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Category: blog EN

Oct 26, 2020

Crowdfunding Service Provider Regulation – What Will Be Regulated by the New EU Regulation?

The European parliament passed the final version of the long-discussed European Crowdfunding Service Provider Regulation (ECSP) on 7th of October 2020. The new regulation is supposed to go into effect in about one year. Just as any other European regulation it will be directly applicable to European citizens and businesses. A transposition into the national law of the respective member states will not be necessary. Providers of crowdfunding services then will be subject to numerous new supervisory provisions. Existing crowdfunding platforms will have to ensure within the next twelve months that they obtain the required authorization as well as the implementation of necessary business processes. But what exactly will be regulated by the new regulation?

CROWDFUNDING SERVICE PROVIDERS GET HARMONIZED AUTHORIZATION REQUIREMENTS THROUGHOUT EUROPE

The creation of harmonized authorization requirements for crowdfunding service providers is the central focus of the European Crowdfunding Service Provider Regulation. A crowdfunding service provider in the sense of the ECSP is a service provider that matches the financing needs of investors and project developers via a platform solution, either through the brokerage of loans or through the brokerage of transferable securities in the sense of MiFID II. The ECSP will be applicable to platform operators that publicly offer crowdfunding projects with a funding goal of up to 5 million euro. Operators of crowdfunding platforms will have to meet numerous requirements and provide a series of verifications in order to obtain the newly established authorization. They will, e.g. have to dispose over regulatory collaterals to the amount of 25.000,00 euros or over a quarter of the established fixed costs of the previous year, which ever amount is higher. They will also have to establish internal control mechanisms and be led by fit and proper managing directors. The authorization requirements will be standardized throughout the European Union. There will therefore be a passporting option available, meaning that a crowdfunding service provider which is authorized in one EU member state will be able to offer his services in another EU member state on the basis of its original authorization and without the necessity to apply for another authorization in the target member state.

NUMEROUS ORGANIZATIONAL, DUE DILIGENCE AND CONDUCT OBLIGATIONS FOR CROWDFUNDING PLATFORMS

Next to the new authorization obligation and the respective provisions regarding the application process, the ECSP will also introduce a number of organizational, due diligence and conduct obligations for the operators of crowdfunding platforms. These platforms will all have to be operated in the legal form of a legal person. Furthermore, the operators will have to ensure that they have no conflicts of interest while operating the platform and that they fulfil the strict information and transparency obligations towards their investment clients. These information and transparency obligations stipulate among other things that the operator must inform the potential investor about the investment risks associated with the investment if the investment exceeds 1,000 euros and that he additionally has to provide the investor with an investment information sheet that may not exceed the volume of six pages and which has to be created by the project developer. Operators of crowdfunding platforms will also be obligated to provide information regarding the default rates of projects that were offered on their platform. They will also be obliged to fulfil strict requirements with regards to the publication of marketing publications concerning projects that are offered on their platform.

DO LICENSED FINANCIAL SERVICE PROVIDERS ALSO NEED TO APPLY FOR THE NEW AUTHORIZATION?

Financial service providers that intend to offer securities of projects with an issuing volume of less than 5,000,000 euros to small retail investors via a platform solution will have to grapple with the requirements of the new regulation, even if they are already authorized for conducting placement business and/or investment brokerage services. There will be the option to adjust the business model in order to avoid the new obligations to be applicable. If this is option is not wanted or feasible, the strict provisions of the new regulation will have to be implemented.

Attorney Lutz Auffenberg, LL.M. (London)

I.  https://fin-law.de

E. info@fin-law.de

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    Oct 19, 2020

    Technical Service Providers in Crypto Business Models – In BaFin’s Crosshairs Without Own Authorization Requirement?

    Not all business activities that are related to crypto assets or blockchain are automatically subject to authorization pursuant to the German Banking Act (KWG). The obligation to apply for a BaFin authorization is reserved for business models that involve a banking or financial service and that are related to blockchain units which are either considered crypto assets or another form of regulated financial instruments. For a lot of providers whose business models in one way or another revolve around the acquisition and disposal of cryptocurrencies, the operation of the business constitutes a banking or financial service which is subject to authorization. In this context, it is also thinkable for specific business models that various companies work together and some of them exclusively perform mere technical services or another form of complementary activity that can be provided without a prior authorization by BaFin. But do technical service providers really do not have any relation to BaFin?

    SUPERVISORY OBLIGATIONS ARE APPLICABLE TO TECHNICAL SERVICE PROVIDERS IF ESSENTIAL ACTIVITIES ARE OUTSOURCED

    Even though technical service providers in general do not require a BaFin authorization for their activities, if their contribution to the product cannot be qualified as banking or financial services, they nevertheless may still be subject to supervisory obligations if they provide their services to businesses that are supervised by BaFin and the Federal Bank of Germany and if the service constitutes as the outsourcing of an essential activity. A service may be deemed as the outsourcing of an essential activity, if e.g. the provided service is either essential for the business model of the outsourcing business or if it is related to the compliance obligations of the outsourcing business such as AML, internal revision or risk management. Should the provision of a technical service be qualified as the outsourcing of an essential activity, BaFin requires the outsourcing entity to fulfil certain requirements when concluding the contract with the service provider. These minimum requirements stipulated by BaFin revolve around subjects such as unlimited information rights with regards to the provided services that have to be provided to the supervised business as well as to the supervising authorities and to commissioned auditors, the right of the supervised institution to instruct the service provider to comply with supervisory obligations at any time, the agreeing upon reasonable cancelation periods and many more. On basis of such contractual provisions, the technical service provider may indirectly be subject to supervisory obligations that originally targeted the outsourcing institute.

    FULL RANGE OF SUPERVISORY RIGHTS IN CASE OF ILLEGAL BUSINESS ACTIVITIES EVEN WITHOUT OUTSOURCING AGREEMENT

    Supervisory actions of BaFin may target technical service providers even without an outsourcing agreement, if the outsourcing institute is not authorized for conducting its business while being subject to an authorization requirement. Entities being involved in such illegal activities may be forced by BaFin to cease their entire business activity immediately or to rescind the provided services. A thorough and careful examination of the crypto-related business models of a cooperation partner is therefore advisable to any technical service provider prior to entering in a cooperation agreement. The involvement in illegal banking or financial services of business partners may not only lead to the sanctions from BaFin but also to a permanent damage of the business reputation of the technical service provider.

    Attorney Lutz Auffenberg, LL.M. (London)

    I.  https://fin-law.de

    E. info@fin-law.de

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      Oct 05, 2020

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

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

      MANAGEMENT OF CRYPTO SECURITY REGISTRIES ONLY WITH BAFIN AUTHORIZATION

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

      HOW ARE CRYPTO SECURITY REGISTRIES SUPPOSED TO BE EQUIPPED TECHNICALLY?

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

      CRYPTO SECURITY REGISTRY MANAGEMENT IS NOT CRYPTO CUSTODY SERVICES

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

      Attorney Lutz Auffenberg, LL.M. (London)

      I.  https://fin-law.de

      E. info@fin-law.de

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        Sep 21, 2020

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

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

        CRYPTO CUSTODY BUSINESS SHALL BE EXTENDED

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

        SECURITY TOKENS ARE NOT NECESSARILY CRYPTO ASSETS

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

        Attorney Lutz Auffenberg, LL.M. (London)

        I.  https://fin-law.de

        E. info@fin-law.de

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          Sep 14, 2020

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

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

          OPERATION OF CRYPTO ATMS IS POSSIBLE IN GERMANY

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

          OPERATION OF CRYPTO ATMS MAY ALSO QUALIFY AS INVESTMENT BROKERAGE

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

          Attorney Lutz Auffenberg, LL.M. (London)

          I.  https://fin-law.de

          E. info@fin-law.de

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            Sep 07, 2020

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

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

            DEPOSITORY BUSINESS AS THE CENTRAL FORM OF FINANCIAL PRODUCT CUSTODY

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

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

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

            CRYPTO CUSTODY BUSINESS AS A CATCHALL ACTIVITY

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

            Attorney Lutz Auffenberg, LL.M. (London)

            I.  https://fin-law.de

            E. info@fin-law.de

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              Aug 31, 2020

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

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

              ADVANTAGES OF CRYPTO CUSTODIANS OVER DEPOSITORY BANKS

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

              WHAT ARE THE ADVANTAGES FOR ISSUERS AND INVESTORS?

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

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

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

              Rechtsanwalt Lutz Auffenberg, LL.M. (London)

              I.  https://fin-law.de

              E. info@fin-law.de

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                Aug 24, 2020

                Electronic Securities and Crypto Securities – What are the Differences?

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

                SECURITY TOKENS CREATE THE NEED FOR ELECTRONIC SECURITIES

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

                CRYPTO SECURITIES AS A SPECIAL FORM OF ELECTRONIC SECURITIES

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

                Attorney Lutz Auffenberg, LL.M. (London)

                I.  https://fin-law.de

                E. info@fin-law.de

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                  Aug 10, 2020

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

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

                  NEW GERMAN ELECTRONIC SECURITIES ACT (EWPG)

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

                  NEW REGULATED ACTIVITY IN THE GERMAN BANKING ACT (KWG)

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

                  APPLICABILITY OF THE SECURITIES DEPOSIT ACT TO ELECTRONIC SECURITIES

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

                  Attorney Lutz Auffenberg, LL.M. (London)

                  I.  https://fin-law.de

                  E. info@fin-law.de

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                    Aug 03, 2020

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

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

                    SUPERVISORY PRIVILEGES ONLY FOR THOSE SOLELY OFFERING CRYPTO CUSTODY SERVICES

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

                    UNREGULATED ANCILLARY SERVICES MAY BE OFFERED

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

                    UTILIZATION OF STORED CRYPTO ASSETS FOR OWN COMMERCIAL ACTIVITIES

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

                    STRICT LEGAL REQUIREMENTS FOR INTERIM USE OF CRYPTO ASSETS

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

                    Attorney Lutz Auffenberg, LL.M. (London)

                    I.  https://fin-law.de

                    E. info@fin-law.de

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                      Jul 27, 2020

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

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

                      USING BLOCKCHAIN TECHNOLOGY FOR INTERNAL BUSINESS PROCESSES

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

                      EXPANDING THE BUSINESS MODEL WITH ADDITIONAL FINANCIAL SERVICES

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

                      Attorney Lutz Auffenberg, LL.M. (London)

                      I.  https://fin-law.de

                      E. info@fin-law.de

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                      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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