(Editor's note: This Guest Opinion article features the views of Frank Mausen, Philippe Noeltner, and Roman Mazhorov. The questions and answers have been edited for clarity. The thoughts expressed in this Guest Opinion are those of Allen Overy Shearman Sterling SCS and do not necessarily reflect the views of S&P Global Ratings.)

Institutional adoption of blockchain (or distributed ledger technology, DLT) in financial markets is accelerating. However, the legal frameworks that underpin financial markets globally were mostly built before this technology emerged. One of the most frequently cited roadblocks to adoption is a lack of legal clarity for DLT-based transactions, with uneven progress between jurisdictions in modernizing legal frameworks. Luxembourg is an example of a jurisdiction that has updated legislation to address digital securities and the use of DLT in financial markets. In this guest opinion, S&P Global Ratings asks Allen Overy Shearman Sterling SCS some of the fundamental legal questions that inform our ratings analysis for tokenized financial instruments, in the context of Luxembourg's updated legal framework.

Questions And Answers

How has Luxembourg's legal framework evolved with respect to tokenized financial instruments in Luxembourg?

Rather than creating a standalone regime, the Luxembourg legislator has adapted the existing legal framework with targeted interventions aimed at accommodating the specificities of DLT. This supports the issuance of tokenized financial instruments "natively" on a blockchain (rather than creating a token on the blockchain that represents a traditional off-chain financial instrument). Owners of these instruments can transfer and hold them on DLT networks and use them as collateral for financial collateral arrangements governed by Luxembourg law.

• Blockchain Law I (dated March 1, 2019) modified the Securities Act 2001, enabling securities account keepers to transfer and hold fungible securities ("fungible securities" means securities of the same class and type issued by the same issuer and carrying identical rights, in other words, these securities are interchangeable) created and maintained on DLT networks.
• Blockchain Law II (dated Jan. 22, 2022) modernized the Dematerialised Securities Act 2013, enabling the "native" issuance of securities in dematerialized form directly within a DLT network. It also broadened the type of entity that can record and operate DLT issuances of unlisted debt securities. Any EU-based credit institution or investment firm can now take on this role without the need for an additional license in Luxembourg.
• Blockchain Law III (dated March 15, 2023) updated the Financial Collateral Act 2005, enabling the use of tokenized financial instruments as collateral in Luxembourg law-governed financial collateral arrangements. This is particularly relevant because the Financial Collateral Act 2005, as will be later explained, introduces an out-of-court and expeditious enforcement with respect to financial collateral arrangements.
• Blockchain Law IV (expected to be adopted in 2024) introduces the role of control agent to further streamline the process for registering dematerialized securities on DLT.

How can registered or dematerialized securities be represented on DLT? Is the legal framework complete or will there be further developments regarding the Blockchain Laws?

Securities can exist in three different forms under Luxembourg law: Bearer, registered, and dematerialized. In adherence to the technology neutrality approach, the Luxembourg legislator opted not to create a fourth form of securities but to adapt the legal regime of the existing forms to accommodate the use of DLT technology. Bearer instruments, by definition, cannot be created on a blockchain, so we will focus the discussion on registered and dematerialized securities.

Adapting the traditional forms of securities to DLT technology led to the implementation of different legal solutions depending on the form of securities at hand:

Registered securities:   The Luxembourg act dated Aug. 10, 1915 on commercial companies (the Companies Act 1915) requires that the ownership of such securities, regardless of their equity or debt nature, shall be recorded in a register kept by a registrar agent or by an issuer at the issuer's registered office. The market practice and legal practitioners interpret this requirement as allowing data storage elsewhere if the register remains accessible (although not physically present) from the registered office of the registrar or issuer. This paved the way for the use of DLT to keep a register of securities issued in registered form--with every ownership change recorded on DLT--and for the register to remain accessible from the issuer's registered office through an electronic device such as a computer.

Dematerialized securities:   These are not represented by a physical certificate or through a register entry, but by book entries in securities accounts kept by authorized account keepers such as custodian banks.

Under the current legal framework, dematerialized securities can only be issued through either a central security depository operating a securities settlement system (CSD) or a central account keeper (CAK). These intermediaries keep the securities issuance account in which the number and type of securities issued are recorded. They are responsible for, among other things, verifying that the number of securities in circulation in securities accounts does not exceed the total number issued. In turn, an account keeper such as a custodian bank holds a securities account with a CSD or a CAK. This account reflects the aggregate securities holdings of all the bank's clients. A custodian bank is responsible for the administration of these securities on behalf of its clients who are the end investors, and who in turn hold their personal accounts with the bank. Each time a securities transaction occurs, changes in ownership are reflected through electronic book entries at these various participants involving various costs linked to the reconciliation between the transaction records kept by the different intermediaries.

Blockchain Law IV introduces the new role of the control agent. The control agent--which can be a CSD or any EU credit institution or investment firm--uses cryptographic electronic registration mechanisms, including DLT, to issue dematerialized securities governed by Luxembourg law. The agent maintains the issuance account. It also monitors the chain of custody of dematerialized securities held in securities accounts and verifies that the total amount of each issue recorded in an issuance account is equal to the sum of the securities recorded in the securities accounts of account holders. Most importantly, the control agent does not have a custody relationship with the account keepers. This avoids cumbersome compliance and operational costs linked to the exercise of the custody function by using DLT features. It increases parties' flexibility on how to organize the framework governing their operations.

Allen Overy Shearman Sterling SCS expect that the relationships between the issuer, the control agent, and the account holders will be defined on a contractual basis, which is not subject to pre-approval by the Luxembourg competent authorities.

Under Luxembourg law, can you use tokenized financial instruments as eligible collateral?

By clarifying that tokenized financial instruments can serve as eligible collateral under the Financial Collateral Act 2005, the Blockchain Law III has opened to these types of assets an advantageous, expeditious, and out-of-court enforcement procedure.

The Financial Collateral Act 2005 provides for an enforcement procedure that applies in relation to financial collateral arrangements, such as pledges, title transfer, and repurchase arrangements. The enforcement procedure under the Financial Collateral Act 2005 derogates from the ordinary enforcement procedures under the civil procedural law and introduces an out-of-court enforcement of collateral.

The transfer of possession of collateral is effective and binding against third parties when the pledge has been notified or acknowledged by the issuer of the pledged financial instruments or by the third-party custodian. This process can now also take place for tokenized financial instruments.

Under Luxembourg law, if a security is issued natively as a token on-chain, what legal rights and obligations do tokens represent? Are they legally enforceable in court? Do token holders have property rights in the tokens, or merely contractual rights?

The law recognizes equal rights and obligations for a tokenized asset as those that would apply to the asset if it were not tokenized. This includes court enforcement and, after Blockchain Law III, out-of-court enforcement in case of financial collateral arrangements.

The question can be more complex for debt securities because parties choose the governing law applying to their terms and conditions (lex contractus). If the parties choose a different jurisdiction to Luxembourg, considerations for that jurisdiction will apply.

If a token represents off-chain assets, does ownership of the token equate to a unique and legally enforceable claim on the tokenized assets? How is the investor's security interest over the tokenized assets created and perfected?

Real-world assets (RWAs) comprise financial assets (such as loans) and physical assets (such as real estate, art, luxury items, and commodities).

There are various ways to structure the tokenization of RWAs in Luxembourg. Typically the underlying RWAs will be acquired by a Luxembourg special (securitization) vehicle in the form of a limited liability company or a fund, which will finance the acquisition of the RWAs by issuing tokenized financial instruments, usually structured as debt instruments. The investors will have a claim against the issuer, and, ultimately, on its assets, based on their holdings of tokenized financial instruments. The structure is similar to a traditional securitization.

Are smart contracts enforceable under Luxembourg law? How would a dispute regarding a smart contract be addressed?

Allen Overy Shearman Sterling SCS is not aware of any reason why smart contracts should not qualify as legally valid and binding contracts under Luxembourg law, as long as they include the following essential conditions: (i) The consent of the parties, (ii) their capacity to enter into the contract, (iii) an object that is certain, and (iv) a cause that is licit.

Contractual arrangements are enforceable if parties have reached an agreement on the contract's essential elements. In compliance with the principle of technological neutrality, all arrangements that present the essential characteristics of a contract should be considered as contracts under the Luxembourg contractual regime.

Article 1101 of the Luxembourg Civil Code defines contracts as agreements "by which one or several persons obligate themselves toward one or several others to give, to do, or not to do something". From a legal perspective, a contract can be concluded, documented, or executed regardless of whether its support is in traditional form or by virtue of a digital tool. Moreover, Article 1322-2 of the Luxembourg Civil Code explicitly recognizes the validity of contracts in digital form. Therefore, Luxembourg legislation does not, in theory, prevent a smart contract to qualify as a contract.

However, to Allen Overy Shearman Sterling SCS' knowledge, no relevant case law has yet emerged to clarify the subject.

It should also be considered that, under Luxembourg law and in commercial matters, the burden of proof is governed by the principle of free assessment of evidence. Article 109 of the Luxembourg Commercial Code provides that, in case of litigation between parties carrying out commercial activities, trades between the parties can be proved by all means available to the parties. As most transactions (registration and transfer operations) carried out on DLT should be deemed of a commercial nature, the provisions of the Luxembourg Commercial Code should apply. This means that smart contracts, despite their digital, alphanumeric, and self-executing nature, can be eligible means of proof in a Luxembourg court.

How are interactions with public permissionless blockchains considered under Luxembourg law?

The Luxembourg legislation does not restrict the nature of the distributed ledger (e.g., public/private, permissioned/permissionless etc.) to be used for the issuance of tokenized financial instruments, provided that certain control and security mechanisms and IT systems are in place. One of the main hurdles to the use of public permissionless blockchains is to define the responsibility of intermediaries in the event of a public DLT network breakdown. We anticipate that supervisory authorities would focus on enforcing claims and establishing liability against trading platforms, as they usually have some form of contractual ties (either explicit or implicit) with their users. It is more difficult to target DLT network developers, who design and update the software that runs the network, as they often have no formal contractual links with the users and are sometimes anonymous, with most of these networks being open source. If these developers can be identified, their liability could be based on tort liability.

What tax considerations apply when tokenizing RWAs or issuing securities on-chain?

The Luxembourg government has not intervened much in tax considerations for blockchain-based transactions. So far, the Luxembourg government has only issued two circulars that address specifically the tax treatment of cryptocurrencies. There is no rule or guidance on the taxation of income from DLT-based transactions that do not involve cryptocurrencies. Therefore, general tax law principles apply.