How do the Regulators classify and decide on whether a crypto-asset will be subject to the regulatory framework under the laws in Cyprus?  (Classification of Tokens Design)

Whether a crypto-asset will be subject to regulation depends on its characteristics. Since there is no official regulatory framework for classifying crypto-assets in Cyprus, the relevant authorities apply the international practice standards for the classification. A crypto asset that qualifies as a financial instrument (e.g., security token) will be subject to financial instrument laws. A crypto asset that does not qualify as a financial instrument will be excluded from the scope of application of such legislation. The classification of other crypto-assets will then occur through a process of elimination. A crypto-asset could be characterised as a utility token (providing access to the goods or services of the issuer) or a payment token (used as a means of exchange, payment or consideration for the provision of goods or services). To protect investors, the regulators also consider the potential risks that crypto assets entail.

Therefore, each Token has its characteristics, and the classification of the Token is to be conducted by the International Common Practice.

Following The Directive for the Registration of CASPs in accordance with section 61E of the Law 188(I)/2007, (Law) the Cypriot law transposing the Anti-Money Laundering and Counter-Terrorist Financing Directive 2018/843 (AMLD5) in Cyprus

*References to Key Articles

1.1.6. Depending on their structure, crypto-assets may, inter alia: i. Qualify as financial instruments under the Investment Services and Activities and Regulated Markets Law, transposing MiFID II5 (the “Investment Services Law);

ii. Qualify as Electronic Money under the Electronic Money Law, transposing EMD27 (the “E-Money Law”);

iii. Be a digital representation of value that is neither issued nor guaranteed by a central bank or a public authority. It is not necessarily attached to a legally established currency and does not possess the legal status of currency or money but is accepted by natural or legal persons as a means of exchange and can be transferred, stored, and traded electronically, and it qualifies neither as fiat currency nor as any of the instruments referred to in points (i) and (ii) above.

1.1.7. For the purposes of this Policy Statement, the term “Crypto-assets” will hereinafter be used to describe the products referred to in point iii of the previous paragraph, whereas the products of points of i and ii of the previous paragraph, will be referred to as (“Financial Instrument Tokens” or “FIT”) and (“E-Money Tokens” or “EMT”), respectively.

1.1.8. Where a token qualifies as a financial instrument under the Investment Services Law, the existing regulatory framework in relation to investment services applies and depending on the instrument and/or activity in question other sectoral rules may also apply. For instance, in the case of FITs which are Units in Collective Undertaking (“UCI”), the relevant rules in relation to the specific type of UCI apply, or in case of offerings of FITs that qualify as Transferable Securities the Prospectus Regulation or the Crowdfunding

Regulation , may apply, depending on the specificities entailed. The use of DLT for the purposes of FIT’s trading, is envisaged to be facilitated under the European Commission’s (“EC”) proposed DLT Pilot Regime, which is currently under discussion by the EU Co-Legislators.

1.3.2.3. iii. “Crypto-asset” means a digital representation of value that is neither issued nor guaranteed by a central bank or a public authority, it is not necessarily attached to a legally established currency and does not possess a legal status of currency or money, but it is accepted by natural or legal persons as a means of exchange and which can be transferred, stored, and traded electronically, and it is not –

a) fiat currency, or b) electronic money, or c) financial instruments, as these are specified in Part III of the First Appendix to the Investment Services and Activities and Regulated Markets Law;

iv. “Crypto Asset Services Provider” or “CASP” means a person who provides or exercises one or more of the following services or activities to another person or on behalf of another person, which do not fall under the services or activities of the obliged entities mentioned in paragraphs (a) to (h) of article 2A of the AML/CFT Law:

a) Exchange between crypto-assets and fiat currencies;

b) Exchange between crypto-assets;

c) Management, transfer, holding and/or safekeeping, including custody, of crypto-assets or cryptographic keys or means which allow the exercise of control over crypto-assets;

d) Offering and/or sale of crypto-assets, including the initial offering; and

e) Participation and/or provision of financial services regarding the distribution, offer and/or sale of crypto-assets, including the initial offering;

What rules and restrictions govern the conduct of and investment in, initial coin offerings (ICOs)?

The Cyprus Securities and Exchange Commission (CySEC) initially had an introverted approach towards ICOs and drew the attention of investors and firms involved in ICOs to the relevant warnings and statements of the European Securities and Markets Authority. CySEC wanted to emphasise that ICOs, depending on their structure, may fall within the scope of existing EU legislation.

The increasing interest in financial technology took CySEC a step further as it launched its Innovation Hub, giving guidance to innovative products, including token offerings that fall within the existing regulatory framework and, thus, under its supervision.

Following the amendments of the Anti-Money Laundering Law (the AML Law), an ICO that does not fall within the scope of any existing legislative framework (eg, STOs) may be considered as a service relating to crypto-assets pursuant to the AML Law; therefore, entities proceeding with such an ICO may be subject to registration and organisational compliance as a crypto-asset service provider (CASP).

There have been cases where Cyprus companies have been used for ICOs, mainly utility token offerings that do not fall within the existing financial regulatory framework; however, this has been to a limited extent.

The provisions of the AML law on CASPs is expected to bring back activity to ICOs.

When launching an ICO, an entity should, among other things, carefully consider:

• whether the tokens issued are considered as securities or financial instruments under MiFID II and general MiFID II compliance;
• whether the offering falls within the provisions of the Prospectus Directive;
• whether the offering qualifies as a licensed investment scheme; compliance with legislation on anti-money laundering (AML) and the General Data Protection Regulation; and
• possible tax implications for the parties involved.

Crypto-Asset Classification – Utility or Security Test

Based on the above information as stated under Section 6., the Test for the Classification of Token on whether a crypto-asset will be subject to regulation depends on its characteristics. Since there is no official regulatory framework for the classification of crypto-assets in Cyprus, the relevant authorities apply the international practice standards for the classification.

Important to mention, that even if a Token is classified as a Utility Crypto-Asset it still has the obligation to be registered as a CASP under Cyprus Regulatory Framework. The only possible exemption applicable for a Utility Token to be classified as a CASP is only if the Howey Test has been successfully passed and the token is not tradable neither is accepted as a means of payment on any exchange or even through peer to peer transactions. However, even in that case, other applicable laws could still be in place, with the requirement of obtaining a license and/or approval by CySEC.

Therefore, whether a crypto-asset will be subject to regulation depends on its characteristics. Since there is no official regulatory framework for the classification of crypto-assets in Cyprus, the relevant authorities in accordance with the above sections as mentioned through this opinion letter, apply the international practice standards for the classification to identify on whether it’s a security token or not.

Is the Token a Security?

In the context of tokens and crowd sales such as ICOs and IEOs, the test for establishing whether a token is a security varies from jurisdiction to jurisdiction. To be able to evaluate the chances of a token to be considered either as a security or a utility token, we must first note that the laws surrounding token categorization are still emerging and unsettled. The answer will very much depend on the laws of the jurisdiction which is of concern.

One of the toughest tests, is that which is applied by the U.S. Courts, i.e. the ‘Howey Test’ which has been utilized by the US Courts for some time now in order to determine whether an instrument qualifies as an ‘investment contract’ as defined by federal and state securities laws. In the case of United Housing Foundation, Inc. v Forman (1975), the test was summarized as follows:

“the basic test for distinguishing the transaction from other commercial dealings is whether the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others. . . This test, in shorthand form, embodies the essential attributes that run through all of the Court’s decisions defining a security. The touchstone is the presence of an investment in a common venture premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others. By profits, the Court has meant either capital appreciation resulting from the development of the initial investment, . . . or a participation in earnings resulting from the use of investors’ funds, . . . In such cases, the investor is “attracted solely by the prospects of a return” on his investment. . .. By contrast, when a purchaser is motivated by a desire to use or consume the item purchased. . . – the securities laws do not apply.”

Additionally, the SEC has previously released a report on the application of US securities laws to the Decentralized Autonomous Organization (the “DAO”) and the blockchain token associated with it (the “DAO Token”) where it clarified that:

A) The Howey test can be applied to blockchain token investments just as it applies to investment contracts.

B) The facts and circumstances of each token will determine whether it will be deemed to be a security or not.

C) When tokens are offered or sold to U.S. persons., then US securities laws can reach sellers in foreign jurisdictions.

The Howey Test establishes 4 criteria which must be met collectively in order for a token to be considered as a security token.

According to the Court ruling which applies to cryptographic tokens as well, they shall be considered as securities if there is:

• an investment of money or other tangible or definable consideration;

• this investment is in a common enterprise;

• with an expectation of profits

• which comes solely from the efforts of others (e.g., a promoter or third party).

Applying the test above to our tokens, we find that per the Whitepaper Each Token has its own unique and special characteristics, and the classification of the Token is to be conducted by the above framework and Tested within its unique dedicated Ecosystem and Platform whereas either the Tokens is to be Utilized and/or used for Exchange and/or Investment with Expectation purposes.

This article is only for informative purposes. Should you require further expert guidance, please do not hesitate to contact Simon Zenios & Co LLC below:

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