Tokens such as cryptocurrencies have caused turmoil in the financial market. Regulators are trying to catch up on the latest developments and adapt 20th century legislation to match up with 21st century technology. In this context, the United States Securities and Exchange Commission (“SEC“) has taken enforcement action against two cryptocurrency exchange platforms, Binance and Coinbase, in an attempt to clarify U.S. law applicable to tokens. The Swiss regulators have taken a more pragmatic approach. This article sets out the current situation in the U.S. and then turns to the legal regime in Switzerland.

By Thomas Werlen / Simon Weber (Reference: CapLaw-2023-39)

1) Overview

Lately, the crypto market has gained considerable attention of regulators worldwide (see also Franca Contratto, Crypto Markets: Regulators Worldwide Are Sharpending Their Knives, CapLaw 4/2023, p 4 et seqq.). In June 2023, the SEC commenced legal proceedings against two major cryptocurrencies exchange platforms: Binance Holding Ltd. (“Binance“) and Coinbase Global Inc. (“Coinbase“). The SEC is accusing both exchange platforms of intentionally evading U.S. federal securities law. At the heart of these proceedings is the question whether specific digital assets such as tokens fall within the scope of the definition of a ‘security’ under U.S. law.

Whilst decisions are not expected anytime soon in said proceedings, recent developments in similar cases might give the exchange platforms a spark of hope. Indeed, on 13 July 2023, Ripple secured a partial victory in its court battle against the SEC: New York district judges ruled that the sale of cryptocurrency XRP on public exchanges does not violate securities law. However, the ruling states that the decision is based on a case by case analysis. In short, it does not clarify the question of what makes a digital asset a security.

Similarly, on 29 August 2023, U.S. asset management company Grayscale obtained a favourable decision against the SEC by the District of Columbia Circuit Court of Appeals. The Court held that the SEC mistakenly rejected Grayscale’s application to convert the so-called ‘Grayscale Bitcoin Trust’ into an ETF.

Switzerland on the other hand, one of the biggest banking and finance hubs globally, decided to apply a different approach. To remain on the spearhead of innovation, it has continuously updated its regulatory framework to adapt to market innovations. Along the same lines, Switzerland has been proactively promoting the use of digital tokens to become a hub for digital token companies. The Canton of Zug is openly and actively promoting itself as ‘Crypto Valley’. Ever since 2016, the city of Zug has accepted cryptocurrencies as a form of payment for counsel and city taxes. Since its introduction, more than CHF 2 million in taxes have been paid in Bitcoin or Ether.

This article sets out the current situation in the U.S. (2)) and then turns to the legal regime in Switzerland (3)).

2) The U.S. approach

In the U.S. the SEC is at the forefront of the regulation of crypto currencies and digital token. Recently, it has been involved in various legal battles against businesses active in the sector. In particular, the SEC’s enforcement actions against Coinbase and Binance stand out (a)). The crux of these enforcement actions is the definition of what constitutes a ‘security’ under the so-called Howey test (b)).

a) The SEC’s allegations

Whilst the SEC’s accusations against Coinbase appear to be limited to the offer and sale of securities, Binance is facing more serious charges. The SEC accuses Binance not only of having offered and sold unregistered securities, but also of having artificially inflated its trading volumes and of having diverted customer funds.

These SEC lawsuits bring back the burning question of whether the issuing of tokens qualifies as an offering of securities. According to the SEC’s chair, Gary Gensler, Bitcoin cannot be characterised as a security. However, in his view, all other cryptocurrencies can. This stands opposed to the former SEC director William Hinman’s statement that another cryptocurrency, Ether (“ETH“), was not a security.

Ultimately, the question will have to be answered by the U.S. courts.

b) The Howey test

Under general U.S. law, Section 2(a)(1) of the U.S. Securities Act defines the term ‘security’. This statutory definition has been further refined by the legal test established by the U.S. Supreme Court in the SEC v. W. J. Howey Co., 328 U.S. 293 (1946) case (“the Howey test“). According to the Howey test, the determination of whether assets are securities depends on three criteria. Regardless of its form, anything that:

1. represents an investment,

2. in a common enterprise,

3. with the expectation of profit solely through the effort of others

qualifies as a security.

However, the evolution of tokens and the ever-increasing trading options on various crypto-trading platforms has led to legal questions. The SEC, competent in all things U.S. securities, must determine whether such digital tokens fall within the scope of their tasks. These legal questions have prompted the SEC to commence legal action against two of the world’s biggest crypto-trading platforms.

3) Crypto-regulation in Switzerland

In Switzerland the Financial Market Supervisory Authority (“FINMA“) is facing similar challenges. However, FINMA is approaching the topic of new technology and digital tokens with an open mindset and has been described as “one of the most proactive regulators of crypto assets“. It is putting considerable effort into implementing new regulations and issuing regulatory guidance to increase legal certainty. As such, Switzerland is aiming to position itself as a favourable crypto hub with a supportive regulatory environment and infrastructure.

The Swiss regulator FINMA is competent to supervise and regulate the Swiss financial market. If a token qualifies as a relevant asset traded on the Swiss financial market, it enters into FINMA’s jurisdiction. This means that any FinTech company that plans to launch operations in Switzerland must ascertain whether they comply with authorisation, licensing, and anti-money laundering requirements.

There are five licences that are typically relevant for companies active in the digital asset field. These licences are issued by FINMA upon application and include the following: i) a banking licence, ii) a FinTech licence, iii) a securities firm licence, iv) a Distributed Ledger Technology “DLT” trading facility licence (see below for more information on the DLT licence), and v) an insurance licence.

Below, we address FINMA’s categorisation of tokens (a)) before we move on to summarise Switzerland’s legal framework (b)) and remind the reader of anti-money laundering provisions (c)).

a) FINMA’s categorisation of tokens

Generally, FINMA distinguishes between three categories of digital tokens: payment tokens, utility tokens, and asset tokens. Note that some tokens might have more purposes and/or characteristics (FINMA refers to such tokens as hybrid tokens). Hence, they might fall within several of the below categories.

Payment tokens are tokens that function as a means of payment or as a means of money or value transfer. This also means that the user does not have any claim against the issuer of the tokens.

Utility tokens are tokens designed for a specific use. For example, to provide access to a service or digital application.

Asset token are tokens that either represent an underlying asset or are economically a capital market instrument. They are hence similar to stocks, bonds, and derivatives. These tokens, if standardised and freely tradeable, constitute securities that fall within the scope of Swiss securities laws.

Depending on the type of token digital asset companies engage with, various regulations may apply, such as the Anti Money Laundering Act (“AMLA“), which sets forth obligations of financial intermediaries to prevent money laundering.

The Banking Act may also apply to issuers of tokens that qualify as deposits. Finally, the Financial Services Act applies to all public offering of securities, which might include tokens.

Identifying the type of token dealt with is therefore of vital importance to ensure compliance with the Swiss regulations.

b) Switzerland’s unique legislative framework: the DLT Act

In 2018, the Swiss Federal Council has already identified the need for improvement of the Swiss financial market law due to the never-ending development of new technologies and digital tokens.

A first draft of the new Act was published in 2019. In September 2020, the Swiss Parliament adopted the Federal Act on the Adaptation of Federal Law to Developments in Distributed Ledger Technology (“DLT Act“), which amended several federal laws. DLT is a digital system used to record the transaction of assets by registering the existence of such transactions and their specific details in multiple places at the same time.

It allows shared data management and more particularly, shared accounting among participants who neither know nor trust each other’s identity. The DLT Act entered into force on 1 August 2021.

The main innovation the DLT Act brings along is the introduction of a new form of uncertified securities, in the Swiss Code of Obligations: registered uncertificated securities or “ledger based security“. Uncertificated securities are formed through an agreement between the parties (a registration agreement), with rights registered, claimed, and transferred to others solely via a securities ledger that meets certain technical requirements.

Under the DLT Act, the transfer of registered uncertificated securities therefore no longer requires a written and signed cession of the security, which facilitates their transfer.

To accommodate the multilateral trading of these newly developed securities, a specific licence was introduced: the “DLT licence“. These new licences are regulated by the Financial Market Infrastructure Act (“FMIA“) and granted by FINMA.

Licensing as a DLT trading entity is required if the latter’s purpose is either:

1. the simultaneous exchange of bids between several participants and the conclusion of contracts based on non-discretionary rules;

2. to hold DLT securities in central custody based on uniform roles and procedures; or

3. the clearance and settlement of transactions in DLT securities based on uniform rules and procedures.

It must be noted that to obtain this new licence, the DLT facility must be incorporated in Switzerland and have its registered head office in Switzerland. It is also advisable, and even recommended by FINMA, for companies applying for a licence to arrange a meeting with FINMA representatives to present their business projects and receive initial feedback before submitting any applications.

c) Anti-money laundering

For the sake of completeness, note that under Swiss law, traders of digital assets must comply with the regulations set out by the AMLA. The AMLA has also been updated to now apply to DLT traders, which are considered as financial intermediaries under the anti-money laundering rules.

Exchange platforms therefore need to abide by anti-money laundering due diligence requirements set forth in the Act.

4) Conclusion

Unlike the SEC, FINMA and the Swiss legislator are trying to create a safe haven for companies active in the field of digital assets. The adoption of a targeted and updated legislative framework aims at establishing an environment in which both the regulators as well as the users reach the highest potential in the world of digital assets.

Companies trading with digital tokens in Switzerland should not only make use of the current, liberal framework and the close contact with FINMA but also of the regulator’s open ears for innovation and development.

Thomas Werlen (thomaswerlen@quinnemanuel.swiss)
Simon Weber (simonweber@quinnemanuel.swiss)