In the current issue of the renowned German economics journal WirtschaftsWoche, FIN LAW and founding partner Lutz Auffenberg, LL.M. were named as Top Law Firm and Top Laywer 2022 in the field of banking and finance law. In total, 21 law firms and 35 colleagues were selected by WirtschaftsWoche. The identification of the award winners was made by the Handelsblatt Research Institute by interviewing more than 1,600 lawyers from 123 law firms.
Who’s Who Legal (WWL) has nominated Attorney Lutz Auffenberg, LL.M. in the 2021 issue as one of the world’s leading practitioners in the field of Blockchain. Along with FIN LAW Partner Lutz Auffenberg only five other advisors have been nominated for the German jurisdiction. The determination of the leading practitioners resulted from a comprehensive market analysis and interviews of WWL’s editorial office with the market participants as well as lawyers advising in the field of Blockchain law.
The participation in economic life is steadily being digitalized and that even prior to the outbreak of the current pandemic. An increasing number of everyday contracts is entered into via the internet. Consumers that enter into contracts with entrepreneurs via the internet are generally entitled to a legal right of revocation versus the entrepreneur under German law. The effective exercise of such a legal right of revocation leads to the rescission of the revoked contract. However, the legally stipulated fourteen-day revocation period only starts, if and when the entrepreneur correctly informs the consumer about the right of revocation. Consumers may also have such a right of revocation for contracts concerning financial services which are entered into via the internet. But what about the distribution of security tokens via the internet? Who has an obligation to inform the consumer about the right of revocation when it comes to the public offering of tokenized investment products?
Legal Right of Revocation Only in Certain Constellations at the Capital Markets
To begin with, a legal right of revocation in accordance with German private law is only granted to investors that do not act as entrepreneurs. For the field of investment this means that a legal right of revocation is not granted to institutional investors that invest on a professional and commercial scope. The differentiation between a consumer and an entrepreneur with regards to the investment activities may be difficult when it comes to private, wealthy individuals who are experienced in the capital markets and also when it comes to smaller family offices. Regardless of the degree of professionalism of the respective investor, the features of the security token itself may determine the existence of a legal right of revocation. According to German law, consumers are not entitled to a legal right of revocation for contracts on the acquisition of goods and services of which the prices are dependent on fluctuations on the financial markets the entrepreneur has no influence on and which may occur during the revocation period. This may for example be the case with security tokens, which immediately show a market price because they are directly listed for trading on a crypto exchange. Tokenized investment products granting an unconditional repayment and interest claim to the investor and which are not tradable with a fluctuating market price are most likely not subject to this exemption.
Who is Subject to the Information Obligation During a Security Token Offering?
Subject to the obligation to inform the consumer about an existing legal right of revocation is the entrepreneur, who enters into a contract concerning the subscription of the respective tokenized investment product with the consumer. This may first of all obviously be the issuer of the tokens when selling them to the investor via the internet. Nevertheless, it is also possible that a professional interim owner, e.g. an issuing house, is the one that sells the product to the consumer. In these cases, the contract regarding the purchase of the respective security tokens is entered into by the consumer and the interim owner who now acts as a provider. Then, the obligation to inform the consumer lies with the provider. On the other hand, issuers or providers should refrain from informing investors of a right of revocation where a legal right of revocation does not exist – for example if the investor is not a consumer – because an unnecessary information about a right of revocation may be interpreted as a voluntary granting of a contractual right of revocation.
Is there a legal right of revocation in Security Token Offerings? What must be observed by issuers and providers in this context and what may be the legal consequences in case of unfulfilled obligations?
The Electronic Securities Act (eWPG) went into effect in June of 2021. According to the unambiguous intention of the legislator, the eWPG relates solely to unsecuritised bearer bonds and it is in its current iteration intended as somewhat of a test for the possible introduction of other unsecuritised financial instruments such as e.g. electronic stocks. With the introduction of the eWPG, the legislator nevertheless also altered a number of provisions in other codes of law regarding securities and capital markets law. The legislator e.g. amended the Capital Investment Act (KAGB) to provide for the option to introduce crypto fund shares. The specific legal design of these crypto fund shares is delegated by the legislator to the Federal Ministries of Finance (BMF) and Justice (BMJ) which are authorized to issue executive ordinances in this matter. The two Federal Ministries acted on this authorization last week and published a draft for a Crypto Fund Shares Regulation (KryptoFAV).
What is Supposed to be Regulated by the Crypto Fund Shares Regulation?
The published draft of the KryptoFAV consisting of just four paragraphs is rather short. According to the draft, crypto fund shares are intended to be electronic participation certificates that are registered in a crypto security registry. Next to the legal definition of crypto fund shares it also regulates the mutatis mutandis applicability of the eWPG provisions concerning crypto securities and crypto security registries to crypto fund shares. The draft intends for a special feature for the depository of crypto fund shares, which in contrast to those of electronic securities, mandatorily has to be the registry operator for the registration of the issued investment fund so that it can fulfill its legal control and information obligations towards the investors of the fund. Crypto fund shares will therefore not differ much from crypto securities pursuant to the eWPG other than in this particularity. The supervisory regulations of the KAGB will be applicable to crypto fund shares in the same way as they are applicable to traditional fund shares.
Can Fund Shares Be Tokenized in a Different Way?
The KryptoFAV intends to provide market participants with the option to issue tokenized shares of investment funds which may be acquired in an unencumbered, bona fide way by investors, similar to securitized participation certificates. Crypto fund shares will then be just as suited for an organized secondary market as traditional securitized fund shares. That being said, capital management companies are not restricted to crypto fund shares, if they intend to issue tokenized shares of investment capital. There will still be the option to tokenize fund shares without the registration in a crypto security register and observation of the requirements of the KryptoFAV by creating a legally valid contractual connection between the shares and the tokens representing it. The advantages of crypto fund shares regarding a bona fide, unencumbered acquisition is in this case lost, but on the other hand a registration in the crypto security registry of a depository that is also authorized as a crypto securities registry operator is also not required.
Last week, the Federal Ministry of Finance published its draft for a new Crypto Funds Shares Regulation (KryptoFAV). How will crypto fund shares be legally designed according to the ministries publication and what are the possibilities for investment funds arising from it?
In almost no other field the EU Commission is as active as in the field of regulation of the combat against money-laundering and terrorism financing. The fourth Anti-Money-Laundering Directive had only been released in 2015 and had to be transposed by the member states until the 26th of June 2017. Even prior to the expiration of this deadline, the issuance of the fifth Anti-Money-Laundering Directive had already been initiated. The fifth Anti-Money-Laundering Directive was the first piece of regulation that included virtual currencies into the regulatory regime of European anti-money-laundering prevention and it also regulated certain crypto exchange and crypto custody service providers as obliged entities in the sense of the AML regulations. In June of 2021 the EU Commission announced that it intends to fundamentally revise the European money-laundering and terrorism financing regulation again and published drafts for a total of four very far-reaching regulatory projects: The centerpiece is the new European AML Regulation, which as a so-called Single-Rule-Book will provide uniform regulations for the entirety of the Union and which is intended to be directly applicable to all market participants. The sixth Anti-Money-Laundering Directive will especially be focused on the regulation of the cooperation of the national and European authorities that are tasked with money-laundering prevention. The new AMLA Directive intends to create a new centralized European authority, which is supposed to facilitate the flow of information between the competent national authorities and the market participants being regulated as obliged entities. The fourth project is focused on the implementation of Travel Rule, as it is recommended by the Financial Action Task Force (FATF).
How Does the EU Commission Intend to Implement the FATF Travel Rule?
The FATF included the critically discussed Travel Rule already in 2019 in its recommendations to the member states regarding effective anti-money-laundering and terrorism financing measurements. According to the FATF Travel Rule, member states are supposed to obligate service providers that are involved in crypto transactions to collect comprehensive information about the individual transaction itself as well as about the transaction participants and to share this information with each other. The recommendation calls for data such as the names and addresses, the national identification numbers and the whereabouts of the transaction participants as well as the transaction date, associated wallet addresses and banking information where applicable. The EU Commission now tackles the implementation of the Travel Rule and chooses a rather obvious way to do so. By amending the European Money Transfer Regulation to include crypto service providers, the FATF regulations are intended to be uniformly implemented in Europe. The actual implementation seems somewhat unimaginative, because the obligations that are already applicable to service providers engaging in the transaction of book money are merely amended to also be applicable to crypto service providers and crypto transactions.
Is the Inclusion of Crypto Transactions in the European Money Transfer Regulation the Right Way?
The approach of the EU Commission to expand the scope of application of the Money Transfer Regulation to include crypto service providers is at first sight natural. Nevertheless, this approach does not take into account the technical features and intricacies of crypto transactions. Transactions of crypto assets generally work in a decentralized way, so that the involvement of crypto service providers is not compulsory. Especially transactions for money-laundering or terrorism financing purposes will therefore seldom or rather never include transaction participants that actually choose to involve a crypto service provider, but instead will be settled directly between the transaction participants. Therefore, these measurements will affect primarily the honest and fair users and service providers. The application of a Money Transfer Regulation which is also applicable to crypto transactions will nevertheless substantially limit the options of money-laundering and terrorism financing, especially when it comes to the exchange of crypto assets to fiat money. Furthermore, the market participants will collect a huge amount of data for the prosecution authorities, which will probably increase the effectiveness of backtracking crypto transactions in the European Union considerably. A targeted regulation that takes the technical features and intricacies of crypto transactions into account would nevertheless be preferable for the future. A new regulatory proposal which tackles this subject could be put forward at the latest in the year after the next, should the EU commission keep up its pace regarding AML regulations.
The EU commission intends the implementation of no less than four regulatory measurements to the European Anti-Money-Laundering regulation. In the process it will also tackle the implementation of the FATF Travel Rule.
The rising interest in cryptocurrencies, especially of professional investors and the steadily growing acceptance of tokenized investment products on the capital markets prompted the German legislator to introduce crypto securities as a new sub-type of securities. These are a special form of electronic bearer bonds which do not require securitization in a paper document. With crypto securities, the ownership of investor rights resulting from the bearer bond are represented through the ownership of the crypto token. The German legislator chose a registry-based solution in order to implement the aforementioned system in a legally sound way. The ownership of the tokens which represent the crypto securities as well as the current terms of the bearer bonds and additional base-data regarding the issuance will be displayed in a crypto security registry. The operation of such a registry will be reserved for so-called registry operators, which are authorized by BaFin to conduct this activity. It is for this reason, that the financial service of operating a crypto security registry has been introduced to the German Banking Act (KWG).
What is the Activity of Operators of Crypto Security Registries?
The registry operators for crypto security registries must keep the registries on a recording system that is forgery-proof, records the data in the correct chronological order and is secured against unauthorized deletion and subsequent changes. DLT solutions are therefore especially well suited as infrastructures for crypto security registries. The applicable law is nevertheless worded in a technology neutral manner which leaves room for future innovations. Beyond the obligation to register the the owner and the issuer of the securities, registry operators must also register the nominal amount, the issuance volume, the essential rights that are connected to the respective security as well as the associated securities identification number (ISIN). It is within their responsibility, that the current ownership of a crypto bond is at all times comprehensibly and accurately displayed. The public may legally rely on the correctness of the displayed data in a crypto security registry.
What are the Regulatory Requirements that Operators of Crypto Security Registries Must Fulfill?
The law sets out strict requirements for obtaining an authorization for operation of a crypto security registry, even though these requirements are considerably lower for businesses which intend not to offer any other financial services, but instead exclusively operate a crypto security registry. To begin with, operators of a crypto security registry have to dispose over a regulatory starting capital of 150,000 euros. They are furthermore required to have a fit and proper director, reliable owners and especially important, a proper business organization. Should it be intended to exclusively operate crypto security registries and no other financial services, the requirements regarding the disposable funds, overall liquidity, required capital buffers and the remuneration systems for employees are considerably lower in comparison with those placed on other financial institutions.
Transition Period Allows Operators of Crypto Security Registries to Obtain a Preliminary Authorization
For not interfering with already existing business models and for facilitating the transition of the crypto market to the new rules, the KWG provides for transitional rules for businesses which intend to offer crypto security registry operation or already do so. Operators of crypto security registries may obtain a preliminary authorization for their business, if they begin the business activity until the 10th of December 2021 and notify BaFin at least two months prior to the start of their activities. The last possible date for a valid submission of such notification to BaFin is therefore the 10th of October 2021. The submission to BaFin must set out that a sufficient starting capital is indeed in place, that the director/directors is/are fit and proper and that the applicant has worked out a sustainable business plan with regards to the intended operation of a crypto security registry. In case of filing a valid notification to BaFin, the applicant must submit a full and comprehensive application for operation of crypto security registries at least six months after the date of the notification.
In 2018, the first first piece of codified regulation regarding blockchain and DLT units was introduced in the European Union with the creation of the so-called fifth Anti-Money-Laundering Directive. Since then, virtual currencies are defined by the European AML regulation as a digital representation of value that is not issued or guaranteed by a central bank or a public authority, is not necessarily attached to a legally established currency and does not possess a legal status of currency or money, but is accepted by natural or legal persons as a means of exchange and which can be transferred, stored and traded electronically. A month ago, the EU Commission published its draft version of a new EU Anti-Money-Laundering Regulation (EU AML Regulation), which is supposed to be applicable in the future in the member states without the requirement of a transposition into national law. The EU Commission seeks to standardize the anti-money-laundering prevention within the union in order to enhance the efficiency of the combat against money-laundering and terrorism financing. But the EU AML Regulation shall not set out the term of a virtual currency anymore.
Crypto Assets Instead of Virtual Currencies
The new EU AML Regulation will provide a definition for crypto assets instead of one for virtual currencies. The departure from the term of virtual currencies is consistent and logical, because firstly, the recommendations of the Financial Action Task Force (FATF) utilize the term crypto assets since 2019 and secondly, because there have been considerable problems with the definition of virtual currencies since Central and South American countries openly consider making Bitcoin their legal tender. By becoming a legal tender, Bitcoin would no longer be subject to the definition of virtual currencies. A definition of crypto assets is not provided in the draft version of the EU AML Regulation itself. The Commission in a rather eager attempt to create homogeneous regulation will define the term crypto asset in the Markets in Crypto Assets Regulation (MiCA), which is also in a draft state. This definition will be applicable to the EU AML Regulation as well. Consequently, crypto assets will be defined in the EU as digital representation of value or rights which may be transferred and stored electronically, using distributed ledger technology or similar technology. The requirement of a lack of status of a legal tender will no longer be included into the definition, so Bitcoin will be qualified as a crypto asset regardless of the developments in Latin America.
The German Legislator Must React Anyways
The German Federal Government, on the basis of its blockchain strategy initiated in early 2020 a national solo-effort and instead of regulating virtual currencies in the Anti-Money-Laundering Act regulated crypto assets in the German Banking Act (KWG). In close resemblance to the definition of virtual currencies in the fifth Anti-Money-Laundering Directive, the German KWG defines crypto assets as digital representations of value that are neither issued nor guaranteed by a central bank nor any other public authority and that do not possess the legal status of currency or money, but are accepted by natural or legal persons as a means of exchange or payment on basis of an agreement or actual practice or which serves investment purposes and which can be stored, traded and transferred electronically. There is no way for the German Legislator to keep this definition in effect, because MiCA as a European regulation will take precedence over German national law.
The draft version of the new Anti-Money-Laundering Regulation of the EU Commission does not refer to the definition of virtual currencies anymore that had just been introduced with the fifth Anti-Money-Laundering Directive and will instead regulate crypto assets.
There are not only electronic securities but also crypto securities since the Act on Electronic Securities (eWpG) went into effect on the 10th of June 2021. According to the legal definition, the term also includes unsecured electronic bearer bonds which are registered in a crypto security register. The legislator simultaneously turned the operation of such crypto security registers into an activity which is subject to authorization by amending the German Banking Act (KWG) accordingly. Whoever intends to commercially operate a crypto security register in Germany is therefore obligated to obtain prior authorization from BaFin and to fulfill all the legal requirements to obtain such an authorization. However, looking at the eWpG and the KWG it is not absolutely clear who exactly is subject to this new obligation to obtain authorization.
WHO OPERATES A CRYPTO SECURITY REGISTER?
It is however certain according to the KWG, that only persons and businesses who actually operate a crypto security register can be subjected to this obligation. In order to determine who indeed operates a crypto security register, it first has to be clear what a crypto security register actually is. The eWpG does not provide a definition. It merely stipulates that crypto security registers are a subset of electronic security registers. Crypto securities are defined by the eWpG as electronic securities, which are registered with a crypto security register. It is furthermore defined in sec. 16 of the eWpG that crypto security registers have to be kept on a recording system that is forgery-proof, records the data in the correct chronological order and is secured against unauthorized deletion and subsequent changes. More informative than the eWpG itself is the associated explanatory memorandum, in which the legislator clarifies that not necessarily the operator of the register’s infrastructure is subject to the obligation to obtain authorization, but rather the body which is competent for the registration. The eWpG defines this as the person or entity, which has been named as the competent body for the registration by the issuer of the crypto security vis-à vis the bearer of the crypto security. Also the issuer itself can be the competent body for the registration. The definition of operating a crypto security registry in the KWG is therefore a somewhat unfortunate one. It would have been clearer and better to understand to explicitly regulate the activities of the competent bodies of registration which are connected to crypto securities as a financial service.
CAN A CRYPTO REGISTER BE OPERATED BY ACCIDENT?
The operation of a crypto security register is regulated by the KWG as a financial service which is subject to authorization. It is therefore prohibited to operate a crypto security register without the proper authorization by BaFin. Market participants who do so without authorization commit a criminal offence and also conduct unauthorized business, which can immediately be prohibited and rescinded by BaFin. Problems may arise in this context, if companies which accompany token issuances offer to the issuer of a tokenized bearer bond to keep a register of data related to the issuance. The fact that crypto security registers have to be designed in a decentralized way and that the eWpG specifically determines which data has to be kept by the competent body of registration in the crypto security register merely stipulates an obligation for the competent body of registration. Conversely, infringements of these obligations cannot lead to the result that an activity as a competent body of registration is not given. This would reduce the new obligation to obtain authorization to the point of absurdity. At least as problematic as the aforementioned one is the case in which issuers of tokenized bearer bonds keep data related to the issuance themselves, without naming a competent body of registration. In these cases, they are considered by the eWpG as the competent body of registration themselves. According to the wording of the KWG, the operation of a crypto securities register is generally subject to authorization and it is not necessary that the activity is performed for a third party. It can therefore not be ruled out that the obligation to obtain authorization is applicable to the issuers of tokenized bearer bonds themselves.
HOW CAN ISSUERS AND SERVICE PROVIDERS ACCOMPANYING ISSUANCES MITIGATE THIS RISK?
BaFin should immediately issue a guidance to the abovementioned definition issues and also determine within its administrative practice at what point an activity as a competent body of registration is assumed. Considering the fact that up to this point in time no company has been issued the authorization to operate a crypto security register by BaFin, issuers and service providers accompanying issuances can right now only be advised to not design tokenized securities as bearer bonds, because the stipulations of the eWpG are currently only applicable to those. Tokenized securities which are designed as registered bonds are currently not included, so that they are not subject to the abovementioned risks.
The Electronic Securities Act (eWPG) came into effect on the 10th of June 2021 in Germany. Since then, businesses have the opportunity to issue bonds in the form of electronic securities. A special form of electronic securities are crypto securities, which are electronic securities that are registered in a crypto security registry. However, the eWPG itself does not call for crypto securities to relate in any way to cryptographic technology. It merely stipulates that crypto registries have to be kept on a forgery-proof recording system, which records data in chronological order and secures said data against unauthorized deletion as well as subsequent modification. The Legislator intentionally chose a technology-neutral wording that is applicable to blockchain and distributed ledger technologies as basis for crypto registries while at the same time does not exclude future technologies.
TOKENIZED SECURITIES NOT AUTOMATICALLY CRYPTO SECURITIES
Prior to the eWPG going into effect, businesses already had the option to issue securities in tokenized form as so-called security tokens. The rights and obligations of the issuer and investors of tokenized bonds are connected to the tokens via the underlying bond terms. In the event of transferring the tokens, the rights connected with the tokens are reassigned to the new token bearer simultaneously. Security tokens will remain a legal alternative to the legislator’s design because crypto securities can only be qualified as such if they are registered in a crypto registry and security tokens without such a registration cannot be qualified as crypto securities. Token issuers can therefore choose between the issuance of a crypto security and a traditional security token. But what are the advantages and disadvantages connected to each of the variants?
REGISTRATION OBLIGATION OF CRYPTO SECURITIES
Crypto securities have to be registered with a crypto securities registry. This registration obligation is connected to considerable additional expenditure for the issuer. Even though the eWPG grants issuers the option to act as registration provider for their own crypto securities and to perform all the legally required entries into the crypto securities registry, it will however in practice be easier and therefore more common to commission a specialized service provider with the registration, which in turn is obviously connected to additional expenditure. A clear advantage of crypto securities however is the protection of legitimate expectations and good faith granted by the eWPG. Should an investor acquire a crypto security from an unauthorized seller the investor may still become the rightful owner of the crypto security if he was unaware of the lacking authorization during the acquisition process. This characteristic enables a reliable transfer of crypto securities and therefore may also enable exchange-based trading of crypto securities in the future. The protection of good faith and legitimate expectations can therefore be categorized as an unambiguous advantage of crypto securities.
TRADITIONAL SECURITY TOKENS CAN BE SAFEGUARDED BY CRYPTO CUSTODIANS
One advantage of traditional security tokens is the option to have them safeguarded by crypto custody service providers. The safeguarding of crypto securities which qualify as securities in the sense of the German Securities Deposit Act on the other hand requires an authorized depository bank. In contrast to the requirements for depository banks, the requirements for crypto custody service providers are rather low, meaning that the safeguarding of traditional security tokens will most likely be cheaper than the safeguarding of crypto securities.
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Holders of crypto assets that are suitable for the so-called delegated staking may delegate their crypto assets to a staking provider in order to participate in the underlying consensus mechanism for the validation of transactions in the network. The rewards for the abovementioned participation are newly issued blockchain units, which are generated and issued by the system, and which are shared between the staking provider to which the crypto assets had been delegated and the holder of the crypto asset who delegated them. There are different forms of delegated staking, all of which have in common that they require the delegation of the specific crypto asset to a third party in order to participate in the consensus mechanism and therefore in the mining process. However, they differ in the method of how the delegation can be effectuated.
NOT ONLY CUSTODY OF CRYPTO ASSETS CAN BE CRYPTO CUSTODY BUSINESS
Service providers intending to offer crypto custody services in Germany require the prior authorization of BaFin to do so. According to the legal definition in the German Banking Act (KWG), there are currently three different actions defined as crypto custody business. Thus, the custody, management or the safeguarding of crypto assets respectively of the connected private keys for others may be qualified as crypto custody business. Staking providers, which actually receive the delegated crypto assets on their own wallets may in some cases fulfill the custody variant of the definition. According to the administrative practice of BaFin, which was published in one of the authorities’ publications, BaFin defines the custody of crypto assets as a service for a third party in a way “that the customer does not have any knowledge and therefore possibility of disposing of his crypto assets”. Therefore, custody of crypto assets in cases of delegated staking can only be assumed, if the staking provider actually receives the crypto assets in one of his own wallets from the customer.
MANAGEMENT OF CRYPTO ASSETS IN DELEGATED STAKING SOLUTIONS
However, it is in most cases not required that the holder of the crypto assets actually transfers his crypto assets to the staking provider in order to participate in the consensus mechanism. The delegation of crypto assets rather works via a dedication in a specific smart contract on the underlying blockchain to the staking provider of the holder’s choice. In these cases, the crypto assets remain in the wallet of the staking customer. BaFin qualifies the abovementioned practice in certain cases as a management of crypto assets for others and therefore as a variant of the crypto custody business which is subject to authorization. According to the legislator’s explanatory memorandum to the implementation of the crypto custody business into the KWG as well as BaFin´s own publication on the subject of crypto custody business, management of crypto assets is defined as “in the broadest sense the ongoing exercise of rights from the crypto asset”. BaFin defines validation rights as well as voting rights as rights from the crypto asset. Pursuant to BaFin´s broad interpretation it could therefore constitute a management of crypto assets for others, which is subject to authorization, should the staking customer delegate rights in the aforementioned sense to the staking provider. In this context a counter point to BaFin’s interpretation could be that the authority itself requires in its published administrative practice the actual custody of crypto assets for all three variants as necessary.
MERE PROVISION OF STAKING INFRASTRUCTURE NO CRYPTO CUSTODY
BaFin however does not assume a managing of crypto assets in cases in which merely the technical infrastructure to participate in a delegated staking consensus mechanism is provided. In such cases, when e.g. a mining node is operated and customers are only offered to partake in the validation of transactions, a regulated management activity is not conducted. A transfer of voting rights or validation rights does not occur to the effect that there is no room for assuming a crypto management as a regulated activity.
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Most probably the German legislator did not expect the following when introducing crypto assets as financial instruments: On the 9th of June 2021, the small Latin American country of El Salvador passed a new legislation that will declare Bitcoin its unrestricted, domestic legal tender. As of the new legislation will come into effect, payments made in Bitcoin will have to be accepted by everyone in El Salvador and these payments will be legally effective. Prices can be displayed in Bitcoin and taxes and other public charges may be paid in Bitcoin. The passed law also regulates that profits made from Bitcoin transactions will not be subject to any capital gains tax just as gains from transactions with other foreign legal tender. This new law is a milestone for the national monetary policy of El Salvador, a country which hasn’t had an own national currency in over 20 years and instead used the US dollar as main currency. But even in Europe and especially Germany, the upgrading of Bitcoin to the status of a legal tender will probably not be without legal consequences.
LEGAL TENDER CANNOT BE A CRYPTO ASSET
According to the definition of crypto assets in the German Banking Act (KWG) that has been introduced in early 2020, crypto assets are defined as digital representations of value that are neither issued nor guaranteed by a central bank nor any other public authority and that do not possess the legal status of currency or money, but are accepted by natural or legal persons as a means of exchange or payment on basis of an agreement or actual practice or which serves investment purposes and which can be stored, traded and transferred electronically. According to the unambiguous wording of the law, digital representations of value that possess the status of a legal tender are not covered by the definition. Therefore, the legal consequence from a German regulatory point of view would be that when the new legislation comes into effect in El Salvador, Bitcoin can no longer qualify as a crypto asset in the sense of the KWG. As this result will most probably not be intended by neither the German legislator nor by the competent supervisory authority it will be important to wait and see how BaFin positions in this matter.
BITCOIN STILL A REGULATED FINANCIAL INSTRUMENT
Even though the wording of the definition of crypto assets in the KWG seems to be unambiguous, Bitcoin will remain a regulated financial instrument under German law in the form of a unit of account. BaFin never gave up their long-standing administrative practice, according to which Bitcoin and comparable cryptocurrencies qualify as units of account and consequently as a financial instrument. The German legislator also emphasized in the legislative materials when introducing crypto assets into the catalogue of financial instruments in the KWG that in their view the aforementioned administrative practice is legitimate and legally sound. Therefore, Bitcoins will remain regulated financial instruments in the form of units of account under the German supervisory regulations, even though they might no longer qualify as crypto assets in the future.
HOLDING BITCOINS FOR OTHERS IN THE FUTURE STILL A REGULATED CRYPTO CUSTODIAN SERVICE?
The financial service of crypto custodian service that was also introduced into the KWG early 2020 is conducted where a customer is offered the safeguarding or management of crypto assets respectively the private keys relating to crypto assets. Whoever intends to offer such services in Germany requires a prior authorization of BaFin. According to the legal definition, crypto custody services as an activity which is subject to authorization can only relate to crypto assets. Custody services relating to other financial instruments therefore do not qualify as crypto custodian service. Most importantly, custody services relating to units of account do not constitute a crypto custodian service, which was one of the major motivations for regulating the activity by introducing the crypto custody business in 2020. Strictly speaking, the custody of Bitcoins or private keys related to Bitcoins for a third party can therefore no longer constitute a crypto custody service when respecting the wording of the law. However, the question of how and to what extent the legislative decision in El Salvador affects German regulatory law is up to BaFin in the first place, even though it may be tested by the competent administrative courts at a second stage. The assessment and interpretation of the matter by BaFin should therefore be waited for.
EFFECTS ON OTHER EUROPEAN COUNTRIES PROBABLE
The German definition of crypto assets is based on the definition of virtual currencies from the so-called fifth Directive on Anti Money Laundering, which also requires the digital representation of value to not qualify as legal tender. Conversely, this means that a legal tender cannot be a virtual currency in the sense of this directive. The fifth Directive on Anti Money Laundering had to be transposed by the EU member states into national law by January 2020, meaning that El Salvador´s decision will most likely also stir a regulatory discussion throughout the rest of the continent. The whole subject illustrates that the European legislator chose a wording for the definition of virtual currencies which enables non-European countries to cause massive turbulences within the European crypto regulation. The European as well as the German Legislator should therefore swiftly take appropriate action to undo this mistake.
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On the 26th of June 2021, the new supervisory regime for investment firms – the Investment Firms Act (WpIG) – will go into effect in Germany. The new regulation will be relevant for all businesses which offer financial services such as investment brokerage, investment advisory services, proprietary trading or financial portfolio management and comparable services. Until now, the supervision of these businesses has been uniformly regulated together with the supervision of credit institutions in the German Banking Act (KWG). With the transfer of the supervisory regulations for investment firms to the WpIG, the German legislator expects to achieve a clearer, more efficient supervisory practice and simplifications with regards to the transposition of the European Investment Firm Directive (IFD), on which the WpIG is based. The KWG will stay in effect and will continue to provide the supervisory framework for companies that operate banking businesses, such as e.g. deposit business or credit business.
CRYPTO CUSTODY SERVICES CONTINUE TO BE REGULATED IN THE KWG
Not all activities that were formerly regulated as financial services will be transferred to the new WpIG. Crypto custody services which have been introduced as a financial service to the catalogue of the KWG on the 1st of January 2020 will remain exclusively regulated in the KWG as well as such activities as e.g. factoring, finance leasing and investment management. This is because the aforementioned activities are subject to authorization because of decisions made by the German legislator and not because of European provisions. Therefore, the abovementioned activities are not defined as investment services or investment ancillary services by the IFD and are therefore not subject to authorization according to the IFD. The application for an authorization to offer crypto custody services will therefore remain also in the future be regulated by the KWG after the WpIG has come into effect.
CLEAR SEPARATION OF THE REGULATORY REGIMES OF KWG AND WPIG INTENDED
In order to ensure a strict separation between the regulatory regimes, the WpIG will include an exclusivity precept stating that an authorization in accordance to the WpIG cannot be connected to an authorization granted pursuant to the KWG, the Payment Services Supervisory Act (ZAG), the Insurance Supervision Act (VAG), or the Capital Investment Act (KAGB). This may be a valid measure for preventing regulatory contradictions with regards to the regulatory requirements which investment firms must fulfill. It nevertheless causes some interpretive problems. On the 5th of May 2021, BaFin contacted the German securities trading banks which are currently under its supervision and requested the provision of information regarding the actual use of possibly held authorizations for factoring, finance leasing and investment management. BaFin interprets the exclusivity precept of the WpIG in a way, that the aforementioned services may in the future only be provided by companies, which are regulated under the KWG and not under the provisions of the WpIG. By this request for information, the authority tries to get an overview of the effects that the introduction of the WpIG may have on the investment firms market.
HOW DOES THE EXCLUSIVITY PRECEPT OF THE WPIG AFFECT INVESTMENT FIRMS?
The aforementioned interpretation of BaFin affects all investment firms and other companies that offer investment services insofar, as they will not be able to simultaneously also be authorized for providing crypto custodian business. Should these companies intend to integrate crypto custody services into their service portfolio, they will be forced to establish a separate legal entity which may apply for an authorization pursuant to the KWG. This approach has been advisable from a practical point of view even prior to the introduction of the WpIG, as crypto custody service providers that do not additionally offer other financial services are eligible for attractive privileges especially regarding their equity quotas to be fulfilled. It is however questionable, if the aforementioned legal position of BaFin is actually correct, because the legislator did also choose to apply changes to the KWG which strongly suggest a different interpretation of the exclusivity precept. In the future an authorization in accordance to sec. 32, subsection 2a KWG can only be granted if an authorization to conduct at least one of the banking businesses is simultaneously applied for. According to the new wording of the KWG, there will be no restrictions for companies which simultaneously apply for an authorization for provision of crypto custody services and which conduct the banking businesses or financial services exclusively in relation to units of account or crypto assets. In such constellations the KWG will remain applicable.
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