Crypto regulation and where Lykke is going 

November 29th, 2022. 

Nataliya Prysyazhnyuk, Attorney–at–Law, LLM (General Counsel at Lykke) asks 10 questions our users often ask Dr Martin Hess, Attorney–at–Law (External Counsel to Lykke) 

Q1 Nataliya: Lykke Switzerland could rely on your valuable legal advice on regulatory and corporate issues in Switzerland for many years. Also, thanks to you, Lykke has managed to stay on the safe side in this turbulent and unstable crypto market. Could you tell us anything more about this? 

Martin: Lykke launched its first projects in 2016. It always aimed to democratise capital markets and offer regulated services for trading assets in tokenised form for everybody. These aims are still up to date but have been not fully reached so far, neither by the ambitious projects of Lykke nor by its competitors. 

Q2 Nataliya: Why were the targets not reached over six years?

Martin: The reasons for this are manifold: Firstly, the regulators slowly but steadily developed some understanding of the new technology, but often too slowly for start-ups in Distributed Ledger Technology (DLT) such as Lykke. And the regulator's attitude changed over time, so compliance was a moving target.

Secondly, Lykke always was in contact with the Swiss regulator (Finma) and had to follow the development of the regulator's approach. A lot of money and energy were needed for this long path. Once the regulator's requirements became too burdensome, the projects had to be adjusted to a leaner objective. 

Third, the appetite of investors to support the new technology was big at the outset in 2016 and 2017 but decreased over the years till we reached the crypto winter in 2022.

Switzerland’s DLT Act which entered into force in 2021 has provided clarity and certainty on various aspects regarding distributed ledger technology and the business models based on such technology, in particular: 

• the clarity in civil law on the legal effects of tokens in the form of ledger-based securities, 
• the clarity in bankruptcy law regarding the segregation of tokens from the bankruptcy estate
• creation of a new financial market infrastructure called DLT Trading Facility which provides a one-stop shop for trading settlement and custody of ledger-based securities. 

Lykke has kept the skills to profit from the new regulations brought by the DLT Act in the future.

Last but not least, FINMA is still reluctant to give up some practices developed for traditional finance.

Q3 Nataliya: What are the main challenges of creating a new digital security token? 

Martin: First, a digital security token is more complex than paper-based negotiable security. Security in certified form (paper) serves for the following items:

• Proof of ownership – the holder is the owner
• Proof of rights certified in the document, e.g. dividends, voting rights, interest payments
• Proof of transfer of ownership, transfer of documents means the transfer of ownership of use as collateral for full title transfer
• Proof of use of the security as collateral 

Digital security tokens, called ledger-based securities in the Swiss Code of Obligations are not so easily legible as certified security in paper form. The rights in a token are not evident from the outside. Therefore, the law requires from every issuer a registration agreement. It is the first purpose to demonstrate how all the proofs mentioned above for certificated securities are implemented with DLT and how the entitled persons can have access to such proof.

Second, there is still no regulated secondary market for trading digital security tokens in Switzerland accessible to everyone without recurring to an intermediary such as a broker, etc.

Third, for the settlement of transactions in ledger-based securities, a means of payment in tokenised form is missing. This is due to the lack of binding rules for stablecoins in Swiss law.

Q4 Nataliya: Tokenization – what does it mean? And what about its benefits? 

Martin: I am not in favour of tokenising every good and asset. Some items need to remain physical, i.e. food and beverages, animals etc. Tokenisation of financial claims is welcome because it facilitates their tradability.

In case a regulated secondary market exists and a legally approved stable coin for the cash leg of the transactions in tokens is available, trading and settlement can take place without the involvement of intermediaries. The counterparty and market risks for such a set-up would be neglectable or inexistent. 

With the distributed ledger a digital notary for all tokens and transactions is possible. This allows more certainty on past transactions which are all recorded on one ledger and cannot be changed once approved.

Q5 Nataliya: What will happen next in the world of DLT and crypto?

Martin: Crypto meaning the DLT certainly has a future as technology for Financial Market Infrastructures such as payment systems, custodians/wallets or trading venues. Standardised operations like payments or settlements will rather be performed by algorithms of decentralized systems than by centralised systems.

Q6 Nataliya: What about cryptocurrencies?

Martin: First, it is not clear what cryptocurrency is. It is in most cases - depending on the stage of development of the project – in the beginning, a means for financing a project, then a means of accessing a platform and later a means of payment for services on the platform. Some regulators changed, therefore, the terminology to “Crypto Assets”.

Second, I have serious doubts regarding the unregulated markets for so-called cryptocurrencies. More regulation will come and this is beneficial, see the disasters starting with Mount Gox and currently ending at FTX.

Q7 Nataliya: Will the existing regulation apply to DLT?

Martin: If the new technology is used for activities which are already in the traditional analogue world regulated such as lending, issuing derivatives, asset management, structured products, collective investment schemes, trading assets, etc. the provider of such activities will either be closed down by regulators or will have to be licensed as a financial institution in the suitable form (e.g. bank, trading venue, investment fund, broker, asset manager)

Q8 Nataliya: What about DeFi (decentralised finance)?

Martin: I am rather sceptical regarding DeFi. First, even the blockchain could be controlled by several miners if they act in a coordinated way and have 51 percent of the mining power. In the proof of stake systems, staking pools could become too dominant. The concept of DAO (decentralised autonomous organisation) is a dream which has not come true. Most DAOs are governed by their council, i.e. there is a centralised element.

Q9 Nataliya: Often the opinion is published that tokens facilitate money laundering. Is this true?

  Martin: Anti Money Laundering and Counter-Terrorism regulation are constantly developing under the guidance of standard setters such as the FATF. There is a tendency to characterise every token as a means of payment. We do hope that the tendency to consider every financial activity of daily life in tokenised form as financial intermediation will come to an end.

Besides this critical remark, AML laws apply to any financial intermediation with tokens. Financial intermediation is given if the financial intermediary has the power of disposition over third parties’ assets. This is the case for centralised exchanges for digital assets or custodial wallet providers. 

Q10 Nataliya: Which are the use cases for DLT-based projects in the future?

Martin: I cannot cover all possible use cases and mention just three:

• Ledger 1 technology will serve as a basis for financial market infrastructure projects and the IT structure of financial institutions.
• Clearly defined and regulated stablecoins could allow payment services without banks, i.e. the original purpose of bitcoin would be fulfilled.
• DLT will allow verification of goods and the absence of falsification.