Government Decides to Regulate Digital and Virtual Assets

The Securities and Exchange Commission of Pakistan (SECP) has decided to issue a regulatory framework for regulation and monitoring of the digital and virtual assets to control the misuse of virtual currencies in Pakistan having a global market value of over EUR 7 billion worldwide.

Please note: We had inaccurately mentioned in this news that cryptocurrencies will also be regulated by SECP, which is not the case. We regret the factual mistake.

In this regard, the SECP has drafted a document on the regulation of Digital Asset Trading Platforms in Pakistan.

This is for the first time that any of the regulatory bodies have taken the initiative to regulate the digital/virtual assets in Pakistan.

Although there is still no consensus over the definition of Digital Assets, the shared commonalities between all of them are:

• Digital/Cryptocurrencies; digital tokens/assets; Utility Tokens
• Security Tokens – either backed by real assets or cryptographic Distributed Ledger Technology.

The SECP’s objective with the regulatory framework is to support financial inclusion efforts and the advancement of technological innovation in a responsible and balanced manner; ensure the safety and efficiency of the capital market and its institutions; ensure consumer and investor protection; minimize opportunities for regulatory arbitrage; combat the circumvention of exchange control rules and regulations; illicit financial flows, money laundering and the financing of terrorism.

According to the SECP, digital assets, also known as Virtual Assets, and Crypto Assets are the start of a new era of Digital Finance and demand innovative regulatory measures and approaches by the regulators across the world. This can only be possible by the initiation of a new era that re-invents regulatory regime/measures as they are known to the regulators globally today.

A global consensus has not yet emerged in relation to giving a unanimous definition to Digital Assets. This is because digital assets have been treated differently by regulators across the world, some giving prime importance to the operational perspective of digital assets while others have taken an approach to define them to be able to make the regulations robust to minimize Anti-Money Laundering, terrorist financing, and tax evasion reservations for their respective jurisdictions.

The problem is significant as even though the full scale of misuse of virtual currencies is unknown, its market value has been reported to exceed EUR 7 billion worldwide, SECP said.

The SECP stated that there is a need to develop a policy and regulatory response to Digital Assets in Pakistan, driven by the following:

• Digital assets are a form of innovation that may impact the financial sector of the country
• Digital assets do not fit within the current regulatory framework
• Digital assets may create conditions for regulatory arbitrage while posing risks;
• Increasing interest, investment and participation in Digital Assets.

The SECP has also talked about the approaches available to regulate digital assets.

First, can be regulating and restricting new products according to existing regulations, and may in some instances even entail outright banning. Under this approach, innovators are obliged to adapt to the prevailing regulatory environment.

Second is based on the conjecture of ‘let-things-happen’ approach, described by the Commodity Futures Trading Commission (CFTC) as the ‘do-not-harm’ approach, where the financial sector is considered as dynamic and the associated need to innovate is strongly emphasized. The do-not-harm approach is highly cognizant of not letting overregulation stifle innovation, and supports finding the optimal balance between innovation, the concomitant risks and the wider safety of the financial system.

The SECP has also explained the two types of Digital Assets i.e. Utility Token and Security Token.

Utility Token

These tokens are designed to be used for a particular purpose, usually within the application/platform for which they are developed. The most common use of a utility token is a payment option for purchases within the platform. For instance, Medipedia Platform – A blockchain-based healthcare startup aimed for Medical Tourists. The platform has issued utility tokens i.e. MEP tokens can be used for payment of healthcare services within the Medipedia platform.

Security Token

Token issued with some investment dimension through an initial security offering is classified as a Security token. Such tokens bear more similarity to financial instruments than to cash. Security tokens should be thought of as assets providing rights such as ownership, right to share in future profits or cash flows, or payment of a specific sum of money (e.g., dividends).

The asset tokenization of real assets on distributed ledgers or the issuance of traditional asset classes in the tokenized form with the application of smart contracts has the potential to deliver a number of advantages over the traditional system.

These include transparency i.e. near to impossible duplication/cheating avenues inherent in the system; Improved liquidity potential i.e. enabling tradability of illiquid assets; efficiency gains due to disintermediation and automation; comparatively efficient clearing and settlement mechanisms.

Besides the above-mentioned advantages, a rather revolutionary impact of security tokens lies in its inherent potential to democratize the financial systems i.e. by enabling fractional ownership of assets which will further cause lowering of barriers to investment and inclusive access to retail investors to previously unaffordable or insufficiently divisive asset classes.

An option would be registering the Initial Exchange operators (IEO’s), who shall perform the due diligence to allow public offering through the capital market by mode of issuing security tokens. A probable process can be an issuer to submit its application including a white paper to an IEO operator for approval.

The IEO operator will then assess the issuer and white paper and, if approved, facilitate the offering of the tokens to investors. The SECP will be working with the IEO operator in assessing the IEO issuer. Once approved, the public may then invest in the issuer’s tokens from the IEO platform. This would require designing regulations to register Initial exchange operators (IEO’s) as well as prescribe a criterion to operate as such by the Commission. Resultantly, the IEO’s can only be offered by registered operators meeting the suitability criteria.

An option would be to allow IEO’s for secondary trading as Decentralized Exchange Platforms (i.e. performing the services of trading; settlement and custodian). The second option could be to separately register Digital Assets Trading (DAT) operators, DAT operator shall be providing the services of trading settlement and custodian services. The third option could be allowing secondary trading through Pakistan Stock Exchange, and the traditional mechanism of settlement and custody be followed.

In order to assess the above, SECP intends to hold multiple discussion sessions and welcomes any input/comments, SECP added.