Tokenised crowdfunding – obstacles, opportunities and the outlook ahead in the EU

RegCORE Client Alert | EU Digital Single Market

QuickTake

The mechanics of crowdfunding, with its roots dating back to the 18th century, has undergone a transformative journey. The modern concept, driven by internet-based platforms, encompasses donation-based, reward-based, equity-based and debt-based models which aim to cater to a diverse spectrum of needs of project owners as well as investors.

Despite its increasing global popularity over recent years, the European Union’s (EU) crowdfunding market has faced hurdles in the form of regulatory divergence and a lack of standardised rules. This has meant that access to and across the EU’s Single Market has been fragmented along national lines, ultimately limiting the full potential that crowdfunding offers for businesses and investors alike.

In response, the EU pressed ahead with the European Crowdfunding Services Provider Regulation (ECSPR), which came into force in 2021. The ECSPR is a legislative landmark and is poised to reshape the crowdfunding landscape across the EU. Designed to harmonise and standardise crowdfunding rules on a pan-EU basis, the ECSPR aims to foster a more uniform regulatory environment across Member States and how crowdfunding service providers (CSPs) operate vis-à-vis project owners and investors.

Moreover, in opening up the Single Market for crowdfunding, the ECSPR aims to provide the EU’s more than 20 million small to medium sized businesses with an ability to access new alternatives to funding for their innovative projects. While ECSPR offers a promising start, certain legacy legal and regulatory tax issues remain in individual as well as across certain Member States. These require resolution in order for pan-EU crowdfunding to reach its full potential.For further details of PwC Legal Business Solutions contributions to advancing the debate on how the ECSPR is shaping crowdfunding across the EU please see here.Show Footnote

In addition to ECSPR, the much-anticipated Markets in Crypto Assets Regulation (MiCAR) has equally entered into force in 2023. MiCAR creates the world’s first comprehensive regulatory framework on crypto-assets and is set to provide for technological overlap with crowdfunding business models. As described below, there are a number of potential synergies between the respective regulatory regimes of ECSPR and MiCAR. Some of these may require further fine-tuning so as to make the Single Market more single and these two regimes more interoperable as core pillars of the EU’s Digital Finance Package and the EU’s delivery of a true Capital Markets Union.

Key takeaways

On 9 June 2023 MiCAR was published in the Official Journal of the EU, thereby bringing to life the first ever comprehensive cross-jurisdictional regulatory and supervisory framework for those crypto-assets that were previously unregulated under EU law. MiCAR will become fully implemented by 31 December 2024.

MiCAR’s provisions aim to be technology neutral as well as asset class and jurisdiction agnostic and therefore allow for the use of both permission-less and permission-based distributed ledger technology (DLT). Crucially however, MiCAR defines which types of digital assets qualify as “financial instruments”, which are governed by the existing financial services regulatory regime and those tokens that qualify as “crypto-assets” and which are governed by MiCAR. Allocating token types to either MiCAR or traditional financial services legislation also drives how respective activity is regulated and supervised as well as what exemptions may apply.

The MICAR regulated activities constituting “crypto-asset services” are conceptually largely similar to those falling under the currently applicable body of EU financial regulation (notably MiFID II). Persons engaging in “crypto-asset services” will, save where exemptions apply, trigger licensing as well as compliance requirements both for crypto- asset-service providers (CASPs) and crypto-asset issuers (CAIs). Consequently, the majority of business activity related to crypto-assets in the EU (which does not already fall under existing EU regulation) is likely to fall under MiCAR and hence requires authorisation and compliance with comprehensive on-going obligations.

Further details on how to apply and comply with MiCAR are covered in PwC Legal Background Briefing on Mastering MiCAR (available here) and in subsequent thought leadership as well as more broadly in PwC’s Global Crypto Report which offers an outlook on global key developments on the horizon in 2024 and beyond.

Potential in tokenised crowdfunding

Although blockchain-based crowdfunding campaign models may at first glance be economically similar to traditional crowdfunding, there are notable key operational and regulatory differences. Crowdfunding typically involves conventional financial instruments as part of equity-based or loan-based crowdfunding via a centralised platform operated by a CSP. In most instances there may not be a (sufficiently liquid) secondary market for crowdfunding interests beyond activity that may take place on “bulletin boards” operated by CSPs allowing interested parties to express interest and/or offers.

DLT-based issuance is typically decentralised and tokenised crowdfunding can offer investors digital tokens that represent some form of ownership, access, or reward that may go beyond traditional equity-based or loan-based crowdfunding of projects. The further development of DLT use cases has the potential to transform crowdfunding, especially for historically difficult to transfer assets (certain types of equity, real estate) or those that are of low to illiquid nature.

Tokenisation makes transferability easier, thereby broadening the investor base, including geographically, thereby increasing liquidity along with potential for faster settlement, lower costs and more transparency in risk management. Tokens benefiting from increased liquidity and tradability (i.e., the quality of being easily transferred, exchanged and/or sold on secondary markets including crypto-exchanges or decentralised platforms including outside the original CSP) may also yield more opportunities for price discovery, risk diversification, and exit strategies for the tokenised crowdfunding project owners, as well as more incentives for the token issuers to deliver on their promises and maintain their reputation.

Tokenisation also has the potential to enable more flexibility and innovation in the design and governance of the tokens, as they can be embedded with smart contracts that define and execute the rules, rights and obligations of the token holders and issuers. For example, tokens can be tailored to specific use cases, such as utility tokens that grant access to a service or platform, equity tokens that confer ownership or profit-sharing rights, debt tokens that represent a loan or bond, or reward tokens that offer discounts or benefits. Moreover, tokens can also enable more democratic and participatory decision-making processes, such as voting, feedback, or consensus mechanisms, that involve the token holders in the direction and development of the project or venture.

As a result, tokenisation (more broadly) may also foster more social and environmental impact, as it can align the interests and values of the tokenholders and issuers and create more accountability and transparency in the use and distribution of funds raised. Tokenised crowdfunding can also support causes that are underserved or overlooked by traditional finance, such as social enterprises, non-profit organisations, or grassroots movements, and create more awareness and engagement among the tokenholders and the wider community.

Use cases in the tokenised crowdfunding context can be split between those that (i) are beneficial to how individual projects are funded and the contingent benefits for investors as well as (ii) benefits to the functioning of the crowdfunding service provider’s own ecosystem, equally for the benefit of investors in what they can do on that CSP’s platform.

Other changes that DLT introduces are a potential for operational efficiencies for crowdfunding platforms and thereby for project owners and investors alike. Typically, crowdfunding platforms are more centralised, meaning that contracts and other information are stored on the platform and only accessible to a select few. Tokenising information, introducing digital or smart-contracts that recognise and secure rights while improving transparency (including for previous transactions) can provide benefits to how crowdfunding platforms can engage with project owners and investors throughout the investment lifecycle i.e. from project funding, monitoring use of proceeds through to generating secondary markets and driving deeper liquidity.

Some crowdfunding platforms have already built or otherwise intend to develop DLT-based business solutions, inevitably linked to crypto-assets or for such platforms to themselves become a CASP for MiCAR purposes (hereinafter Crypto-Crowdfunding Platforms). Moreover, some efforts have also focused on crowdfunding investors being able to use (i) their own tokens or coins in lieu of investing cash and/or (ii) for project owners or for Crypto-Crowdfunding Platforms themselves to raise capital from their own token offerings. Some CSPs, where eligible, have begun to consider experimenting on how tokenised crowdfunding use cases could operate in the EU’s “DLT Pilot Regime”Regulation (EU) 2022/858 of the European Parliament and of the Council of 30 May 2022 on a pilot regime for market infrastructures based on distributed ledger technology.Show Footnote. The DLT Pilot Regime allows eligible market participants to operate under a temporary and conditional exemption from some of the existing EU rules that may not be fully compatible or proportionate with how DLT operates.

The promise of tokenisation’s potential for crowdfunding is premised that certain legislative and regulatory safeguards are further developed to make sense for how DLT operates and then equally put in place and complied with by project owners, CSPs (including Crypto-Crowdfunding Platforms) and investors. This is important in light of certain potential operational challenges and risks of tokenised crowdfunding faced by CSPs but also project owners and investors alike.

Tokenised crowdfunding may pose challenges for compliance, taxation, consumer protection and dispute resolution, as it may involve anonymous or pseudonymous actors and decentralised or self-enforcing systems with no established precedent on their legal personality. Tokenised crowdfunding may expose market participants to more volatility and fraud, as the tokens may be subject to high price fluctuations, market manipulation, hacking, or theft and even the token issuers may themselves not deliver on their commitments, misrepresent their information, or disappear with the funds. Tokenised crowdfunding may also require more due diligence, education and awareness from the participants, as they may not fully understand the risks and rewards of the tokens, the terms and conditions of the smart-contracts, or the quality and viability of the projects or ventures. Lastly, tokenised crowdfunding may create more technical and operational challenges, as it may depend on the reliability, scalability, and security of the underlying blockchain technology, the interoperability and compatibility of the different platforms and DLT protocols relevant to how tokens are issued, traded and settled as well as ultimately the availability and accessibility of the digital infrastructure and tools.

Scaling such positive benefits from DLT use cases in a sustainable and safe manner are, at present, hampered where such safeguards are absent or nascent at best in the current legislative and regulatory landscape. Furthermore, wider-reaching perceptions or actual concerns around financial crime and terrorist financing remain despite the legislative and regulatory toolkit being reformed comprehensively along with increasingly more intrusive supervision. As currently covered under the Wire Transfer Regulation (the WTR), and as set to be harmonised across the EU by December 2024 with the application of the EU’s recast WTR (the WTR II), the so-called “travel rule” requires that information on the source of the crypto-asset and its beneficiaries travels with the transaction and is stored on both sides of the transfer. Although subject to exclusions, as covered individually in a separate EU RegCORE Client Alert on the EU’s WTR II, crypto-asset service providers (CASPs) are equally required to provide this information to (national) competent authorities under WTR II if an anti-money laundering (AML) and/ or countering terrorist financing (CTF) investigation is commenced by such authorities. Such standard would not apply under traditional crowdfunding.

Ultimately, whether tokenised crowdfunding is useful for market participants depends on the nature of use cases and whether the token types being proposed or employed. At the heart of that assessment is the focus on the substance of a token rather than its form as this will drive the regulatory treatment for MiCAR (as well as MiFID II) as well as for ECSPR purposes and thus what type of license as well as exemptions may apply to each respective activity. Market participants and in particular Crypto-Crowdfunding Platforms will want to carefully assess compliance obligations during the current legislative and regulatory interplay of MiCAR and ECSPR.

The current legislative and regulatory interplay

Prior to, as well as upon adoption of the ECSPR, CSPs had to grapple with the limitations set by applicable financial markets regulations, both in and across individual Member States and at the EU level. The concept of ‘transferable security’ under MiFID II has been adopted differently across Member States, resulting in diverging classification of “financial instruments”. In turn, this had, prior to ECSPR, created regulatory fragmentation in terms of strictness and applicable regimes (i.e., MIFID II and Prospectus Regulation) to crowdfunding services across Member States.

Although firms and other undertakings can issue a variety of tokens, however, the respective applicable framework also depends on the categorisation of those tokens themselves. These can include non-fungible tokens (NFTs) – largely outside the scope of MiCAR, initial coin offerings (ICOs), security token offerings (STO) and initial exchange offerings (IEOs) – all of which are governed under MiCAR or MiFID II and traditional financial services regulation depending on the design and functionality of the token. While on one hand STOs are typically associated with the sale of more traditional (tokenised) securities, such as equities, giving their holders rights on the reference entity’s profits, ICOs on the other are generally associated with pre-sold utility tokens, giving their holders a claim against the issuer. Notably, the ESCPR underlines in Recital 15 that ICOs are not covered by the ESCPR as such offerings ‘differ considerably from crowdfunding services […]’.
The ECSPR defines crowdfunding as consisting of i) the facilitation of granting of loans, and ii) the placing without firm commitment of transferable securities and admitted instruments. For crowdfunding purposes, the ESCPR included, in Article 2(1)(n), shares of private limited companies as an admitted instrument, although only where these are not subject to restrictions that would effectively prevent them from being transferred, including in the way these are offered or advertised. Against the backdrop of issues discussed relating to shares of limited liability companies, the question whether security tokens (i.e., tokenised equity instruments) are effectively permissible for crowdfunding activities under the ESCPR may (if left unclarified), lead to further fragmentation in regulatory frameworks across the Member States as the transferability of admitted instruments as such are ultimately subject to national law.

Moreover, under Article 2(2) ECSPR, the national competent authority (NCA) granting authorisation to CSPs remain vested with the task of deciding whether to permit the use of shares of private liability companies for crowdfunding purposes. In Austria or Germany, for example, the transferability of shares of limited liability companies’ is subject to a notarial deed. While this does not mean that such private limited shares are legally prevented from being transferred, a tokenised interest in such private limited shares provides additional avenues to improve transferability.

Nevertheless, in the context of tokenised crowdfunding, as set out above, the introduction of MiCAR has now resulted in a regulatory overlap in as much as the same kind of services – i) reception and transmission of orders and ii) placing of securities without a firm commitment – could apply to the realm of certain crypto-assets. While tokens are widely traded on secondary markets, the instruments offered via crowdfunding are, in principle, not (currently even where they may be capable of being) traded on secondary markets. An additional conceptual conflict may arise where a Crypto-Crowdfunding Platform provides simple custody of a security token in a so-called hot wallet (i.e., DLT solution), as such activity is a regulated activity under MiCAR and thus MiFID II/IFR/IFD that triggers a licensing requirement.

On a similar note, ESMA has given CSPs permission to “trade” financial instruments on secondary markets, via so-called bulletin boards. In practice, this means that in organising fully functional secondary market trading amid bulletin-boards, CSPs are substantially limited and would find themselves competing with MiFID II regulated multilateral trading facilities or with fully automated and MiCAR-regulated trading in secondary markets. In the alternative, there is the risk that a Crypto-Crowdfunding Platform itself qualifies as a multilateral trading facility, where a protocol is employed that allows for the matching of buying and selling interests via the use of smart-contracts which result in transfer transactions.

Moreover, the ECSPR introduced a cap on the size of transactions that can be concluded on crowdfunding platforms. This relatively small cap is to conceivably create a burden in that the European crowdfunding market will face an uphill battle to develop. In summary, some of the vast advantages of tokenised crowdfunding include that it constitutes a method of raising capital which can access a bi