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Think back to 2017, chances are that your street-smart cousin was busy liquidating his Bahria town file to invest in expensive Nvidia graphics-cards and comparing the per unit cost of electricity generated via solar panels and gas-generators. Your confusion was probably short-lived as by the end of the year the price of bitcoin exceeded US$ 13,000/- and the numbers forced a more mainstream recognition of “cryptocurrency mining”.

This unregulated gold rush appeared to come to a grinding halt in April 0f 2018 when the State Bank of Pakistan (SBP) issued a circular restricting all manner of financial institutions operating in the country from processing or dealing in cryptocurrencies. While there was no meaningful interplay with the formal banking services even before the circular came into effect, the variety of crypto exchanges and mining operations were now relegated to the more dubious side of the economy (exclusive group chats advising on swaps and cash-out options). The SBP’s policy decisions since then have encouraged adoption of blockchain in financial services, but the restriction on accepting cryptocurrency as legal tender still stands. The SBP subsequently introduced a regime for licensing non-bank companies as “Electronic Money Institutions” to promote cash-less payments. Despite confusion created by news reports at the time, this “e-money” is just a digital representation of fiat currency deposited in a bank – very different from cryptocurrency. With efforts underway to pull Pakistan out of the FATF grey list, from the perspective of a central bank, there is appreciable wisdom in forestalling cryptocurrency-adventurism.

Fast forward to November 2020, the Securities and Exchange Commission of Pakistan (SECP) has issued a position paper exploring the possibility of regulating digital / virtual tokens. The SECP paper – which at the outset recognizes there is a “demand [for] innovative regulatory measures” – is a welcome development. Despite Pakistan’s fintech landscape being in its nascent stages, the SECP paper elevates the discourse around tokens to a more nuanced level i.e. their classification as securities instead of currencies – issues still being grappled with in more developed jurisdictions. Albeit an oversimplification, the question is, whether the token has the role of an investment (security) or a means of payment (currency)? The latter is not possible due to the SBP’s restriction mentioned earlier and the SECP has subsequently clarified that it is aligned with the central bank on this front.

One of the key areas for regulation of digital assets revolves around the distinction between “security tokens” and “utility tokens” – as is recognised by the SECP in the position paper. For the sake of brevity, we will assume that security tokens would be considered securities in the conventional sense i.e. being units of: (i) ownership in a company; (ii) income bearing assets; or (iii) a pool of receivables. Consequently, there should be less debate as to whether the public trade of such tokens is regulated by the SECP – as is the case with shares, modaraba certificates, REITs, or debt instruments.

Utility tokens on the other hand are by their nature constructed on a blockchain for a specific use-case. In order to explain the concept of utility tokens, the United States Securities and Exchange Commission of the United States (USSEC) uses the example of a book club. Perhaps in Pakistan’s case, the flourishing fitness industry would be a better illustration. Imagine a gym-owner who develops a blockchain-powered app to issue tokens to members in order to fund the acquisition of equipment. Members who purchase the tokens would be able to use such tokens to buy different packages for gym membership. The limited function of such a utility token – on a closed loop – would not amount to a “security” or warrant regulation by the SECP.

This may not necessarily be the case for all utility tokens. Let’s imagine that the gym expands into a lucrative franchise and such tokens are subsequently: (i) made freely tradeable with non-members; (ii) priced according to market forces; and (iii) acquired and re-sold by individuals with the intent of profit instead of exercise. Such tokens start to look more like securities.

The possibilities of use-cases create the apprehension that a futuristic regulatory paradigm shift is required. This is perceived as alarmist by some commentators who reflect back to the arrival of the internet which gave rise to similar fears. Instead, they witnessed a steady development of telecom and media laws. It must also be appreciated that even for ICO’s in the United States, the USSEC uses its traditional Howey test to determine if a digital token amounts to a “security” requiring regulation. The test – emanating from a US Supreme Court decision of 1946 – has three requirements: (i) an investment of money; (ii) in a common enterprise; and (iii) with an expectation of profits from the efforts of others. The features of this criteria – which has already been tested against digital assets – are familiar to the financial products currently floated in Pakistani capital markets.

In order to capture digital assets under its mandate, codifying the Howey test into regulations issued under Securities Act, 2015 (the Act) would be the easy part. The Act empowers the SECP to expand the definition of “securities” through a notification. However, digital assets would then inherit the infrastructure of controls prescribed under Act for primary and secondary trading of securities. We can briefly acknowledge that there is substantial debate as to whether digital assets trading – executed on a de-centralized blockchain network – actually requires the role of centralized intermediaries such as depositories, clearing companies, and custodians. Nevertheless, as is the case with other jurisdictions, a fully de-centralized model may not see light of day in Pakistan and the position paper of the SECP suggests as much. Accordingly, the Act is technically not insufficient for publically trading tokens – necessary amendments to the requirements of public offering, licensing, clearing, settlement, blockchain adoption etc. can be implemented through subordinate regulations issued under the Act. Unfortunately, the Act only permits custody of securities in terms of the Central Depositories Act, 1997 i.e. book entry of dematerialized securities. Contrastingly, custody of digital assets is a technology intensive exercise of safekeeping cryptographic-keys which give the ultimate owner “bearer” status with respect to those digital assets and legislative amendments will be required to facilitate this.

The success story of virtual tokens can be attributed in a large part to the ability to freely purchase them online - without consideration as to geography of the issuers and the buyers. Conversely, acquisition and divestment of Pakistani securities is subject to foreign exchange restrictions prescribed by the SBP. It is theoretically possible to follow the model of SCRA – local accounts which can be opened for non-residents specifically for the purpose investing in listed shares. However, such an approach may not be a good fit for the retail segment - internationally the main target market for crypto trading - which relies on credit-cards and wallets to fund crypto-trading. Adapting the substance of FX controls applicable to conventional securities, it is possible to impose pricing controls specifically to trades involving non-resident traders (who will have to be identified in any event for KYC purposes). Such developments and permissions can be introduced by the SBP in the Foreign Exchange Manual along with robust AML/CFT rules if cross-border trading of digital assets is contemplated.

In evaluating new proposals, the SECP has historically demonstrated protection of retail consumers from predatory practices as one of its chief concerns. With reports of price manipulation by international crypto-exchanges, one of the central areas of focus in this regime should be consumer protection. This may be essential in ensuring sustainable financial inclusion.

NOTE : The views expressed in the article are the author’s personal views and do not represent that of his organisation.

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Asif Hussain

Asif Hussain is a lawyer in the financial sector. He is also an experienced advisor in the digital payments and wider technology space.