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Category: blog EN

Aug 16, 2021

Operating Crypto Security Registers – Who is Addressee of the Authorization Requirement?

There are not only electronic securities but also crypto securities since the Act on Electronic Securities (eWpG) went into effect on the 10th of June 2021. According to the legal definition, the term also includes unsecured electronic bearer bonds which are registered in a crypto security register. The legislator simultaneously turned the operation of such crypto security registers into an activity which is subject to authorization by amending the German Banking Act (KWG) accordingly. Whoever intends to commercially operate a crypto security register in Germany is therefore obligated to obtain prior authorization from BaFin and to fulfill all the legal requirements to obtain such an authorization. However, looking at the eWpG and the KWG it is not absolutely clear who exactly is subject to this new obligation to obtain authorization.

WHO OPERATES A CRYPTO SECURITY REGISTER?

It is however certain according to the KWG, that only persons and businesses who actually operate a crypto security register can be subjected to this obligation. In order to determine who indeed operates a crypto security register, it first has to be clear what a crypto security register actually is. The eWpG does not provide a definition. It merely stipulates that crypto security registers are a subset of electronic security registers. Crypto securities are defined by the eWpG as electronic securities, which are registered with a crypto security register. It is furthermore defined in sec. 16 of the eWpG that crypto security registers have to be kept on a recording system that is forgery-proof, records the data in the correct chronological order and is secured against unauthorized deletion and subsequent changes. More informative than the eWpG itself is the associated explanatory memorandum, in which the legislator clarifies that not necessarily the operator of the register’s infrastructure is subject to the obligation to obtain authorization, but rather the body which is competent for the registration. The eWpG defines this as the person or entity, which has been named as the competent body for the registration by the issuer of the crypto security vis-à vis the bearer of the crypto security. Also the issuer itself can be the competent body for the registration. The definition of operating a crypto security registry in the KWG is therefore a somewhat unfortunate one. It would have been clearer and better to understand to explicitly regulate the activities of the competent bodies of registration which are connected to crypto securities as a financial service.

CAN A CRYPTO REGISTER BE OPERATED BY ACCIDENT?

The operation of a crypto security register is regulated by the KWG as a financial service which is subject to authorization. It is therefore prohibited to operate a crypto security register without the proper authorization by BaFin. Market participants who do so without authorization commit a criminal offence and also conduct unauthorized business, which can immediately be prohibited and rescinded by BaFin. Problems may arise in this context, if companies which accompany token issuances offer to the issuer of a tokenized bearer bond to keep a register of data related to the issuance. The fact that crypto security registers have to be designed in a decentralized way and that the eWpG specifically determines which data has to be kept by the competent body of registration in the crypto security register merely stipulates an obligation for the competent body of registration. Conversely, infringements of these obligations cannot lead to the result that an activity as a competent body of registration is not given. This would reduce the new obligation to obtain authorization to the point of absurdity. At least as problematic as the aforementioned one is the case in which issuers of tokenized bearer bonds keep data related to the issuance themselves, without naming a competent body of registration. In these cases, they are considered by the eWpG as the competent body of registration themselves. According to the wording of the KWG, the operation of a crypto securities register is generally subject to authorization and it is not necessary that the activity is performed for a third party. It can therefore not be ruled out that the obligation to obtain authorization is applicable to the issuers of tokenized bearer bonds themselves.

HOW CAN ISSUERS AND SERVICE PROVIDERS ACCOMPANYING ISSUANCES MITIGATE THIS RISK?

BaFin should immediately issue a guidance to the abovementioned definition issues and also determine within its administrative practice at what point an activity as a competent body of registration is assumed. Considering the fact that up to this point in time no company has been issued the authorization to operate a crypto security register by BaFin, issuers and service providers accompanying issuances can right now only be advised to not design tokenized securities as bearer bonds, because the stipulations of the eWpG are currently only applicable to those. Tokenized securities which are designed as registered bonds are currently not included, so that they are not subject to the abovementioned risks.

Attorney Lutz Auffenberg, LL.M. (London)

I.  https://fin-law.de

E. info@fin-law.de

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    Jul 05, 2021

    Crypto Securities vs. Security Tokens – What is the Difference and what are the Advantages and Disadvantages?

    The Electronic Securities Act (eWPG) came into effect on the 10th of June 2021 in Germany. Since then, businesses have the opportunity to issue bonds in the form of electronic securities. A special form of electronic securities are crypto securities, which are electronic securities that are registered in a crypto security registry. However, the eWPG itself does not call for crypto securities to relate in any way to cryptographic technology. It merely stipulates that crypto registries have to be kept on a forgery-proof recording system, which records data in chronological order and secures said data against unauthorized deletion as well as subsequent modification. The Legislator intentionally chose a technology-neutral wording that is applicable to blockchain and distributed ledger technologies as basis for crypto registries while at the same time does not exclude future technologies.

    TOKENIZED SECURITIES NOT AUTOMATICALLY CRYPTO SECURITIES

    Prior to the eWPG going into effect, businesses already had the option to issue securities in tokenized form as so-called security tokens. The rights and obligations of the issuer and investors of tokenized bonds are connected to the tokens via the underlying bond terms. In the event of transferring the tokens, the rights connected with the tokens are reassigned to the new token bearer simultaneously. Security tokens will remain a legal alternative to the legislator’s design because crypto securities can only be qualified as such if they are registered in a crypto registry and security tokens without such a registration cannot be qualified as crypto securities. Token issuers can therefore choose between the issuance of a crypto security and a traditional security token. But what are the advantages and disadvantages connected to each of the variants?

    REGISTRATION OBLIGATION OF CRYPTO SECURITIES

    Crypto securities have to be registered with a crypto securities registry. This registration obligation is connected to considerable additional expenditure for the issuer. Even though the eWPG grants issuers the option to act as registration provider for their own crypto securities and to perform all the legally required entries into the crypto securities registry, it will however in practice be easier and therefore more common to commission a specialized service provider with the registration, which in turn is obviously connected to additional expenditure. A clear advantage of crypto securities however is the protection of legitimate expectations and good faith granted by the eWPG. Should an investor acquire a crypto security from an unauthorized seller the investor may still become the rightful owner of the crypto security if he was unaware of the lacking authorization during the acquisition process. This characteristic enables a reliable transfer of crypto securities and therefore may also enable exchange-based trading of crypto securities in the future. The protection of good faith and legitimate expectations can therefore be categorized as an unambiguous advantage of crypto securities.

    TRADITIONAL SECURITY TOKENS CAN BE SAFEGUARDED BY CRYPTO CUSTODIANS

    One advantage of traditional security tokens is the option to have them safeguarded by crypto custody service providers. The safeguarding of crypto securities which qualify as securities in the sense of the German Securities Deposit Act on the other hand requires an authorized depository bank. In contrast to the requirements for depository banks, the requirements for crypto custody service providers are rather low, meaning that the safeguarding of traditional security tokens will most likely be cheaper than the safeguarding of crypto securities.

    Attorney Lutz Auffenberg, LL.M. (London)

    I.  https://fin-law.de

    E. info@fin-law.de

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      Jun 21, 2021

      Delegated Staking as Crypto Management – BaFin Assumes Authorization Requirement in Certain Constellations

      Holders of crypto assets that are suitable for the so-called delegated staking may delegate their crypto assets to a staking provider in order to participate in the underlying consensus mechanism for the validation of transactions in the network. The rewards for the abovementioned participation are newly issued blockchain units, which are generated and issued by the system, and which are shared between the staking provider to which the crypto assets had been delegated and the holder of the crypto asset who delegated them. There are different forms of delegated staking, all of which have in common that they require the delegation of the specific crypto asset to a third party in order to participate in the consensus mechanism and therefore in the mining process. However, they differ in the method of how the delegation can be effectuated.

      NOT ONLY CUSTODY OF CRYPTO ASSETS CAN BE CRYPTO CUSTODY BUSINESS

      Service providers intending to offer crypto custody services in Germany require the prior authorization of BaFin to do so. According to the legal definition in the German Banking Act (KWG), there are currently three different actions defined as crypto custody business. Thus, the custody, management or the safeguarding of crypto assets respectively of the connected private keys for others may be qualified as crypto custody business. Staking providers, which actually receive the delegated crypto assets on their own wallets may in some cases fulfill the custody variant of the definition. According to the administrative practice of BaFin, which was published in one of the authorities’ publications, BaFin defines the custody of crypto assets as a service for a third party in a way “that the customer does not have any knowledge and therefore possibility of disposing of his crypto assets”. Therefore, custody of crypto assets in cases of delegated staking can only be assumed, if the staking provider actually receives the crypto assets in one of his own wallets from the customer.

      MANAGEMENT OF CRYPTO ASSETS IN DELEGATED STAKING SOLUTIONS

      However, it is in most cases not required that the holder of the crypto assets actually transfers his crypto assets to the staking provider in order to participate in the consensus mechanism. The delegation of crypto assets rather works via a dedication in a specific smart contract on the underlying blockchain to the staking provider of the holder’s choice. In these cases, the crypto assets remain in the wallet of the staking customer. BaFin qualifies the abovementioned practice in certain cases as a management of crypto assets for others and therefore as a variant of the crypto custody business which is subject to authorization. According to the legislator’s explanatory memorandum to the implementation of the crypto custody business into the KWG as well as BaFin´s own publication on the subject of crypto custody business, management of crypto assets is defined as “in the broadest sense the ongoing exercise of rights from the crypto asset”. BaFin defines validation rights as well as voting rights as rights from the crypto asset. Pursuant to BaFin´s broad interpretation it could therefore constitute a management of crypto assets for others, which is subject to authorization, should the staking customer delegate rights in the aforementioned sense to the staking provider. In this context a counter point to BaFin’s interpretation could be that the authority itself requires in its published administrative practice the actual custody of crypto assets for all three variants as necessary.

      MERE PROVISION OF STAKING INFRASTRUCTURE NO CRYPTO CUSTODY

      BaFin however does not assume a managing of crypto assets in cases in which merely the technical infrastructure to participate in a delegated staking consensus mechanism is provided. In such cases, when e.g. a mining node is operated and customers are only offered to partake in the validation of transactions, a regulated management activity is not conducted. A transfer of voting rights or validation rights does not occur to the effect that there is no room for assuming a crypto management as a regulated activity.

      Attorney Lutz Auffenberg, LL.M. (London)

      I.  https://fin-law.de

      E. info@fin-law.de

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        Jun 14, 2021

        Bitcoin as Legal Tender in El Salvador – Massive Implications for German Crypto Regulation?

        Most probably the German legislator did not expect the following when introducing crypto assets as financial instruments: On the 9th of June 2021, the small Latin American country of El Salvador passed a new legislation that will declare Bitcoin its unrestricted, domestic legal tender. As of the new legislation will come into effect, payments made in Bitcoin will have to be accepted by everyone in El Salvador and these payments will be legally effective. Prices can be displayed in Bitcoin and taxes and other public charges may be paid in Bitcoin. The passed law also regulates that profits made from Bitcoin transactions will not be subject to any capital gains tax just as gains from transactions with other foreign legal tender. This new law is a milestone for the national monetary policy of El Salvador, a country which hasn’t had an own national currency in over 20 years and instead used the US dollar as main currency. But even in Europe and especially Germany, the upgrading of Bitcoin to the status of a legal tender will probably not be without legal consequences.        

        LEGAL TENDER CANNOT BE A CRYPTO ASSET

        According to the definition of crypto assets in the German Banking Act (KWG) that has been introduced in early 2020, crypto assets are defined as digital representations of value that are neither issued nor guaranteed by a central bank nor any other public authority and that do not possess the legal status of currency or money, but are accepted by natural or legal persons as a means of exchange or payment on basis of an agreement or actual practice or which serves investment purposes and which can be stored, traded and transferred electronically. According to the unambiguous wording of the law, digital representations of value that possess the status of a legal tender are not covered by the definition. Therefore, the legal consequence from a German regulatory point of view would be that when the new legislation comes into effect in El Salvador, Bitcoin can no longer qualify as a crypto asset in the sense of the KWG. As this result will most probably not be intended by neither the German legislator nor by the competent supervisory authority it will be important to wait and see how BaFin positions in this matter. 

        BITCOIN STILL A REGULATED FINANCIAL INSTRUMENT

        Even though the wording of the definition of crypto assets in the KWG seems to be unambiguous, Bitcoin will remain a regulated financial instrument under German law in the form of a unit of account. BaFin never gave up their long-standing administrative practice, according to which Bitcoin and comparable cryptocurrencies qualify as units of account and consequently as a financial instrument. The German legislator also emphasized in the legislative materials when introducing crypto assets into the catalogue of financial instruments in the KWG that in their view the aforementioned administrative practice is legitimate and legally sound. Therefore, Bitcoins will remain regulated financial instruments in the form of units of account under the German supervisory regulations, even though they might no longer qualify as crypto assets in the future.        

        HOLDING BITCOINS FOR OTHERS IN THE FUTURE STILL A REGULATED CRYPTO CUSTODIAN SERVICE?

        The financial service of crypto custodian service that was also introduced into the KWG early 2020 is conducted where a customer is offered the safeguarding or management of crypto assets respectively the private keys relating to crypto assets. Whoever intends to offer such services in Germany requires a prior authorization of BaFin. According to the legal definition, crypto custody services as an activity which is subject to authorization can only relate to crypto assets. Custody services relating to other financial instruments therefore do not qualify as crypto custodian service. Most importantly, custody services relating to units of account do not constitute a crypto custodian service, which was one of the major motivations for regulating the activity by introducing the crypto custody business in 2020. Strictly speaking, the custody of Bitcoins or private keys related to Bitcoins for a third party can therefore no longer constitute a crypto custody service when respecting the wording of the law. However, the question of how and to what extent the legislative decision in El Salvador affects German regulatory law is up to BaFin in the first place, even though it may be tested by the competent administrative courts at a second stage. The assessment and interpretation of the matter by BaFin should therefore be waited for.

        EFFECTS ON OTHER EUROPEAN COUNTRIES PROBABLE

        The German definition of crypto assets is based on the definition of virtual currencies from the so-called fifth Directive on Anti Money Laundering, which also requires the digital representation of value to not qualify as legal tender. Conversely, this means that a legal tender cannot be a virtual currency in the sense of this directive. The fifth Directive on Anti Money Laundering had to be transposed by the EU member states into national law by January 2020, meaning that El Salvador´s decision will most likely also stir a regulatory discussion throughout the rest of the continent. The whole subject illustrates that the European legislator chose a wording for the definition of virtual currencies which enables non-European countries to cause massive turbulences within the European crypto regulation. The European as well as the German Legislator should therefore swiftly take appropriate action to undo this mistake.       

        Attorney Lutz Auffenberg, LL.M. (London)

        I.  https://fin-law.de

        E. info@fin-law.de

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          Jun 07, 2021

          Crypto Custody Services provided by Investment Firms – Will that still be Possible in the Future?

          On the 26th of June 2021, the new supervisory regime for investment firms – the Investment Firms Act (WpIG) – will go into effect in Germany. The new regulation will be relevant for all businesses which offer financial services such as investment brokerage, investment advisory services, proprietary trading or financial portfolio management and comparable services. Until now, the supervision of these businesses has been uniformly regulated together with the supervision of credit institutions in the German Banking Act (KWG). With the transfer of the supervisory regulations for investment firms to the WpIG, the German legislator expects to achieve a clearer, more efficient supervisory practice and simplifications with regards to the transposition of the European Investment Firm Directive (IFD), on which the WpIG is based. The KWG will stay in effect and will continue to provide the supervisory framework for companies that operate banking businesses, such as e.g. deposit business or credit business.

          CRYPTO CUSTODY SERVICES CONTINUE TO BE REGULATED IN THE KWG

          Not all activities that were formerly regulated as financial services will be transferred to the new WpIG. Crypto custody services which have been introduced as a financial service to the catalogue of the KWG on the 1st of January 2020 will remain exclusively regulated in the KWG as well as such activities as e.g. factoring, finance leasing and investment management. This is because the aforementioned activities are subject to authorization because of decisions made by the German legislator and not because of European provisions. Therefore, the abovementioned activities are not defined as investment services or investment ancillary services by the IFD and are therefore not subject to authorization according to the IFD. The application for an authorization to offer crypto custody services will therefore remain also in the future be regulated by the KWG after the WpIG has come into effect.

          CLEAR SEPARATION OF THE REGULATORY REGIMES OF KWG AND WPIG INTENDED

          In order to ensure a strict separation between the regulatory regimes, the WpIG will include an exclusivity precept stating that an authorization in accordance to the WpIG cannot be connected to an authorization granted pursuant to the KWG, the Payment Services Supervisory Act (ZAG), the Insurance Supervision Act (VAG), or the Capital Investment Act (KAGB). This may be a valid measure for preventing regulatory contradictions with regards to the regulatory requirements which investment firms must fulfill. It nevertheless causes some interpretive problems. On the 5th of May 2021, BaFin contacted the German securities trading banks which are currently under its supervision and requested the provision of information regarding the actual use of possibly held authorizations for factoring, finance leasing and investment management. BaFin interprets the exclusivity precept of the WpIG in a way, that the aforementioned services may in the future only be provided by companies, which are regulated under the KWG and not under the provisions of the WpIG. By this request for information, the authority tries to get an overview of the effects that the introduction of the WpIG may have on the investment firms market.

          HOW DOES THE EXCLUSIVITY PRECEPT OF THE WPIG AFFECT INVESTMENT FIRMS?

          The aforementioned interpretation of BaFin affects all investment firms and other companies that offer investment services insofar, as they will not be able to simultaneously also be authorized for providing crypto custodian business. Should these companies intend to integrate crypto custody services into their service portfolio, they will be forced to establish a separate legal entity which may apply for an authorization pursuant to the KWG. This approach has been advisable from a practical point of view even prior to the introduction of the WpIG, as crypto custody service providers that do not additionally offer other financial services are eligible for attractive privileges especially regarding their equity quotas to be fulfilled. It is however questionable, if the aforementioned legal position of BaFin is actually correct, because the legislator did also choose to apply changes to the KWG which strongly suggest a different interpretation of the exclusivity precept. In the future an authorization in accordance to sec. 32, subsection 2a KWG can only be granted if an authorization to conduct at least one of the banking businesses is simultaneously applied for. According to the new wording of the KWG, there will be no restrictions for companies which simultaneously apply for an authorization for provision of crypto custody services and which conduct the banking businesses or financial services exclusively in relation to units of account or crypto assets. In such constellations the KWG will remain applicable.

          Attorney Lutz Auffenberg, LL.M. (London)

          I.  https://fin-law.de

          E. info@fin-law.de

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            May 31, 2021

            New Crypto Asset Transfer Regulation – Germany Tackles Implementation of FATF Travel Rule

            [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=”/neue-kryptowertetransferverordnung-deutschland-macht-sich-an-die-umsetzung-der-fatf-travel-rule/” 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=”{}”]

            The Financial Action Task Force (FATF) is an international organization, which issues recommendations to its member states for effective money laundering and terror financing prevention. The recommendations of FATF have been the driving force for the global regulation concerning money laundering prevention ever since the organization was established. Especially the EU has displayed exemplary dedication when it comes to the implementation of the FATF recommendations. Crypto assets are now explicitly included in the recommendations of the committee under the term of virtual assets since the last update of the FATF recommendations in summer of 2019. FATF defines virtual assets as digital representations of value that can be digitally traded or transferred and which can be used for payment or investment purposes. The definition therefore covers both traditional cryptocurrencies such as Bitcoin or Ether as well as e.g investment tokens that are smart contract-based.   

             

            FATF RECOMMENDS COMPREHENSIVE COLLECTION AND SHARING OF INFORMATION

            Accompanying its recommendations, FATF also publishes interpretive notes. In the current version of these interpretive notes, FATF advises its member states to ensure that service providers with connections to virtual assets must collect information regarding the senders and the recipients of virtual assets and disclose this information to other service providers which are involved in the transaction and to authorities upon request. This recommendation, which is known as the Travel Rule does not have any direct legal effect, because FATF does not have any direct legislative power. The German Federal Ministry of Finance is now eager to transpose the Travel Rule into German law and published a draft for a Crypto Asset Transfer Regulation.  

             

            WHAT EXACTLY DOES THE DRAFT OF THE CRYPTO ASSET TRANSFER REGULATION REGULATE?

            Contentwise, the draft of the Crypto Asset Transfer Regulation exclusively obligates regulated banks and financial service institutions to apply the stipulations from the Credit Transfer Regulation mutatis mutandis to crypto asset transfers. Consequently, the obligated institutions will have to provide the name and address of their client to the crypto service provider of the transaction recipient. Additionally, because the Credit Transfer Regulation calls for the disclosure of the bank account number of the client, a mutatis mutandis application of the Credit Transfer Regulation to crypto asset transfers would necessitate the disclosure of the blockchain address respectively of the public key of the client. Should there be no service provider involved on one side of the crypto transaction, the obligated service provider on the other side of the transaction would have to collect and store the aforementioned information itself, so that it could relay to an authority upon request. 

             

            CURRENT DRAFT ONLY RELATES TO CRYPTO ASSETS

            Interestingly enough, the current draft version of the Crypto Asset Transfer Regulation is only applicable to crypto assets as they are defined in the German Banking Act (KWG), which is not as far-reaching as the definition of virtual assets of the FATF. To illustrate: Cryptocurrencies which are only useable within limited trading networks are not defined as crypto assets by the KWG while the definition of the FATF does not intend for such an exemption. It has to be noted, that the current draft is the first proposal of the ministry to tackle this issue and that the draft is currently subject to debate. It can therefore not be ruled out that the draft of the Crypto Asset Transfer Regulation may be revised and amended in the upcoming months.

             

            Attorney Lutz Auffenberg, LL.M. (London)

            I.  https://fin-law.de

            E. info@fin-law.de

             

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              May 24, 2021

              Tokenized Debenture Bonds and Deposit Business – What must STO Issuers Observe during the Planning Process?

              Next to the credit business, the deposit business is probably the most prominent banking business. According to the legal definition, deposit business is conducted, if unconditionally repayable funds are accepted by a third-party. However, the definition of deposit business intends for an important exemption for cases in which the repayment claim is securitized in bearer or registered bonds, in order to offer commercial enterprises of the real economy an alternative to bank financing. In cases of tokenized debenture bonds, the participating parties are confronted with the problem, that Germanies highest courts as well as BaFin only deem a right resulting out of a debenture bond as securitized, if it is embodied in a paper document as a physical object, so that the bearer of the document can legitimize himself as the bearer of the right and assert said right against the issuer of the debenture bond. Tokens as merely virtual positions are therefore generally unable to trigger the aforementioned exemption for debenture bonds.

              DOES THE NEW LEGISLATION ON ELECTRONIC SECURITIES (EWPG) OFFER A SOLUTION?

              The introduction of electronic debenture bonds is particularly devised to serve the purpose of enabling bona fide transfers of unsecuritized debenture bonds, meaning that the acquirer of an electronic security will effectively become the owner of the security, even if the transferor was not the owner of the security and the acquirer had no knowledge of this fact. This is achieved by the registration of electronic debenture bonds in an electronic securities registry. Should the debenture bond be tokenized, it must be registered in a specific crypto securities registry. The aforementioned exemption within the definition of the depository business has not been adjusted by the German legislator when it introduced the electronic security to the German law, meaning that the exemption is still only applicable to securitized – paper-based – debenture bonds. However, the newly introduced eWPG expressly states that electronic securities – and therefore also crypto securities as a subtype of electronic securities – shall have the same legal effects as securities, which are securitized in paper form as long as the eWPG does not stipulate otherwise. This clear and unambiguous stipulation should be a sufficient argument for the equation of crypto securities with securitized securities for the applicability of the exemption in the definition of the deposit business. 

              WHAT ARE THE OTHER OPTIONS FOR TRADITIONAL SECURITY TOKENS?

              Issuers of security tokens are not mandatorily obligated to issue their tokens as crypto securities. There are other ways to avoid the qualification as deposit business for the issuer, in cases in which tokenized debenture bonds are issued without them being registered in a crypto security registry, but instead in a “traditional” way without the privileges offered by the eWPG. The most common option is a contractual agreement which includes a qualified subordination clause in the token terms. According to the established administrative practice of BaFin, such qualified subordination clause excludes an unconditional repayment claim. Another highly attractive option is the provision of standard bank collaterals or comparable assurances for the default risk of the issuer. BaFin accepts collaterals in the aforementioned sense for the inapplicability of the depository business, if they are provided in a way that investors can make use of them immediately and in an uncomplicated way in the event that the issuer defaults on the repayment claim.  

              Attorney Lutz Auffenberg, LL.M. (London)

              I.  https://fin-law.de

              E. info@fin-law.de

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                May 17, 2021

                The Dream of Tokenized Property – Is That Legally Possible?

                Currently, Non-Fungible Tokens (NFT) are in the state of a real hype. Unlike other blockchain tokens NFTs are not fungible in the sense that they are not interchangeable with other, identically designed tokens of the same kind. They are rather individual tokens which each represent a specific right or object. In this context, the idea of tokenized ownership right with regard to a specific object is very popular. The ownership of an NFT insofar is intended to represent the ownership of a specific object such as a car, a piece of art or a precious gem. That is the idea from a technical point of view. But is the tokenization of property rights feasible in a legally watertight way?   

                LEGALLY WATERTIGHT CONNECTION BETWEEN TOKEN AND PROPERTY RIGHT IS THE KEY REQUIREMENT

                The decisive aspect when it comes to the tokenization of property rights is the difficult task of connecting the token with the property in a legally watertight way. The German law generally does not intend for such a connection, because it is aligned with the fate of the respective object itself and not with the fate of the token. A contractually invoked dependency between property rights of a specific object and ownership of a specific token is also not possible, according to the current legal situation in Germany. This is because of the applicable “principle of abstraction” which differentiates between the contractual relations, which are subjected to the law of obligations and the property law, which defines property rights. Contracts can merely obligate a party to transfer property rights to someone else. The ownership of an object is never automatically transferred to the other party by entering into a contract with them. The actual transfer of the property rights to a specific object takes place disassociated from any contractual obligations by means of an agreement concerning the transfer of the property and the actual delivery of the object itself to the acquirer. The ownership of a virtual token is irrelevant according to the current legal situation. 

                ADDITIONAL OBSTACLES WITH INTERNATIONAL DEALS

                Parties hailing from different countries face additional problems when they try to transfer property rights. Property law is designed differently in different countries. Since property law cannot be modified by contractual arrangements, the attempt to connect a token with property rights may lead to critical complications. According to the German international private law rules, the law of the so-called res sitae, meaning the law of the jurisdiction in which the respective object is situated, is applicable. Should therefore e.g. the ownership of a piece of art being situated in Germany be transferred to a Japanese acquirer, German property law would be applicable for the fate of the property rights with the consequence that the ownership of a token would be irrelevant. 

                COULD CONNECTION BETWEEN TOKEN OWNERSHIP AND RIGHT OF DISPOSITION REGARDING THE OBJECT BE A SOLUTION?

                A possible way to tokenize property in accordance with German law could be to connect token ownership in the form of knowledge of private keys of a token with the power of disposition in a way so that exclusively the bearer of the private key could actually dispose of the respective object. In order to do so, the token would have to become a de-facto key to the object. Should the ownership of the token e.g. be necessary to open a safe, which holds the object being intended to be transferred, the transfer of the token ownership, comparable to the transfer of a safe key, could represent a delivery in the aforementioned sense. However, the ownership of the token would lose all relevance for the determination of the ownership of the object, as soon as the object would be taken out of the safe. Truly tokenized property is therefore only realizable in a very limited way under German law, even with the help of the aforementioned design.

                Attorney Lutz Auffenberg, LL.M. (London)

                I.  https://fin-law.de

                E. info@fin-law.de

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                  May 10, 2021

                  Dispute over Stock Tokens – Transferable Security or unregulated Blockchain Tokens?

                  By the end of April, BaFin announced via their website that they have reasons for suspecting that a well-known crypto exchange publicly offers securities in the form of so-called stock tokens in Germany without required security prospectuses. Stock tokens are one of the newest innovations in the crypto industry. The way that a stock token works is via a special-purpose entity, which acquires stocks and then tokenizes the value of the acquired portfolio. The hereby created tokens are then offered to interested investors on crypto exchanges, which in turn can participate at the price development of the underlying stocks. The specific legal design of a stock token is dependent on the respective provider and the tokenization options offered by the chosen jurisdiction. To date, it is strongly disputed, if stock tokens are securities pursuant to German regulatory law, as stated by BaFin.

                  ARE STOCK TOKENS STOCKS OR COMPARABLE SECURITIES PURSUANT TO THE EU-PROSPECTUS REGULATION?

                  Everyone that publicly offers securities in the sense of the EU-Prospectus regulation is required to create a comprehensive security prospectus and have it authorized by the competent supervisory authority. Subsequently, the authorized security prospectus has to be published by the issuer and a copy of it has to be deposited at the supervisory authority. That way, investors can obtain all the necessary information in order to make an informed investment decision. The EU-Prospectus regulation classifies stocks as securities. In light of the aforementioned design, which involves a special-purpose entity, it is obvious, that investors of stock tokens do not directly acquire stocks. However, the regulation also defines other products as securities, if they are comparable to stocks or company shares. Stock tokens on the other hand do not entitle their bearers to acquire shares of the special-purpose entity. The ownership of stock tokens entitles investors solely to participate at the price development of the underlying stocks.

                  ARE STOCK TOKENS SECURITIES IN THE FORM OF DERIVATIVE FINANCIAL PRODUCTS?

                  The EU-Prospectus regulation next to stocks and comparable securities is also applicable to financial products, which entitle investors to a cash compensation that is derived from indexes or other metrics. The market value of stocks is such a metric, meaning that stock tokens may be securities in the form of derivative financial products. In order to qualify a financial product as a security in the sense of the EU-Prospectus Regulation it is also a mandatory requirement for the respective financial product to be transferable.

                  ARE STOCK TOKENS TRANSFERABLE BETWEEN INVESTORS?

                  Judging by the current discussion, the transferability of stock tokens seems to be the decisive factor for the answer to the question, if stock tokens can be qualified as securities pursuant to the EU-Prospectus regulation. The abovementioned crypto exchange argues in this context that investors are only able to trade the tokens on their platform with a regulated German securities trading Bank and that the tokens are therefore not directly transferable. BaFin in contrast argues that the transferability of a token can be assumed, if the token can technically and legally be transferred to another user. The fact that stock tokens can be acquired and sold back to the securities trading bank at any time, if the token bearer decides to do so is a strong indicator in favor of the transferability of stock tokens. The EU-Prospectus regulation does not differentiate for the qualification of a product as a security, if the investor can only transfer the product with a multitude of intermediaries of a trading platform or merely with a single market maker such as a securities trading bank.

                  Attorney Lutz Auffenberg, LL.M. (London)

                  I.  https://fin-law.de

                  E. info@fin-law.de

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                    Apr 26, 2021

                    Investment Firms Act (WpIG) Passed the Bundestag – What Are the Implications for the Crypto Industry?

                     The German Bundestag passed the new Investment Firms Act (WpIG) on the 15th of April 2021. The new legislation is scheduled to go into effect on the 26th of July 2021 and is intended to implement the statutory requirements of the European Investment Firms Directive (IFD). The new law will exclude small and medium-sized investment firms from the strict regulations of the German Banking Act (KWG), in order to subject them to a more fitting and suitable regulatory regime. According to the definition of the WpIG, investment firms are businesses which commercially or to an extend that requires a commercially organized business operation offer investment services and possibly associated ancillary services. Investment services in this context are largely those activities that are defined by the KWG as financial services, e.g. the financial commission business, investment brokerage services, investment advisory services, proprietary trading and the operation of a multilateral trading facility.

                    IS CRYPTO CUSTODY BUSINESS ALSO INVESTMENT SERVICE PURSUANT TO THE WPIG?

                    As of the 1st of January 2020, crypto custody services are defined as financial services, which are subject to authorization in Germany. However, since the European IFD does not regulate crypto custody services as services, that are subject to authorization, the WpIG in turn does not qualify the crypto custodian services as an investment service. The obligation of crypto custody service providers to obtain an authorization will therefore also in the future be determined by the regulations of the KWG. Companies providing other investment services related to crypto assets such as Bitcoin, Ether or Litecoin will have to apply for authorization according to the regulations of the WpIG, because the new legislation explicitly defines units of account as well as crypto assets as financial instruments in the sense of the WpIG. Companies dealing with crypto assets for own account (proprietary trading) or providing brokerage services (investment brokerage) may therefore qualify as investment firms pursuant to the WpIG. The majority of companies with crypto asset-based business models will therefore be subjected to the supervisory regime of the WpIG in the future.

                    HOW DOES WPIG AUTHORIZATION DIFFER FROM THE RULES OF THE KWG?

                    The applicability of the new rules to crypto service providers is not necessarily disadvantageous for them. One focal point of the new WpIG is the discharge of small and medium-sized, systematically not relevant firms, with regards to the capital requirements. The required minimum capital is slightly higher as it has been according to the regulations of the KWG. Companies intending to deal financial instruments for their own account have to show 750,000 euros instead of 730,000 euros. Investment advisors, investment brokers and financial portfolio managers without access to customer funds or customer securities must show 75,000 euros instead of 50,000 euros minimum capital and all other investment firms must show 150,000 euros minimum capital. On the other hand, investment firms authorized under the WpIG and ongoingly supervised by BaFin and the Bundesbank are not subject to the to the strict and static provisions of the CRR anymore, but instead must show a sufficient risk-bearing capacity. The exact requirements will have to be determined by the specific investment firms themselves in close coordination with the supervising authorities. An ongoing determination of the actual risks as well as sufficient risk-bearing capacity at all times will be required. Furthermore, medium-sized investment firms will also be required to guarantee a sufficient liquidity at all times.

                    AT WHAT POINT IS AN INVESTMENT FIRM CATEGORIZED AS SMALL, MEDIUM-SIZED OR BIG?

                    The categorization of investment firms as small, medium-sized or big results from the directly applicable European Investment Firms Regulation (IFR). Certain requirements must be fulfilled in order to categorize an investment firm as small. Specifically, the Assets under Management (AUM) must remain below 1.2 billion euros, the balance sheet total must remain below 100 million euros and the average total gross earnings may not exceed 15 million euros. Investment firms are categorized as medium-sized, if the IFR requirements are not entirely fulfilled. An investment firm is categorized as big, if BaFin categorizes the company as such or if the firm shows a balance sheet total in excess of 15 billion euros. Companies of the crypto industry will therefore regularly be categorized as small or medium-sized investment firms.

                    Attorney Lutz Auffenberg, LL.M. (London)

                    I.  https://fin-law.de

                    E. info@fin-law.de

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                      Apr 19, 2021

                      Do dPoS Staking Providers Require Authorization in Germany?

                      Prior to start of operations in Germany most blockchain-based business models require BaFin authorization, because of the legal qualification of most cryptocurrencies as financial instruments in the sense of the German Banking Act (KWG). The German legislator explicitly confirmed his administrative practice of BaFin being in place already since 2011 by explicitly regulating crypto assets as financial instruments and by introducing the financial service of crypto custodian service to the KWG, which is subject to authorization requirement. Nevertheless, the obligation to obtain authorization in accordance with the KWG is not automatically given as soon as a business model is related to cryptocurrencies. Instead, a BaFin authorization is only required if the business activity qualifies as a banking business or a financial service pursuant to the KWG.

                      WHAT ARE DPOS STAKING PROVIDERS OFFERING TO THEIR CLIENTS?

                      A rather new business model within the blockchain community is the offering of dPoS staking infrastructures. In this business model providers run servers which they let participate as nodes for the specific consensus-mechanism of blockchains which work on basis of the Delegated Proof-of-Stake (dPoS) mechanism. Customers may delegate their tokens to nodes of the specific blockchain in order to participate in the staking rewards generated by the nodes in form of newly created tokens. The delegation of tokens works via a smart contract on the underlying blockchain in the way that customers intending to delegate their tokens need to inform the smart contract that their tokens shall be delegated to a node of the provider. An actual transfer of tokens is not required. The tokens and the associated private keys remain entirely with the customer. The tokens that are newly generated as a result of participation in the consensus mechanism are credited by the smart contract both to the client as well as to the provider in the amount of the ratio as laid down in the smart contract.

                      DPOS STAKING PROVIDERS DO NOT PROVIDE CRYPTO CUSTODIAN SERVICES

                      The operation of dPoS staking infrastructuresthat are offered to customers for use is therefore a purely technical service in the first place. It is not a crypto custody service, because of the fact that at no point in time tokens are transferred and because the private keys to the tokens remain with the customer. According to the administrative practice of BaFin, crypto custody services always require access to the crypto assets respectively to the associated private keys of third parties. This mandatory requirement is generally not fulfilled by operators of dPoS staking infrastructures. The other two variants of the crypto custody business regarding neither fulfilled, because BaFin deems the possibility of disposal a base requirement also for these variants.

                      ADDITIONAL SERVICES MAY TRIGGER THE OBLIGATION TO OBTAIN AUTHORIZATION

                      Individually, the offering of dPoS staking infrastructures as a service does generally not trigger any authorization obligations pursuant to the KWG. However, this does not necessarily mean that there can never be any any additional services performed within the business model that can potentially trigger authorization requirements. Should for example a provider offer additional services such as the sale or brokerage of deals concerning the acquisition or disposal of tokens which are suited for staking, this additional service might trigger an authorization requirement, depending on the details of the specific case.

                      Rechtsanwalt Lutz Auffenberg, LL.M. (London)

                      I.  https://fin-law.de

                      E. info@fin-law.de

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                        Apr 12, 2021

                        Token Sale as Public Offering or Private Placement – What are the differences?

                        Over the last years, so-called token sales have emerged as a new method of financing for businesses. By such, companies that seek funding offer interested investors their self-created blockchain tokens for purchase. These tokens allow their bearers the assertion of certain connected rights vis-à-vis the issuer. The rights that can be associated with the tokens may be of very versatile nature, depending on the legal design of the tokens. Tokens may allow their bearers access to certain services of the respective issuer or they may grant discounts for services that are offered by the issuer within the specific business model. Alternatively or additionally, tokens can also be connected to return or repayment claims or to voting rights. According to the administrative practice of BaFin and depending on the specific nature of the connected rights, they may be qualified as digital vouchers or access permissions (so-called utility tokens), as alternative means of payment (so-called currency tokens), or as regulated investment products (so-called security or investment tokens). For the last category, the issuer is regularly confronted with the question, if the token sale can solely be conducted on the basis of a prospectus to be approved by BaFin and other, potentially required documentation.

                        PUBLIC OFFERING OF SECURITY TOKENS AND INVESTMENT TOKENS GENERALLY REQUIRE PROSPECTUS

                        In case that the offered tokens, respectively the connected rights represent transferable securities, shares in an investment fund or other asset investments for the token bearers according to the applicable regulations, a comprehensive sales prospectus and possibly further distribution documentation must be drawn up, approved by BaFin and be published by the issuer and every further offeror. Even though the applicable regulation regimes of the EU Prospectus Regulation, the Capital Investment Code (KAGB) as well as the Asset Investment Act (VermAnlG) intend for certain exemptions, these exemptions are all only applicable to offers that either target professional investors or that only have a small volume. Anyhow, all three regulatory regimes require a public offering of the tokens for being applicable. Should this essential requirement not be met by a token sale, the project would not be subject to prospectus or transparency obligations under the named regulatory regimes.

                        AT WHAT POINT IS A TOKEN SALE A PUBLIC OFFERING?

                        The EU Prospectus Regulation defines the public offering as a communication to persons in any form and by any means, presenting sufficient information on the terms of the offer and the products to be offered, so as to enable an investor to decide to purchase or subscribe for those products. According to its scope, the EU Prospectus Regulation only relates to securities. However, the definition can also be used for the interpretation of the term “public offering” in the context of asset investments and shares in investment funds, because neither the KAGB nor the VermAnlG contain a definition of their own. The offering of tokens is therefore public, if it is targeted at investors that are unknown to the issuer, respectively the offeror and if those unknown investors are informed about the essential parameters such as e.g. the purchase price. Usually the term “public offering” is interpreted in a rather broad way, so that it is not sufficient to withhold essential investment information from the potential investor to qualify the offering as not public. Should the offer only be targeted at investors that are known to the issuer, with which a private or business relation had been established prior to the offer, the offer may not be qualified as public. These private placements can be conducted without the prior creation of a prospectus other documentation.

                        Attorney Lutz Auffenberg, LL.M. (London

                        I.  https://fin-law.de

                        E. info@fin-law.de

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