On the legal validity of tokens

– an interview with Charles Kerrigan, Partner at CMS, author of several books, and one of the UK’s leading influencers on blockchain.

In this interview, we will discuss some of the more tricky questions surrounding the legal validity of tokens. We are especially interested in asset-backed tokens. When buying an asset-backed token, how can rights such as ownership be ensured not only for the token but also for the asset represented by the token? 

Is keeping an off-chain ownership registration and certification parallel to the on-chain token necessary? Or should it be legally possible to eliminate the off-chain part completely and introduce a new kind of ‘nativeness’ even for asset-backed tokens? And is that even desirable? A few countries, like Liechtenstein, have already taken that step, while most others, including those governed by English law, are still more reluctant or undecided. 

Partner at CMS in London Charles Kerrigan knows these questions and the different jurisdictions’ standpoints better than anyone.

Michael Juul Rugaard (MJR): In your latest book, Crypto and Digital Assets Law and Regulation (Nov. 2023), native tokens are one of the topics discussed, and for our discussion today, this might be a good place to start. In chapter 10, you discuss the difference between native tokens/native issuance and non-native tokens issued by a ‘proof of ownership model’. So, first of all, could you please help define this term? When is a token a native token?

Charles Kerrigan (CK): The most straightforward definition of a native token is to say that it only has existence on-chain. But there’s more than one answer to this, and I would like to answer it by telling a story about how lawyers have been working with these things – if you want to hear it?

MJR: Yes, absolutely!

CK: Okay, and I’ll reference English law, which is precedent-based. This is the common law system, unlike the civil law system. The judges can kind of develop the law, and lawyers like to categorise things. So, lawyers have categorised types of property, and for about 150 years under English law, we have clear categories of property. We have tangible property and intangible property. Tangible property you can bump into or trip over. Intangible property, you can’t. Cryptoassets clearly can’t be tangible property. 

MJR: Not physical… 

CK: Exactly. So, when we look into definitions of intangible property, some things are covered by the common law that judges make and some by legislation. Intellectual property rights are the best example of intangible property created by legislation. Under English law copyright exists because we have the Copyright Act, which says when a copyright is recognised by our law. Under common law, the best example is contracts. They are property because you can go to court and a judge will recognise your interest and give you remedies for that interest.

Turning to crypto, bitcoin is the classic example. We’ve already established that it’s not in any of the categories of tangible property. But when we examine categories of intangible property nor does it fit with those. It isn’t intellectual property because its creator has made it open source and disappeared. But it’s also not a contract because, among other things, there aren’t counterparties as we need them to establish something we recognise as a contract. If you buy a bitcoin, that’s different: you are buying from someone who owns it. But that isn’t a transaction with bitcoin. The significance of crypto falling outside our rules for what is property started around 2018 because bitcoins became valuable. Once that happened, people started stealing it. When cases were heading to the courts, we realised that the property analysis was a problem. Theft is defined as taking someone else’s property.  So the offence of theft hangs off there being property.

We faced the unfortunate possibility of criminal cases where the defendant would stand up and say I did take the bitcoin, but I didn’t steal it. Theft requires me to steal property, and I didn’t do that.

To fix this, in 2019 there was a statement sponsored by the most senior judge in the UK, and I was involved in that. It said that if we go back to first principles, property has certain characteristics like it’s identifiable and it can only be owned by one person at a time. So, the legal statement got us to the position where we weren’t embarrassed but there was still work to do, and that is what you can see has been the wonderful work of the UK Law Commission since then. Their digital assets consultation paper and final report are masterworks. And in this way, crypto has inspired some of the most notable fundamental legal work in the UK in my career.

MJR: Okay, so now we know that bitcoin is a property that can be stolen. But what about tokens representing an asset? 

CK: Well, we fixed the problem by saying that a crypto token is a property, and bitcoin is a native crypto token – we mean that there is nothing apart from its on-chain existence. But, by fixing this problem, we raised a new problem: When you put, for instance, a bond on-chain, the representation on-chain is a piece of property according to this analysis, but we already know that a bond contract is a piece of property. Now it looks like we’ve got two pieces of property when we really only wanted one! 

We can address this by interpreting this form of digital asset as not being distinct from the underlying financial instrument. And to be sure, we have a clause in the contract that says these two things can never exist apart from one another. We call this stapling.

MJR: So, would that be what you could call a certificated, tokenized asset, a token that is stapled together with some kind of certificate and registered in some central register like a CSD – a central securities depositary? In contrast to a fully native and uncertificated token?

CK: We’re trying to avoid a separate analysis relating to certification. A bond can be certificated or not under its terms. That doesn’t change the analysis in relation to tokenization. The issue with CSDs arises because the regulations don’t contemplate assets that are natively on-chain. The regulations predate wide adoption of digital assets.

MJR: But what about those in the industry who would like to see more decentralisation and suggest getting rid of anything but the token registered only on the blockchain?

CK: The technical people would definitely prefer that. The regulators aren’t so sure. But if we can convince them that features of blockchains such as immutability and transparency make their job easier, then they would support efforts to update the CSD regulations that are currently an obstacle.

MJR: But it’s already possible in, for instance, Lichtenstein…

CK: Yes. true, where you have a blockchain law. Luxembourg and Switzerland as well. In those countries natively on-chain shares and bonds are specifically recognised under new laws.

MJR: But if we don’t pursue that new path, wouldn’t that be to remain in the past and prevent ourselves from fully reaping the potential of tokenization? 

CK: We have this conversation a lot with the technologists saying exactly what you are saying. The other side of that argument, represented most by the regulators, is that where people’s money is concerned, things have to be done in the safest possible way. And the safest way of making a change is to have the old registers as well for a time, as a back up. So initial approaches tend towards belts and suspenders, as the Americans would say.

MJR: But then you are stuck with a seemingly inefficient situation where you need to handle and update everything in two different systems? 

CK: For a period, yes. But we wouldn’t expect to be doing this in five years. This is what I hope we will look back and see as a transition period.

MJR: Okay, so when this transition period is over, what sort of development do you expect to see in the jurisdictions governed by English law?

CK: I think it’ll be what you describe. Maybe I’m being too optimistic, but I have now spent so much time with the techies that I can’t help seeing it from a technologically positive point of view. 

I also think we’ll move towards permissionless blockchains. And then the next question will be about decentralised operations. And it’s not so easy to have a hybrid model here like having on-chain and off-chain ledgers: you are either decentralised or not. However, the jump into decentralisation will be extremely difficult from a regulator’s perspective because it will be experimental. 

MJR: But let’s say we manage to make the DeFi jump. Do you think that will come with a price? For instance, with the current stapling methods, it’s likely not a big deal if you lose your private key. It will still be possible to document the token’s rightful owner if it’s registered in a CSD, and a new token can probably be issued. But what if that part is gone and everything is decentralised, and you lose your key or it’s being stolen?

CK: Yes, you are right. Your argument is for customer safety, while the proponents of decentralisation argue to avoid a single point of failure. They would say that since we know that anything can be hacked now, having a centralised entity holding the only record of all the information, in theory, sounds like a terrible idea.

On the other hand, I think one of the most interesting things about the CSD regulations is they were a regulatory response to the financial crisis to deal with the fact that the derivatives market, in particular, was so fragmented, and there was more risk in the market than people understood. The European Commission’s answer to that was the requirement of using a CSD. 

However, an alternative could be to use blockchains, where all the information is transparent. A blockchain is a technical solution that could address the structural solution introduced by the policymakers. I am attracted by that argument, but the regulators I talk to seem to think that this is an interesting observation rather than serious policy. But perhaps it will change.

MJR: So we are not quite at a stage yet where regulators will say: okay, that’s a great idea. Let’s just record everything on blockchain, and then we are good to go, and everybody is happy and safe…

CK: Not yet!

MJR: If you, from an English law perspective, should look for inspiration elsewhere in other jurisdictions, where would that be? Would you, for instance, take inspiration from Liechtenstein and its token container model, or would you look at legal frameworks developed in Switzerland or Luxembourg? These are all examples of rather innovative countries that have come quite a long way in answering the questions of native security tokens and certification requirements.  

CK: Well, those three are the ones that we look to. Lichtenstein, Luxembourg, and Switzerland have gone further and been more holistic in their approach than most common law countries. So, they’re generally what I’m referencing when I am having this conversation with lawyers. 

MJR: Okay, so do you expect English law to move in that direction step by step? And what timeframe are we talking about?

CK: Adoption can come in unexpected ways. While we were thinking through the challenges of making the tech efficient and safe, we had a win with the crypto ETFs recently being licensed in the US. Suddenly things happened very fast – $50bn of bitcoin exposure through traditional financial products. What happened in that case was a meeting of customer demand and a few heavyweight incumbents, which just knocked everything else out of the way and changed that game.

So, I think this is a pretty good time to have this conversation. In every report I have read about BlackRock and other ETFs, the amount of money invested kept being described as “mind-blowing”. And it really was. 

MJR: That’s very true; when someone like Larry Fink, in his position as CEO of a giant like BlackRock, decides to act, it’s almost like a kind of gravity power that affects everything in its proximity. It’s a power able to move and accelerate things if it wants to.

CK: Yes, I completely agree. You never know how long it will take for these things to happen. It can be a slow process, but there are very influential people and firms out there who think that these techniques and approaches have something going for them. They can improve markets. We should not be ideological about blockchains. If they improve markets let’s use them. Meanwhile, let’s keep testing the proposition – do they improve markets?

Photo by Raul Varzar on Unsplash

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