BaFin published its long-awaited leaflet on crypto custodian services (German only) at the start of last week. Since the legislative process took almost till the end of 2019 and the crypto custodian service was however introduced on the 1st of January 2020 into the German Banking Act (KWG), BaFin had little time to develop an administrative practice on the new financial service. The leaflet offers an explanatory interpretation of the different criteria of the new legislation and thereby clarifies which activities of service providers are subject to authorization. In addition, the authority answers the question if security tokens, meaning tokenized securities, can be safeguarded by service providers that are authorized for crypto custody services. According to the wording of the new legislation, crypto custody is applicable to the safeguarding of crypto assets which were also introduced to the KWG on the 1st of January 2020 as a new form of financial instruments. According to the legal definition, crypto assets can be digital means of payment or exchange as well as digital investment products. Therefore, currency tokens as well as security tokens can be qualified as crypto assets depending on the case at hand. According to the new administrative practice that has now been published in the leaflet, the question if a security token can be safeguarded by a crypto custodian has to be answered for each case individually.
UNDER WHICH CIRCUMSTANCES CAN SECURITY TOKENS BE SAFEGUARDED BY CRYPTO CUSTODIANS?
The exact regulatory classification of a security token is essential for the answer to the question if the token can be safeguarded by a service provider with authorization for crypto custodian services. The term “security token” obviously relates to tokens that are designed as securities but tokens that are designed as e.g. asset investments in accordance to the German Asset Investment Act or as shares of investment funds in accordance to the AIFM directive can also be digital investment products. Depending on the specific design of the token, issuers and providers of such security tokens or investment tokens must abide by the applicable capital markets regulations and, if necessary, create a sales prospectus for them. In the newly issued leaflet, BaFin explicitly states that security tokens – in accordance to the current legal situation – are not securities in the sense of the Securities Deposit Act (DepotG) and that therefore the safeguarding of security tokens does not require an authorization in accordance to the DepotG but can also be offered on basis of an authorization for crypto custody business. The background of this administrative practice stems from the fact that, according to BaFin, the security depository business only applies to products that are securities in the sense of the DepotG. Since the regulations of the DepotG all relate to securities that are securitized in paper documents, it seems farfetched to apply these rules to securities that are embodied in a digital token. The KWG however does not make this distinction in its legal wording. Nevertheless, BaFin keeps up this interpretation with regards to security tokens even though the very same leaflet also cites the explanatory memorandum of the Federal Government for the introduction of crypto assets into the KWG which states that the custody of security tokens requires authorization in accordance to the DepotG if the tokens in question are securities in the sense of the DepotG. It would have been helpful if BaFin had also explained which requirements a security token has to fulfill to be considered a security in the sense of the DepotG, especially as the authority states in the same leaflet that security tokens are not securities in the sense of the DepotG.
WHAT ARE THE CONSEQUENCES FOR THE SECURITY DEPOSITORY BUSINESS?
BaFin’s new administrative practice regarding the custody of security tokens by crypto custodians could have a massive impact on the tokenization of the capital markets in general and especially on the market for depository business for securities. While securities that are securitized in single or global certificates can only be safeguarded by banks that are authorized in accordance to the DepotG, tokenized securities can now be safeguarded by crypto custodians for investors. The second option is not only more cost-efficient but also regulatorily privileged. These facts threaten the business-model of traditional depository banks and might even make them obsolete if the infrastructure of the capital markets continue to improve for tokenized financial products.
Attorney Lutz Auffenberg, LL.M. (London)
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