In September 2019, the German Federal Government presented its blockchain strategy, which should have established Germany's position as a pioneer in crypto-regulation in the future. In particular, attention was paid to the ambition to open up the German capital market to electronic securities, so that the – currently mandatory – embodiment of securities in a document would no longer strictly apply. This would bring enormous advantages for issuers. After nine months – the corresponding paper of the Federal Ministry of Finance and Federal Ministry of Justice dates from March 2019 – a certain disillusionment seems to have replaced the (justified) euphoria. Does this digitalisation stop result in a disadvantage to German FinTechs?
The global competition in digitalisation is particularly pronounced in the financial sector. Distributed ledger technology (such as blockchain) is at the forefront of this. The technology allows innovations that have been needed for a long time, as it enables, for example, the virtual representation of values and rights (“Tokenisation”) of different types to be transferred directly electronically. To a great extent, this can happen without having to use expensive intermediaries (such as clearing house, securities depositories or brokers). The result should– at least in theory – be considerable time and cost savings for capital-seeking companies if issuing, administration and custody of the virtual values/rights (“Tokens”) could also largely be carried out by a computer protocol integrated on an underlying blockchain (so-called Smart Contracts).
(Bad) reputation of ICOs – effects on STOs
The blockchain-based issuance of Tokens (starting with the so-called “Initial Coin Offerings” or “ICOs” – details on the regulatory framework here, German only) has been perceived from the outset as an alternative and – compared to traditional financial financing via bank loans and the like – significantly more cost-effective way of raising capital. Since 2017, however, there has been a decline in ICO launches. The most likely reason for this is that many ICO initiators were under the illusion that they could launch regulation-free ICOs, which was not the view of the regulators. The partially fraudulent business practices of individual ICO initiators, in some cases depriving investors of their money, also contributed to this.
In contrast, so-called Security Token Offerings (and other “sub-forms” such as Equity Token Offerings (ETO), Initial Exchange Offerings (IEO), Continuous Token Offerings (CTO), etc.) quickly developed. Unlike most ICOs, these were tailored to investment purposes and were moving more in the direction of (securities) regulation – and thus in the opposite direction of ICOs. However, STOs could not shake off the negative reputation of ICOs.
This was one of the reasons why a more tailored regulation of tokens and their issuance was demanded, dealing with the particularities of the blockchain. Through more legal certainty and the related investor protection, the trust of potential investors should be regained step by step – particularly compared to other jurisdictions.
Status quo under German law
The central aspect of this crypto-regulation should be that Tokens issued within the scope of an STO should be classified as securities in accordance with both civil and regulatory law. According to the current legal situation, this classification may diverge, which in part causes great uncertainty.
Securities under regulatory law
The prerequisites for the classification of Tokens as securities under regulatory law (so-called “Security Token”) are:
There are no further requirements for the classification of Security Tokens as securities, as confirmed by BaFin in a publication in July 2018. In particular, from a regulatory point of view, it is not necessary for Security Tokens to be embodied in a document.
Securities under civil law
The civil law concept of securities is a significant hurdle the German legislator has to face on the way to electronic securities, in order to achieve confidence in the reliability of an investment in Security Tokens.
To date, the legal situation in Germany does not provide for securities to be fully tokenised (in the civil law sense), i.e. dematerialised. Investment products (such as shares or bearer bonds) must be securitised in the form of a document in order to be considered securities under civil law. This is intended to ensure a reliable transfer of securities, for example to a secondary holder, because the values/rights contained in the document are automatically transferred to the purchaser (so-called legitimation and transfer function).
For bearer bonds – to which the planned new crypto-regulation will initially be limited – as a type of security in the civil law sense, this follows from sections 793 et seq. German Civil Code (“BGB”). Up to now, these have been characterised by the fact that the debtor must essentially only fulfil their obligations in case a document on which the underlying claim is described in more detail is presented.
This is the only way to ensure the protection of good faith – which is irrelevant from a regulatory law point of view. This is why purchasers of securities do not have to fear losing their money if, for example, the claim “embodied” in a bearer bond has not been lawfully assigned to them, but the corresponding document is nevertheless available.
From a regulatory law point of view, however, it would suffice for the token holder and the rights embodied in the Token to be documented – for example, on a register based on blockchain technology.
Planned regulation of electronic securities
In order to remove this distinction, a change in law is planned, whereby securities (in the regulatory and civil law sense) could be issued in the future by mere entry in a register (e.g. on a blockchain). This register is to serve as a “document substitute” in which the holder of the Security Token and individual characteristics of the securities (e.g. a number, comparable to an International Securities Identification Number for shares) are recorded in a way that is visible to everyone.
To this end, high demands shall be placed on the register, as the entry on the blockchain must enable the holder to be identified beyond doubt (authenticity) and the unadulterated nature of the security (integrity). To ensure this, the register shall be thus kept by the official authorities or under official authority’s supervision, i.e. by registrars licensed under regulatory law.
Federal Government hesitates
The Federal Government’s hesitation seems incomprehensible. As things currently stand, an entry in a (securities) register is already sufficient to establish ownership for the purposes of embodiment in a global certificate. A change in the law, according to which certificates in paper form would no longer be required as a prerequisite for securities in the civil law sense, does not appear to be such a big step.
At European level, further progress has already been made in this matter. On 10 June, a panel of experts presented to the European Commission its final report on the further development of the Capital Market Union. The report recommends embedding Security Tokens and blockchain technology in European financial market regulation. Most recently, Liechtenstein pushed ahead with the draft of a digital value right that eliminates the document requirement for certain financial instruments.
According to the plans of the Federal Government, Germany should take a pioneering role (we reported here and here, German only). It is therefore difficult to understand why the Federal Government – contrary to its ambitious announcement – is not taking more decisive action. To blame this solely on the Coronavirus crisis seems to be too short-sighted.