Liquidity pools – can DeFi offer a secondary market for security tokens?

Specialist lawyer Lutz Auffenberg and his law firm Fin Law have specialized in the field of fintech and innovative technologies. In particular, blockchain technology and its regulation is the focus of his work. In his guest article he deals with liquidity pools and the question of whether DeFi can offer a secondary market for security tokens.

This article is first on the Fin Law blog appeared.

The public offer of tokens for financing on the crypto market has been an alternative worth considering for innovation-open companies since 2017 at the latest. The possibilities for capital seekers range from the issue of so-called utility tokens, which have the character of a digital voucher for use exclusively in the respective business model of the token issuer, to so-called security tokens, which grant token holders return, participation or repayment claims. While utility tokens are usually not regulated investment products, providers of security tokens as well as providers of classic investment products must observe the applicable capital market regulations. In particular, depending on the specific design of the security token, you have to prepare extensive sales prospectuses in accordance with the EU Prospectus Regulation, the Capital Investment Code or the Asset Investment Act if you want to offer your token to investors publicly for purchase on the market.

Secondary market for security tokens is still in its infancy

From a regulatory and technical point of view, public offers of security tokens are no longer a major problem. There are now numerous providers who offer technical support for tokenization projects. In legal terms, the responsible capital market supervisory authorities have positioned themselves in the last two years with an administrative practice adapted for token projects, which enables security token offerings in Germany and Europe and largely coincides with the administrative practice on the issue of classic investment products. However, the only very slowly developing secondary market for security tokens is still problematic. Internationally, there are only a few exchange platforms that enable trading with regulated security tokens. Established stock exchanges have been announcing for years that they want to create trading segments for security tokens. However, the economic and legal implementation is complex and apparently requires significantly more time than planned. Investors of security tokens therefore often have the problem of the lack of tradability of their tokens, which should actually be the outstanding added value of tokenized investment products.

Decentralized liquidity pools as a solution to the secondary market problem of security tokens?

One way of quickly establishing the tradability of freshly issued tokens that has become popular in the crypto market in the recent past is the use of so-called decentralized liquidity pools (LP). Token providers can use a smart contract to create an LP on a compatible blockchain on their own initiative, which they can initially equip with a freely selectable number of their tokens and other common cryptocurrencies such as Bitcoin, Ether or USDC, for example. LPs are decentralized exchanges (DEX), so that the tokens and cryptocurrencies they contain can be bought and sold by investors via direct interaction with the LP immediately after the LP has been launched. The provider’s tokens can thus be traded immediately against the other cryptocurrencies in the LP. The creation of liquidity pools presupposes a final surrender of a number of its tokens and a sufficient amount of other cryptocurrencies on the part of the provider. However, he wins an immediately available secondary market for his tokens.

Does the initiator of liquidity pools meet regulatory obligations?

There are good legal arguments in favor of equipping a liquidity pool with its own security token to create a secondary market. Since token issuers would of course not exclusively issue their security tokens via LPs without consideration, but also via traditional distribution channels, a corresponding sales prospectus or other investor documentation would have to be created and published for the Security Token Offering (STO) if the legal requirements are met will. With regard to the trading activity of the LP, the question also arises as to whether the initiator can be regarded as the operator of the LP from a regulatory perspective and therefore, for example, would need a permit to operate a multilateral trading system. In this respect, the technical design of the LP will be decisive in the individual case. If the initiator no longer has any technical influence on the LP after the launch and does not receive any trading fees or other benefits from the LP’s trading activity, it will usually be difficult to establish an operator status in the regulatory sense.