Risks involved in tokenized securities / assets
TAURUS SA DRAWS THE EXPLICIT ATTENTION OF ISSUERS/INVESTORS REGARDING SOME OF THE MAIN RISKS INVOLVED IN THE USE, CUSTODY, TRADING, ISSUANCE OR INVESTMENT IN TOKENIZED SECURITIES/ASSETS, SECURITY TOKENS, ASSET/INVESTMENT TOKENS, DLT SECURITIES AND/OR LEDGER-BASED SECURITIES (“TOKENIZED SECURITIES”). THE BELOW LIST IS NOT EXHAUSTIVE.
To understand the risks associated with tokenized securities/assets (e.g., tokenized shares issued by a Swiss corporation, ledger-based securities, DLT securities), each issuer/investor should thoroughly and in detail assess and analyze this document. Prospective issuers/investors should carefully consider each of the risks described below and all of the other information in this document before deciding to issue/invest in tokenized securities. Issuers’ business, financial condition and results of operations could be materially adversely affected by any of these risks. As a result, the price of tokenized securities may decline and investors may lose their investment. The risks described below are not the only ones applicable to the issuer. Additional risks that are not known at this time, or that may be currently considered as immaterial based on regular risk assessment, could significantly impair the issuer’s business activities and have a material adverse effect on the issuer’s business, financial condition or results of operations. The order in which these risks are presented is not intended to provide an indication of the likelihood of occurrence nor of their severity or significance. Therefore, only prospective issuers/investors who are fully aware of the risks described in this document and who are financially able to bear the possible loss of their entire investment should consider investing in tokenized securities.
Tokenized securities are recorded outside of a traditional custodian system and transfers of tokenized securities are subject to legal uncertainty
Securities (e.g., shares, bonds, participation certificates) are typically associated with tokens, i.e. digital tokens recorded on a blockchain (e.g., public Ethereum mainnet). Tokenized securities are not expected to be deposited with professional custodians (such as banks, brokers or central securities depositaries) as is the case for most securities issued by public companies, and no main register of intermediated securities under the Swiss Federal Act on Intermediated Securities are maintained. As a result, the ownership of tokenized securities is not determined by credits on a securities account held by a professional custodian pursuant to the Swiss Federal Act on Intermediated Securities, but on the record of the digital tokens associated with those securities on a decentralized ledger maintained by a community of users.
To date, there are no court precedents regarding the acquisition or transfer of tokenized securities. In addition, the Swiss legislator may adopt new rules regarding the acquisition or transfer of tokenized securities, the impact of which cannot be predicted. Such acquisition or transfer is therefore subject to legal uncertainties that are more significant than for non-tokenized securities.
If a court were to decide that a transfer on the relevant blockchain is not sufficient to transfer the rights and obligations associated with tokenized securities, the validity of transfers of tokenized securities effected by transferring the relevant tokens on a blockchain may be challenged.
These factors, and the resulting uncertainty regarding tokenized securities and tokens/digital assets in general, may significantly affect the price and ability of investors to acquire or dispose of tokenized securities. In addition, if tokenized securities become more difficult to acquire or transfer, we may be forced to rely on other ways of raising capital, which may be significantly more expensive. This could materially affect our ability to execute our strategy and our prospects.
Securities are associated with digital tokens recorded on a blockchain
Securities, once issued, are associated with tokens, i.e. digital tokens, which are recorded on the public version of a blockchain. The issuer has adopted internal regulations, pursuant to which the tokens and the underlying tokenized securities are tied to each other in a manner that prevents tokenized securities from being transferred without the corresponding tokens and vice-versa.
The tokens are created and managed under the terms of a so-called “smart contract”, i.e. computer code that defines the manner in which digital tokens can be created, transferred and cancelled. Smart contracts are non-trivial pieces of computer code and their interactions with the blockchain for which they have been created are complex. It cannot be excluded that the computer code for the smart contract used by the issuer contains flaws, errors, defects and bugs, which may disable some functionality of the tokens, expose tokenholders’ information or otherwise be harmful to the tokenholders or the issuer. Investors contemplating an investment in tokenized securities should review the functioning of the smart contract underpinning the tokens and seek advice from third party experts, if necessary, to understand it before acquiring tokenized securities. Should the smart contract based on which the tokens are operated cease to function for any reason, the ability of existing holders of tokenized securities to transfer such securities to third parties or the ability of the acquirers of tokenized securities to exercise the rights associated with such tokenized securities may be impaired. The regulations that an issuer has adopted to associate tokenized securities with tokens make it possible for the issuer to cancel existing tokens and to issue replacement tokens or to issue tokenized securities in a different form (e.g. in the form of paper certificates). Such an operation may however complicate the transfer of tokenized securities or the exercise of the rights associated with newly acquired tokenized securities.
Risks related to blockchain technology
Blockchain technology (e.g., Ethereum) is new and untested and subject to known and unknown risks, including the risks set out below:
The blockchain source code could be updated, amended, altered or modified from time to time by the developers and/or the community of users. There can be no guarantee that such update, amendment, alteration or modification will not adversely affect the functionality of tokens.
Changes to the protocol that govern the blockchain may result in the development of parallel chains of blocks (so-called “hard forks”) when some of the blockchain’s nodes are validating transactions on the basis of the old version of the protocol, while other nodes are validating transactions on the basis of the new protocol. The smart contract governing the issuer’s tokenized securities makes it possible for the issuer to “freeze” the digital tokens associated with tokenized securities (i.e. to prevent execution of transactions on the blockchain) until the issuer has made a decision as to which version of the protocol it will support. In the event of such a freeze, holders of frozen tokenized securities will not be in a position to transfer their tokenized securities. Such a freeze may however occur after the hard fork has started to take effect. This could lead to significant uncertainties as to the ownership of tokenized securities which have been transferred (by way of the token) immediately before the freeze has been implemented.
Blockchain technology functions based on concepts belonging to asymmetric cryptography, or public key cryptography. Scientific research regarding blockchain technology is still at an early stage. Code cracking or technical advances such as the development of quantum computers, could present a risk for all blockchain technology. This could result in the theft, loss, disappearance, destruction or devaluation of tokens.
Hackers or other groups or organizations may attempt to interfere with wallets maintained by tokenholders in any number of ways, including without limitation denial of service attacks, Sybil attacks, spoofing, smurfing, malware attacks or consensus based attacks. In addition, the blockchain is susceptible to mining attacks, including but not limited to double-spend attacks, majority mining power attacks (or “51% attacks”), “selfish-mining” attacks, and race condition attacks.
Information about DLT securities and ledger-based securities according to Swiss law
According to the Swiss Financial Market Infrastructure Act, DLT securities are securities in the form of: (a) ledger-based securities (Art. 973d CO); or (b) other uncertificated securities that are held in distributed electronic registers and use technological processes to give the creditors, but not the obligor, power of disposal over the uncertificated security.
A ledger-based security is a right which, in accordance with an agreement between the parties:
- is registered in a securities ledger in accordance with the conditions described below; and
- may be exercised and transferred to others only via this securities ledger.
The securities ledger must meet the following requirements:
- It uses technological processes to give the creditors, but not the obligor, power of disposal over their rights.
- Its integrity is secured through adequate technical and organisational measures, such as joint management by several independent participants, to protect it from unauthorised modification.
- The content of the rights, the functioning of the ledger and the “registration agreemen"t are recorded in the ledger or in linked accompanying data.
- Creditors can view relevant information and ledger entries, and check the integrity of the ledger contents relating to themselves without intervention by a third party.
The obligor must ensure that the securities ledger is organised in accordance with its intended purpose. In particular, it must be ensured that the ledger operates in accordance with the “registration agreement” at all times. The transfer of the ledger-based security is subject to the provisions of the “registration agreement”.
Information regarding the governance and use of the public Ethereum mainnet (or similar) as securities ledger for ledger-based securities/DLT securities according to Swiss law
The Ethereum distributed ledger technology is a technology that allows the operation of a distributed ledger, i.e. a ledger that is not kept by a trusted intermediary, but by a community of independent participants. The distributed ledger technology, as implemented on the Ethereum distributed ledger is based on complex mathematical and cryptography concepts, which are described in this document at a high level only. The technology makes it possible to keep records of data relating to persons whose identity is protected by asymmetric cryptographic methods. Such methods are based on the interplay between a public key and a private key, which are two numbers that are mathematically related. The public key (often referred to as the “distributed ledger address”) is available to all ledger participants, while the private key must remain secret. The holder of the private key can generate “signature messages” that can be identified as authentic (i.e. as having been generated with the private key) by the ledger participants. Such signature messages can be used to initiate “transactions”, i.e. new entries in the ledger. In a distributed ledger that functions as a “blockchain”, the participants validate transactions in blocks, by adding a new set of data to a chain of pre-existing blocks. Each ledger participant maintains its own copy of the ledger, and updates such copy when a participant includes a new “block” in a manner consistent with the chain’s protocol. This regime aims to ensure the transparency and immutability of the transactions recorded in the ledger.
For Ethereum, the distributed ledger has two functions. The first is related to Ether (or ETH). Ether is a cryptocurrency (or digital currency) that is recorded and traded on the distributed ledger. Users of the distributed ledger can trade Ethers on the distributed ledger and use such Ethers as a means of payment. The second is the use of “smart contracts”. The distributed ledger allows for the creation of computer codes called “smart contracts”, which can perform a large number of functions, including creating a record of digital tokens on distributed ledger addresses. A “token” is an entry in a register that is maintained by means of the smart contract. Each token is attributed to a particular distributed ledger address. The fact that the register maintained through the smart contract contains a corresponding entry is evidence that a token is attributed to the relevant distributed ledger address. Entries in the distributed ledger are validated by a large number of participants. Any person or entity may act as validator and validate transactions in the distributed ledger, subject to technical requirements unrelated to the identity of the person or entity (e.g. technical infrastructure requirements and/or minimum amount of Ethers “staked” (i.e. locked on a distributed ledger address for a certain period of time)). More information about Ethereum and its governance are available at the following link.
Legal and regulatory risks associated with the use of blockchain technology
Blockchain technology is recent. In many jurisdictions, the legal and regulatory regime applicable in case of use of that technology in the financial sector remains debated, and regulatory actions by the Swiss or foreign governments restricting the ability to use the technology in the manner contemplated by the issuer cannot be excluded. To associate tokenized securities with digital tokens, the issuer shall typically be relying on a legal tokenization model, developed and published by an association, such as for example the Capital Markets and Technology Association (CMTA), a nongovernmental organization based in Geneva, Switzerland. The legal aspects of the tokenization of securities are however debated in Switzerland, and no court decision has been published on the topic. Disputes regarding certain aspects of the acquisition and transfer of tokenized securities in the form of digital tokens, such as for example the validity of transfers, cannot therefore be excluded. Court decisions, depending on their content, may result in the issuer having to cancel the digital tokens associated with tokenized securities, and to issue tokenized securities in a different form (e.g. in the form of paper certificates). This could restrict the ability of the holders of tokenized securities to transfer such securities.
Inability of holders of non-voting shares to influence the decisions of the issuer
In the case of non-voting shares (e.g., participation certificates), holders of tokenized securities are not able to exert significant influence over the election of the issuer’s directors or independent auditors, or the appropriation of the issuer’s earnings (and in particular the distribution of dividends). Holders of tokenized securities have none of the rights generally associated with voting rights under Swiss corporation law, such as the right to request the holding of a general meeting of shareholders, the placement of items of the agenda of a general meeting of shareholders or the right to ask questions or to make proposals on the occasion of such meeting. Accordingly, the holders of the issuer’s voting shares will continue to be able to exert voting control and will be able to elect all of the issuer directors, to determine the outcome of any matter being voted upon by shareholders, including the declaration of dividends, amendments to the issuer’s articles of association, capital increases or decreases, the conversion of voting shares into non-voting shares, mergers and other important matters.
The traditional framework for combatting anti-money laundering and terrorist financing does not apply to tokenized securities
The offering and the safe-keeping of tokenized securities may be carried out without the involvement of professional custodians, but through the transfer of digital tokens recorded on a decentralized ledger. The mechanisms generally applicable for the prevention of money laundering and terrorist financing do therefore generally not apply.
To be in a position to determine the source of the capital raised and avoid becoming the recipient of funds of illicit origin, the issuer shall typically rely on AML standards such as for example the “AML Standards for Digital Assets” (in their version of October 2018) adopted by the Capital Markets and Technology Association, a non-governmental organization based in Geneva, Switzerland. Although these standards seem to be sound and reasonable, the Capital Markets and Technology Association is not a governmental or regulatory authority and the standards it issues are not “safe harbors”. Regulatory actions against the issuer under Swiss or foreign regulations against money laundering or terrorist financing cannot consequently be excluded in the future. The issuer may also be restricted in its ability to open or maintain accounts with banks or other regulated financial intermediaries if the manner in which it identifies the source of the capital raised through an offering or future capital raisings is, in the future, deemed inappropriate. If the issuer is subject to investigations or regulatory actions in connection with money laundering or terrorist financing, or if it is unable to open or maintain bank accounts at satisfactory conditions, it may be unable to execute its strategy, face material financial difficulties and may even be forced to cease operations.
Risk of non-completion of an offering
The completion of an offering and the issuance of tokenized securities is contingent on the ability of the issuer to place a number of tokenized securities that it considers sufficient at a price that it considers to be satisfactory.
The issuer’s ability to successfully place tokenized securities depends on many factors, many of which are beyond the issuer’s control, such as general market and economic conditions as well as macro-economic and geopolitical developments. There can consequently be no guarantee that an offering will be completed or that all the offered tokenized securities will be placed in an offering.
Volatility in the market for and the price of tokenized securities
The market for and the market price of tokenized securities (to the extent such a market develops) may be highly volatile. Such volatility could be caused not only by the issuer’s operational performance or other events involving the issuer and/or its customers, suppliers or competitors, but also by changes in general conditions in the economy or the financial markets, and the industry in particular. As a result of such fluctuations, holders of tokenized securities may not be able to resell their tokenized securities at or above the offering price and may incur losses.
Factors that could cause this volatility in the market price of tokenized securities include, but are not limited to: (i) actual or anticipated fluctuations in the issuer’s results of operations or financial condition; (ii) market expectations for the issuer’s financial performance; (iii) investor perception of the success and impact of an offering on the issuer’s strategy; (iv) the entrance of new competitors or new products in the markets of the issuer; (v) actual or anticipated sales of the issuer’s tokenized securities; (vi) the liquidity of the market for tokenized securities; (vii) new laws or regulations or changes in interpretations of existing laws and regulations affecting the business of the issuer; (viii) general market and economic conditions; (ix) sentiment in the industry of the issuer; (x) expiration of the lock-up undertakings; (xi) announcements of developments related to the issuer’s business; (xi) local market conditions.
Risk of lack of liquid market for tokenized securities
In many cases, there are no market for tokenized securities, and tokenized securities are not, and will not be, listed on a stock exchange or admitted to trading on a multilateral trading facility (MTF).
Upon completion of an offering and subject to certain conditions, Taurus SA (as a regulated securities firm) may in some cases agree to trade tokenized securities on the organized trading facility (the “OTF”) that it operates under the name T-DX. The decision of Taurus SA to trade toeknized securities on its OTF is however subject to conditions and may be reversed at any time by Taurus with no guarantee of liquidity at all. As a consequence, there can be no assurance (i) that an active and liquid trading market, or even a market at all, develops or continues, (ii) that the market price of tokenized securities will not decline below the issuance price after completion of an offering or that (iii) prospective investors will be able to sell their tokenized securities quickly or at all.
The issuance price of tokenized securities is determined solely by the issuer. The issuance price may not be indicative of the market price of the issuer’s tokenized securities after completion of an offering and there can be no assurance that the market price of tokenized securities will reflect the issuer’s actual financial performance or the state of its business, results of operations and/or prospects.
Lack of analyst coverage
Tokenized securities are not traded on a stock exchange or a multilateral trading facility. They may be traded on a market that is not systematically followed by professional financial analysts. The unavailability of financial analysts’ coverage may prevent or delay the development of a liquid market for tokenized securities.
Potential decline in market price of tokenized securities due to the sale of a substantial number of units
The market price of tokenized securities may decline as a result of future sales of such tokenized securities in the market by members of the board of directors or executive management of the issuer following the expiration of their lock-up undertakings or as a result of a perception that such sales could occur. A shareholder resolution to convert voting shares into tokenized securities may also be perceived as a willingness of holders of voting shares to dispose of their shares in the market, and could also negatively affect the market price of the issuer’s tokenized securities. Such a decline in the market price of tokenized securities may make it more difficult for the issuer to issue equity securities in the future at a time and price that it deems appropriate.
Non-application of the Swiss rules applicable to listed companies
Issuers of tokenized securities have typically not requested the listing or admission to trading of their securities or of their tokenized securities on any stock exchange or multilateral trading facility and do not typically contemplate making any such request. If issued, tokenized securities are traded off-exchange exclusively. As a result, the Swiss regulations that apply to issuers that have equity securities listed on a stock exchange in Switzerland do not apply to tokenized securities. In particular, the provisions of the Swiss Financial Market Infrastructure Act (“FMIA”) regarding the mandatory disclosure of large interests in listed companies (Article 120 et seq. FMIA) or public takeovers (Article 125 et seq. FMIA) do not apply. This means, among other things, (i) that the beneficial owners of large interests in the issuer are not be under any duty to make the nature of their interest in the issuer public, (ii) that the provisions of the FMIA designed to guarantee equal treatment and undistorted choice of shareholders in the event of a public takeover offer will not apply if a public takeover offer is made for the shares of the issuer and (iii) that the provisions of the FMIA that require any person who acquires more than one third of the voting rights of a company to make a cash offer at a minimum price for all the listed shares of the company will not apply. Also, the provisions of the FMIA prohibiting insider trading and market manipulation do not apply to the trading of tokenized securities. Swiss authorities have therefore have less legal means to sanction market abuses relating to tokenized securities than they would have had tokenized securities been listed on a stock exchange in Switzerland.
Risk of loss or theft of the digital tokens associated with tokenized securities
Control over the issuer’s tokenized securities requires a so-called “private key”, i.e. a code that is paired with the blockchain address on which the digital tokens associated with the relevant tokenized securities have been recorded. Loss or theft of the private key associated with a particular blockchain address makes it impossible for the owner of such private key to identify itself as the legitimate owner of the digital tokens recorded on the relevant blockchain address.
Contrary to what is the case for securities incorporated into physical certificates, Swiss law does not contemplate any legal means to dissociate securities from the digital tokens with which they have been associated. The issuer’s regulations specify the procedure to be followed if a tokenholder loses access to its digital tokens, e.g. because the corresponding private key has been lost or stolen. The applicable procedure involves the tokenholder being in a position to demonstrate in a manner satisfactory to the issuer that it is the rightful owner of the lost or stolen digital tokens. Such demonstration may be difficult to bring if the tokenholder has not previously identified itself to the issuer as the owner of the blockchain address with which the lost or stolen private key is associated.
The complete trading history of each digital wallet is available to the general public and it may be possible for members of the public to determine the identity of the holders of tokenized securities
Tokenized securities are associated with tokens, i.e. digital tokens recorded on the public version of a blockchain (e.g., public Ethereum mainnet). Any trades of tokenized securities are public shortly after such trades are entered into. Although the data made available on the public version of a blockchain is anonymous, it includes the blockchain address of each tokenholder transacting in tokenized securities, and the entire trading history of each blockchain address (including the number of securities traded by each digital wallet, the price of each trade and the balance of the securities held in each digital wallet). As a result, the trading history of each blockchain address is available to the general public. It may be possible for members of the public to determine the identity of the holders of certain blockchain addresses based on publicly available information.
Potential investors who desire to execute their trades in relative anonymity may find these aspects of tokenized securities unattractive, which may further limit the liquidity in tokenized securities and may have a material adverse effect on the development of any trading market in tokenized securities.
Transaction fees are payable in the native cryptocurrency of the blockchain
Tokenized securities are only transferable in the form of digital tokens recorded on a blockchain. For example, on the Ethereum blockchain, every operation of the smart contract is subject to a fee (so-called “gas”), which must be paid in a cryptocurrency called “Ethers”. Gas fee is not only due in the event of transfer of digital tokens from one blockchain address to another but also for other operations, such as the deployment of the smart contract on the blockchain or communications between tokenholders and the issuer (provided that such communications take place through the blockchain by means of the smart contract).
On a blockchain, operation fees are generally levied on the party that initiates the operation. For transfers of the issuer’s tokenized securities, the fees are levied on the transferor. Because such fees must be paid in the native cryptocurrency of the underlying blockchain, the ability of any holder of a tokenized securities to transfer such tokenized securities requires such holder to own a sufficient quantity of the native cryptocurrency (e.g., Ethers).
Tokenized securities are often risky illiquid private unlisted investments
Tokenized securities are often private unlisted investments (e.g., private equity, private debt) that are highly speculative and involve a high degree of risk. Consequently, investors who cannot afford to lose their entire investment should not invest. Investors should carefully consider the risk warnings and disclosures for the investments set out therein and in the subscription documents. The value of an investment may go down as well as up and Investors may not get back their money originally invested (risk of partial or entire loss of the money invested). Investors understand that they may not receive any return on their investment and that private unlisted investments are not a savings product. Typically, Investors should not invest more than 10% of their net worth in private unlisted investments, alternative investments, crowdfunding projects or equivalent. Additionally, Investors will typically receive illiquid and/or restricted membership interests that may be subject to holding period requirements and/or liquidity concerns. Investments in private unlisted securities are highly illiquid (liquidity risk) and those Investors who cannot hold an investment for the long term (at least 10 years) should not invest. Investors may not be able to sell the investment instruments when they wish. Resale of such securities is not guaranteed; it may be uncertain, or even impossible.**
The tax value of non-listed/private tokenized securities may not be the trade price
Tokenized securities are often non-listed/private securities that are not admitted for trading on any stock exchange, nor on any multilateral trading facility (MTF). Consequently, the tax value of those kinds of securities may differ significantly from the last trade price on digital asset exchange or organized trading facilities such as TDX. Consequently, investors should seek for proper advice from their own tax advisor. For example for Swiss companies, investors shall ask directly the issuer for the last tax value calculated by the Swiss tax authorities (e.g., calculation in accordance with Circ. 28 published by the Swiss Tax Conference).