The Need for Establishing a Regulatory Framework for Wrapped Tokens
It is crucial to establish a regulatory framework for wrapped tokens, which can cause confusion regarding regulatory boundaries. Wrapped tokens refer to tokens that are issued in connection with the value of a specific underlying token existing on the same or different distributed ledger networks.1 The issuer of the wrapped token or the smart contract stores and manages the underlying assets, and the holder of the wrapped token has the right to redeem the underlying assets according to predefined rules. The linking ratio between the underlying assets and the wrapped tokens is typically 1:1.2
Some non-fungible tokens (NFTs) can be used to wrap other fungible tokens, meaning that the rights to the underlying tokens can be expressed as NFTs.3 Although wrapped tokens issued as NFTs cannot be directly used as a means of payment, if the underlying tokens have such functions, there is a risk that NFT-based wrapped tokens can be exploited to circumvent regulations on virtual assets and payment services. For instance, malicious actors may utilize the combination of NFT purchases, transfers, and refunds, or link NFT and fungible token (FT) smart contracts to enable a sequence of actions like NFT purchase, NFT transfer, NFT burning, FT transfer, and FT sale (cashing out), effectively bypassing regulatory oversight.
Moreover, wrapped tokens can be misused to evade regulations on financial investment products. Investment products can be created and distributed in the form of wrapped tokens, and the lack of an appropriate regulatory framework for these NFTs may lead to regulatory loopholes. A case in point is using NFTs to package multiple fungible tokens into an investment portfolio. If such NFTs are not covered by the Capital Markets Act simply because of their non-fungible nature, it could result in a violation of the "same function, same risk, same regulation" principle.
To address these risks, financial authorities should first clearly define wrapped tokens and specify prohibited activities through guidelines. During the implementation of the guidelines, policymakers should review the necessity and specifics of amending related laws such as the Act On Reporting And Using Specified Financial Transaction Information(AML Regulation), the Act on the Protection of Virtual Asset Users(Virtual Asset or Crypto-asset Regulation), and the Electronic Financial Transactions Act(Payment Regulation).
Furthermore, while establishing a regulatory framework for digital currencies like stablecoins, it is vital to put in place safeguards against the use of wrapped tokens for circumventing payment regulations. This is particularly relevant given the concerns raised in studies about the potential abuse of wrapped CBDC to bypass CBDC limit rules, as highlighted by Francesca Carapella et al. in their paper "Financial Stability Implications of CBDC" (2024)4, and reports from industry associations like UK Finance on the risk of stablecoins-related regulatory arbitrage using NFTs.5
Policymakers should also consider measures to prevent the misuse of NFTs for money laundering, terrorist financing, and tax evasion by exploiting the linkages between NFTs and fungible tokens. For example, regulators could mandate enhanced due diligence and reporting requirements for transactions involving NFT-FT combinations, and develop advanced data analytics tools to detect suspicious patterns.
The rapid development of wrapped tokens calls for a proactive and comprehensive regulatory response to mitigate the risks of regulatory arbitrage and ensure the integrity of the financial system. By implementing the proposed measures, regulators can foster a sound and innovative environment for the digital asset ecosystem while safeguarding the public interest.
It is important to note that the arguments presented in this article are preliminary and intended to stimulate further discussion and research. I am committed to building upon these ideas and developing more concrete policy recommendations through additional studies. I welcome feedback and collaboration from interested parties in this endeavor. Please feel free to reach out to me anytime to share your thoughts and insights on this critical topic.
Together, we can work towards shaping a regulatory landscape that harnesses the potential of digital assets while mitigating the risks they pose to consumers, investors, and the broader financial system. I look forward to engaging with the community and contributing to the advancement of this exciting and rapidly evolving field.
* This blog post builds upon and modifies some of the content from my article titled “Addressing Challenges in the Act on the Protection of Virtual Asset Users: Focusing on Definitions, Regulatory Boundaries, and User Protection”, which is scheduled to be published in the 57th issue of the Ilkam Law Review(Institute of Legal Studies Konkuk University), April 2024.
** Due to other pressing commitments, I have been unable to continue with the subsequent posts in "Global Trends in Stablecoin Regulatory Frameworks and Implications for South Korea's Regulatory Landscape" series. I plan to resume this series at a later stage when time permits. Stay tuned.
Giulio Caldarelli, "Wrapping Trust for Interoperability: A Preliminary Study of Wrapped Tokens", Information Vol 13, no. 1, 2022. <https://www.mdpi.com/2078-2489/13/1/6>
Id.
UK Finance, “DIGITAL ASSETS: NON-FUNGIBLE TOKENS”, 2023. <https://www.ukfinance.org.uk/system/files/2023-04/Digital%20Assets%20-%20Non-Fungible%20Tokens.pdf>
Francesca Carapella/Jin-Wook Chang/Sebastian Infante/Melissa Leistra/Arazi Lubis/Alexandros P. Vardoulakis, “Financial Stability Implications of CBDC”, Finance and Economics Discussion Series 2024-021, Washington: Board of Governors of the Federal Reserve System, 2024. <https://www.federalreserve.gov/econres/feds/files/2024021pap.pdf>
UK Finance, supra note 3.