Followers of blockchain technology will be familiar with the prediction that it is only a matter of time before every asset class - shares, bonds, currencies, commodities - is digitalized. The digitalization or tokenization of assets and the creation of new infrastructure to trade and manage these digital assets or tokens using blockchain technology is set to be as transformative to the world economy as the advent of the internet. A report published by the World Economic Forum predicts that, by as early as 2027, around 10% of global GDP could be stored on blockchain technology. The tokenization of real estate in the US is well underway, with the partial sale of the St. Regis Aspen Resort in Colorado in 2018 earning headlines as one of the first major real estate properties in the US to tokenize. This has been followed by an announcement from Inveniam Capital Partners (ICP) of its plans to tokenize USD260 million in four private real estate and debt transactions, including downtown Miami's WeWork building and a 469-unit apartment development on Florida's gulf coast, with ICP set to accept investment denominated in the top 50 cryptocurrencies by market capitalization at launch.
In this article we aim to provide a jargon-busting introduction to tokenization, an analysis of its potential and challenges in the real estate sector, together with an overview of the regulatory responses and anticipated developments in relation to the digitalization of assets and real estate in the Middle East.
Tokenization refers to the process by which an asset is digitally represented on a blockchain-based system and divided into fractional ownership interests that are capable of being traded digitally. Issuers raise funds, in fiat or cryptocurrencies, by selling tokens that operate on a network or exchange platform. This is known as an Initial Token Offering or, more commonly, an Initial Coin Offering (ICO).
On a basic level, two broad categories of tokens have emerged: (1) utility tokens; and (2) security or asset tokens.
Utility tokens are digital assets designed to be spent within a particular blockchain platform. They can be thought of as currency in a micro-economy, where the tokens grant holders rights in the usage of the issuer's products or services and could, for example, be used by hoteliers to tokenize a hotel inventory.
Security or asset tokens are tokens which represent ownership in underlying assets. They can represent an ownership interest in an investment vehicle, for example, a share in a single-asset special purpose vehicle (SPV) or a unit in a Real Estate Investment Trust (REIT), where token holders expect to receive an economic return in the form of appreciated value and/ or distributions. This is private securities investment in the traditional sense, enhanced with a digital wrapper which allows investors to trade their tokens on a peer-to-peer platform without the involvement of a third party. This is particularly exciting for investments in non-listed securities and other illiquid assets and is the basis on which the tokenization of real estate is proceeding. Developments are required in relation to land registration formalities before authorities can issue tokenized title on a blockchain. Authorities will have to be capable of pre-vetting token holders for anti-money laundering (AML) compliance with changes required to land transfer rules in many jurisdictions to permit electronic transfers of real property interests.
Why tokenize real estate?
From a developer or sponsor perspective, the potential for increased capital access is a primary attraction of tokenization. Fractionalizing ownership shares to offer lower minimum investments and undertaking the fund-raising process in a digital marketplace has the potential to increase access to capital globally. The ability to sell minority ownership interests also gives the issuer a desirable level of flexibility, allowing for extraction of liquidity without the loss of control. The challenge to the so-called democratization of the real estate asset class to retail investors is the need to comply with securities laws, resulting in sales being restricted to accredited or qualified investors. This not only restricts the pool of potential investors in a given market, but threatens the global reach of real estate security token investments as issuers are required to ensure that the marketing of their tokens complies with the regulations in the jurisdictions where the investors are located.
Perhaps the greatest selling point, and differentiator, for tokenization is the aspirational transaction efficiencies made possible through blockchain technology and its indisputable ledger of ownership. The goal is for blockchain to enable tokens to trade 24/7/365 with near instant settlement. It is widely acknowledged that blockchain is an excellent tool to enhance security and transparency of a real estate asset, such reasons underpinning why it has long been presented as the future of land registries globally.
However, the challenges arising from tokenization are numerous and varied and include complicated questions regarding availability of exemptions from securities laws, investment vehicle structuring and token-holder voting rights, AM L and sanctions compliance on initial and secondary sales, tax treatment, currency exchange regulations, data transfers, custody solutions and cybersecurity, to name a few.
Regional regulatory developments
The United Arab Emirates (UAE) Securities and Commodities Authority (SCA), the country's markets regulator, has announced that it will introduce regulations for ICOs in the UAE in 2019. This, in addition to the UAE being noted to accelerate blockchain adoption in the country with its launch of the Emirates Blockchain Strategy 2021 (which involves transformation of 50% of government transactions into the blockchain platform), will seek to make the UAE an attractive destination for new projects willing to raise capital through token sales.
It is interesting to note the developments in recent years in this area. The recent announcement that we are expecting regulations on ICOs in the UAE reflects a turnaround from the SCAB previous position in February 2018 and they are currently working towards a regulatory sandbox and a rulebook for the issuance of ICOs. The aim of the regulations is encourage crypto fundraising and develop a market for trading within the UAE, while still ensuring protection against key risks such as AML and consumer protection.
When the Central Bank of UAE in January 2017 issued the Regulatory Framework for Stored Value and Electronic Payment Systems (Stored Value Regulations), a one-sentence provision stated that "All virtual currencies (and any transactions thereof) are prohibited," which was interpreted to mean that cryptocurrencies and digital tokens were not permitted within the UAE. Despite this, several real estate brokers and entrepreneurs were willing to receive property payments in bitcoin and it became a tolerated practice. The governor of the UAE Central Bank, Mubarak Al Mansouri, was later quoted as stating that the Stored Value Regulations do not cover digital currency, defined as "any type of digital unit used as a medium of exchange, a unit of account, or a form of stored value" and "do not apply to bitcoin or other cryptocurrencies, currency exchanges, or underlying technology such as blockchain."
In addition to the proposed ICO regulations, it is interesting to note that the Central Bank of UAE has announced plans to launch a digital currency in collaboration with the Saudi Arabian Monetary Authority for cross-border transactions.
In a bid to lead the way in blockchain technology, the Financial Services Regulatory Authority (FSRA), the financial regulator of the Abu Dhabi Global Markets (ADGM), a free zone in Abu Dhabi, was the first regulator in the UAE to issue guidance and regulations on cryptocurrency-related activities. FSRA issued supplementary guidance on the regulation of Initial Coin/Token Offerings and Virtual Currencies (under its Financial Services and Market Regulations), under which it commented on ICOs. Under the guidance, FSRA will, on a case-by-case basis, determine whether a proposed coin token is a security or a commodity. If the former, the ICO would be subject to the Financial Services and Market Regulations but if not, the ICO is unregulated. Following on from this, on June 25, 2018, FSRA issued a publication on the Regulation of Crypto Asset Activities in ADGM which introduced a regulated activity of operating a crypto asset business, which includes operation of crypto assets exchange houses, but excludes issuances of ICOs.
A variety of reforms (including those from the Dubai Financial Services Authority (DFSA), the regulatory vehicle of Dubai International Financial Centre) and new regulations point to increased awareness on a policy maker level. Historically, we have seen central banks and regulators be more cautious in their approach in supporting digital tokens and some countries in the region such as the Kingdom of Saudi Arabia do not ban bitcoin specifically but they promote risk awareness in particular against their speculative natures. The central banks of Lebanon and Jordan, however, do not permit dealings in virtual currencies.
Most recently, on February 21, 2019, the Central Bank of Bahrain (CBB) published a new Module on Crypto-Assets (CRA Module) which was pioneering for the Middle East. As the CBB accepts that the market for crypto-assets is growing both in the Kingdom of Bahrain and globally, the CRA Module has been published as part of the CBB's recent initiative to nurture Bahrain's financial technology ecosystem and help mitigate against the risk of financial crime and illegal use of crypto-assets within or from Bahrain.
This is an exciting space to watch in the region and the imminent publication of the ICO regulations, in addition to all developments in the free zones and neighboring countries will most definitely lay the foundations for start-up financial technology companies to flourish in the Middle East.
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