India has an estimated 100 million debit and credit cards that are used for approximately 1.5 crore daily transactions totaling Rs. 4000 crores. According to the Reserve Bank of India’s (hereinafter referred to as “RBI”) Annual Report, the Indian digital payments market was worth Rs. 14,14,85,173 Crores in the year 2020–21.
The global Fintech environment is being revolutionised by the mechanisms underlying cryptocurrencies, particularly the Blockchain and Digital Tokenization. Moreover, Initial Coin Offerings have become a cutting-edge method for Fintech companies to raise funds.
The companies typically function as blockchain-based funding processes that permit the issue of digital coins or tokens in exchange for payments made in fiat money or other cryptocurrencies.
As an alternative to the conventional sources of finance, the issuing of virtual currency has originated. These tokens can be traded on cryptocurrency exchanges and transferred across nodes of the network.
Digital payments have sparked and maintained economic growth. Given the scope of the growth of Tokens in the future, India shall explore the potential of the same as time advances.
Thus, the present article examines the concept of tokenization, especially pertaining to securitization, through an analytical lens.
An “asset” is represented digitally through tokenization. This can be the claim to ownership of tangible commodities like real estate, stock in a business, or the implied right to use platform services in the future. Tokenization relies on blockchain technology to operate effectively.
A blockchain serves as the basis for immutable ledgers, or records of transactions that cannot be changed, removed, or destroyed; which gives rise to the “Distributed Ledger Technology” (hereinafter referred to as “DLT”). These transactions are called the blocks and are linked to each other using robust cryptography.
Tokenization entails replacing current card information with a special code called a “token”. In this process, important data such as credit card or PAN details, are replaced with a random string that may have a structure similar to the original data but otherwise has no relation to it.
The cardholder will then implement the tokenization request using the Additional Factor of Authentication (hereinafter referred to as “AFA”). By enabling payments without disclosing your bank information, this algorithmically produced token safeguards sensitive data and prevents card fraud.
During the transaction, the data is encrypted and securely stored. The database of the originator can only match the token with the original information. One of the most crucial methods for facilitating safe cloud-based payments is tokenization.
In India, ICICI Bank was the first to introduce Host Card Emulation (hereinafter referred to as the “HCE”)-based mobile payments in March, 2016 through its pocket app at any contactless-enabled terminal. Another example of this technology is, Apple Inc.’s mobile payment system, i.e., Apple Pay.
There are 3 types of tokens that have penetrated the FinTech sector, they are-
- Security Tokens
- Payment Tokens
- Utility Tokens
Out of these, the Security Tokens are quintessentially prevalent in the market. These are tokens of special characteristics that are similar to traditional instruments like shares, debentures, or units in a collective investment scheme. They may provide the holder of such security token, the ownership of assets and entitlements to use them, profit sharing, and voting rights.
UTILITY AND ADVANTAGES OF SECURITY TOKENS
Security Tokens are similar to financial instruments. They can be considered as transferable securities, as they are digital representation of existing securities such as shares in future profits, cash flows, equities, debt instruments etc. A Security Token grants both an ownership right as well as a right to a portion of future earnings or cash flows.
A token might, for instance, represent a portion of ownership in real estate or in a financial product like a bond or other debt security. Security Tokens are similar to traditional financial assets in this aspect because they are designed to reflect a guarantee regarding a future cash flow or a claim to a portion of a business (equities, bonds futures, options, etc).
Similar to regular securities, Security Tokens include transferability and negotiability. Tokens are transferable as they can be assigned to any other person, meaning that that their ownership can be passed on and, they are negotiable as they have the ability of being traded on regulated markets.
The Security Token are exchanged through Security Token Offering (hereinafter referred to as “STO”), just as Initial Public Offering and Follow-Up Public Offerings of shares and traditional securities of a corporation. An STO is the procedure by which a digital asset that is a representation of a financial security is issued.
The Security Tokens render the following advantages:
- The benefit of smart contracts.
- Much more transparent and less tedious documentation and compliance processes, such as KYC.
- It functions on an automated trading process, which can prove to be fail-proof and standardized.
- Time and cost-efficient method of acquiring and dealing in financial securities.
- Enhanced liquidity.
- It can be used for an array of securities, such as; property, paintings, antiques, cars, digital artwork, IP, songs, etc.
- It allows assets to be divided into smaller units and acquired in order for the investors to make a big purchase
It is now pertinent to note the regulatory stance over these security tokens around the world.
THE DEVELOPMENT OF TOKENIZATION IN FOREIGN NATIONS
Viewed from a regulatory angle, as long as the regulatory and legal status of the underlying assets maintain status quo, the tokenization processes should not have an impact on an asset’s status. Using a token to represent an asset that is already regulated will not alter its status.
However, the type and organisation of the DLT ecosystem in which the security token is present could change how much regulation is relevant.
China has strictly banned the issuance or trade of crypto assets. The Peoples Bank of China has issued directions in this regard. Accordingly, entering into transactions involving crypto-assets such as security tokens can result in a violation of Chinese laws.
Whereas, on the contrary, Security tokens are accepted and governed in the United States of America. The Department of Financial Services in New York State is responsible for issuing licenses required by all for virtual trading called ‘BitLicenses’.
According to the New York Financial Services Law, virtual currency business activity can be classified into one of five categories. These categories include activities involving the following;
- receiving virtual currency for transmission or transmitting virtual currency
- holding virtual currency on behalf of others
- buying and selling virtual currency as a customer business
- providing exchange services as a customer business
- controlling, administering, or issuing virtual currency
Similarly, in the United Kingdom a crypto-asset registration is a mandate, for participating in a virtual asset service that is categorized in one of the following:
- exchanging, or arranging or making arrangements with a view to the exchange of, crypto-assets for money or money for crypto-assets
- exchanging, or arranging or making arrangements with a view to the exchange of, one crypto-asset for another
- operating a machine that utilises automated processes to exchange crypto-assets for money or money for crypto-assets.
In Hong Kong, entities participating in trading of security tokens, have to seek licence and permission from Securities and Futures Commission. Such a license regulates the activities of the operator of a centralized online trading platform that provides for trading in security tokens.
Additionally, even the government of Singapore has allowed and regulated security tokens. Accordingly, a Digital Payment Token services license has to be taken from the Monetary Authority of Singapore as per the Payment Services Act. This covers services associated with the purchase and sale of any digital payment token in exchange for money or other Digital Payment tokens.
The fact that Security Tokens typically fit inside the purview of the current regulatory frameworks for securities in most nations is one of their key characteristics. Digital Security Tokens can be governed and regulated similarly to traditional financial securities.
Despite the fact that the definition of securities differs from one country to another jurisdiction, there are notable parallels between traditional securities and these tokens. These include:
- investing money or other assets
- anticipating a return on the investment
- investing money in a shared venture, which means that investors pool their resources to fund a project
- the profit in its entity is dependent upon third-party and not the investors themselves.
It is interesting now to understand what stance India has taken with respect to this.
INDIA’S STANCE vis-à-vis SECURITY TOKENS
Only authorised and recognised exchanges in India are permitted to trade recognised securities, such as stocks and commodities, and all trading is overseen by the Securities Contract (Regulation) Act, 1956.
Although, Security Tokens are not yet classified or recognised as “securities” under Indian law, and no regulatory body or authority has any control over or recognition of the trading platforms where such tokens are traded yet The Securities Contract (Regulations) Act, 1956 (hereinafter referred to as the “Act”) governs the industry to stop unfavourable transactions in securities.
The Supreme Court in Sudhir Shantilal Mehta v. Centra Bureau of Investigation 2009 SCC OnLine SC 1482 stated that Section 2(h) of the Act’s definition of “securities” is inclusive rather than exhaustive. While, in another case between Naresh K. Aggarwala & Co. v. Canbank Financial Services Limited [(2010) 6 SCC 178] it held that the definition of securities is broad enough to include “unlisted securities” and that SAFTs, which are unlisted securities sold to private investors prior to a public offering of tokens, are also securities.
Furthermore, the Supreme Court observed in Sahara India Real Estate Corporation Limited and Others v. SEBI and others [Civil Appeal No. 9813 of 2011] that, “Section 2(h) of the SCR Act gives emphasis to the words “other marketable securities of a like nature”, which gives a clear indication of the marketability of the securities and gives an expansive meaning to the word securities. Any security which is capable of being freely transferrable is marketable. The definition clause in Section 2(h) of SCR Act is a wide definition, an inclusive one”.
Hence, it can be understood that in absence of any specific legislation or regulation over digital security tokens, this has remained uncharted territory. It can be hoped that a positive change is brought by the Parliament through the Bill on Cryptocurrencies that is set to be tabled in the near future.
Businesses have traditionally sold investors stakes in the future worth of their assets through securitization, effectively turning their assets into cash. One of the most prevalent methods of capital formation globally is securitization. To refer to transactions that monetize non-financial assets as well as support non-cash-flow monetization, the FinTech industry uses the words “tokenization” and non-fungible tokens, or “NFTs,” respectively.
Tokenization will offer an additional layer of security to users’ sensitive data, reducing online and digital data breaches in a world where online frauds and cyberattacks are a persistent barrier to the adoption of digital payments.
One of the most popular and practical venues for receiving services and making purchases right now is digital. The majority of us have been preserving our payment information on merchant websites due to the growing frequency of our online transactions, which means that our payment partners have access to the sensitive financial information that ordinarily would be very personal.
This can positively be aided by tokenization without compromising one’s security of data. Thus, tokens are the new tomorrow.
-Team AMLEGALS, assisted by Mr. Alay Raje (Intern)
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