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Oct 05, 2020

Managing Crypto Security Registries – What is the Background of the Proposed New Financial Service?

The German legislator intends the introduction of electronic securities. It is intended that securities no longer necessarily have to be issued in paper form in order to be tradable in a bone fide, unencumbered way through the introduction of an Electronic Securities Act (eWpG) and several amendments and changes to the German Banking Act, the Securities Deposit Act and other applicable regulations regarding securities. New legislative regulations for this subject are long overdue and could help facilitate the trade of tokenized securities (security tokens) and could possibly also help making security tokens eligible before a listing on stock exchanges. By the proposed new rules, the legislator intends to treat tokenized securities as a special form of electronic securities. While electronic securities will be mandatorily registered in an electronic security registry, which will necessarily have to be managed by an authorized central securities depository (CSD) such as e.g. Clearstream AG, crypto securities on the other hand will need to be registered with a crypto security registry. But who will manage such a crypto security registry, how will it be designed and what are the regulatory requirements for the management of it?

MANAGEMENT OF CRYPTO SECURITY REGISTRIES ONLY WITH BAFIN AUTHORIZATION

The management of a crypto security registry shall only be conducted by entities that obtained a prior, corresponding authorization by BaFin. For this reason and according to the current version of the proposed bill, the legislator intends the introduction of a new financial service in the German Banking Act (KWG). In future, the “management of a crypto security registry” shall be an activity that is subject to authorization. Interestingly enough, the proposed wording of the draft does not call for a service element to be fulfilled to trigger the necessity for authorization. Therefore, issuers of crypto securities intending to register their issued crypto securities themselves will have to be authorized to manage crypto security registries. According to the wording of the proposed legislation the manager of a crypto security register will be the entity appointed by the issuer. The issuance of crypto securities will therefore be impossible without the assistance of specialized service providers. Applicants for authorization will have to show a regulatory starting capital of at least 730,000 euros in order to be authorized to conduct the managing of a crypto security register. Additionally, they will also have to fulfil all the standard criteria for a BaFin application for authorization to conduct a financial service, meaning they will have to submit a sustainable business plan and provide proof of sufficient internal control mechanisms. One of the most important aspects will most likely be the internal IT security processes of the applicant.

HOW ARE CRYPTO SECURITY REGISTRIES SUPPOSED TO BE EQUIPPED TECHNICALLY?

According to the current draft of the legislation regarding the introduction of the new financial service, crypto security registries have to mandatorily be kept on a recording system that is decentralized and forgery-proof, that records the data in the correct chronological order and that is secured against unauthorized deletion and subsequent changes. According to the explanatory memorandum of the draft legislation, the wording of the aforementioned technical requirements is intended to be as tech-neutral as possible. Even though the most obvious choice to fulfil the requirements would probably be a distributed-ledger-structure, other technical solutions will still be a possible option. Unfortunately, the draft legislation is not clear on what the requirements for the decentralization part are. It is only pointed out that next to “public permissionless” also “private permissionless” DLT structures may be used. The wording setting out that the recording system must be “forgery-proof” is also somewhat unfortunate, because a 100% data security in an IT system cannot be guaranteed, not even by the use of public permissionless blockchain structures.

CRYPTO SECURITY REGISTRY MANAGEMENT IS NOT CRYPTO CUSTODY SERVICES

It is important to emphasize that according to the draft legislation, an authorization for managing crypto security registries does not also allow for the provision of crypto custody services. It is intended for the two activities to each be subject to an individualauthorization. The draft legislation therefore explicitly intends to add the custody of private keys for crypto securities to the wording of the crypto custodian business.

Attorney Lutz Auffenberg, LL.M. (London)

I.  https://fin-law.de

E. info@fin-law.de

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    Sep 21, 2020

    Evolution of Crypto Custody Business – Which Changes for Crypto Custodians come with the Introduction of the Crypto Security?

    The German Ministries of Finance and Justice published their long-awaited joint draft legislation concerning the introduction of electronic securities in late July of 2020. The reform proposals included in the draft are not limited to a mere equating of paper-based securities and electronically issued securities to be introduced, but instead the Electronic Securities Act (eWPG) is supposed to implement a comprehensive legal framework that is intended to introduce crypto securities as a subcategory of electronic securities as well as centralized security registries and crypto security registries. While centralized security registries shall only be operated by authorized central security depositories, crypto security registries on the other hand are intended to be operated by private companies which will have to obtain a corresponding authorization in accordance to the German Banking Act (KWG) once the aforementioned authorization and its requirements are implemented into the KWG.

    CRYPTO CUSTODY BUSINESS SHALL BE EXTENDED

    Another change intended by the draft legislation relates to the crypto custody business, which in turn was just introduced at the beginning of this year. The draft legislation intends for crypto custodians to not only be allowed to offer the management, custody and safekeeping of crypto assets but also the safekeeping of private keys which correspond to crypto securities. In its guidance published in March 2020 regarding the crypto custody business, BaFin already clarified that the authority does not consider tokenized securities (so-called security tokens) as securities in the sense of the Securities Deposit Act and that therefore crypto custodians are authorized to take custody of security tokens. The reason is that BaFin only demands authorization as a depository bank from providers that offer custody services for securities that qualify as such under the provisions of the Securities Deposit Act. The current draft legislation of the ministries now explicitly intends for crypto securities just as for electronic securities in general to be subject to the Securities Deposit Act. The extension of the crypto custody business to also include private keys related to crypto securities could therefore be a way to allow crypto custody service providers to offer limited services in relation to crypto securities. The actual custody and management of crypto securities would still be reserved for depository banks. In this regard it will be interesting to see whether the market develops a need for the mere safeguarding of private keys connected to crypto securities or not.

    SECURITY TOKENS ARE NOT NECESSARILY CRYPTO ASSETS

    According to the draft legislation, crypto securities are electronic securities that are registered in a crypto security registry. Furthermore, the draft legislation intends for electronic securities to be issued by registering them in an electronic securities registry. Issuers will therefore still have the option to issue security tokens not as crypto securities but instead as mere tokens that are connected to investor rights. This kind of security tokens of which numerous examples of issued tokens already exist in Germany could still be managed and kept in custody by crypto custody service providers even if the current draft legislation goes into effect, provided that BaFin does not change its administrative practice.

    Attorney Lutz Auffenberg, LL.M. (London)

    I.  https://fin-law.de

    E. info@fin-law.de

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      Sep 14, 2020

      Operating Crypto ATMs – What Impact does BaFins Clarification have on this Business Modell?

      Last week, BaFin published clarifications regarding the operation of crypto ATMs via its website. In this rather short publication pointed out the supervisory authority that the public placement of ATMs at which cryptocurrencies (e.g. Bitcoin, Dash, Litecoin or Ether) can be acquired or sold may constitute proprietary trading or financial commission business in the sense of the German Banking Act (KWG). BaFin furthermore pointed out that both proprietary trading as well as financial commission business are activities that are subject to an authorization requirement in Germany so that engaged operators are required to obtain a corresponding authorization prior to the start of the respective activity. Furthermore, BaFin explicitly stated that the unauthorized operation of crypto ATMs constitutes a criminal offence that can also be stopped by the authority by way of administrative compulsion. Sealing of ATMs as happened recently in the case of the “shitcoins.club“ is therefore a viable measure that the authority can take to stop and prevent illicit activities. Even persons and businesses that are merely involved indirectly in the operation of crypto ATMs will be targeted by the authority. In this regard, BaFin pointed out that the supply of venues as well as the provision of electricity or internet access for supporting the operation of crypto ATMs may constitute illicit supportive activities which BaFin is authorized to stop by coercive measures.

      OPERATION OF CRYPTO ATMS IS POSSIBLE IN GERMANY

      In the last couple of months there have been numerous reports in the relevant media stating that the operation of crypto ATMs in Germany is either unwelcome by BaFin or even outright prohibited. These statements are not correct, as can be seen from the latest publication of BaFin on this subject. Quite contrary to the aforementioned reports, the operation of crypto ATMs is possible and legal in Germany as long as the operator of the ATMs abide by the regulatory rules. The placement and operation of crypto ATMs in Germany requires a certain degree of professionalism of the operator, because crypto assets are regulated as financial instruments in the sense of the KWG. The operator is required to have an appropriate business structure with a sufficient internal control, a fit and proper managing director as well as sufficient starting capital and equity for the intended activity. Operators that meet these criteria will be granted an authorization from BaFin for the operation of crypto ATMs if they apply for it and can therefore legally operate crypto ATMs in Germany. Market participants that do not abide to the current regulatory law will be brought to heel by the competent administrative and law enforcement authorities.

      OPERATION OF CRYPTO ATMS MAY ALSO QUALIFY AS INVESTMENT BROKERAGE

      Unfortunately, the recently published opinion of BaFin falls short. The operation of crypto ATMs cannot only be conducted as either proprietary trading or a financial commission business. Instead, operators can also act as mere investment brokers, if they do not trade crypto assets with the ATM users for account of their own books but on behalf and for the account e.g. of a bank or an appropriately authorized financial institute. The crypto ATMs do not necessarily have to be connected to the crypto wallets of the technical operator. In such cases, the activity of operating a crypto ATM may also be considered as investment or acquisition brokerage which both place considerably lower regulatory requirements than proprietary trading or the financial commission business on the operator. The mere technical operation of an ATM without any commission or brokering activity might in certain cases not require any form of authorization at all. In these cases, the technical operator should nevertheless consider the aforementioned fact that his contribution to the ATM operation may be considered as a supportive activity to illicit activities of the actual operator. The technical operator should therefore make sure that the actual operator of the crypto ATM is authorized for his activity by BaFin.

      Attorney Lutz Auffenberg, LL.M. (London)

      I.  https://fin-law.de

      E. info@fin-law.de

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        Sep 07, 2020

        Depository Business, Limited Depository Business, Crypto Custody Business – What are the Differences?

        The commercial custody of financial products for customers has become a highly regulated and differentiated service with respect to German supervisory banking regulations. There are not less than three different kinds of custody businesses that are subject to authorization regulated in the German Banking Act (KWG): The depository business, which is qualified as a form of banking business, the crypto custody business and the limited depository business which both are qualified as financial services. Each of these businesses demand different requirements that vary in intensity for their respective operators. But how do they differ from each other in terms of intensity and which authorization is necessary for each respective activity?

        DEPOSITORY BUSINESS AS THE CENTRAL FORM OF FINANCIAL PRODUCT CUSTODY

        According to the wording of the law, depository business is given when securities are held in custody for others. Within its administrative practice BaFin restricted the necessity of the authorization for depository business to businesses that keep custody of financial products that meet the requirements for securities as defined in the German Securities Deposit Act. As of now, these requirements are only fulfilled by securities that are embodied in a single, global certificate or in numerous, individual certificates. Securities that are not embodied in certificates, but instead are represented e.g. in tokens or in another digital form therefore do not meet the requirements of the German Securities Deposit Act and custody services for these kinds of securities therefore do not trigger an authorization requirement pursuant to the German Securities Deposit Act. The German legislator with its draft proposal for the introduction of electronic securities intends to subject digital securities to the German Securities Deposit Act. However, it will probably take quite some time until the final draft of the law comes into effect.

        LIMITED CUSTODY BUSINESS AS A PRIVILEGE FOR CUSTODIANS FOR ALTERNATIVE INVESTMENT FUNDS (AIF)

        The limited depository business is a subset to the depository business and is only applicable to the custody of securities for alternative investment funds. Therefore, just as with the depository business only securities in the sense of the German Securities Deposit Act can be subject of the limited depository business. The difference between the two forms of custody lies in the category of serviceable customers. While the authorization for depository business grants its bearer the ability to offer custody services to all kinds of customers, the authorization for the restricted depository business merely grants its bearer the authorization to offer custody services regarding securities for Alternative Investment Funds (AIF). The reason is that MiFID II categorizes custodian services as ancillary services and not as a fully- regulated investment service. As a consequence, the supervisory requirements to be fulfilled by custodians of financial instruments are lower than those to be fulfilled by fully regulated investment firms. Given the fact, that in Germany the deposit business is regulated as a full banking service anyways, the German legislator wanted to establish a privilege for depositories that only hold securities in custody for AIF investment funds.

        CRYPTO CUSTODY BUSINESS AS A CATCHALL ACTIVITY

        The crypto custody business that has been newly introduced at the beginning of this year allows for the custody, management and safeguarding of crypto assets for others in Germany. A crypto custodian service is given where someone holds private keys for others that are required for transferring crypto assets. Interestingly, the German Banking Act (KWG) explicitly allows for crypto assets to serve investment purposes. This often leads to the situation that crypto assets are considered securities in the sense of the EU-Prospectus Regulation and MiFID II at the same time and that they are therefore also subjected to the regulations of these provisions. An authorization for depository business or limited depository business is nevertheless not necessary for their custody, because naturally these tokens are never issued in paper form. Anyways, the German legislator and also BaFin nevertheless explicitly stated in the explanatory memorandum for the legislation, respectively in the corresponding publication on the administrative interpretation, that crypto custody business is designed as a catchall Activity. It therefore is subsidiary to the depository business and the limited depository business if one of these is applicable to a custodian activity.

        Attorney Lutz Auffenberg, LL.M. (London)

        I.  https://fin-law.de

        E. info@fin-law.de

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          Aug 31, 2020

          Crypto Custody vs. Depository Business – What are the Advantages of the Digital Custody of Securities?

          BaFin expressly stated in the publication on crypto custody business dated 2nd of March 2020 that it does not consider security tokens as securities in the sense of the German Securities Deposit Act under the current legal framework. This results in the fact that providers offering the custody of security tokens currently do not require authorization as a depository bank. According to the established administrative practice of BaFin, custody service providers are instead required to obtain authorization for the depository business, if they take custody of securities that are subject to the German Securities Deposit Act. According to the authority’s opinion, security tokens as a paperless form of securities do not fulfill this requirement. Custody services for security tokens can therefore legally be offered with an authorization as a crypto custody service provider. Crypto custody services have been introduced earlier this year as a new category of financial services. Does this mean that security tokens have a market advantage over paper-based securities and that the tokenization of financial instruments offers a real-world added value?

          ADVANTAGES OF CRYPTO CUSTODIANS OVER DEPOSITORY BANKS

          From the custodian’s point of view, the regulatory requirements for the operation of a crypto custody service are significantly lower than the requirements for the operation of a depository bank. While the operation of a depository bank constitutes a banking business, the operation of a crypto custody service provider is merely considered a financial service. This results in a significant difference regarding the minimum starting capital that is required for the respective services. Required starting capital for an authorization as a depository bank may be up to 5 million euros, while crypto custody service providers only have to show 125,000.00 euros as a minimum starting capital. Moreover, crypto custody service providers enjoy some very attractive privileges as long as they only offer crypto custody services and no other banking or financial services. For example, they are not subject to the capital requirements of the CRR and they do not have to comply with the German Remuneration Regulation for Institutions when compensating their employees. Additionally, as shown above, they are also not subject to the German Securities Deposit Act while depository banks must observe these regulations when taking custody of securities.

          WHAT ARE THE ADVANTAGES FOR ISSUERS AND INVESTORS?

          The lower regulatory requirements for crypto custody service providers as compared to depository banks result in lower operating costs concerning the custody of security tokens which will in the end also be beneficial for the investors. When issuing security tokens, issuers do not have to create and safeguard a global certificate as it is the case with traditional securities. Moreover, investors always have the option to safeguard their security tokens themselves on their own electronic devices in wallets that are compatible to the security tokens to be stored.

          ARE THERE DISADVANTAGES TO SECURITY TOKENS COMPARED TO TRADITIONAL, PAPER-BASED SECURITIES?

          In contrast to paper-based documents, security tokens are not tangible objects and therefore not considered as objects in a legal sense by the German civil law. Therefore, the stipulations regulating the unencumbered, bona fide acquisition of objects of the German Civil Code (BGB) are not applicable to security tokens. However, the possibility of an unencumbered, bona fide acquisition is a mandatory requirement for a security to be listed at a stock exchange. That means, that for the time being, issuers that intend to have their security listed at a stock exchange should therefore take the traditional approach and issue the security in a paper-based form and create a global certificate for it. The German legislator showed his intention to change the abovementioned situation earlier this month by publishing his legislative draft concerning the introduction of the electronic security. The actual introduction of electronic securities into German civil law will certainly take at least until the end of the year.

          Rechtsanwalt Lutz Auffenberg, LL.M. (London)

          I.  https://fin-law.de

          E. info@fin-law.de

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            Aug 24, 2020

            Electronic Securities and Crypto Securities – What are the Differences?

            With the introduction of the Electronic Securities Act (eWPG), the German legislator intends to create a legal alternative to paper-based securities. The corresponding draft legislation to the eWPG dated 23rd of July 2020, which for the time being shall only be applicable to bearer bonds, therefore proposes the introduction of electronic securities as an alternative to traditional securities. Additionally, the draft legislation to the eWPG also proposes new rules regarding the regulation of crypto securities. But what exactly shall be the differences between electronic securities and crypto securities according to the intention of the legislator?

            SECURITY TOKENS CREATE THE NEED FOR ELECTRONIC SECURITIES

            The main motivation for the German legislator to create electronic securities was probably the increasing interest that Security Token Offerings (STO) have enjoyed over the last couple of years. Security tokens are blockchain units that are connected to rights comparable to those that are connected to securities, such as repayment and interest claims or shareholder participation and voting rights. Since the emergence of security tokens, the capital markets show an increasing need for a legal framework that equates digitally represented securities to traditional, paper-based securities. According to the current version of the legislative draft, the issuance of electronic securities would require the registration of the specific electronic security with the central electronic security registry in contrast to traditional securities which require the securitization of the specific security in a paper document. According to the current version of the proposed draft, the legal effects of an electronic security shall be equal to those of a paper-based security, provided the law does not stipulate otherwise. In order to ensure that the existing regulations concerning securities will also be applicable to electronic securities, a legal fiction that equates electronic securities to objects in the sense of the German civil law is also intended by the draft legislation because the German civil law currently only recognizes tangible objects as objects in a legal sense.

            CRYPTO SECURITIES AS A SPECIAL FORM OF ELECTRONIC SECURITIES

            According to the draft legislation, crypto securities are electronic securities that are registered in a crypto security registry. They are therefore by definition a subcategory of electronic securities. The draft legislation expressively states that crypto securities cannot simultaneously be electronic securities that are registered with the central electronic security registry. The explanatory memorandum to the draft emphasizes that the regulation of crypto security registries itself as well as the registered crypto securities will be technology-neutral. Under the current version of the draft it would therefore be possible to issue crypto securities that are not based on a distributed ledger technology. The main difference between electronic securities and crypto securities would therefore be the registration. While electronic securities would have to be registered in a centralized registry operated by a provider that is authorized as a central securities depository, crypto securities would have to be registered in one of many decentralized crypto security registries. According to the draft legislation, these crypto security registries would be operated by authorized providers that would have to ensure that the required minimum information about the crypto securities will be registered. Crypto security registries would therefore have to contain information about the main rights and obligations that are connected to the registered crypto security and an identification number, information about the issuer of the crypto security and information about disposal restrictions, eventual third-party rights as well as information regarding the kind of custody – individual or collective – in which the crypto security is kept.

            Attorney Lutz Auffenberg, LL.M. (London)

            I.  https://fin-law.de

            E. info@fin-law.de

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              Aug 10, 2020

              Draft Legislation for Introduction of Electronic Securities – What will Be the Major Changes?

              The German crypto-scene has been waiting a long time for the Federal Ministry of Justice to publish its draft legislation on the introduction of electronic securities, especially since this draft was announced by the ministry for the last quarter of 2019. It was finally published last Friday. The Federal Government deems the development of regulations for electronic securities necessary, because it holds the view that German law currently mandatorily requires the embodiment of a security in a paper document. In a joint effort, the Federal Ministry of Justice and the Federal Ministry of Finance now presented a comprehensive draft for this legislation that proposes not only changes to the German civil law, but also extensive changes to the German regulatory banking and capital markets law. It has to be noted, that the published document is just a first draft that may be subject to significant changes during the course of the subsequent legislative process. Nevertheless, the published draft already shows the direction that the legislator intends to take for the regulatory framework for the security of the future.

              NEW GERMAN ELECTRONIC SECURITIES ACT (EWPG)

              Instead of selectively changing the German Civil Code (BGB), the legislative draft proposes the introduction of a separate legislative act that contains the majority of the relevant regulations for the electronic security. The new eWPG will initially only be applicable to bearer bonds. Registered bonds and other securities such as e.g. stocks will initially not be covered by the new law, but their inclusion is intended once some experience is gained with the new eWPG. The intention of the eWPG is to equate electronic securities with those that are securitized in a paper document. In order to achieve this goal, the eWPG not only stipulates that electronic securities are to be treated similar to objects under German property law, but it also contains comprehensive, special regulations for the transfer of ownership and the bona fide acquisition of electronic securities. The legislative draft differentiates between two kinds of electronic securities, namely between crypto securities and electronic securities in the strict sense of the term.

              NEW REGULATED ACTIVITY IN THE GERMAN BANKING ACT (KWG)

              The published draft legislation intends for the transfer of electronic securities to be done by assigning them to their new owners in central registries. These registries could not be managed by the issuers of the electronic securities, but instead would have to be operated by BaFin authorized and supervised financial service institutes. All electronic securities would have to be registered with such a central registry, which itself would have to be operated by a company that is authorized as a central securities depository. In addition, crypto securities would also have to be entered into a crypto securities registry. The draft legislation therefore calls for the introduction of crypto security registry management into the KWGs catalogue of activities that are subject to authorization.

              APPLICABILITY OF THE SECURITIES DEPOSIT ACT TO ELECTRONIC SECURITIES

              Somewhat surprisingly, the custody of electronic securities according to the newly proposed draft shall be regulated in the future by the Securities Deposit Act. BaFin seemed to have a different point of view with regards to the custody of security tokens when the crypto custody service for the custody of tokenized securities was introduced earlier this year. For clarification purposes, the draft legislation now calls for a change of the Securities Deposit Act in order to explicitly include electronic securities. However, it is important to understand that even though the draft legislation regulates electronic securities, it continues to allow the possibility of issuing tokenized securities that do not meet the requirements of an electronic security. Those would most likely continue to potentially be safeguarded by crypto custody service providers, while tokens that meet the requirements of an electronic security would have to be safeguarded by depository banks.

              Attorney Lutz Auffenberg, LL.M. (London)

              I.  https://fin-law.de

              E. info@fin-law.de

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                Aug 03, 2020

                Inventory Management in Crypto Custody Service – What must be Observed when Taking Custody of Crypto Assets?

                According to BaFin, over fifty potential service providers already informed the supervisory authority about their intention to apply for an authorization to conduct crypto custody services until the end of November 2020. Less than ten actual applications have been submitted to BaFin until now. Even though it can be assumed that some of those that informed BaFin about their intentions will, in fact, change their mind and not apply for authorization, it is obvious that there will be numerous authorized crypto custody service providers in close future in Germany. These competitors will only be able to coexist, if their respective business models differ from each other and cater to different market niches. This leads to the question of what, if any, the supervisory options are that crypto custodians have to differentiate themselves from their competitors.

                SUPERVISORY PRIVILEGES ONLY FOR THOSE SOLELY OFFERING CRYPTO CUSTODY SERVICES

                One problem that occurs when designing business models that include crypto custody services stems from the fact, that the German legislator opted to only privilege those crypto custody service providers with specific supervisory exemptions, that do not provide any financial services as defined in the German Banking Act (KWG) other than crypto custody services. Crypto custodians therefore have very little leeway when it comes the actual design of their business model. The abovementioned exemptions are real simplifications that providers should not waive without good reason. Specifically, the provisions concerning the capital requirements with regards to the EU Capital Requirements Regulation (CRR) and the German Solvency Regulations are only applicable to these service providers to a limited extent. Furthermore, in contrast to other financial service institutes pure crypto custodians are not subject to limitations when it comes to the non-commercial granting of large-scale loans and they are unaffected by the German regulation on the supervisory requirements for institutions’ remuneration systems, meaning that they can freely decide on their payment structure. There are therefore numerous good reasons for financial service providers to offer exclusively crypto custody services.

                UNREGULATED ANCILLARY SERVICES MAY BE OFFERED

                Business models that intend to offer crypto custody services and unregulated ancillary services can be implemented without the loss of the abovementioned supervisory privileges. Ancillary services in this sense are services that are not classified as banking services or financial services in the sense of the KWG. Examples for these services would for example be user-friendly and easy to use interfaces, additional features that support the user with the creation of declarations for the tax authorities or the general supply of crypto deposit statements.

                UTILIZATION OF STORED CRYPTO ASSETS FOR OWN COMMERCIAL ACTIVITIES

                The business model of crypto custodians evolves around the safeguarded crypto assets. They are being managed, stored and safeguarded for the customer. Certain business models might also intend to utilize the safeguarded customer crypto assets for their own business purposes, e.g. to supply other customers with temporary liquidity for trades on the crypto market. BaFin clarifies in its published administrative practice on the crypto custody business that the core element of crypto custodian services is that the service provider has the private keys and therefore actual access to the safeguarded crypto assets. BaFin explicitly states that the custody of crypto assets can also be provided in collective holding. The authority therefore accepts business models that mix crypto assets of different customers in centralized wallets. In these cases, the crypto custodian owes its customers the transfer of crypto assets of comparable kind and quality, if the customer demands the repayment of the stored amount and not the transfer of the originally submitted assets. An interim use of the crypto assets by the crypto custodian for its own business purposes would therefore not per se be unthinkable.

                STRICT LEGAL REQUIREMENTS FOR INTERIM USE OF CRYPTO ASSETS

                Crypto custodians always have to ensure that they are at any point in time able to transfer the owed amount of crypto assets to the customers should they demand it. Furthermore, they have to ensure that the interim usage of the safeguarded crypto assets does not constitute an additional banking or financial service for not losing the supervisory privileges for crypto custodians. Customers of crypto custodians may expect a secure custody of their crypto assets, which means that the requirements for the contractual terms of custody are appropriately high. In any case in which the business model of a crypto custodian intends the interim usage of the stored crypto assets, an early dialog with BaFin prior to the actual application is highly advisable in order to avoid problems during the authorization process.

                Attorney Lutz Auffenberg, LL.M. (London)

                I.  https://fin-law.de

                E. info@fin-law.de

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                  Jul 27, 2020

                  Crypto Me Up – What must be Reported to BaFin by Financial Service Providers When Implementing Crypto Services?

                  Blockchain technology created a veritable crypto-hype during the last couple of years, especially in the financial industry. That said, a direct investment in crypto assets is not necessarily at the center of attention for the established financial markets participants. Blockchain technology, especially when applied to the financial industry offers a variety of innovations and solutions that can be implemented in the business models of financial service providers. This applies not only to the simple inclusion of crypto assets in the consulting, placement and trading portfolios of a financial service institution but also to internal processes such as KYC or to the execution of projects such as the issuing of a tokenized capital markets product. But what do financial service providers under ongoing supervision have to observe when they intend to integrate blockchain technology or crypto assets into their business model?

                  USING BLOCKCHAIN TECHNOLOGY FOR INTERNAL BUSINESS PROCESSES

                  The usage of technical innovations to fulfill obligations in areas such as AML or securities compliance or for the management of internal databases or access rights is not only permitted but also necessary for financial service providers in order to remain competitive. A coordination with the competent supervisory authority is not explicitly stipulated in the German Banking Act (KWG) for cases in which internal, technical processes are reformed, but is nonetheless advisable if the security and functionality of these processes are affected. Supervised institutes e.g. have to ensure that the requirements for IT-security in accordance to the Supervisory Requirements for IT in Financial Institutions (BAIT) are always met. The authority may impose measures to address any organizational deficiencies, should the fulfillment of these obligations be affected because of a technical alteration of internal processes. A coordination with BaFin prior to any alteration of internal processes is therefore advisable.

                  EXPANDING THE BUSINESS MODEL WITH ADDITIONAL FINANCIAL SERVICES

                  Financial service providers have less latitude in cases in which they intend to expand their business model with additional services and offers with regards to crypto assets. An investment broker e.g. that intends to provide personalized investment advice to his customers in the future will have to expand his authorization to include investment advisory services. Another example would be a securities trading bank that is authorized for financial commission business and proprietary trading and now intends to operate a crypto exchange with an automated order-matching process. The securities trading bank would need to expand its authorization to include the operation of a multilateral trading facility. The aforementioned cases require an application to BaFin to expand the existing authorization to include the intended activities. A successful application requires the applicants to match the regulatory requirements from the KWG and to prove this to BaFin. The authority therefore requires the applicants to submit an upgraded version of the sustainable business plan that includes the intended activities, proof of the necessary starting capital and proof that the internal business procedures are adjusted to the new business model.

                  Attorney Lutz Auffenberg, LL.M. (London)

                  I.  https://fin-law.de

                  E. info@fin-law.de

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                    Jul 20, 2020

                    Acceptance Feature for Security Tokens – What is it and Why is it Important?

                    [et_pb_section fb_built=”1″ _builder_version=”4.9.10″ _module_preset=”default” global_colors_info=”{}”][et_pb_row _builder_version=”4.10.6″ _module_preset=”default” global_colors_info=”{}”][et_pb_column type=”4_4″ _builder_version=”4.10.6″ _module_preset=”default” global_colors_info=”{}”][et_pb_button button_text=”for German version click here” _builder_version=”4.10.8″ _module_preset=”default” custom_button=”on” button_text_size=”13px” button_border_width=”1px” button_border_radius=”0px” hover_enabled=”0″ global_colors_info=”{}” button_url=”/acceptance-funktion-bei-security-token-was-ist-das-und-warum-ist-sie-wichtig/” sticky_enabled=”0″][/et_pb_button][/et_pb_column][/et_pb_row][et_pb_row _builder_version=”4.9.10″ _module_preset=”default” global_colors_info=”{}”][et_pb_column type=”4_4″ _builder_version=”4.9.10″ _module_preset=”default” global_colors_info=”{}”][et_pb_text _builder_version=”4.9.10″ _module_preset=”default” global_colors_info=”{}”]

                    Since the approval of the first security prospectus for a security token offering on the German market, the issuance of tokenized securities has become an interesting alternative to the issuance of traditional, paper-based securities. Security token offerings are a technical milestone for the capital markets. They eliminate e.g. the need for depository banks, which are a mandatory requirement for traditional security offerings in Germany. Furthermore, they bring the investment product closer to the investor by allowing him or her to directly take custody of the tokens by storing them in a self-controlled wallet. In addition, security token offerings also allow trading and transferring the tokenized investment product without the need of an intermediary. The needs of investors that either prefer their tokens being safeguarded in professional custody or that are obligated to take that route are also satisfied since the introduction of crypto custody services as a financial service at the beginning of this year. Nevertheless, tokenization in general is still in its early stages in Germany. It will take time and pioneering projects until the infrastructure of the capital markets truly open up to adopt these new products. For example, there is still no regulated trading segment for tokenized securities at an authorized security exchange. Security token trading therefore takes place outside of security exchanges. This circumstance potentially leads to massive problems with regards to trading security tokens which can be solved by an acceptance feature.

                     

                    WHAT IS THE ACCEPTANCE FEATURE?

                    The long-established, Hamburg based shipping company Vogemann issued the Greenshiptoken (GST) this month. GST is a security token that includes an acceptance feature according to its token terms. The acceptance feature solves the problem that arises from the fact that GST tokens will not be transferred on the secondary market via a security exchange or any other centralized marketplace, but instead immediately and directly between investors. The problem with this arrangement from a civil law point of view is that rights that stem from the security, especially the repayment and interest claims, will always have to be transferred collectively with the tokens. The German civil law ensures for paper-based debt securities that the right from the paper follows the right at the paper. The owner of a debt security in paper form is therefore legally always the owner of the claims that stem from that security as well. The German civil law currently does not allow a comparable legal fiction for tokenized debt securities.

                     

                    HOW ARE CLAIMS THAT STEM FROM SECURITY TOKENS TRANSFERRED TO THE PURCHASER OF THE TOKENS?

                    Therefore, the transfer of security tokens and of rights that are connected to them has to be specifically regulated by the underlying token terms. Since the rights in question are claims, they can legally only be passed on from the seller to the purchaser via assignment to the purchaser. Legally this requires an assignment contract. According to German law, an effective contract requires two components, an offer and an acceptance related to the offer. At this point the decentral nature of blockchain solutions results in a technical problem. Even though the transfer of a blockchain token is actively initiated by the owner – in this case the seller – of the token, the recipient – the purchaser of the token – normally has no option to actively confirm the acceptance of the token. Blockchain tokens are simply added to the blockchain address of the recipient without the recipient being required to take any action whatsoever. Therefore, the offer to transfer a token and the rights connected to the token can be seen in the initiation of the blockchain transaction by the owner, but there is no visible action of the recipient that could legally be qualified as an acceptance of that offer. The acceptance feature solves this problem and ensures that the transfer of a security token will only be included in the underlying blockchain, if the recipient actively confirms the acceptance of the token and the connected rights.

                     

                    WHY IS THE ACCEPTANCE FEATURE IMPORTANT?

                    The acceptance feature ensures that the rights connected with the security token will be passed on from the seller to the purchaser in the legally required form of an assignment contract. The absence of a legally effective acceptance of the offer poses the danger that the token could be transferred to the purchaser without the associated rights as set out in the token terms. These rights would then remain with the previous owner of the tokens while the security token would be transferred. The acceptance feature therefore enables the legally effective transfer of security tokens and their associated rights on the secondary market. Security tokens that can only be traded over centralized marketplaces do not necessarily need an acceptance feature, because the seller as well as the purchaser place a trading order which can be viewed as an offer respectively as an acceptance. But as long as such marketplaces do not exist for security tokens the acceptance feature is a valid way to ensure the legally effective transfer of security tokens and the associated investor rights.

                     

                    Attorney Lutz Auffenberg, LL.M. (London)

                     I.  https://fin-law.de

                    E. info@fin-law.de

                     

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                      Jul 06, 2020

                      Buy or Build – Is the Acquisition of an Institute an Alternative to a BaFin Application?

                      Business ideas in the blockchain sector in Germany can often not be realized without the appropriate authorization of BaFin. The obligation to obtain a BaFin authorization as a consequence of the extensive regulation of crypto assets and blockchain tokens often comes as a showstopper for startups if they cannot find a cooperation partner that offers the required regulatory framework as a Whitelabel solution or as a service. The authorization requirement can pose a serious obstacle even for well-funded projects, especially because the application process can take anywhere from six to twelve months depending on the specifics of the project. Many entrepreneurs therefore feel that the acquisition of an already existing and authorized bank or financial institute might be an elegant alternative to the rather time-consuming application process. But is the acquisition of an already authorized institute really faster than the aforementioned application process?

                      COMPLEXITY OF A BAFIN AUTHORIZATION PROCESS DEPENDS ON THE SPECIFIC PROJECT

                      Entrepreneurs should generally be aware of the fact that the specific business model and its realization and implementation as well as the ownership structure of the obligated company have a significant influence of the complexity of the authorization application. The authorization process for e.g. a GmbH with just one natural person as its shareholder intending to offer investment brokerage services related to cryptocurrencies will potentially be prepared and approved by BaFin and Bundesbank a lot faster than e.g. the application of a stock company which is part of an international group of companies intending to offer Market Making on an international crypto exchange, financial commission services for cryptocurrencies and financial portfolio management services for tokenized financial instruments. The preparation time for the application and the time required until authorization is granted is therefore much shorter for simpler, more focused business models than for more complex and versatile business models.

                      BANK ACQUISITION AS AUTHORIZATION PROCESS IN A DIFFERENT FORM

                      The acquisition of an existing institute is also subject to supervisory requirements. The purchaser of a bank or authorized financial institute must undergo a scrutinizing ownership control procedure, just as would be required in case of application for authorization directly. In this procedure, all of the intended owners that would hold substantial shares of the bank or institute to be acquired must provide information and documentation, such as e.g. certificates of good conduct and trade register excerpts. This might cause a similar workload as the preparation for an authorization process would, especially for purchasers that are part of an international group of companies. If additionally the business model of the to-be acquired institute must be changed or amended to suit the purchasers needs, a new and viable business plan must be submitted to BaFin as well. This business plan will be then be reviewed and checked in detail for economic and regulatory sustainability by BaFin and the German Central Bank. The internal processes also have to be adjusted, should the new business model trigger new compliance obligations for the institute. The creation of new documents such as report templates, ToS or customer contracts might also be necessary.

                      ACQUISITION OF AN INSTITUTE FOR THE REALIZATION OF NEW BUSINESS MODELS IS SELDOMLY THE RIGHT CHOICE

                      The acquisition of a bank or financial institute in order to realize a new business model is almost never worth it. The time-saving effect usually diminishes completely, because the acquisition of the institute can only become effective if the competent supervisory authorities approve the acquisition and they will only do so after a successful ownership control procedure. Furthermore, there is typically the risk that the acquirer also brings the institutes bad debts into his own books. For new crypto related business models, it is therefore usually preferable to directly apply for an own BaFin authorization.

                      Attorney Lutz Auffenberg, LL.M. (London)

                       I.  https://fin-law.de

                      E. info@fin-law.de

                      OUR BLOG ARTICLES IN A MONTHLY NEWSLETTER?

                      The FIN LAW Newsletter provides you with all blog articles of the month via monthly e-mail. Our newsletter is published regularly at the beginning of every month. Feel free to sign in to the FIN LAW Newsletter by clicking the button below. Of course can can sign off at any time if you do not wish to receive our newsletter anymore.

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