulate what I think is needed for STOs to grow and prosper in the future: 1) availability of investment capital, 2) technological hubs, 3) crypto-exchanges and 4) a friendly policy environment.

Let´s see then where the EU stands on those issues vs the competition.

1. Availability of investment capital for the Crypto sector

According to Crypto Fund Research data of 2017, the US leads by far with 50% market share. Then comes China with 8,8% and the UK with a 6,4% market share. Switzerland comes — after Singapore — with 4%. Germany, the first among EU countries, comes after Canada and Australia with only 2,2% market share. I could not find a detailed number for those EU based funds which have been included among the “other” residual category.

But then looking at the number of funds in isolation can be deceptive, if not compared with the dimension of those funds.

So how much money have those funds under management?

The vast majority of the 620 funds surveyed — 49% of them — manages less than US$ 10m. They are minuscule by any standard. Only 6% of them exceed US$ 100m under management.

And when we look at the top 10 funds by capital under management the EU´s weak position is evident: 9 of the largest funds are US based and 1 is based in China. None among the top 10 is based in the EU.

2. Technological hubs

As far as the top tech global hubs are concerned, the statistics that I have looked at did not differentiate between general tech investments and specifically blockchain or crypto related investments. It is however illuminating to see which tech hubs are attracting more funds and therefore can count on key resources to fund research and development also in the crypto sector.

Even here the EU does not come out particularly well.

According to this report from CB Insights, Silicon Valley beats all by far, followed by Beijing, NY and Shanghai (figure below). Even London does not make the cut to the top 4 and comes only 5th. If we look at the hubs which did the most valuable deals (unicorns), the ranking is exactly the same, while EU tech hubs such as Amsterdam, Stockholm, Berlin and Paris come in that order far down the line. If we tentatively group the 4 most important EU tech hubs, they will all together rank somewhere in between Los Angeles and New Delhi (same figure below).

Also, it is interesting to note that CB Insights classifies the tech hubs as “heavyweight”, “high growth” and “up and comers”. While no EU city makes it to the “heavyweight” league (London does it), there are positive developments among the “high growth” hubs with cities such as Berlin — particularly active in the crypto sector — and Paris, followed by Amsterdam, Barcelona and Stockholm among the “up and comers”.

This is, at least, encouraging.

Moreover, the data in the figure below from Crunchbase News, which looks specifically at Blockchain start-ups, evidences yet again the US, the UK, Singapore and Swiss dominance. Also here we have 46% of Blockchain start-ups which are based in “other or unknown” countries. Some of those will be certainly based in EU countries. But exactly how much of this percentage can be attributed to EU based start-ups we do not know.

3. Crypto-exchanges.

What about then the Top 20 Crypto Exchanges per market share and volume? When I looked up the ranking — the 12.11.18 — Malta based Binance stood out on the 2nd place with a 14% market share. But then, unfortunately, there are no more EU based crypto exchanges among the Top 20. Please note that even if this ranking is extremely volatile — depending on which exchanges attract more trading on a specific day — the exchanges on the top 20 list are more or less consistently the same.

This indirectly confirms that the EU badly needs to incentivize crypto businesses, as it is evidenced by Binance having recently moved to Malta thanks to the efforts of the Maltese government.

Finally, if we take into account the upcoming specialized exchanges for tokenized securities, the situation does not improve. The biggest candidates here are likely going to be Bakkt in the US, the LSE in the UK and SIX and SCX in Switzerland. Again, I do not know where to place Gibraltar based GBX because of the Brexit issue. In the meantime also Deutsche Börse studies the sector, and there are “rumors” about Börse Stuttgart entering the sector. But even if this is confirmed, they will be likely behind the above mentioned early movers.

4. Policy environment.

A competitive policy environment is more important than all of the previous factors in order to foster the growth of the sector and bring a stable flow of investments.

The US has in force a very good set of flexible regulations which benefits so called Emerging Growth Companies (EGCs). This is dealt with by the JOBS Act of 2012, which provides a number of exceptions and relaxed compliance rules to the 1933 Securities Act to favour EGCs when dealing with prospectuses and other information requirements.

Under Rule 506c of reg. D for example, the issuer can do without registering the offering with the SEC provided it only sells to accredited investors. Or the so called Reg. A+, allows a simplified “offering-circular” rather than a full prospectus, together with the possibility of selling securities to both accredited and unaccredited investors up to a US$ 50m offering threshold (please always consult a US qualified lawyer on specific issues).

And what about taxation?

In 2017 the US administration has cut the corporate tax rate from 35% to a flat 21%, a 40% reduction. Now, that´s an incentive to do business when compared with Germany´s 30% or France´s 33%.

But also other countries are not sitting on their hands.

The Swiss for instance, in addition to having an 18% corporate tax rate, they were the first to introduce a new set of ICO guidelines back in February 2018. Since then FINMA did not address specifically the security token issue, but Geneva´s based Mt Pelerin — which claims to be the first tokenized bank — claims to have issued fully compliant tokenized shares representing 5% of its share capital. How they did this — based on the documentation available on their website — it is still not totally clear to me and I will report more on that issue in one of my future articles. However — if this is real — then we must assume that they have done this somehow with FINMA´s knowledge. If so, the conclusion to be drawn is that the Swiss are progressing towards either removing or at least by-passing some existing regulatory hurdles in order to make security tokenization happen.

Now, going back to Brussels, what happens there?

In October a resolution on DLTs and Blockchain was issued by the EU Parliament. It is a first step, but now facts have to follow.

Sure thing securities are thoroughly disciplined both at EU level — by MiFID, Prospectus Directive, AMLD etc — and at national level by overlapping internal legislations. So one may legitimately say that nothing else is needed right? Yet, it is not that simple.

Existing laws and regulations have been crafted for traditional and well known financial instruments and although the same regulations can be applied to tokenized securities, a thorough and unconstrained application may certainly hinder the sector growth. Specially in such a competitive environment where more agile countries create shortcuts and incentives for the sector. In addition, patching up additional layers of new regs upon the old, is often less productive than making “tabula rasa” and have a fresh start with a new specially crafted piece of legislation for the sector.

As we stand now, a number of frictions and incompatibilities must be addressed. For instance, Annex I to MiFID II provides for information requirements about the issuer or the tokens, which can be hard if not outright impossible to apply to start-ups or the trading of tokenized securities on the blockchain.

There are pros and cons for introducing exemptions to current regs. For instance, an Annex to MiFID II could be drafted only for tokens and kept as an evolving reg. paper which could be amended and integrated from time to time when need be. Or, alternatively, a brand new, EU wide, purpose made legislation could be drafted for the sector. Either way, the EU must act without further delays.

Conclusions

Single countries are already at work to solve those issues and to carve out for themselves a leading position to attract crypto businesses. We are aware — for example — of recent round tables and meetings taking place with German legislators and BAFIN regulators on those very same issues. The Merkel government has also announced that a blockchain strategy for Germany should be in place by summer 2019. But, as I mentioned above, this will only increase jurisdiction shopping and, worse of all, this can only be a temporary advantage for single jurisdictions which may well backfire on businesses when the EU — as a whole — will move to create a regulatory level playing field. Therefore my personal message to EU legislators is to come together quickly on that issue, if the EU does not want to loose the opportunity to stay with the leaders in this incredibly promising sector. There is “no need to reinvent the wheel”, just look at what others do and improve on that.

What is needed — in my opinion — is the following:

• a task-force must be created at EU level to evaluate policy measures for the sector staffed with representatives of businesses, advisors and of course policy makers;
• a facilitated compliance “fast-track” is needed, with reduced prospectus and information requirements about the issuer, similar to those mentioned above in the US JOBS Act;
• bureaucracy and compliance costs can be dramatically reduced by doing all the filings electronically;
• a fairly high threshold for raising capital is needed, under which the issuer will benefit from the exemptions and “fast-track” compliance regime. If the US have a US$50m threshold, let´s make it €100m here.
• Taxation is a national matter, however EU countries cannot compete in attracting the highly moveable crypto business with corporate rate taxes of 30% and above. We have to beat the US and Swiss tax rates to compete.
• On the regulatory side a number of modifications to the Annex I to MiFID II will be required together with some other legislative interventions.

Much more on those very same issues you will hear soon from the Think Block Tank (of which I am among the founders and Board Members) which is about to release a pan-European paper, drafted with contributions by the leading lawyers and academics of the sector, analysing the laws and regulations which apply to tokens at both EU level and in seven specific European jurisdictions.

Once friendly and efficient regulatory policies are in place, then capitals will start to flow in and businesses will relocate. Even if the EU lags behind others on availability of crypto funds or crypto-exchanges, once smart policies are enacted the rest will more or less automatically follow suit.

Looking at the business development side of things, at Untitled-Inc we are aware of substantial foreign capital waiting on the sidelines to be deployed to invest in EU tokenization projects. They just wait the green light to start moving in our direction. The hope is that we can get that green light from our legislators sooner rather than later.