Blockchain technology, also referred to as ‘distributed ledger technology’ or ‘DLT,’ has the ability to transform the trading and settlement of real-world assets by making the processes easier, cheaper, and more reliable. The network of independent ‘nodes’ that support the relevant blockchain together function as a public server that eliminates the need for institutional intermediaries and the complex layers of IT systems, reconciliations, and other administrative processes inherent in traditional trading, clearing, and settlement structures. By providing a decentralized, publicly accessible, and transparent platform, DLT can simplify the execution of transactions, reduce costs, and enhance reliability. This transformative approach not only simplifies processes but can also democratise access to asset trading by removing barriers imposed by conventional financial systems and markets. The following discussion explores how DLT facilitates these improvements and examines the legal implications, particularly under English law.
DLT allows the creation of an independent record of units of a certain kind and description, known as ‘tokens,’ that are allocated to one or more ‘network addresses’ or, by way of shorthand jargon, ‘wallet addresses.’ Once one or more units of a certain type and description are allocated to a wallet address, only the holder of that wallet’s private key can request changes to the unit balance recorded at or in respect of that wallet address, e.g. by requesting a ‘transfer’ to another wallet address. The transfer request results in a debit and corresponding credit of units, akin to the traditional accounting system process. A ‘transfer’ of a token, therefore, should not be analysed as a situation where an identifiable asset changes hands. Rather, a contract or protocol entitlement recorded at one wallet address, a token balance, is reduced, and a new or increased entitlement is created at the intended recipient’s wallet address.
Token balances are created at two different levels in the DLT stack: at protocol level (‘protocol tokens’) and at smart contract level (‘application tokens’). Protocol tokens are created as an intrinsic part of the blockchain protocol to provide utility at blockchain operational level. Application tokens are created one level up in the stack to provide utility within the smart contract ecosystem (‘dApps’) and facilitate interactions and transactions at that level. The utility of application tokens is limited only by the limits on their design or use objectives.
Tokens may exist sui generis, that is, they have no function outside the blockchain on which they are created. This type of token is commonly referred to as a ‘function token.’ Function tokens are protocol tokens and application tokens that are used only to facilitate the execution of a function within the relevant blockchain ecosystem, mostly to serve as a form of value transfer. Function tokens derive their economic value from their utility within the network. Prominent examples of function tokens are Bitcoin and Ether, protocol tokens that are typically also referred to as ‘cryptocurrencies.’
Function tokens must be distinguished from tokens that are used to create records of ownership of property interests in all manner of ‘real world assets,’ or ‘off-chain’ assets. Such tokens may be called ‘asset tokens.’ At its core, a token is merely a cryptographically protected electronic record of a certain number of units or fractions of units that are allocated to a certain blockchain address. That recording function can be used to record interests in or rights in respect of tangible property such as commodities, or intangible property such as intellectual property rights. The process of creating ownership records relating to an off-chain asset by way of token issuance is commonly referred to as ‘tokenization’ of the relevant off-chain asset.
It is generally accepted that function tokens are a form of personal property. The notion that a DLT generated token constitutes personal property introduces an extra layer of property law complexity if the token is an asset token, rather than a function token. If an asset token, independently, were an object of property, the question must be answered how the token relates in property law terms to the asset to which that asset token is supposed to be linked. It raises the question, therefore, whether the asset token ought to be characterized as a separate and independent asset, or should it instead be characterized as a form of ownership record that can be amended by way of a token transfer process, which affects the status of the linked off-chain asset. The amendment of the ownership record would have the effect of transferring the asset to which the asset token is linked, not because the linked asset follows the token, but because the token transfer complies with transfer requirement applicable to the linked asset.
An English law example may illustrate the point. Under English law, transfer of a property interest that is an equitable interest in an asset is effected by way of assignment, which must be in writing and must be signed. There appears to be consensus among English jurists that a statutory signature requirement is “highly likely to be capable of being met by means of a private key” because an “electronic signature which is intended to authenticate a document will generally satisfy a statutory signature requirement, and a digital signature produced using public-key cryptography is just a particular type of electronic signature”. Equally, the updated smart contract state recorded as part of the relevant blockchain “can be said to be representing or reproducing words and be made visible on a screen or printout is likely to fulfil a statutory writing requirement”. The legal mechanism whereby the holder of a legal right or interest in an asset is identified by reference to a token is called ‘stapling’. In the case of stapling by way of a smart contract maintained register of property interests, the balance of tokens recorded at a wallet address would not itself be an object of property. If the token balance were itself the object of property, it would transform the stapled property interest, which is not the intention where DLT is used only to demonstrate entitlement, as a certificate would, and to create a mechanism to transfer the tokenisation subject matter property, as a written assignment would. Where the intention is to embed the tokenisation subject matter property into the token and transform that property into a negotiable bearer instrument, the conclusion could be different. Overall, the starting point ought to be that smart contract-based ownership records must be characterised as a record only, and not as somehow creating independent objects of property, unless there is clear evidence of intention to embed the tokenised property into the token so that it ceases to be an independent object of property.
Having said that, once the token operation can function as a mechanism that transfers legal ownership of the real-world asset, all manner of efficiencies manifests. The token smart contract can be linked to a trading venue smart contract so that when a wallet owner successfully accesses the decentralised trading venue to buy or sell the real-world asset, the settlement can be immediate and finite at the time the trade is executed. In summary, DLT is paving the way for more accessible and dependable trading and settlement of real-world assets by simplifying ownership records and transfer mechanisms. This decentralization reduces transaction costs, minimizes delays, and enhances transparency and security. As DLT continues to integrate into asset transactions, it holds the potential to enhance, fundamentally, the efficiency and reliability of trading systems.
December 2024