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Category: blog EN

Mar 29, 2021

Trading Volume Through Decentralized Liquidity Pools – Can DeFi Provide a Secondary Market for Security Tokens?

The public offering of security tokens on the crypto markets for financing purposes has become a viable alternative for innovative businesses since 2017. The options for funds-seeking companies range from the issuance of so-called utility tokens, which resemble a digital voucher usable exclusively within the business model of the token issuer to so-called security tokens, which grant their bearers participation, rate of return or repayment claims. While utility tokens regularly do not constitute regulated investment products, offerors of security tokens must observe the specifically applicable capital markets regulations, just as providers of traditional investment products. Specifically, providers of security tokens might have to create comprehensive prospectuses pursuant to the EU Prospectus Regulation, the German Investment Code or the Asset Investment Code, if they intend to offer their tokens to investors on a public market.

SECONDARY MARKET FOR SECURITY TOKENS STILL IN ITS INFANCY

The public offering of security tokens does not pose great difficulties from a technical or regulatory point of view anymore. Numerous providers that offer technical support for tokenization projects have emerged. From a legal point of view, it has to be noticed that the competent capital markets supervisory authorities in Germany and Europe have positioned themselves with adjusted administrative practices within the last two years, which allow for token offerings and which are in large parts congruent to the administrative practices that are applicable to the issuance of traditional investment products. That said, the remaining problem of token offerings is the lack of a development of secondary market for security tokens. Even internationally there are only few exchanges that allow for the trading of regulated security tokens. Some established exchanges are announcing for several years now that they intend to create trading segments for security tokens. The economic and legal implementation however is complex and seemingly requires a lot more time than estimated. Investors in security tokens are therefore often facing the problem that their tokens lack tradability, which should be the defining feature of tokenized investment products.

DECENTRALIZED LIQUIDITY POOLS AS A SOLUTION FOR THE SECONDARY-MARKET-PROBLEM OF SECURITY TOKENS?

An option that lately became popular within the crypto market to quickly establish tradability of newly issued tokens is the usage of so-called decentralized Liquidity Pools (LP). Token issuers themselves may create an LP via smart contract on a compatible blockchain, which they can equip with an initially freely choosable amount of their own tokens and with other common cryptocurrencies such as Bitcoin, Ether or e.g. USDC. LPs are Decentralized Exchanges (DEX), meaning that tokens and cryptocurrencies with which they are equipped can be purchased and sold by investors immediately after the launch of the LP via a direct interaction with the specific LP. Tokens of the provider are therefore immediately tradable with the other cryptocurrencies with which the LP is equipped. Even though the creation of Liquidity Pools requires that the provider ultimately commits a certain amount of his tokens and a suitable amount of units of other cryptocurrencies, the fact that he thereby creates an immediately accessible secondary market for his tokens may be worth it.

IS THE INITIATOR OF A LIQUIDITY POOL SUBJECTED TO REGULATORY OBLIGATIONS?

Valid legal arguments can be made that the equipment of a Liquidity Pool with one’s own security tokens in order to create a secondary market would constitute a public offering. That being said, issuers of security tokens will obviously not only distribute their tokens via LP´s and without return but also via traditional distribution channels for which they would be required to create and publish a corresponding prospectus respectively other required investor information and documentation anyways. The question arises, if the initiator of an LP can be considered its operator with regards to the trade activities of the LP which would maybe trigger the obligation to acquire authorization for the operation of a multilateral trading facility. The decisive factor to answer this question is the technical design of the specific LP. An operating quality of the initiator in the regulatory sense will regularly be hard to justify, should the initiator not have any technical influence over the LP after its launch and if he does not receive any trading fees or other contributions from the trading activities of the LP.

Attorney Lutz Auffenberg, LL.M. (London)

I.  https://fin-law.de

E. info@fin-law.de

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    Mar 15, 2021

    Regulation of Non-Fungible Tokens – Are NFT Financial Instruments in Germany?

    Germany assumed a unique position within the European Union early on, concerning the regulation of cryptocurrencies and business models relating to blockchain technology. Shortly after the emergence of bitcoin as the first cryptocurrency, BaFin established for the German jurisdiction that Bitcoin and comparable cryptocurrencies such as Litecoin shall qualify as units of account and therefore as financial instruments in the sense of the German regulatory banking regime. This qualification has not always been uncontested. , BaFin still stucks to its qualification until today, even if due to the introduction of a new category of financial instruments as of January 2020 the majority of transferable tokens can also be qualified as crypto assets and therefore as financial instruments pursuant to the German Banking Act (KWG), as long as they serve as an alternative means of payment or as an investment vehicle. Therefore, a strict regulation which often also requires BaFin authorization prior to the start of any business activity is applicable in many cases that concern business models related to crypto tokens.

    NON-FUNGIBLE TOKENS AS A NEW FORM OF BLOCKCHAIN UNIT

    In the meantime, there have been multiple innovations made in blockchain-technology and connected to those innovations a multitude of new applications for this technology arose. Nowadays, especially the option to run so-called smart contracts within blockchain infrastructures opens up the possibility to create and issue crypto tokens that are not identical to each other, but rather equipped with individual features. Such Non-Fungible Tokens are regularly neither intended nor suited as a means of payment and only under certain circumstances suited for serving as an investment vehicle, because this use-case usually requires the individual tokens to be interchangeable with tokens of the same kind and quality. On the other hand, there is a need for tokens that are non-fungible in the gaming industry and in projects that intend to tokenize valuable objects such as art, automobiles or gemstones.

    NON-FUNGIBLE TOKENS ARE NOT UNITS OF ACCOUNT PURSUANT TO THE KWG

    BaFin justified the qualification of Bitcoins as units of account in an expert article published in December 2013 by stating that the definition of units of account in accordance with the administrative practice of the authority also includes value units that have the function of a private means of payment or of a substitute currency as a means of payment in multilateral settlement accounts. NFT regularly will not fulfill this requirement because of their non-fungible nature. Even though they may be accepted as barter for other objects in a settlement system, they will not be generally accepted as a bartering item in multilateral settlement accounts.

    QUALIFICATION OF NFT AS CRYPTO ASSET POSSIBLE IN SPECIFIC CASES

    Units that are used as means of payment or that serve investment purposes may be qualified as crypto assets according to the wording of the legal definition. The same reasons that prevent the qualification of NFT as units of account also prevent NFT to be used as a means of bartering or payment. The individual design of NFT prevent a usage of the units as units of account in exchange relationships. The situation may potentially be different in the other class of cases that is covered by the law, namely those cases in which the unit serves investment purposes. Tokens that represent the ownership of a valuable object may also serve investment purposes. This may especially be the case, if the token bearer only receives an asset position, but never uses the tokenized object itself or takes possession of it. It is conceivable that in these cases a regulatory qualification of the NFT as an asset investment pursuant to the Asset Investment Act (VermAnlG) is made. Asset investments are financial instruments pursuant to the KWG. Commercial dealings with NFT that qualify as asset investments may therefore trigger authorization obligations, if the business activities of the involved provider qualify as banking business or as a financial service pursuant to the KWG.

    Attorney Lutz Auffenberg, LL.M. (London)

    I.  https://fin-law.de

    E. info@fin-law.de

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      Mar 08, 2021

      Between the Poles of Authorization Requirement and Geoblocking – What Can BaFin Demand from Service Providers from Other EU Countries?

      In Germany, companies often require prior authorization from BaFin for commercial handling of cryptocurrencies if their offered services qualify as banking businesses or financial services. For example, the operation of an exchange platform, which enables users to trade cryptocurrencies will regularly qualify as a financial service, which is subject to authorization either because it qualifies as the operation of a multilateral trading facility, as investment brokerage or as proprietary trading. Besides the qualification of the activity as either a banking business or a financial service, the obligation to obtain authorization pursuant to sec. 32 of the German Banking Act (KWG) also requires that the respective service provider offers the service on a commercial scale with a reference to Germany. While BaFin assumes a commercial scale where the service is not only offered temporarily and the service provider is acting on basis of an intention for generating profits, the authority’s administrative practice regarding the question whether a service is offered with a reference to Germany is a lot more differentiated. BaFin will always assume so if the provider has its registered seat in Germany. However, BaFin may also assume a service to be offered with a reference to Germany if a service provider from abroad repeatedly and intentionally targets potential clients on the German market with his offer of banking and financial services.

      WEBSITE IN GERMAN MAY TRIGGER AUTHORIZATION OBLIGATION PURSUANT TO SEC. 32 KWG

      BaFin always evaluates a possible reference to Germany of an activity in the sense of sec. 32 KWG on a case-to-case basis. A strong indicator for a reference as required for triggering the authorization obligation is a website that is available in German. Since there are other countries in the EU besides Germany in which German is spoken, the overall context and the details of the specific case are then decisive factors. Should for example an Austrian service provider have a German internet presence, it cannot automatically be assumed that the offered services target German customers. In these cases, the question arises if BaFin can demand from the service provider to make the website unavailable to internet users with a German IP-address by means of geoblocking measurements.

      GEOBLOCKING REGULATION PROHIBITS SERVICE PROVIDERS USING GEOBLOCKING MEASUREMENTS

      Service providers within the European Union are subject to the EU Geoblocking Regulation. The EU regulation, which is directly applicable to service providers is intended to strengthen the European single market and counteract discrimination that is based on nationality, residency or the place of establishment. Inter alia, the Geo-blocking regulation prohibits service providers to block or limit a customer’s access to the service provider’s online interface for reasons related to the customer’s nationality, place of residence or place of establishment through the use of technological measures or otherwise,. By applying geoblocking measurements, operators of crypto exchanges and other financial service providers from EU member states would therefore infringe on applicable EU law. BaFin cannot create a situation like that through its administrative practice.

      NO PRIORITY OF GERMAN REGULATORY LAW

      According to an exemption clause from the Geoblocking Regulation, the prohibition of discrimination is not applicable where the blocking or limitation of access is necessary in order to ensure compliance with a legal requirement from the laws of a member state in accordance with the law of the European Union to which the service provider’s activities are subject. The obligation to obtain authorization as it is stipulated in the German regulatory law cannot trigger this exemption, because the clarification that an offered service is not targeted towards German customers can also be achieved with a clear wording and disclaimers on the website as well as by omission of marketing activities that aim at the German market. Important in this context is also the passive freedom to provide services which is guaranteed under European law and which allows service providers to serve customers in Germany without triggering of authorization obligations also according to BaFin´s administrative practice, if the customer initially approaches the service provider. This business opportunity would be denied to service providers that would be forced by the supervisory authorities to implement geoblocking measurements.

      Attorney Lutz Auffenberg, LL.M. (London)

      I.  https://fin-law.de

      E. info@fin-law.de

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        Mar 01, 2021

        Are Merchants Allowed to Accept Bitcoin as a Means of Payment?

        In the last couple of months, Bitcoin gained attention primarily as a very attractive investment opportunity. At this point in time, not only a few adventurous private investors, but also more and more institutional investors such as investment funds and investment banks invest in the best-known cryptocurrency. Even though Bitcoin is currently recognized as the hottest investment asset of the hour, the originally described and intended application for Bitcoin in Satoshi Nakamoto’s whitepaper was the creation of an alternative electronic means of payment that functions in a decentralized manner and does not require a central settling institution. This originally intended application has not been completely forgotten. Elon Musk for example announced that his company Tesla, which caused a stir by investing 1.5 billion dollars in Bitcoin earlier, intends to accept Bitcoin as a payment for Tesla automobiles in the future. But what legal obstacles do traders face, if they intend to accept Bitcoin or comparable cryptocurrencies as a means of payment for their goods and services?

        PAYMENT WITH BITCOIN ONLY POSSIBLE IF MERCHANT AND CUSTOMER CONSENT

        From a private law point of view, it first has to be noted that Bitcoin does not have the status of a legal tender in Germany. According to the German Central Bank Act, legal tender, which can always be used to settle financial obligations due to legal order, are exclusively coins and banknotes denominated in euros. The payment of goods and services with Bitcoin is nevertheless possible under German private law, if both parties of a contractual relationship agree that a Bitcoin payment shall have the effect of settling the payment obligation. On the other hand, a customer has no possibility to force a merchant to accept Bitcoin instead of euros as a payment. An effective payment in Bitcoin from a civil law point of view therefore requires that the merchant and his customer validly agree on the exchange of Bitcoins for goods contractually.

        ACCEPTANCE OF BITCOIN AS A PAYMENT GENERALLY NOT SUBJECT TO AUTHORIZATION

        Merchants offering their customers the option to pay in Bitcoin for their offered goods or services generally do not require a prior authorization from BaFin for this activity. The mere acceptance of Bitcoin as a means of payment is possible without an authorization because the acceptance of Bitcoin does not constitute a banking business or a financial service. However, according to the administrative practice of BaFin the acceptance of Bitcoins as a means of payment may be associated with activities that require prior authorization, if the merchant offers additional services to the customer which are considered as a banking business or a financial service pursuant to the German Banking Act.

        SUBSEQUENT TRADING ACTIVITIES AS REGULATED PROPRIETARY TRADING

        In case of accepting Bitcoin as a means of payment, merchants will regularly face the question of how to commercialize the received Bitcoins in order to turn them to their business account. In most cases, the employees of the merchant want to be paid in euros and not in Bitcoin. Additionally, facility rents and other operation expenses will usually only be payable in euros. This is obviously always the case for tax payments to the German tax authority. Bitcoin stocks will therefore have to be exchanged by merchants to euros on a regular basis. This activity under certain circumstances may constitute proprietary trading, which would be subject to a prior authorization requirement from BaFin. However, the obligation to obtain authorization will only be triggered if the volume of the trading activities reaches a significant volume and a regular frequency. An obligation to obtain authorization will therefore be avoidable in most cases with a diligent planning.

        Attorney Lutz Auffenberg, LL.M. (London)

        I.  https://fin-law.de

        E. info@fin-law.de

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          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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