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Category: blog EN

Feb 15, 2021

Tokenization of Assets – How does that Legally Work?

With the rise of blockchain-based smart contracts, the subject of tokenization also gained in relevance. The decentralized issuance of tokens, which are transferable between users of a network without an intermediary enables the digitization of all kinds of objects from a technical point of view. Tokenization rapidly became a prominent topic in the field of capital markets. However, the possibilities of tokenization are not limited to the digital representation of financial instruments. Equally feasible and already realized in the past is the tokenization of real-world tangible assets, which enables the completely digital transfer of property of real-world objects and with that a proof of property for these objects. But what has to be observed from a legal point of view when it comes to projects dealing with tokenization and can an inextricable legal link between token and tokenized object be created?

LEGAL REQUIREMENTS DEPEND ON THE OBJECT TO BE TOKENIZED

A generally applicable blueprint for the legal implementation of tokenization projects does not exist, because the legal requirements of each individual project result from the specifics of the object that is intended to be tokenized. The regulatory characteristics of the specific object as well as the implementation specifics, resulting from the applicable private law must be observed. Should it be intended to tokenize e.g. medicals or special wastes, the regulatory requirements would differ from those that would be applicable to the tokenization of art objects or cars. Should it be physical objects that are intended to be tokenized, there is always the problem that it must be ensured that the connection between the object and the token that represents it, respectively the ownership of it, really is an inextricable link. Moreover, there is a legal difference between a physical object that is represented by a single, non-fungible token and a physical object that is represented by a number of fungible tokens. In the latter case, the tokens could merely represent a co-ownership, respectively fractions of the ownership instead of a full-fledged sole ownership of the object.

INEXTRICABLE LINK BETWEEN TOKEN AND OBJECT AS CENTRAL LEGAL CHALLENGE

The German private law only provides for the establishment or transfer of property in the legal sense on physical objects. For virtual objects such as business ideas or tokens it does not foresee the possibility of establishing property in the legal sense. Therefore, a mechanism must be developed that ensures that the bearer of a specific token is also the property-owner or co-property-owner of the tokenized object, which is represented by the token. In enclosed exchange relationships such as online platforms, there is e.g. the option to determine via terms and conditions that are mandatorily accepted by all platform users upon registration, that the transfer of a token to another platform user is simultaneously connected to an offer to reassign the (co)-property-ownership of the tokenized object to that user. The acceptance of the token – possibly after confirmation of an implemented acceptance-feature – would then also represent the acceptance of the offer to reassign (co)-property-ownership of the tokenized object. Outside of such enclosed platform solution, the attempt of a contractual transfer-of-ownership fiction will regularly fail, because the law allows for the transfer of the tokenized object via an agreement and the handover of the actual, physical object, meaning that a transfer of ownership of the object would still be possible without the transfer of the connected token. In such case, the bearer of the token would not be the owner of the object. The two legal constructs would be separated with the result that the tokenization of the object would end.

Attorney Lutz Auffenberg, LL.M. (London)

I.  https://fin-law.de

E. info@fin-law.de

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    Feb 08, 2021

    DeFi on the Rise – Final Destination for Financial Market Regulation?

    For several month now, projects that provide applications within the decentralized financial markets continue to gain in significance. The buzzword Decentralized Finance or its abbreviation DeFi relates to smart contract applications (DApps), which enable users to conduct business on the financial markets without the need of a central service provider. The most prominent examples are decentralized exchanges (DEX), which enable users to exchange crypto assets into other crypto assets without the necessity of a centralized platform operator, but instead via the usage of an automated functioning smart contract embedded in a blockchain infrastructure. According to German regulatory banking law, the operation of an exchange for crypto assets is an activity which in most cases is subject to prior authorization and ongoing supervision from BaFin respectively by BaFin and the German Federal Bank. Where an exchange lacks an operator, the question of how the financial market regulation can be applicable to such exchange arises.

    DEX AS MULTILATERAL TRADING FACILITY WITHOUT OPERATOR

    The operation of an exchange for crypto assets may fulfill various different banking activities and financial services that are regulated by the German regulatory banking law and that are therefore subsequently subject to authorization. It is conceivable that the operation of an exchange is conducted by way of investment brokerage, proprietary trading, financial commission business or in the form of a multilateral trading facility. In order to trigger an authorization obligation pursuant to the German Banking Act (KWG) with a subsequent institutional supervision, the activity has to be conducted by an operator who can be the addressee of the supervisory obligations, even more so because the KWG only imposes authorization obligations on “someone” (wording of the KWG: “who”), that conducts banking activities or provides financial services on a commercial scale in Germany. It is therefore conceivable that a decentralized exchange, which conducts exchange orders of its customers related to crypto assets in an automated way may qualify as a multilateral trading facility in the sense of the KWG, but due to the lack of an operator an authorization obligation is not triggered anyways.

    SPECIFIC CONTRIBUTION OF THE INITIATORS IS THE DECISIVE FACTOR FOR AUTHORIZATION OBLIGATIONS

    The lack of an operator in the traditional sense for DeFi projects is not necessarily a self-evident fact that can be assumed without any further examination of the concrete project and its history. It is also possible, that a certain contribution of an initiator or an involved party aiming at the implementation of a DeFi project can be qualified as the operation of the project in the sense of the KWG. This of course would trigger the aforementioned authorization obligations for the initiator or involved party. This could for example be the case for projects that do not completely operate in a decentralized manner, but instead have a central instance in the background which has administrative rights for the underlying smart contract and therefore reserves the right to influence the settlement of transactions. The scope of these administrative rights in the specific case determines, if the initiators or involved parties can be qualified as operators in a regulatory sense. Moreover, the obligation to obtain authorization in accordance to the KWG would also require the operator to conduct the operation on a commercial scale and furthermore, the operation itself would have to specifically relate to the Federal Republic of Germany.

    NEW REGULATION FOR DEFI IS NECESSARY

    The current financial market regulation is hardly suitable for the regulation of DeFi projects without an operator. DeFi systems are often out of the reach of the competent authorities when it comes to supervision and therefore also with regards to the fulfillment of financial markets supervisory compliance obligations. The complete lack of regulation in this area poses a significant threat to the stability and integrity of the financial markets as well as for investors. Incorrect code may lead to irreversible damages for users as well as for the markets. Money laundering prevention can also not be conducted without a central operator being obligated to conduct audit, documentation and notofocation measures. Without an operator, the fulfillment of general requirements for institutions regarding subjects such as a suitable and effective risk-management or an adequate IT-security cannot be ensured. The creation of an effective and reasonable regulatory regime for DeFi projects should be addressed as soon as possible. In order to avoid national solo efforts, it would be helpful if the subject would be included in the upcoming Markets in Crypto Assets regulation (MiCA) by the European Commission.

    Attorney Lutz Auffenberg, LL.M. (London)

    I.  https://fin-law.de

    E. info@fin-law.de

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      Feb 01, 2021

      Gamestop-Gate and Dogecoin-Rally – Is that Actually Market Manipulation?

      Last week users of the online platform Reddit caused a stir when they coordinated themselves in a subreddit to buy shares of the struggling videogames retailer Gamestop. As a result, the price of the share increased massively and booked gains in the four-digit range. The objective of this campaign by the internet trolls was to attack hedge funds that had previously shorted the share to an extend that even surpassed the number of existing Gamestop shares. The massively increased price of the share resulted in severe financial distress for the involved hedge funds. Following this success, retail investors also coordinated to invest in the crypto market, specifically in Dogecoin. As a result, the cryptocurrency’s price showed a temporal increase of 400 % and more. The coordinated operations of the Reddit users have impressively shown the power of the huge numbers within different markets. But are these actions compatible with the applicable market abuse regulations?

      EU MARKET ABUSE REGULATION ONLY APPLICABLE TO FINANCIAL INSTRUMENTS PURSUANT TO MIFID II

      Within the European Union, the monitoring of market abuse is regulated uniformly by the Market Abuse Regulation (MAR). The regulation is directly applicable to all market participants without the need of a transposition into the national law of member states. However, the MAR is not applicable to all tradable objects. The prohibitions of the MAR for insider trading, for the publication of insider information and for actions, which are considered market manipulation require the tradable object to be a financial instrument pursuant to MiFID II. Tradable shares like those of Gamestop are tradable securities and therefore financial instruments in the required sense. With Dogecoin, the case is different. Cryptocurrencies are not regulated as financial instruments in MiFID II. The MAR may therefore be applicable to manipulative actions with regards to Gamestop shares, but not with regards to Dogecoin and comparable cryptocurrencies.

      MARKET MANIPULATION IN MOST CASES REQUIRES MISLEADING OR DECEPTION

      The call for buying Gamestop shares in internet forums does not necessarily constitute an illegal market manipulation. Most of the actions that are prohibited by the regulations of the MAR require that the action constitutes a form of deception or misleading of investors or that the action can be considered as a form of disseminating false or misleading signals. The mere consent of retail investors with each other to collectively buy Gamestop shares cannot be qualified as either of the aforementioned. The evaluation of the case may differ, if the initiator of the whole affair had bought Gamestop shares prior to his statements in the internet forums and would therefore personally profit from the increased price of the shares. The initiator in this case would have had to disclose such a conflict of interest in a suitable manner prior to making the statement.

      Attorney Lutz Auffenberg, LL.M. (London)

      I.  https://fin-law.de

      E. info@fin-law.de

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        Jan 25, 2021

        Definition of Crypto Custody Business – Changes After Only One Year?

        The crypto custody business is currently the youngest financial service regulated in the German Banking Act (KWG). As of January 1st, 2020, the custody, management and safeguarding of crypto assets or private keys that serve for storing, holding or transferring crypto assets for others is regulated as a financial service that is subject to authorization. Now, not even a year later the German legislator plans to change the wording and thereby the legal definition of this just introduced activity again. In the course of the introduction of the electronic security and thus also while introducing the sub-category of crypto securities, the German legislator plans to expand the crypto custody business to also be applicable to the safeguarding of private keys that serve for storing, holding or securing crypto securities.

        ONLY SAFEGUARDING OF PRIVATE KEYS FOR CRYPTO SECURITIES SHALL BE REGULATED

        The current draft intends for the financial service of crypto custody service to be worded in a way that there will be two variants. While the first variant will continue to relate to the custody, management and safeguarding of crypto assets respectively of private keys corresponding to those, the legislator intends the second variant to regulate the safeguarding of private keys corresponding to crypto securities. The custody and management of crypto securities themselves is not intended to be a case of crypto custody business. According to the draft´s explanatory memorandum published by the federal German government, these two activities will in the future continue to be subject to the regulation dealing with security depository business and will therefore be regulated as banking activities. This approach is consistent, because crypto securities are intended to be a sub-category of electronic securities and these are intended to be securities in the sense of the Securities Deposit Act. According to BaFin’s established administrative practice, the custody of securities in the sense of the Securities Deposit Act is subject to the security depository business.

        HOW DOES THE SAFEGUARDING OF PRIVATE KEYS DIFFER FROM THE CUSTODY OF CRYPTO SECURITIES?

        A custody service in the sense of the crypto custody service is defined by BaFin as the custody of third-party crypto assets. Subject to this are therefore inter alia providers that transfer crypto assets in wallets to which the provider and not the customer holds the private keys. The safeguarding of private keys in the sense of the definition of the crypto custody service on the other hand relates to the storage of private keys for third parties, e.g. by digitally saving the keys or by taking custody of data storing devices such as USB-sticks, hard drives or a simple sheet of paper on which the private keys are saved.

        REGULATORY DIFFERENCES BETWEEN CRYPTO ASSETS AND CRYPTO SECURITIES

        The proposed changes explicitly show, that the legislator makes a clear regulatory differentiation between crypto assets and crypto securities. Crypto securities will not simultaneously be crypto assets, should the proposed introduction of the electronic security come into effect as planned. Otherwise, the differentiation between crypto securities and crypto assets in the definition of the crypto custody business would not make any sense. Crypto securities will be a sub-category of securities in the sense of the Securities Deposit Act, while most other blockchain tokens will continue to be qualified as crypto assets. Interestingly, the possibility to issue security tokens that will not have to be registered with a crypto security registry and which will therefore be qualified as crypto assets will remain an option should the draft bill come into effect. Such security tokens will continue to be qualified as securities in the sense of the European securities regulation, but not as securities pursuant to the Securities Deposit Act.

        Attorney Lutz Auffenberg, LL.M. (London)

        I.  https://fin-law.de

        E. info@fin-law.de

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          Jan 18, 2021

          Systematic Internalization with Crypto Assets – Is that Regulated in Germany?

          The probably most essential innovation of blockchain technology is the enabling of transactions of digital assets between two parties without the need to involve a central intermediary like a bank or any other payment service provider as a settlement institution. Cryptocurrencies exist purely virtual and can be digitally transferred between the payer and the payee. Nevertheless, crypto exchanges have established themselves early in the crypto market as the central marketplaces for cryptocurrencies and settle nowadays the majority of the global crypto transactions. Because of the increasing interest of institutional investors in cryptocurrencies, the number of so-called Over-the-Counter transactions (OTC) for cryptocurrencies increased this year. In Germany, tradings with cryptocurrencies via OTC as well as via exchanges may be subject to authorization, because the German legislator regulated most cryptocurrencies as crypto assets and therefore as financial instruments in the sense of the German Banking Act (KWG).

          PROPRIETARY TRADING WITH CRYPTOCURRENCIES AS A REGULATED ACTIVITY

          Proprietary trading, which is subject to authorization according to German regulatory banking law may occur in four variants. Provider of fixed price trades with cryptocurrencies may be subject to authorization as well as providers that offer to acquire or sell cryptocurrencies as a service for their clients, but as a trade for own account. Another variant of proprietary trading that is subject to authorization is the one in which the service provider operates a crypto exchange, which is designed as a multilateral trading facility and if the trading of crypto assets is conducted by utilizing a high-frequency trading technique. Another variant of proprietary trading which is subject to authorization in accordance to the KWG is given with operations which frequently trade financial instruments in an organized and systemic way for their own account to a relevant extent outside of an organized market, a multilateral trading facility or an organized trading facility without operating an own multilateral trading facility. Such an activity is called systematic internalization. Even though crypto assets are financial instruments according to German regulatory law, systematic internalization may not necessarily be an activity that is subject to authorization from BaFin.

          SYSTEMATIC INTERNALIZATION ONLY REGULATED FOR SPECIFIC FINANCIAL INSTRUMENTS

          According to the legal definition, systematic internalization requires that organized and systemic trades for one’s own account outside of an organized market or a multilateral trading facility are conducted. Because most crypto exchanges are organized as multilateral trading facilities, the systematic internalization is primarily relevant in the crypto market when it comes to OTC trading. Nevertheless, in order to trigger authorization obligations in accordance to the KWG, a systematic internalizer has to trade with specific financial instruments to a significant extend. The KWG explicitly stipulates that systematic internalization that is subject to authorization can only be given, if the upper limits that are set out in the articles 12 to 17 of the Commission’s Delegated Regulation (EU) 2017/565 for organized and systematic trades as well as those for a relevant extend are exceeded. The aforementioned regulations do not stipulate upper limits for trades with crypto assets, because crypto assets are not yet defined as financial instruments in the sense of the European financial market regulation. Therefore, the variant of proprietary trading of systematic internalization cannot be realized by trading crypto assets on the OTC-market.

          OTHER VARIANTS OF PROPRIETARY TRADING HOWEVER POSSIBLE

          Even though systematic internalization in the sense of the KWG cannot be given when trading crypto assets, the obligation to obtain authorization may still result from other variants. Especially the catch-all-variant that regulates the acquisition and/or selling of financial instruments as a service for others, but as a trade for own account is often applicable for example where trades are conducted in order to be able to fulfill client orders.

          Attorney Lutz Auffenberg, LL.M. (London)

          I.  https://fin-law.de

          E. info@fin-law.de

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            Jan 11, 2021

            Security Token Offerings up to 8 Million Euro – Which Changes Does the German Federal Government Plan?

            The German Federal Government published its draft version of the legislation for the introduction of the Electronic Securities Act (eWPG) shortly before the turn of the year. There are several changes to the first draft version that was published in the summer of 2020, mainly consisting of systematical clarifications and the rewording of certain parts. There is little change to the actual content of the previously published draft. Nevertheless, the legislative effort is not limited to the introduction of the eWPG. There are also changes intended to the Securities Prospectus Act (WpPG), which will be applicable to the yet to introduce electronic security and to the crypto security as well as to “traditional” security tokens to which the eWPG itself will not be applicable. The last-mentioned are tokens, which even though they are designed as securities will not have to be registered with an electronic securities registry according to the current draft provisions of the eWPG as according to the current version of the draft version the issuance of security tokens that are not registered in any registry shall still be possible. The eWPG therefore introduces optional and not mandatory regulations for the issuers of tokenized bearer bonds.

            SECURITY TOKEN ISSUANCES OF UP TO 8 MILLION EURO WITH A SECURITIES INFORMATION SHEET INSTEAD OF A COMPLETE SECURITIES PROSPECTUS

            The WpPG offers the option for issuers of all kinds of securities to offer their securities within the European Economic Area (EEA) without the creation and publication of a full securities prospectus, if the volume of the issuance does not exceed 8 million euros and if instead of the aforementioned securities prospectus a three-pages long securities information sheet (WIB) that contains all the relevant investment information has been created and published. These securities information sheets also have to be approved by BaFin. Furthermore, the distribution of a security that is based on a WIB can legally only be carried out in Germany by a BaFin authorized investment brokerage company, which can ensure that retail investors will not exceed the legally defined maximum investment amounts. This exemption is applicable to all securities in the sense of the MiFID II regulation and therefore also to security tokens.

            ADDITIONAL REQUIREMENTS FOR SECURITIES INFORMATION SHEETS OF DIGITAL SECURITIES

            The current draft regulation intends for additional requirements on the contextual design of WIBs of purely digital securities. Affected by this, provided that the draft version comes into effect, would in any case be electronic securities and therefore also crypto securities as defined in the eWPG. The draft furthermore calls for those requirements to be applicable to WIBs of all other digital, unsecuritized securities that do not qualify as electronic securities in the sense of the eWPG. According to the draft, security information sheets of digital securities of all kinds shall now consist of up to four instead of three pages as it is the case for traditional securities. The German Federal Government justifies this with the argument that these WIBs will also have to include information regarding the transferability of the security, its tradability on the financial markets and the technology on which the security is based. These contextual requirements are congruent to the established administrative practice of BaFin which it currently applies to the approval process of security information sheets for tokenized securities. The expansion of WIBs to four pages for digital securities is therefore a sensible and helpful easement for token issuer. Should the offered security be an electronic security in the sense of the eWPG, the WIB will also have to contain information about the registry managing party and where and how investors can examine the registry.

            Attorney Lutz Auffenberg, LL.M. (London)

            I.  https://fin-law.de

            E. info@fin-law.de

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              Dec 14, 2020

              The Tokenized Asset Investment – Dying Product-Category or Valid Option for Fundraising?

              Companies that seek to procure capital have a multitude of options to finance their business in Germany. The first one to turn to is usually to talk to the company’s house bank, even though bank loans are regularly associated to granting of substantial collaterals by the borrower. Especially startups regularly tend to opt for the issuance of shares to business angels and venture capitalists. A third option is the funding of projects via the capital markets. If the owners of the capital-seeking business do not want to issue company shares to potential investors, they also have the option to publicly offer debt instruments. In this case, investors receive interest and a repayment claim at the end of the duration against the issuing company in exchange for the temporary granting of capital. The specifics of such an offer can be designed in various ways. While most of the aforementioned debt products are regulated as securities, there is also a specific regulatory regime for products that are designed in a certain way – the Asset Investment Act (VermAnlG).

              WHAT ARE ASSET INVESTMENTS AND HOW DO THEY DIFFER FROM SECURITIES?

              Asset investments can only be investment products that are neither regulated as securities by the EU prospectus regulation nor as shares of an investment fund by the German Capital Investment Code. It is furthermore required that the acceptance of the investors’ money by the issuer cannot be qualified as a deposit-taking business and therefore as a banking service pursuant to the German Banking Act (KWG). Historically speaking, these products were the investment options on the grey capital market. The term grey capital market was used to refer to investment possibilities, which while legal were not specifically regulated, so that issuers of such products were not subject to prospectus obligations for the public offering. The German legislator intended to regulate products of the grey capital market with the Asset Investment Act and subjected issuers and distributors of asset investments to transparency, publications and conduct obligations. Since then, limited partner´s shares, trust shares, subordinated loans, unsecuritized participation rights, registered bonds and direct investments are all regulated accordingly in Germany. A key characteristic of asset investments is that they are limited in their tradability as well as their transferability. Therefore, they used to be interesting primarily for private and not so much for institutional investors.

              WHAT ARE THE ADVANTAGES AND DISADVANTAGES OF ASSET INVESTMENTS?

              There used to be a considerable market in Germany for products of the grey capital market especially prior to the introduction of the Asset Investment Act. The legislator decided to allow financial asset intermediaries, that do not need authorization by BaFin pursuant to the KWG to continue to distribute these products, not least because he intended to protect the existing market infrastructure. Asset investments can therefore be distributed in Germany on the basis of a mere authorization for financial asset distribution pursuant to the German Industrial Code. Such an authorization can be obtained far easier than an authorization for investment brokerage in accordance to the KWG. Furthermore, there is still a considerable amount of financial asset intermediaries in Germany that can be commissioned with the distribution of asset investments. A disadvantage of asset investments on the other hand is the fact, that the Asset Investment Act is a purely national regulation, meaning that asset investments that are based on the provisions of the German Asset Investment Act can only be distributed on the bases of the corresponding asset investment prospectus within the German borders.

              WHAT ARE THE ADVANTAGES THAT TOKENIZATION HAS TO OFFER TO ASSET INVESTMENTS?

              Tokenization can have considerable advantages for asset investments because it allows for an embodiment of the shares of that product class. Because of the necessary distinction to securitized securities, asset investments are traditionally designed as direct and immediate contracts between the issuer and the investor which stipulate the connected rights and obligations. An embodiment in e.g., a bond certificate was not possible. With the option to embody asset investments in tokens, this product class can now potentially also be interesting for institutional investors. Because of their investment guidelines, institutional investors are usually dependent on their investments being held in custody by a third-party, so that they can provide auditors with third-party deposit statements enabling the auditors to vouch for the portfolio. These deposit statements could be issued by crypto custody institutions for tokenized asset investments. Investment products that are intended to be offered via a vast distribution network to private and institutional investors could therefore profit from a design as an asset investment.

              Attorney Lutz Auffenberg, LL.M. (London)

              I.  https://fin-law.de

              E. info@fin-law.de

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                Dec 07, 2020

                Crypto Assets vs Crypto Assets – the Discrepancy Between German and European Crypto Regulation

                When the European legislator decided to introduce the first piece of codified regulation for the crypto market with the fifth AML directive, he also decided to use the term virtual currencies to describe Bitcoin, Litecoin and comparable, blockchain-based units of value. The German legislator on the other hand did not implement the term virtual currency and the corresponding definition into national law when he transposed the provisions of the fifth AML directive into the German Money Laundering Act (GWG). Instead, the German legislator decided to introduce the term crypto asset and a corresponding definition to the German Banking Act (KWG) in an attempted to cover almost every blockchain-based phenomena. In Germany, crypto assets are therefore financial instruments in the sense of the KWG as of the 1st of January 2020. They 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. The German legislator excluded crypto-based e-money instruments as well as digital means of payment that can only be used in a limited business model from this definition. Germany took a separate route in this matter which is not quite helpful to the harmonization of the European crypto regulation.

                EU COMMISSION USES THE TERM CRYPTO ASSET IN ITS DRAFT REGARDING THE MICA REGULATION

                Simultaneously with the publication of its Digital Finance Package in September of 2020, the EU Commission also released its draft for a uniform regulation of the crypto market. With the Markets in Crypto Assets Regulation (MiCA), the EU Commission intends to provide a reasonable regulation regarding the creation and offer of crypto tokens and stable coins, as well as a uniform obligation to obtain authorization for crypto-related business models throughout the entirety of the European Union. If passed, the MiCA regulation would be directly applicable to all market participants throughout the European Union. Contrary to EU directives, the regulation would not need to be transposed into the respective national law in order to be legally effective. In the context of the MiCA regulation, the EU Commission also proposed a definition of the term crypto asset. The proposed definition differs substantially from the one which was introduced by the German legislator in the KWG at the beginning of this year. A crypto asset according to MiCA shall be defined as a digital representation of value or a right that can be stored and traded electronically using distributed ledger technology or comparable technology. In addition to that, the MiCA regulation in its current form would also introduce subcategories of crypto assets and it also includes a definition of the term distributed ledger technology itself. These subcategories would be asset-referenced tokens, e-money tokens, utility tokens and other crypto assets. The MiCA draft also provides definitions for the subcategories.

                WHAT ARE THE MOST IMPORTANT DIFFERENCES BETWEEN THE DEFINITIONS OF CRYPTO ASSETS IN THE KWG AND THE PROPOSED MICA DRAFT?

                At first glance, the definitions already differ substantially in length. While the MiCA definition utilizes subdefinitions for specific designs of crypto assets, the German solution tries to provide a uniform definition for all manifestations. In addition to that, there are also content-related differences. While the German definition relates to the absence of an issuance or guarantee by a central bank or any other public authority and furthermore to a potential usage as a means of payment or as an investment vehicle, the proposed MiCA regulation does not. The later result from the specific subdefinitions. Therefore, it seems that the European solution is preferable to the German one. The European solution is way better suited to correctly and accordingly tackle the different possible applications of the distributed-ledger-technology. It therefore looks as if the German legislator will have to abolish its unique, specific solution in a timely manner.

                Attorney Lutz Auffenberg, LL.M. (London)

                I.  https://fin-law.de

                E. info@fin-law.de

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                  Nov 30, 2020

                  Prospectus Liability and Token Sale – What are the Risks of an Erroneous Whitepaper?

                  Since around 2015, especially startups often choose to fund their business through a so-called Initial Coin Offering (ICO). These involve the creation of crypto tokens related to the issuers business model, which are subsequently offered to interested investors. Depending on the project, the ICO issuer may choose to connect the issued tokens to additional rights for the token holders such as for example special discounts or other advantages related to the acquisition of goods or services from the ICO-funded business. ICO tokens regularly do not grant investors real company shares and only sometimes co-determination rights. ICO issuers frequently create a document for marketing purposes, which they refer to as a “Whitepaper” to the project obviously referring to the draft paper for Bitcoin released in 2008 by Satoshi Nakamoto. In this document, the issuer lays out the concept of and his vision for the project and he may also provide some additional information regarding the conditions of the planned token sale. The advertisement for investment products is however a subject which should be handled with the utmost diligence by the issuers, because of the liability risks that are associated with it. The specific legal requirements for ICO-related advertisement measures depend on the nature of the offered product and the rights that are connected to it.

                  PROSPECTUS LIABILITY RESULTING FROM SPECIFIC STATUTORY REGULATIONS AND FROM GERMAN PRIVATE LAW

                  As a rule of thumb, it can be said that every publication which is intended for the general public and which gives the impression to be a comprehensive description of the investment product may be considered a prospectus in the sense of the German prospectus liability regulations. The specific legal requirements that have to be fulfilled by such prospectuses depend on the specifically offered investment product. For tokens that qualify as transferable securities in the sense of the harmonized EU-securities regulations, the EU Prospectus Regulation determines the contents that these securities prospectuses must set out and the consequences that issuers will face that do not fulfill these requirements. There are specific regulations for the creation and prospectus liability for tokens, that e.g. are only restrictedly transferable and therefore qualify as asset investments in the sense of the German Asset Investment Act. Should tokens neither qualify as securities nor as asset investments, a prospectus liability for the users of marketing documentation may result from the principles of the so-called private law prospectus liability, which was developed by the German jurisprudence. Pursuant to these principles, every marketing documentation addressed to the public for offering investment products is a potential liability risk. The liability regulations do not make a difference between offerors that call their marketing document a prospectus, a marketing leaflet, a handout or a whitepaper.

                  ISSUERS, OFFERORS AND INITIATORS MAY BE LIABLE FOR ERRONEOUS PROSPECTUSES

                  According to the principles of the private law prospectus liability, not only the issuer but also other parties may be liable for erroneous statements made in marketing tools that qualify as a prospectus from a private law perspective. Liability claims of investors may also be directed at e.g. the publisher of the prospectus, or at initiators, founders or designers that are not the issuer, if they have a considerable amount of influence on the management of the issuer. It is also imaginable that liability claims could be directed against people that made advertising statements in the prospectus and that claim particular trust for themselves and the advertised product. Prospectus liability claims usually entitle the investor to a repayment of the invested sum in exchange for the reassignment of the investment product to the infringer. In addition to that, in some cases investors may also claim lost profits that they could have obtained if they had invested in a different investment product instead.

                  Attorney Lutz Auffenberg, LL.M. (London)

                  I.  https://fin-law.de

                  E. info@fin-law.de

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                    Nov 23, 2020

                    Proprietary Trading vs. Financial Commission Business – Which One is Better Suited for Crypto Trading?

                    Since the prices of Bitcoin, Ether, Litecoin and other cryptocurrencies are approaching new all-time highs these days and more and more institutional investors are interested in including relevant positions of cryptocurrencies into their investment portfolios, also the daily trading volume of the crypto market is increasing accordingly. The 24-hour trading volume over the last couple of days has been constantly between 150 and 200 billion USD, with an upward trend noticeable. The increased interest of investors in the crypto market also means increased business for service providers that provide their customers access to the crypto market and enable them to trade crypto assets. Where such service providers trade crypto assets from and to their own books, the German banking regulatory law generally calls for the service providers to be BaFin authorized for either proprietary trading or financial commission business. But what is the difference between those two forms of financial trading and which variant is better suited for the crypto business?

                    PROPRIETARY TRADING CAN BE GIVEN BY ECONOMICAL SELF AND THIRD PARTY INTEREST

                    Proprietary trading, which is subject to authorization is conducted by those, that acquire or dispose of financial instruments in their own name and for their own account and that additionally fulfill certain specific requirements of the German Banking Act (KWG). Trading cryptocurrencies can be qualified as proprietary trading, because of the fact that cryptocurrencies are generally qualified as crypto assets and therefore as financial instruments in Germany. For example acting as a so-called Market Maker, meaning someone that continually offers and acquires crypto assets at trading venues for self-determined prices, or as a so-called Systematic Internalizer, meaning someone, that systematically and in an organized manner conducts trading with crypto assets outside of trading venues, can be qualified as proprietary trading. Additionally, proprietary trading may be given where a service provider offers his customers the trading of crypto assets, which the service provider conducts for its own account and in a substantial way. Proprietary traders enter directly into agreements with their trading partners as a contractual counterpart. Even though it is subject to discussion, if the obligation to obtain authorization for proprietary trading always requires a service-character, BaFin has not in all cases deemed such as necessary requirement.

                    FINANCIAL COMMISSION BUSINESS ONLY WITH TRADES ON THE CUSTOMER’S BEHALF

                    Financial commission business may be given in cases of trading operations concerning crypto assets, even if the trader acts in his own name. The difference to proprietary trading lies in the fact, that the financial commission business always requires the trade to have economic effect for the account of someone other than the trader, meaning the economic consequences of the trade will always hit the customer and never the service provider. This is the case, if a service provider acquires or disposes of crypto assets because of a client order. This may for example make sense where the service provider has better market access than the customer and can therefore get better prices for the customer. The service provider in this case acts in his own name on the markets but because of the contractual agreement between the service provider and the customer, the economic consequences will be applied to the customer.

                    WHICH VARIANT IS BETTER SUITED FOR CRYPTO TRADING?

                    It cannot be generalized which of the two variants is better suited for crypto trading. The decisive factor to answer this question is the specific business model in the individual case. Business models in which crypto assets are traded with a pure economic self-interest cannot qualify as financial commission business. If each trade on the other hand is based on a client order, the design of the service as a financial commission business seems preferable, since holdings in crypto assets, that belong to the service provider himself, have to be matched in accordance with the CRR-equity quotas with the corresponding equity, no matter if the service is designed as proprietary trading or financial commission business. Additionally, the financial commission business does not require the establishment of a crypto portfolio to match the client demand at all time.

                    Attorney Lutz Auffenberg, LL.M. (London)

                     I.  https://fin-law.de

                    E. info@fin-law.de

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                      Nov 16, 2020

                      The Crypto Security – Overrated or the Next Big Thing?

                      The German ministries of Justice and Finance this summer proposed new regulations regarding crypto securities in combination with the draft legislation for the introduction of electronic securities. According to the proposed draft, crypto securities are intended to constitute a specific form of electronic securities and differ from them only in the way that they are registered with a crypto security registry. These crypto security registries are intended to be run by service providers which are authorized for this activity by the financial supervisory authorities. According to the draft legislation, crypto security registries are intended to be operated on a decentralized, forgery-proof recording system which records the data in chronological order and secures them against unauthorized erasure and subsequent modifications. According to the explanatory memorandum to the draft legislation, the term crypto security registry is not connected to a specific technology, but because the definition calls for a decentralized storage solution, most likely only recording systems that are based on Distributed Ledger technology are suitable at this point in time. The usage of public blockchains is probably not an option for crypto registry managers since the risks connected to a hard-fork-event can hardly be controlled. Private blockchains currently seem to be the only practical solution.

                      WHICH INFORMATION IS SUPPOSED TO BE KEPT IN A CRYPTO SECURITY REGISTRY?

                      Detailed information regarding the registered crypto securities are supposed to be entered in crypto security registries. Specifically, the draft legislation intends for information being kept that enable an unambiguous identification of the security (e.g. ISIN), information regarding the issuer, the bearer, disposal hinderances, third-party rights and information regarding the question if the crypto security is registered in the name of a securities trading bank or in the name of the custodian (collective custody) or in the name of the individual bearer. The new regulation is supposed to ensure that the individual that is labeled as the bearer in the crypto security registry is also the legal bearer. Dispositions regarding crypto securities are supposed to only come into effect if they are entered in the respective crypto securities registry.

                      IS IT MANDATORY FOR TOKENIZED SECURITIES TO BE REGISTERED IN A CRYPTO SECURITIES REGISTRY IF THE LEGISLATIVE PROPOSAL GOES INTO EFFECT?

                      The new regulations regarding crypto securities would not be mandatory for the issuing of tokenized securities. It would still be possible to issue a “traditional” security tokens on a public blockchain that would be connected to certain investor rights, according to the current iteration of the draft legislation. The major advantage of crypto securities over unregistered security tokens would be the possibility to acquire the first named in an unencumbered, bone fide way. This feature, which is according to current securities law only possible if there is a physical embodiment of the security, could make crypto securities marketable on regulated trading facilities.

                      IS A CENTRALIZED REGISTRY FOR CRYPTO TOKENS A MANDATORY PREREQUISITE TO MAKE THEM ACQUIRABLE IN A BONE FIDE, UNENCUMBERED WAY?

                      First, it has to be made clear that the decentralized storage method would not change the fact that the operator of a crypto security registry would keep a centralized database. The draft legislation not only intends for the introduction of the stipulations regarding crypto security registries, but also for a legal fiction that would equate electronic securities to objects in the sense of the German Civil Code (BGB). The elevation of electronic securities to objects in the sense of the BGB is absolutely sufficient to apply the provisions regarding the unencumbered, bone fide acquisition of objects that are stipulated in the BGB to tokenized securities. A central register on the other hand would not necessarily be required. The introduction of a central registry would rather mean a legislative rejection of the technical innovation possibilities of tokenized securities, since it would mean that key efficiency-increase potentials such as the possibility to do without an intermediary such as a central depository would be made impossible by this regulation. The registration of paper-based securities with a central depository may be a sensible solution to enable the electronical trade of the otherwise physical securities. A reason for the mandatory usage of a central database for securities, that are anyways relatable to individual bearers because they exist on a publicly displayable blockchain does however not suggest itself.

                      Attorney Lutz Auffenberg, LL.M. (London)

                      I.  https://fin-law.de

                      E. info@fin-law.de

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                        Nov 09, 2020

                        MaComp and Crypto – Under Which Circumstances is BaFin’s Administrative Practice Relevant for Crypto service Providers?

                        BaFin substantiated its administrative practice with regards to the obligations arising from the German Securities Trading Act (WpHG), the EU Commission’s Delegated Regulation EU 2017/565 (DV) and other regulations that are applicable to financial service providers with the Minimum Requirements for Compliance (MaComp). The publication provides supervised entities with information about the minimum requirements that are placed by BaFin on the implementation of legal compliance obligations. Affected businesses must establish adequate policies and procedures, as well as maintain sufficient budgets to ensure compliance of the business and the employees with the stipulations of the WpHG and the DV. They are e.g. required to establish and fund a compliance unit, to comply with specific internal audit, assessment and quality control processes as well as to provide a diligent documentation and to train their employees in regular intervals. But is this also applicable to BaFin supervised crypto service providers?

                        MACOMP IS NOT APPLICABLE TO CRYPTO CUSTODY SERVICE PROVIDERS

                        The term “compliance” generally describes the fulfillment of laws and other legal obligations. When it comes to financial services, the term is specifically used to describe the fulfillment of supervisory obligations to which investment service providers are subject to. In order to be subjected to the obligations arising from the WpHG and the DV and subsequently MaComp, a service provider must qualify as an investment service provider. Pursuant to the stipulations of MiFID II, which in Germany are transcribed into the WpHG, investment service providers are all credit institutions and financial service institutions that offer investment services. According to sec. 2 para. 8 WpHG, investment services are inter alia finance commission business, proprietary trading, investment brokerage, investment advisory services and the operating of trading facilities for financial instruments. Crypto custody services e.g. are not listed by the WpHG and are therefore not classified as an investment service. Crypto custody service providers therefore do not have to comply with the obligations set out by the WpHG and the DV and therefore are not subject to MaComp neither.

                        ALSO OTHER BAFIN SUPERVISED CRYPTO SERVICE PROVIDERS NOT NECESSARILY SUBJECT TO MACOMP

                        Entities that are involved in the commercial trading of cryptocurrencies as e.g. brokers, counterparties in a trade or operators of trading facilities are often subject to authorization according to the German Banking Act (KWG), because cryptocurrencies are financial instruments in the sense of the KWG since they are either units of account or crypto assets. On the other hand, neither the WpHG nor the MiFID II on which it is based qualify units of account or crypto assets as financial instruments, meaning that dealings with cryptocurrencies alone cannot be the subject of investment services according to these provisions. This makes it possible that e.g. an operator of a crypto exchange may be subject to authorization according to the KWG but is not subject to the WpHG at the same time.

                        MACOMP APPLICABLE TO DEALINGS WITH SECURITY TOKENS

                        Having said that, entities whose business model does not revolve around traditional cryptocurrencies, utility tokens or payment tokens but instead around tokenized securities (security tokens) may still be subject to the WpHG and thereby also to MaComp. Should this be the case, the business has to fulfill the minimum requirements that are stipulated by BaFin in the MaComp, which can result in a substantial additional administrative expenditure. In order to make it possible for small businesses to implement these minimum requirements, the principle of proportionality is in effect when implementing MaComp. According to this, small businesses with limited financial resources can make use of numerous flexibility clauses in MaComp which will allow them for an individual implementation of MaComp.

                        Attorney Lutz Auffenberg, LL.M. (London)

                        I.  https://fin-law.de

                        E. info@fin-law.de

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

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