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Category: blog EN

Apr 04, 2022

New European Funds Transfer Regulation – The End to Self-Custody of Crypto Assets?

Right after the European crypto industry had averted the combined attack of the Green Party, Social Democrats and the Left-Wing Party in the European Parliament on the PoW consensus-mechanism with a narrow majority, new drama is on the horizon. An amendment to the European Funds Transfer Regulation has been proposed, which not only obligates crypto service providers in the European Union to verify the identities of the owners of all involved crypto wallets of a crypto transaction, but also prohibits crypto service providers to allow transfers to wallets which do not allow these identification procedures. The proposal is intended to prevent anonymous transactions involving crypto assets in the regulated financial system of the European Union. It especially aims at ridding money launderers, financiers of terrorism and other crooked market participants of the option to move wealth in crypto assets around and afterwards transfer it back into the regulated financial system. A conversion of crypto into fiat money via a crypto exchange will only be possible for completely identified users, should the aforementioned proposal be adopted, because crypto exchanges will be supervised institutes in Europe as soon as the Markets in Crypto Assets regulation (MiCA) goes into effect.

European Parliament Adopts the Proposal – Trilogue Negotiations Ahead

Last week, the EU parliament voted in favor of the proposed amendment to the European Funds Transfer Regulation with a narrow majority. Nevertheless, the amendment is not yet finally adopted, because the draft bill now must be negotiated and adopted in the so-called trilogue negotiations between the EU parliament, the EU commission and the council of the European Union before it can come into effect. The European crypto industry fears that the usage of crypto assets in most parts of Europe will only be possible when utilizing an authorized and supervised crypto service provider, should the current version be adopted. The crypto service providers fear the enormous administrative effort connected to the proper identification and verification of every party involved in every transaction. This regulation may be a potential showstopper for the connection between the centralized financial system and the decentralized crypto market. This is especially true for so-called unhosted Wallets, meaning crypto wallets that are not operated by an authorized provider, but instead are operated privately or in a decentralized way.

What Are the Implications of the New Regulation for Private, Unhosted Wallets?

With regards to privately managed wallets, it should also in future be possible for operators to identify the respective private person and verify their identity, in case that the proposal is passed. The self-custody option for crypto assets would therefore not necessarily be endangered. From a practical point of view it would nevertheless imply a cost-intensive effort for many operators to identify and verify every private wallet. Operators could therefore come to the business decision to exclude unhosted wallets from transactions altogether. Crypto users could therefore be forced to solely utilize authorized crypto custody service providers which would constitute an additional third-party risk with regards to the “not your keys – not your cryptos” principal. In summary, the regulation would once again lead to a substantially more centralized crypto market. The technical innovation of the blockchain technology, meaning the ability to conduct decentralized transactions without the necessity of a service provider acting as an intermediary would thereby again be heavily reduced.

Attorney Lutz Auffenberg, LL.M. (London)

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    Mar 28, 2022

    Crypto Trading under the Liability Umbrella – Which Requirements must be Fulfilled by Tied Agents?

    A lot of companies are interested in offering their clients access to the crypto markets, ever since cryptocurrencies successfully changed their image from the preferred payment method of money launderers and internet fraudsters to a modern alternative for the investment portfolio. However, because most cryptocurrencies are regulated as financial instruments in the sense of the financial supervisory law in Germany, the commercial offering of trading activities associated with cryptocurrencies generally requires authorization by BaFin. Crypto trading may be qualified as e.g. proprietary trading, financial brokerage or investment brokerage, depending on the specific design of the offered service. The application of the appropriate authorization requires a significant amount of time and financial resources, not only during the preparation for the application itself, but also during the subsequent ongoing supervision by BaFin and Bundesbank once the authorization is granted. The obtaining of such authorization is therefore a supposed showstopper for many companies. The cooperation with a sufficiently authorized institute – the so-called liability umbrella – may be a solution for business models that are designed as investment brokerage, investment advisory or as placement businesses.

    Which Crypto Business Models Can Be Offered Under a Liability Umbrella?

    Not all activities that require authorization can be offered under a liability umbrella. Specifically, proprietary trading, financial brokerage business and the operation of a multilateral trading facility cannot be designed this way. The exemption can only be utilized in cases of intermediary services. The connection to a liability umbrella as a supervisory design tool is out of question, should a business intend to acquire or sell cryptocurrencies in its own name. The activities that are permitted by the exemption being investment brokerage and placement business are only given, if the business itself does not become a contracting party of the commercial transaction, but instead merely acts as an intermediary respectively for the supply and demand. When it comes to placement business, there must also be a placing agreement between the offeror and the seller of the cryptocurrency. Investment advisory services, which are also permitted to be operated under a liability umbrella only relate to the issuing of investment advice that is tailored to the actual profile and needs of the investor. 

    What Are the Supervisory Requirements for a Tied-Agent-Solution?

    The setup of a tied-agent-solution can be implemented relatively quickly and with low costs compared to the application for an individual BaFin authorization. It requires a contractual agreement between the business and an institute, which is authorized to perform Investment brokerage, Investment advisory services or placement business. That agreement must include stipulations for the inclusion of the tied agent in the compliance infrastructure of the liability umbrella and furthermore oblige the liability umbrella to be responsible for all damages vis-à-vis the clients resulting from the covered activities of the tied agent. The fact that the liability umbrella institution takes over the liability must be disclosed by the tied agent to his clients. The inclusion of the tied agent must be reported to BaFin by the liable institute. The liable institute also must confirm to the supervisory authority, that the tied agent is fit and proper. BaFin keeps a public registry on its website where the inclusion of the tied agent after disclosure by the liable institute is published.

    Attorney Lutz Auffenberg, LL.M. (London)

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      Mar 21, 2022

      Turning Point for Proof-of-Work – Could the EU Just Outlaw the PoW Consensus Mechanism?

      The commotion within the crypto industry was huge when the Green Party, the Social Democrats and the Left-Wing Party of the European Parliament last week proposed a last minute change to the Markets in Crypto Assets regulation (MiCA), which, if adopted, could have resulted in a de facto ban of the commercial handling of Bitcoin and also – with regards to its current technical state – Ethereum. The proposal was rejected by a narrow margin, meaning that this danger to the crypto industry is warded off for now. Subject of the proposed change was a regulation according to which crypto assets in the EU could only be issued, offered or authorized for trading, if their consensus mechanism would fulfill minimum requirements regarding ecological sustainability which the EU commission would have had to define. Since the Proof-of-Work consensus mechanism is the least ecological sustainable consensus mechanism, it would probably not have fulfilled the to-be-determined minimum requirements. Especially the dominating cryptocurrency Bitcoin, which uses the PoW consensus mechanism for the validation of transactions in its network, would probably have faced its demise in Europe.

      What Would Be the Consequences of a PoW Ban in Europe?

      The political ambition to ecologically improve the consensus mechanisms of cryptocurrencies is surely a legitimate and in light of the ongoing and escalating, global climate crisis a welcomed one. It nonetheless seems very questionable, if a ban could and should be the way to do so. From an economical perspective, a ban of Ether and Bitcoin which combine account for more than 60% of the market capitalization of the crypto market would have been the deathblow to the European crypto market, because almost no business model in the crypto industry can exist without the utilization respectively the offering of Bitcoin or Ether. Crypto exchanges that do not offer the trading of Bitcoins would be of no interest to users in the current market situation. Tokenization projects also generally run on protocols associated with the Ethereum blockchain and therefore on a PoW based network. This ban would have hit already issued security tokens which run on the Ethereum blockchain hard. The trading of these tokens would have become impossible in Europe and a transfer of the trading to areas outside the European Union would have probably been impossible without a complete remodeling of the mandatory prospectuses which are required under regulatory law. The trading in Europe would only have continued to be possible if the tokens in question would have migrated to a different technical infrastructure which fulfilled the ecological minimum requirements. Both approaches would have been associated with considerable costs for the issuers which in the end the investors would have had to bear.

      Would a PoW Ban in the EU Been Legally Possible?

      Since the Treaty of Lisbon took effect in 2009, the European Charta of Fundamental Rights guarantees the European fundamental rights with which European primary law must be compatible. Also the MiCA regulation as an EU regulation being directly applicable to all Europeans must adhere to the standards set out in the European Charta of Fundamental Rights. Protected by the European fundamental rights is the occupational freedom as well as the entrepreneurial freedom of the citizens of the European Union. A PoW ban in the EU would exclude European crypto service providers from more than 60% of the current crypto market, even though MiCA is intended to provide a suitable and effective regulatory framework for exactly that market. The ban would directly and massively threaten already existing projects and business models in their existence. Especially critical would have been the fact that the proposed amendments for MiCA regarding the PoW ban according to their wording would have delegated the actual ban from the regulation itself to the level of the technical standards concerning MiCA which in turn are going to be determined by the EU commission without any legislative process. The EU Charta of Fundamental Rights would therefore have provided good arguments for a seised court to overturn the PoW ban in the EU. It would have been an interesting legal discussion to see, whether the abovementioned arguments could outweigh the environmental protection that is also imposed by the European Charta of Fundamental Rights.

      Attorney Lutz Auffenberg, LL.M. (London)

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        Mar 07, 2022

        Staking Pools – Can Joint Staking be an Alternative Investment Fund?

        Over the last couple of years, crypto staking has become an attractive and very profitable possibility to generate passive income. It is not only possible for investors to stake their crypto holdings themselves, but instead the market offers numerous easy-to-access offers of service providers offering investors access to staking projects. Such providers pool their client’s funds in so-called staking pools in order to receive more block rewards and thereby generate higher return rates. There is an abundance of service providers for these kinds of services and investors are promised return rates of up to 20% or more per annum. It is obviously highly relevant for the operators of these staking pools, if their services may qualify as Alternative Investment Funds (AIF) from a regulatory point of view. In that case, the management of the assets that are bundled in the pool would require authorization or at least registration according to the German Capital Investment Act (KAGB). There would also be restrictions and information obligations with regards to the marketing of such a staking pool.  

        Staking Pools as Investment Funds

        Staking pools may only be qualified as AIFs, if they qualify as investment funds in the sense of the KAGB. According to the legal definition of the KAGB, an investment fund is any organism for the purpose of joint investments which procures capital from a number of investors in order to invest it in accordance to defined strategies for the benefit of the investors and which is not an operating company outside of the financial industry. An organism in the abovementioned sense can be given in almost any conceivable form. It is e.g. not required that the company is a registered legal entity. Rather, it is sufficient that the capital is pooled in any form. Therefore, silent investments, participation rights constructs or smart contracts may qualify as organisms in the sense of the KAGB. Staking pools in which fiat or crypto funds are being pooled in order to have more assets to dispose over can therefore also qualify as organisms in the abovementioned sense. A defined strategy is generally also given, because staking pools disclose in which staking projects they intend to invest the pooled capital. Since most of the staking rewards will generally be distributed amongst the participants the investment is made for the benefit of the investors.

        Do Staking Pools Serve the Purpose of Joint Investments?

        The requirement of the KAGB according to which the organism must have the purpose to serve joint investments poses problems. An organism serves joint investment purposes, if it procures and pools capital in order to generate a joint rate of return for the investors which results from the joint risk of buying, holding and disposing of assets. This is not necessarily the case with staking pools. This requirement may not be fulfilled, should the participation in a staking project merely require the delegation of the tokens or a voting process associated with the crypto assets and not a direct transfer of the crypto assets itself. The organism will neither buy nor dispose over crypto asset but instead merely hold them, should the investors transfer their crypto assets to the organism solely for the purpose of participating in a staking process. Should investors on the other hand transfer fiat money, the organism will regularly have to acquire the crypto tokens first which it will subsequently use for staking purposes.

        Are Staking Pools Operating Companies Outside the Financial Industry?

        Finally, for the organism to be qualified as an investment fund pursuant to the KAGB it is also required that it is not an operating company outside the financial industry. This requirement is problematic with staking pools, because it cannot be generally assumed that staking pools are a part of the financial industry. Even though many blockchain units that are suitable for staking are also crypto assets and therefore financial instruments pursuant to German regulatory law, there are also other crypto units which do not qualify as financial instruments. Furthermore, the activity of staking blockchain units in staking projects is not necessarily a regulated activity. An activity which would be relevant in the sense of German financial regulatory law cannot be assumed in cases in which the staking pool has no power of disposal over the blockchain units of the investors, because a mere delegation is sufficient or in cases in which the stakeable units do not qualify as financial instruments. In these cases, the staking pool cannot be qualified as a company of the financial industry.

        Attorney Lutz Auffenberg, LL.M. (London)

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          Feb 14, 2022

          Let Me Stake Those Tokens for You – How is Crypto Staking as a Service to Clients Regulated?

          When Bitcoin introduced the world to blockchain technology in 2009 and enabled decentralized transactions, the validation of blockchain transactions worked via the so-called Proof-of-Work consensus mechanism (PoW). Since then, not only the market prices of Bitcoin and other cryptocurrencies massively increased, but the underlying technology of crypto assets has also developed at an astonishing pace. The PoW consensus mechanisms are nowadays rarely used for newly developed blockchain infrastructures. The most popular consensus mechanisms right now are the so-called Proof-of-Stake consensus mechanism (PoS), which are superior to PoW systems, especially in terms of energy efficiency. The discovery of new transaction blocks in PoS systems does not depend on an investment of computing power, but instead on the mere holding of units of the respective blockchain. Nowadays, it is usually not even necessary to transfer the respective crypto assets to another blockchain address in order to partake in the mining process of a PoS system. The participation in the mining process works in many of those systems via a simple delegation of the respective crypto assets to a server which acts as a so-called Mining-Node in the respective blockchain system (delegated Proof-of-Stake, dPoS).

          Staking Participation as a Service can be Reasonable in Specific Circumstances

          Even though the delegation of crypto assets in dPoS systems is usually done by the respective bearer of the crypto assets via the wallet software and usually without a lot of effort, there is still a need for service providers who provide their clients with a service for partaking in dPoS-staking. Especially in cases in which the crypto investor wants to or must keep the crypto assets in the custody of a third-party, a crypto custody service provider who also manages the dPoS staking of the respective crypto assets and thereby the generating of rewards in the form of block rewards is required. There are situations conceivable in which crypto investors grant power of attorney for their crypto wallets to service providers and commission them with the management of their crypto assets. How are these kinds of services regulated in Germany?

          Crypto Staking for Third Parties may qualify as Crypto Custody Service

          Service providers who safeguard crypto assets for their clients and who also dispose over the associated private keys are regulated as crypto custody institutes pursuant to the German Banking Act (KWG) if they offer the custody services to German customers and if they operate this business on a commercial or at least on a professional scale. Should these service providers not only safeguard the crypto assets of their customers but also delegate them in order to participate in dPoS mining, they generally also fulfil the second alternative of the legal definition of crypto custody business, the management of crypto assets for others. BaFin defines the term “management” in the sense of this provision as the exercising of rights resulting from a crypto asset. The suitability of a crypto asset to partake in dPoS mining is a characteristic of the crypto asset itself. A good argument can therefore be made to view the suitability to dPoS staking as a right resulting from the crypto asset, even more so because BaFin emphasizes the broad interpretation of the term in its published administrative practice. BaFin has not yet published anything regarding its opinion and interpretation for the abovementioned case, so that a close coordination with the supervisory authority for service providers intending to offer the aforementioned service is advisable. Should BaFin not assume the management alternative, e.g. because a right has to be assertive versus a third party and that is not the case when receiving block rewards from a decentralized functioning system, a qualification of the activity as financial portfolio management could also be considered.   

          Staking Crypto Assets of Clients in dPoS-Staking as Financial Portfolio Management

          The staking of customer crypto assets in dPoS-mining in order to generate block rewards can also be qualified as financial portfolio management. According to the legal definition in the KWG and the German Investment Firm Act (WpIG), financial portfolio management means the management of individual or multiple patrimonies which are invested in financial instruments for others with discretion. Crypto assets are financial instruments according to the KWG and the WpIG. A credit balance in crypto assets on a client´s wallet can be a patrimony in the sense of the provision. The wording of the provision does not provide any arguments to assume that financial portfolio management requires the prior acquisition or disposition of the financial instrument. The financial instrument that is already present can therefore simply be used to generate a profit. The decisive factor will be whether the service provider effectively takes over the management of the respective client’s patrimony.  

          Attorney Lutz Auffenberg, LL.M. (London)

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            Feb 07, 2022

            Not Your Keys, Not Your Cryptos – Can Legal Ownership be Established for Crypto Tokens?

            On January 12th, 2009, Satoshi Nakamoto initiated the first Bitcoin transaction. Since then, the blockchain technology rapidly rose in popularity and distribution. Not only Bitcoin, but also numerous other cryptocurrencies gained a lot of users since this first crypto transaction over 13 years ago. This tremendous success is most likely based on the technical feature of blockchain units to grant to the respective holder an absolute power of disposition. From a technical point of view, the person disposing over the associated private key to the current blockchain address is the only one being able to initiate a transaction of blockchain units to another blockchain address. But is this factually safe bearer position reflected in German civil law?    

            Legislator Primarily Focuses on the Regulatory Aspects of Cryptocurrencies

            Right from the beginning, the discussion and legislative actions regarding the legal handling of cryptocurrencies in Germany primarily revolved around and focused on the handling of cryptocurrencies with regards to financial supervisory law. BaFin, as the competent authority issued a public statement in 2013 in which it qualified Bitcoin and comparable blockchain units as units of accounts and therefore as financial instruments in the sense of German banking regulations. The former German Federal Government, which according to its coalition treaty intended to turn Germany into a blockchain hotspot, followed suit in 2020 when it introduced crypto assets as a new category of financial instruments into the German Banking Act (KWG). Further regulatory measures in the financial supervisory sector followed with the introduction of crypto securities in the Electronic Securities Act (eWPG) and the Crypto Asset Transfer Regulation. Whereas, when it comes to regulating blockchain units under civil law, the German legislator has up to now been rather reluctant. Solely for the aforementioned crypto securities – which are to this date only issuable in the form of tokenized bonds – there are civil regulations with regards to the possibility of transferring them to the bona fide transferee and the option to establish ownership. For other kinds of blockchain tokens, there have not been any specific civil law rules in Germany since 13 years now.      

            Ownership Under German Civil Law Only Possible on Tangible Items

            The German civil law has not yet entirely arrived at the digital age. The basis for the German civil law is the German Civil Code (BGB) which went into effect on January 1st, 1900. Even though the BGB has been regularly updated and extended, e.g. by introducing consumer protection regulation, so that parts of it comprehend phenomena of the digital era, ownership rights are still solely regulated in the part that regulates property law and therefore relate primarily to tangible items. Blockchain units such as Bitcoins, Utility Tokens or NFTs are intangible and therefore the establishment of ownership rights in the sense of the German civil law on them is generally not possible.

            Would Ownership Rights Be Suited for Crypto Tokens?

            Bearers of blockchain tokens are obviously not completely unprotected under the current law. Blockchain units are – at least according to the prevailing opinion in literature – qualified as other intangible assets, so that claims for damages can for example also be targeted at the transfer of crypto tokens. Since the property law relates to tangible items, it regulates cases that require the tangibility of the item. E.g. the owner of an item has the right to defend himself against an unauthorized removal of his item. This provision is not suited for tokens which exist exclusively virtually. The German property law on the other hand also regulates that the ownership of an object can be transferred to the acquirer without any potential third-party rights, if the acquirer blamelessly did not know of the associated third-party rights. Just as a bona fide acquirer may effectively acquire ownership of an object, if the seller was not authorized to transfer the ownership of the object. Comparable legal mechanisms for crypto tokens would surely lead to more legal certainty for everyone involved. An application by analogy of the property law to crypto tokens would only make sense in certain partitions of the problem. It would therefore be better, if the German legislator on the way to a German blockchain-hotspot created specific civil law provisions for blockchain tokens which are tailored to the technical specifics and the respective market needs of the industry.

            Attorney Lutz Auffenberg, LL.M. (London)

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              Jan 24, 2022

              Offering Counterfactual Wallets – Can That be Regulated as Crypto Custody Business?

              Crypto wallets are essential for the participation of users in the crypto market. They are therefore also of utmost importance to providers of crypto services and often a central building block in the operation of the respective business model. The traditional design – one private key per wallet – allows access to the crypto assets held in the wallet only to those individuals that dispose over the associated private keys. In business models which include wallet services, the private keys regularly remain with the provider while the user is left to interact with the provider via his login information for instructing the provider to dispose over the crypto assets held in the wallet. The central risk for providers in this context is the loss of the private keys. A loss of the associated private keys makes it impossible to dispose over the crypto assets on the respective wallet. Private keys of traditional wallets may be recovered using a so-called seed which can also potentially be lost. The provider will generally be liable and obligated to compensate his client in cases, in which he loses both the private key and the seed.

              Counterfactual Wallets – Smart Contract Wallets on the Blockchain

              Counterfactual wallets are smart contracts executed on a blockchain. As such they offer certain advantages over traditional crypto wallet software. Notably with counterfactual wallets, the private keys which are required to initiate a crypto transaction are not associated with the wallet, as is generally the case with traditional wallet software. Counterfactual wallets instead provide the option to replace lost or compromised private keys. Another advantage of counterfactual wallets is the possibility to guarantee that only the current version of the wallet is being used. The latest version of a counterfactual wallet will automatically be retrieved from the underlying smart contract. Should the code of that smart contract be updated or expanded, all counterfactual wallets based on that smart contract immediately receive an update, e.g. to eradicate security gaps or enhance functionality. The aforementioned option to recover access to counterfactual wallets can e.g. be achieved via a so-called social recovery feature. In this process, a group of other participants of the blockchain is automatically defined, which can change the private keys to the respective crypto wallet upon request of the wallet owner via majority decision. These participants, who are also known as “guardians”, never have access to the private keys of the crypto wallets to which they can alter the private keys, because they do not know each other and, from a technical perspective, there are only fractions of the private keys of the counterfactual wallet stored with them.    

              Can the Offer of Counterfactual Wallets Be a Regulated Crypto Custody Service?

              According to the wording of the law, crypto custody services which are subject to authorization can be given in three scenarios: the custody, management or safeguarding of crypto assets or private cryptographic keys. BaFin has not yet published its opinion on whether or not the operation of counterfactual wallets is subject to any or all of these alternatives and if the operation of counterfactual wallets can be qualified as crypto custody services. The decentralized design could be an argument against an authorization obligation of providers of counterfactual wallets. On the other hand, counterfactual wallets also work with private keys which must be stored, managed and safeguarded against unauthorized usage by third parties. In the case of crypto services with integrated wallet services, this task is always fulfilled by the operator for the clients. With counterfactual wallets, there is furthermore the task to determine guardians. The operator would need to request a social recovery, should it be necessary, and he would also need to correctly store, manage and safeguard the new private keys. The fact that counterfactual wallets are not executed within the central IT-structure of the operator but via a smart contract on a blockchain is irrelevant with regards to the handling of associated private keys. Therefore, the operation of counterfactual wallets for clients will most likely in most cases be a form of crypto custody service and therefore subject to authorization. 

              Rechtsanwalt Lutz Auffenberg, LL.M. (London)

              Rechtsreferendar Gabriel Aslan

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                Jan 17, 2022

                Assignment Restrictions for Security Tokens – Will That Still be Possible in Future?

                In Germany, it is possible to issue bearer bonds in accordance to the Electronic Security Act (eWPG) without securitization in form of so-called crypto securities since last summer. The German legislator thereby created the option to grant owners of security tokens a legal position comparable to the ownership position of owners of paper documents. Acquirers of crypto securities can become legal owners of said crypto also if the seller was not the owner, as long as the acquirer blamelessly did not possess any knowledge of the sellers missing authorization. When it comes to crypto securities, the eWPG stipulates that the rights resulting from the bond are inseparably connected with the token representing them. Next to this, businesses continue to have the possibility to issue security tokens without the use of the options provided by the eWPG. This may e.g. make sense if the issuer does not wish to involve a central registry administrator, which is compulsory to be involved in issuances of crypto securities. In these cases, a legal mechanism has to be created which ensures the inseparable connection of the rights stemming from the bonds with the tokens, just like prior to the eWPG coming into effect.

                Secure Merging of Rights and Token Via Assignment Restriction

                Connecting factor for the connection of investor rights with a token in case of a tokenized bond are the terms and conditions of the bond, commonly also referred to as Token Terms. These Token Terms contractually regulate the rights and obligations of the issuer and investors. Token Terms inter alia contain provisions concerning the rate of return, duration, possible subordination agreements and rights of cancellation. Token Terms of tokenized bonds which are not designed in accordance to the eWPG may include provisions stipulating that token bearers may only assign their tokens to third parties, if they simultaneously assign all rights and obligations stemming from the bond to the assignee of the tokens. This mechanism ensures that token and investor rights and obligations as defined in the respective Token Terms are always allocated to the same person. In order for the mechanism to work reliably, token bearers additionally have to be obligated by the Token Terms to not assign the rights of the security token in any other way as explained above – e.g. without the simultaneous assignment of the token itself.        

                New Consumer Protection Law Complicates the Inclusion of Assignment Restrictions in Token Terms

                The obligation of security token bearers to only dispose of the rights of the tokenized bond via token transaction on the underlying blockchain and only en bloc, constitutes a restriction of the assignment right of the investor. As of October 1st, 2021 the German consumer protection law contains a protective provision according to which clauses in general terms and conditions that restrict the assignment of claims of monetary nature versus the user of the clause may be invalid. Token Terms are designed and worded for a multitude of investor contracts and are therefore always general terms and conditions. According to the explanatory memorandum the new provision – contrary to its wording – is not intended to only be applicable to clauses that entirely eliminate the option to reassign a claim but also to clauses merely restricting it. Assignment restrictions in Token Terms could therefore be affected in the future by this new legal regulation. This whole complex is only relevant to security tokens which are distributed to private investors, because the new provision takes no effect on contracts between professional parties.

                Better Arguments for Inapplicability in Security Token Terms

                The new legal regulation is intended to protect consumers versus businesses and prevent the restriction of the general assignment right of contractual parties via general terms and conditions. The right to assign claims to third parties is a manifestation of the general principle of contractual freedom and therefore an essential civil liberty which should not and cannot be taken away from consumers without good cause. However, the new legal regulation is a provision with margin of discretion. This means that if good reasons are given that argue for the assignment restriction and the rights of the consumers are not unjustifiably restricted, an assignment restriction can still be vaild. Generally, the assignment restriction in Token Terms benefits all involved parties. Issuers can rely on the fact that the token bearers are also the bearers of the bonds. Investors can be sure that the acquired security tokens are really connected to the investor rights of the tokenized bond. Assignment restrictions are therefore instrumental in the creation of legal certainty for all involved parties and they do not restrict consumer rights unreasonably. In the end, the civil courts will have to decide on a case by case basis on the effectiveness of assignment restrictions in general terms and conditions. The specific wording of the restriction and the entire design of the Token Terms will be the decisive factors in cases relating to security token offerings.  

                Attorney Lutz Auffenberg, LL.M. (London)

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                  Jan 03, 2022

                  DeFi Business Model Crypto Lending – Is It Regulated?

                  Decentralized Finance (DeFi) has enjoyed a steady increase in popularity over the last two years. The term describes the trend to change from centralized financial markets, which are controlled by banks and financial service providers to completely decentralized financial markets, which do not necessitate any centralized intermediaries in order to grant users access to banking and financial services. This becomes possible by using smart contracts on adequate blockchain infrastructures such as Ethereum, Aave or Compound. Such smart contracts act as decentralized programs which are fueled by activity on the underlying blockchain and which will independently execute specific and predetermined actions. Users have the option to interact with these smart contracts – e.g. by transferring crypto tokens to specific crypto wallets – and thereby trigger activities of the smart contracts. Designs like these provide the possibility to automate a number of services of the finance sector. One example for this is crypto lending, in which users may receive loans in cryptocurrencies.       

                  How Does Crypto Lending Work?

                  Crypto lending is basically what the name promises: the granting of loans in cryptocurrencies. Crypto lending in the DeFi sector works without a central institution like a bank as a lender. Users may interact with a smart contract and thereby request a loan in cryptocurrency, which will be granted automatically should the specific user fulfill the requirements laid out in the conditions of vesting of the smart contract. The exact conditions of vesting depend on the individual programming of the specific smart contract. The currently existing crypto lending platforms primarily require the provision of sufficient collateral in the form of other cryptocurrencies. Due to the extreme volatility of the crypto market, the required collateral usually exceeds the equivalent of the loan considerably. Taking up a loan via crypto lending is therefore really only sensible in situations where the borrower is in need of short-term liquidity in a specific cryptocurrency and at the same time is not willing or able to sell his other crypto holdings. Taxation issues for example may make such an approach sensible. On the other hand, crypto lending is not yet suited for the temporary increase of purchasing capacity, e.g. for financing real estate, because of the necessity to provide so much collateral. This might change in a timely manner, especially in the light of the announcement of the new German Federal Government in the coalition agreement that it will commission a study to analyze the feasibility of a blockchain-based land registry. Depending on the specifics, a blockchain-based land registry may provide the option to provide collateral for crypto loans in the form of mortgages. Users obviously also have the option to provide cryptocurrencies to the crypto lending smart contract, which will then be granted as loans to third parties. They usually receive very generous interest payments in the form of cryptocurrencies from the smart contract, if they choose to do so. Liquidity risks identical to those that traditional banks have to bear arise, should the pledged collaterals of the borrowers also be lent out.  

                  Is Crypto Lending Subject to Authorization?

                  The great advantage of DeFi is the option to design financial services in a decentralized way. Therefore, there is usually no entity which would act as an operator and thereby as provider of the loan when it comes to smart contracts which settle crypto lending operations. For the purpose of financial supervision, these smart contracts are scrutinized and examined in order to figure out if there is an identifiable administrator or leading developer behind the creation of the smart contract. Those may, in specific cases, be addressees of an authorization obligation. It is also conceivable that users which provide a smart contract with cryptocurrencies in order to receive an interest payment thereby perform an activity which is subject to authorization. Irrespective of the question, if there is a responsible operator or not, regulatory obligations to obtain authorization can only be applicable if the specific activity itself is regulated. The credit business, which is subject to authorization according to the German Banking Act (KWG) only relates to loans that are granted in legal tender and is therefore not applicable to the transfer of crypto assets by way of loan. In specific cases, the administrator of the respective smart contract could be qualified as a crypto custodian and therefore be subjected to authorization because he receives, manages and safeguards crypto assets. Users providing cryptocurrencies to a smart contract based crypto lending operation on the other hand usually have no knowledge of the identity of the borrower. They therefore act solely to receive interest payments and have no intention to provide a service to a third party. They will therefore hardly be subject to authorization. 

                  Attorney Lutz Auffenberg, LL.M. (London)

                  I.  https://fin-law.de

                  E. info@fin-law.de

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                    Dec 20, 2021

                    Trading Platform for Security Tokens – Can a Stock Market Listing be an Alternative to a BaFin Authorization?

                    In Germany, the operation of exchanges for traditional financial instruments as well as for crypto assets has ever since been subject to authorization. If trading on the exchange takes place in form of an automated matching and settlement of buy and sell orders, the exchange will generally qualify as a multilateral trading facility which requires the operator to obtain an authorization as an investment firm pursuant to the German Securities Institute Act (WpIG). The regulatory requirements for the operators of multilateral trading facilities are strict and the granting of the required authorization as well as the ongoing supervision to ensure compliance to all regulatory obligations are carried out by BaFin and the German Central Bank. On the other hand, operators of exchanges in the sense of the German Stock Exchange Act are not considered investment firms. The processing of applications for authorization as well as the ongoing supervision in these cases is not carried out by BaFin and the German Central Bank, but instead by the authorities which are declared competent in the respective federal state, usually the federal states ministry of economic affairs. In this context the question arises, if the application for an authorization to operate a stock exchange enables the operation of a crypto exchange.

                    Crypto Assets not Tradable on Stock Exchanges while Security Tokens are

                    It is legally defined which assets are tradable on stock exchanges. According to the German Stock Exchange Act security exchanges and commodity exchanges are possible options. While on commodity exchanges exclusively commodities such as metals, ores, agricultural products, electricity or other fungible commodities or futures related to the aforementioned are permitted to be traded, it is permitted to trade securities of all kinds such as stocks, debt instruments as well as derivatives of the aforementioned on security exchanges. Traditional cryptocurrencies such as Bitcoin or Ether are neither securities nor commodities in the required sense and are therefore not tradable on stock exchanges in the sense of the German Stock Exchange Act. This does however not apply to security token, which are tokenized securities. Tokenized bonds and stocks or tokenized derivatives would therefore be tradable on stock exchanges should the operator fulfill the technical requirements for the trading itself.

                    What are the Requirements to Operate a Stock Exchange in Germany?

                    Stock exchanges in the sense of the German Stock Exchange Act are required to be institutions under public law with partial legal capacities, to which the administrative provisions of the German Stock Exchange Act are applicable. Stock exchanges are operated by stock exchange operating companies which can be companies under private law. The operation of a stock exchange requires the authorization of the competent state authority. In order to obtain such an authorization, it is required to show to the state authority that the stock exchange disposes over sufficient financial means. The actual amount required is dependent on the volume of the intended business. In addition to that, the stock exchange operating company has to develop a sustainable business plan and it has to dispose over fit and proper managers and reliable shareholders. Furthermore, it has to be ensured that the stock exchange operating company can provide the technical operation of the exchange and that it has in place a sufficient risk management. Moreover, rules of the exchange that adhere to the stipulated requirements of the German Stock Exchange Act are also required.  The German Stock Exchange Act stipulates additional specific obligations for stock exchange operating companies, such as the implementation of a trade monitoring unit and a stock exchange council. The design of fees and charges are also not at the free discretion of the stock exchange operating company. The schedule of fees has to be approved by the stock exchange supervisory authority. In total, the operation of a stock exchange in the sense of the German Stock Exchange Act is not significantly less complex or costly than the operation of a multilateral trading facility.

                    Attorney Lutz Auffenberg, LL.M. (London)

                    I.  https://fin-law.de

                    E. info@fin-law.de

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                      Dec 13, 2021

                      Digital Operational Resilience Act – What Does DORA Hold in Store for the Crypto Industry?

                      One essential component of the cybersecurity strategy of the European Union is the adoption of the Digital Operational Resilience Act (DORA). DORA is intended to improve the IT security of businesses in the European Union. The EU Commission submitted a draft proposal for the regulation already in September 2020 which has been accepted by the EU Council in the meantime. The EU Commission, the Council and the European Parliament will therefore negotiate the final form of the DORA regulation in their trilog-negotiations over the next couple of months. DORA as a EU regulation will be directly applicable to all affected market participants. Those are primarily financial companies such as banks and insurance companies, investment firms and payment institutions. According to the current draft proposal, DORA will nevertheless also be applicable to providers of crypto services, issuers of crypto assets and specific other tokens with asset-like properties. The crypto industry will have to adapt their business models to the new regulation. DORA is expected to go into effect in 2024. 

                      Which Obligations Will DORA Impose on Businesses?

                      DORA is intended to improve the resilience of financial businesses against external attacks on the IT and aigainst other IT-related risks. The ever increasing digitalization within the financial industry and the resulting need for a continuously functioning IT of financial businesses justifies the implementation of uniform minimum standards regarding the IT security of financial businesses for the entirety of the European Union. DORA intends to obligate affected businesses to regularly participate in IT stress-tests and it will stipulate specific minimum requirements regarding the handling of IT-related risks and IT incidents as well as a uniform regulation regarding the designs of the internal risk-management of the affected businesses. Financial businesses often outsource their IT systems and therefore also the IT security management to third-party service providers. These service providers will also have to implement the requirements stipulated by DORA. 

                      How Will DORA Affect Crypto Businesses?

                      IT security aspects are essential to the crypto service industry. The loss or the accidental disclosure of private keys for crypto assets of clients regularly implies the realization of the maximal business-related risk for businesses from the crypto industry. Therefore, DORA is intended to be applicable to crypto service providers and token issuers alike. Which actual businesses and issuers will insofar fall under the the scope of DORA will be determined by the Markets in Crypto Assets Regulation (MiCAR) of the European Union, which currently is also in its draft state. This regulation will define crypto service providers as e.g. providers of custody services for third parties regarding crypto assets, as operators of crypto exchanges, operators of other crypto exchange services and as providers of advisory or brokerage services related to crypto assets. Issuers of crypto tokens are also intended to be subjected to the stipulations of DORA, if their tokens are in any way connected to assets or rights for the token holder. As a result, the vast majority of the crypto industry will have to adhere to the new stipulations. The industry will therefore have to oblige to a lot more administrative obligations, but DORA will surely also lead to a further and welcome professionalization of European crypto businesses.

                      Attorney Lutz Auffenberg, LL.M. (London)

                      I.  https://fin-law.de

                      E. info@fin-law.de

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