Legal and Compliance in Tokenisation

Legal and Compliance in Tokenisation

TLDR:

  • Tokenisation involves converting real-world assets into digital tokens, which requires navigating complex legal frameworks, including securities laws and regulatory compliance.
  • Institutions must adhere to anti-money laundering (AML), know-your-customer (KYC) and securities regulations when dealing with tokenised assets.
  • Working with regulated custody providers and ensuring legal compliance are key to minimising risks in tokenisation.

Introduction 

Tokenisation is transforming how institutions engage with real-world assets by converting them into digital tokens on blockchain networks. While this opens up new opportunities for liquidity, fractional ownership and more efficient asset management, it also brings complex legal and compliance challenges. Navigating the regulatory landscape is critical for institutions to remain compliant with local and international laws. This guide explores the key legal and compliance considerations for institutions looking to leverage tokenisation while avoiding regulatory pitfalls. 

Tokenisation and Securities Laws 

One of the most important legal questions is whether the digital tokens being created are classified as securities. Many tokenised assets—especially those representing ownership in real-world assets such as real estate, equities or commodities—are likely to be treated as securities under most legal frameworks. 

In the US, the Securities and Exchange Commission (SEC) applies the Howey Test to determine whether a token qualifies as a security. If the token meets the criteria, it must be registered with the SEC or issued under an exemption, such as Regulation D or Regulation S, which provide guidelines for issuing securities to accredited or non-US investors, respectively. 

In Europe, the upcoming Markets in Crypto-Assets (MiCA) regulation will provide a more harmonised framework for tokenised assets, classifying them according to their characteristics and governing their issuance, trading and management. Tokenised securities will fall under MiFID II regulations, ensuring investor protection and market integrity. 

Failure to comply with securities laws can lead to penalties, legal action and restrictions on issuing or trading tokenised assets. Institutions must ensure that any tokenisation project is compliant with securities regulations to avoid these risks. 

Anti-Money Laundering (AML) and Know Your Customer (KYC) Requirements 

AML and KYC regulations are central to any financial activity. These rules are designed to prevent money laundering, fraud and the financing of terrorism. Institutions involved in tokenising assets must ensure that they collect and verify customer information, monitor transactions for suspicious activity and report any potential violations to regulatory authorities. 

This means that token issuers and trading platforms must have robust KYC processes in place, ensuring that all participants are identified and vetted. In many jurisdictions, AML and KYC requirements apply not just to the initial issuance of tokenised assets but also to secondary market trading. 

Compliance with these regulations is essential to maintain the integrity of the tokenisation process and avoid penalties or reputational damage. Institutions working with regulated custody providers can simplify this process, as these providers typically handle the AML and KYC checks on behalf of their clients. 

Navigating Jurisdictional Variations in Tokenisation 

One of the major challenges for institutions involved in tokenisation is dealing with the varying regulatory frameworks across different jurisdictions. Each country has its own approach to regulating digital assets, which can create complexities for institutions operating globally. 

United States 

In addition to securities regulations, institutions in the US must comply with the Commodity Futures Trading Commission (CFTC) for any tokenised assets classified as commodities. The Financial Crimes Enforcement Network (FinCEN) also ensures compliance with AML/KYC rules. 

European Union 

The forthcoming MiCA regulation will establish a more unified legal framework across the EU for tokenised assets. Institutions will benefit from greater clarity on how tokenised assets are classified and regulated within the EU. MiCA will also impose stricter rules on stablecoins and security tokens. 

United Kingdom 

To operate successfully in multiple jurisdictions, institutions must stay informed about the regulatory landscape in each market and ensure their tokenisation projects comply with local laws. Working with legal experts and using regulated platforms like Archax can help institutions navigate these challenges more effectively. 

Legal Risks in Smart Contracts 

Smart contracts play a crucial role in tokenisation by automating the processes of issuing, transferring and managing the assets. However, the legal status of smart contracts varies between jurisdictions, and institutions must ensure that these contracts are enforceable under local laws. 

For example, some jurisdictions recognise smart contracts as legally binding agreements, while others are still in the process of clarifying their status. Institutions using smart contracts for tokenisation must ensure that these contracts are coded correctly to reflect the terms of the agreement and that they comply with relevant legal standards. 

One potential risk is that coding errors or vulnerabilities in the smart contract could lead to unintended consequences, such as the mismanagement of tokens or loss of funds. Regular audits and security reviews are essential to ensure that smart contracts are secure and function as intended. 

Custody and Legal Compliance in Tokenisation 

When dealing with tokenised assets, institutions must also consider how these assets will be securely stored and managed. The digital nature of these assets makes them susceptible to hacking, theft or loss if not properly safeguarded. 

Custody solutions play a vital role in mitigating these risks. Regulated custody providers offer secure storage of digital assets through cold storage, multi-signature wallets and other advanced security measures. These providers also ensure compliance with legal requirements, including AML/KYC regulations, and often provide insurance coverage to protect against theft or technical failures. 

Working with a regulated custodian, like Archax, ensures that institutions can manage their tokenised assets securely while staying compliant with relevant legal and regulatory frameworks. 

Tax Compliance in Tokenisation 

Taxation is another critical area of legal compliance for tokenisation. Institutions must ensure that they are meeting tax obligations for both the issuance and trading of tokenised assets. This includes understanding how tokenised assets are classified for tax purposes—whether they are treated as property, commodities or securities—and applying the correct tax treatment to capital gains, income or transaction taxes. 

For example, in many countries, gains from trading tokenised assets are subject to capital gains tax, while the use of tokenised assets for lending or staking in DeFi protocols may trigger additional tax liabilities. Cross-border transactions involving tokenised assets add further complexity to tax compliance, as institutions must consider the tax rules in multiple jurisdictions. 

Institutions must work closely with tax advisors and legal experts to ensure that they are meeting their tax obligations while engaging in tokenisation. 

The Importance of Legal Frameworks in Tokenisation 

Legal frameworks around tokenisation are still developing, but they are essential for ensuring that it can be widely adopted by institutions. Clear and well-defined legal rules provide the foundation for institutions to engage confidently, knowing that their assets are protected, and their activities are compliant with regulations. 

As tokenisation becomes more mainstream, regulators are working to provide more clarity on how these assets should be treated. Institutions that proactively engage with these frameworks and seek legal advice will be better positioned to take advantage of the opportunities that tokenisation presents while managing risks effectively. 

To Sum It Up 

Tokenisation offers opportunities for institutions but navigating the legal and compliance landscape is critical for success. Ensuring compliance with securities laws, AML/KYC regulations and tax obligations is essential to avoid penalties and legal risks. Working with regulated custody providers and legal experts helps institutions mitigate risks and engage with tokenisation in a secure and compliant manner. 

 Fun Fact

Larry Fink, chairman and CEO of BlackRock, said in January 2024, "We believe the next step going forward will be the tokenization of financial assets, and that means every stock, every bond […] will be on one general ledger." source