As one of the most crypto-friendly countries, Switzerland has experienced an exponential growth in blockchain-related companies and the development of the so-called ‘Crypto Valley’, housing a cluster of more than 450 blockchain-related companies in the region stretching from Zug to Zurich. Today, the hot topic in the blockchain eco-system is decentralised finance (DeFi).
DeFi is a developing area at the intersection of blockchain, digital assets, and financial services. DeFi is the general term typically used to describe blockchain-based financial services that are provided without the involvement of centralised traditional financial intermediaries, such as custodian banks, clearing houses and trading venues.
DeFi operates in a decentralised environment on the basis of public, permissionless blockchains and services are generally encoded in open-source software protocols and smart contracts. The market experienced explosive growth since the beginning of DeFi in 2020. Yet DeFi is still in its early stages.
DeFi covers a broad spectrum of blockchain based financial services and applications, ranging from decentralised lending platforms to on-chain asset management. One of the most popular use cases implemented on blockchains are decentralised exchanges (DEX).
A DEX is a decentralised blockchain based exchange which enables direct and immediate trading of crypto assets based on a smart contract embedded on a compatible blockchain, such as Ethereum, Solana or Cardano.
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“Switzerland has experienced an exponential growth in blockchain-related companies” |
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The availability of liquidity on any exchange is critical. Almost all decentralised exchanges use liquidity pools to ensure and maintain a liquid market in a specific crypto asset without the maintenance of an order book typically used on centralised exchanges (CEX).
Trading on centralised exchanges such as traditional stock exchanges or certain crypto-exchanges, are based on the order book model. Potential buyers and sellers can submit bid and ask offers relating to a specified crypto asset which are subsequently recorded in the order book maintained by the relevant centralised exchange.
Whenever corresponding bid and ask offers are recorded in the order book, the centralised exchange matches the respective offers and the seller and buyer enter into a trade. The order book model is reliant on a constant submission of bid and ask orders. On centralised exchanges, therefore, market makers often ensure a constant exchange of bid and ask offers, by committing to quote prices at which it will acquire (bid offer) or sell (ask offer) the relevant securities or crypto assets.
Decentralised exchanges, such as Uniswap or Balancer, on the other hand, are able to function without an order book by ensuring a market for the admitted crypto assets by maintaining liquidity pools. In simplified terms, a liquidity pool is an asset pool that is filled with (usually two different) coins in a certain ratio (usually 1/1). The pool is established and maintained to enable swaps between the two coins in a liquid manner.
Thus, in a liquidity pool consisting of the notional X coins and Y coins, traders can exchange their X coins for Y coins (or vice versa) without having to rely on a counterparty willing to enter into a trade. Instead, a trader sends his X coins directly to the liquidity pool and receives Y coins from the pool in return. A liquid market can therefore be ensured by way of pooling crypto assets in the liquidity pool, with no dependence on a constant submission of bid and ask offers by participants. Liquidity pools, therefore, typically function as an automated market maker.
For DEX and the liquidity pools to function, they rely on liquidity providers. Liquidity providers make their tokens available to the liquidity pool and by doing so are able to generate passive income on the crypto assets they have sent to the pool.
Further, the establishment of liquidity pools maintained on decentralised exchanges also provides service providers assisting their customers in the tokenisation of assets with the possibility to initially ensure a liquid market for the issued tokens.
Liquidity pool set-up and involved parties
Most decentralised exchanges allow their users to create their own liquidity pools. Therefore, the specific functionalities, involved parties and features of different liquidity pools may differ in practice. A model used in the Swiss market involves a service provider (an issuer) offering tokenisation services to its clients under its blockchain based infrastructure.
As an additional service, an issuer will offer to establish and maintain a liquidity pool on a decentralised exchange in order to ensure a liquid market for such tokens issued by the relevant client under its tokenisation platform.
a) Issuance of user tokens: For this purpose, an issuer will deploy a smart contract on the ethereum, or any other compatible blockchain with a fully automated market maker function (the smart contract). The issuer will issue (via the smart contract) a user token (the user token) on a crypto exchange that can be purchased by investors against payment of a specific cryptocurrency (the cryptos). Potential cryptos will typically be liquid tokens, such as Bitcoin, Ether or Polkadot. By buying the user token, the holder acquires access to the smart contract through which he can participate in the respective liquidity pool maintained through the smart contract.
b) Pairing: The cryptos are sent from the buyers of the user token (directly or indirectly through the exchange) to an address of the smart contract on the relevant blockchain. The smart contract pairs the cryptos received from the investors with another token, typically a token created on the issuer’s tokenisation platform for a client (the coin) and sends the paired coin and crypto to a liquidity pool established on a decentralised exchange (e.g. Balancer or Uniswap) on a fully automated basis.
c) Minting of liquidity tokens: In return for sending the paired cryptos and coins to the liquidity pool, so-called ‘LP tokens’ or liquidity tokens (the liquidity token) are generated (‘minted’) and sent from the liquidity pool to an address of the smart contract. The liquidity token represents the liquidity providers pro rata share in the liquidity pool, determined based on the aggregate value of paired cryptos and coins sent to the liquidity pool. Further, the liquidity token serves as evidence to receive the relevant pro-rata share of the commissions realised by the liquidity pool.
d) Automated market making: As outlined above the liquidity pool enables a trading in the crypto and the coin. Any interested buyer or seller on the relevant decentralised exchange may now exchange their cryptos for coins (or vice versa) in a liquid manner without having to rely on a counterparty willing to enter into a trade. Whenever a trade is executed through the liquidity pool, the transactor is charged a transaction fee which is then distributed to the holders of the liquidity token, such as the smart contract, on a pro rata basis.
e) Distribution of fees: The commissions received by the smart contract from the liquidity pool are split between the holders of the user token (for providing liquidity to the pool by acquiring the user token with the coin) and the issuer (for deploying the smart contract allowing the holders of the user token to participate in the liquidity pool) in a pre-defined proportion in accordance with the smart contract.
Selected Swiss regulatory considerations
The use of decentralised exchanges, in general, and liquidity pools, in particular, are becoming increasingly relevant use cases as the number and value of coins and tokens increase. However, whilst such applications raise a number of regulatory questions, they remain novel applications that are typically not subject to specific regulation in the involved jurisdictions.
The decentralised exchanges on which liquidity pools are created and maintained are typically established by parties with no physical presence in Switzerland and will, therefore, generally not be subject to Swiss financial market regulation. Conversely, depending on the features and functionalities of the relevant user token, an issuer domiciled in Switzerland may potentially be subject to Swiss financial market laws.
In this short overview, we will be focusing on the applicability of the Swiss Anti-Money Laundering Act (AMLA) and the legal qualification of a user token and, as a consequence of such qualification, the applicability of the prospectus requirement under the Swiss Financial Services Act (FinSA).
a) Anti-Money Laundering Act: The AMLA imposes various obligations on Swiss financial intermediaries to prevent money laundering, such as the requirement to become a member of a self-regulatory organisation, the duty to identify the contracting party and ultimate beneficial owner and certain regulatory notification duties in case of suspicious transactions. In particular, persons or entities that provide services related to payment transactions, qualify as financial intermediaries subject to the regulatory requirements under AMLA. Such regulated payment services, include the facilitation of or assistance in the transfer of virtual currencies, such as cryptocurrencies, if such service provider (i) maintains a durable business relationship with its counterparties or (ii) may exercise control over the virtual currencies. According to recently published legislative guidance relating to the AMLA, fully autonomous systems that do not enter into a permanent business relationship with its users are excluded from the scope of the AMLA. In consequence, where the smart contract deployed by the issuer fully autonomously pairs the crytpos with the coin and subsequently sends the paired tokens to a liquidity pool, without the issuer having any control or discretion, the issuer will not be deemed a financial intermediary under AMLA and will not be subject to the requirements and duties set out thereunder.
b) Legal qualification and prospectus requirement: Pursuant to FinSA a person publicly offering securities (Effekte) to retail investors in Switzerland is required to prepare and publish a prospectus in accordance with FinSA. Accordingly, the applicability of the Swiss prospectus requirement depends on the qualification of a user token. Only in constellations in which a user token qualifies as a ‘security’ within the meaning of Swiss law, an issuer, subject to certain exemptions defined under FinSA, will be required to publish a prospectus, if it publicly offers the user tokens to retail investors in Switzerland.
According to Swiss law, securities are standardised certificated and uncertificated securities which are suitable for mass trading. Whether or not a specific token qualifies as a security within the meaning of Swiss law, must according to the Swiss Financial Market Supervisory Authority FINMA (FINMA) be determined on a case-by-case basis.
In this context, FINMA generally distinguishes between payment, utility and asset tokens. Payment tokens (synonymous with cryptocurrencies) are tokens which are intended to be used, now or in the future, as a means of payment for acquiring goods or services or as a means of money or value transfer. Cryptocurrencies give rise to no claims against the issuer. Utility tokens, on the other hand, are tokens which are intended to provide digital access to an application or service by means of a blockchain-based infrastructure. Finally, asset tokens represent an underlying asset such as a debt (structured product, derivative or bond) or equity claim against the issuer.
According to legislative materials and FINMA’s practice, utility tokens do not constitute securities if their sole purpose is to confer digital access rights to an application or service and if such utility token can effectively be used in this manner. The same applies to payment tokens: Given that they are designed to act as a means of payment and are not analogous in their function to traditional securities, FINMA does, as a rule, not treat payment tokens as securities. Conversely, FINMA qualifies asset tokens as securities.
User tokens that merely grant an investor access to the smart contract (and no monetary claims against the issuer), allowing the holder to participate in the respective liquidity pool and to receive the corresponding commission via the smart contract, will in our view typically be deemed utility tokens within the meaning outlined above.
Whilst each token would have to be assessed on a case-by-case basis, we, therefore, believe that it can be reliably argued that a user token does not qualify as a security within the meaning of Swiss law.
However, in order to reach this conclusion, we believe the smart contract and user token will have to satisfy the following requirements:
The holder of the user token has no contractual relationship with the issuer under which the holder acquires monetary claims against the issuer;
The functionalities of the smart contract are operated fully autonomously on the relevant blockchain without any involvement of or control by the issuer;
The issuer cannot unilaterally change and/or amend the smart contract; and
The coins, the liquidity tokens, or any commissions generated under the liquidity pool are transferred fully automatically under the smart contract and the issuer at no time exercises any custody or control there over.
Conversely, in constellations in which it is not ensured by the issuer that the user token and corresponding smart contract adhere to the requirements outlined above, we believe there is a risk that FINMA may conclude that the user token qualifies as a security. In consequence, any issuance and public offering of the user tokens to retail clients in Switzerland would require a prospectus within the meaning of FinSA.
Finally, the absence of a qualification of the user token as a security is typically also of practical relevance for the admission of the user tokens to trading on a crypto-exchange, as such exchanges typically request a confirmation by potential issuers, stating that the tokens for which an admission to trading is being requested do not qualify as a securities in the relevant issuers home jurisdiction.
For the sake of completeness, it should be highlighted that the views expressed above are limited to constellations in which the relevant user token grants access to a fully automated smart contract enabling a participation in a specified liquidity pool.
In constellations in which the issuer has discretion with regard to the allocation of the involved cryptos to a specific liquidity pool, it would have to be assessed whether the issuer is performing asset management and/or brokerage services regulated under FinSA and the Financial Institutions Act.
Finally, if the issuer at any stage acquires custody over the cryptos and/or the commissions paid under the liquidity pool, the issuer may potentially be performing regulated deposit taking, requiring a banking or fintech-license under the Federal Act on Banks and Savings Institutions.
Civil liability for the functioning of the smart contract?
As outlined above, the issuer’s role will generally be limited to the deployment of the smart contract and the subsequent issuance of the user token. However, in cases, in which for technical reasons the smart contract malfunctions, e.g. if the commissions realised under the liquidity pool are not correctly sent to the holder due to an error in the smart contract, and an investor incurs a loss as a consequence thereof, the question will arise whether the issuer can be held liable for any failure in the functioning in the smart contract.
The issuer deploying the smart contract and the holder of the user token will typically not have entered into a contract which would give rise to liability claims in case of the smart contract malfunctioning. Further, and in absence of fraudulent actions by the issuer, at least under current Swiss legislation there are no protective provisions (Schutznorm) in effect which would lead to a tortious liability (ausservertragliche Haftung) of the issuer in case the error in the smart contract leads to consequential losses for the holders of the user tokens.
In absence of a legal basis establishing an issuer’s liability for deploying a smart contract, its business model will be highly dependent on its reputation in the DeFi-ecosystem. For the Swiss DeFi-market as a whole, we, therefore, believe it will be of great importance that relevant market standards and best practices in relation to the functioning, integrity and security of the relevant applications are developed, which could in relation to a specific tool, smart contract or application be verified under a technical audit performed by a third-party service provider.
Daniel Haeberli
Partner, Homburger
T: +41 43 222 16 33
E: daniel.haeberli@homburger.ch
Daniel Haeberli is a partner at Homburger.
Daniel is in the banking & finance as well as in the capital markets team. His areas of expertise include derivatives, structured products and bonds as well as syndicated debt financing and financial restructurings. Daniel is also the co-head of Homburger’s TechGroup and regularly advising clients on blockchain related projects.
Daniel has a master’s degree in law from the University of Zurich and a LLM in corporate law from the New York University School of Law. He is mandated by the Swiss Structured Products Association SSPA as Director of Legal & Regulation and a member of the Appeals Board of the Swiss exchange BX Swiss.
Alexander Wherlock
Associate, Homburger
T: +41 43 222 17 50
E: alexander.wherlock@homburger.ch
Alexander Wherlock is an associate at Homburger.
Alexander’s practice focuses on financial markets and banking law. He regularly advises on banking regulation as well as the regulation of derivative markets and complex financial products.
Alexander has a master’s degree and a PhD in law from the University of Zurich.
