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Tokens, blockchain and the law

The world of blockchain technology does not cease to surprise and fascinate. Over the last year, one of the most frequently discussed blockchain-associated concepts has been tokens.

I wrote about tokens for the first time in “Legal Aspects of Initial Coin Offerings and Token Crowdsales” in the report on blockchain, smart contracts and DAO of 2016.

Let’s take a closer look at tokens. We can consider them from three perspectives: technological, economic and legal.

Token technology

At present, most tokens are generated on the Ethereum blockchain. Although this isn’t the only platform that can be used for this purpose, Ethereum is by far the most popular. Therefore, we can take it as an example.

Tokens exist due to smart contracts. A corresponding smart contract specifies a list of blockchain addresses (in our case, on the Ethereum blockchain), the number of tokens assigned to each address, the methods used to make changes to this list, such as token transfers, as well as rules for who can make such changes. The technical standard in common use for tokens is ERC20. With these types of standards, individual applications, such as exchanges, do not have to readjust each time to a new token.

Clearly, tokens have no physical attributes. They are just records in a database maintained by a smart contract.

The token economy

With some degree of generality, tokens may also be regarded as a cryptocurrency, like bitcoin. This is because tokens may be seen as accounting units that enable the possession of some asset to be tracked among a group of firms or individuals.

Increasingly, tokens are being referred to as a central element of a whole new set of business models based on blockchain technology. The bitcoin example perfectly demonstrates how tokens, even in their most basic form, enable the creation of previously unheard, innovative and dispersed economic structures (increasingly described as “crypto-economic”).

There are many types of tokens, but the simplest division is into protocol tokens and asset-backed tokens.

The former are used in projects with the objective of creating protocols. A simple example of such protocols are those used by blockchains themselves: they consist of economic rules, implemented using cryptographic methods, among others, which maintain dispersed consensus across decentralised networks. A basic example of this type of token is ether: a token that fuels the Ethereum platform.

The value of protocol tokens does not follow from their association with any existing store of value, but rather to the ability of using them for protocols. Theoretically, the source of ether’s value is primarily the ability to use it for creating smart contracts (although, of course, in practice, ether’s valuation is largely the outcome of speculation and other factors).

On the other hand, the value of asset-backed tokens arises from their association with goods that surround us. Tokens can represent, among other things, shares, securities, property rights and intangible assets (such as IP rights). We are currently seeing a trend towards “tokenisation”, namely moves towards creating tokens that are inseparably tied to various assets. With these types of tokens, the legal aspects are particularly important. This is so, because, it is not usually possible, using just technology, to associate a token with a financial instrument in such a way that the holder of the token has rights that are the same as those of a shareholder – it requires a proper legal structure.

Law of tokens

These days, we read about tokens mainly in connection with spectacular public token sales (or, initial coin offerings (ICO), known also as token crowdsales). The main role of an ICO is to fund projects in which tokens play the main role. Following the wave of successful ICO fundings, we should expect rapid development of token-based projects.

When evaluating the legal nature of such projects, it is becoming increasingly important to define the legal and tax characteristics of tokens. This is because the legal qualification of a token has practical implications for the legal status of its creator (therefore, also legal obligations on that party), for token trading rules and for requirements with respect to other parties (buyers of tokens, or intermediaries in their trade).

Although from an economic perspective it is possible to consider several categories of tokens, such generalisations are difficult, if carrying out a legal analysis. In practice, a separate analysis is required to determine the legal status and the regulatory or tax consequences of each token. As part of it, one must examine:

  • the technological aspects of the given token,
  • the economic aspects of the token (e.g. distribution model, token supply, economic functions of the token),
  • the given token’s context.

This last issue concerns the external conditions in which a token is to function, irrespective of its technological or economic structure, or the token’s planned role in the project. This criterion will be, most likely, the hardest to assess legally, because the context of a given token’s use may change over time, regardless of its creators’ intentions. Today, tokens are in common use as investment (and even speculative) goods, despite having been created for the use value in a given project. Similarly, it is not possible to exclude, among others, that a given token will not start to be used in practice as money (currency). Such external circumstances may be crucial for a legal (and tax) evaluation of the token.

As mentioned, it is difficult to make any generalisations in practice, because each token should be subjected to a separate legal analysis. This difficulty also arises from the fact that tokens with completely different economic and legal characteristics may be in the same technological form.

Thus, a token may be likened to a white sheet of paper (this accurate analogy is from Michał Kibil). One may inscribe on it a legally completely inconsequential text, as a result of which the sheet will remain just a piece of paper. Nevertheless, if it contains the words “bill of exchange”, a signature and other elements prescribed in law, its legal status changes diametrically: the sheet becomes a security. In addition, depending on circumstances, it may also be a contract, a carrier of a work and so on.

The future of token law

There are many signs that tokens will be with us for a long time and will have an increasingly important role to play. In this situation, it may prove extremely ineffective to try to analyse legally each token separately. We should strive for a greater standardisation of legal solutions that would lead to greater legal security for developers of projects involving tokens. One cannot rule out, though, that this may turn out to be impossible without legislative intervention, or appropriate interpretations from public authorities.

Jacek Czarnecki