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Category: blog EN

Nov 30, 2020

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

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

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

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

ISSUERS, OFFERORS AND INITIATORS MAY BE LIABLE FOR ERRONEOUS PROSPECTUSES

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

Attorney Lutz Auffenberg, LL.M. (London)

I.  https://fin-law.de

E. info@fin-law.de

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    Nov 23, 2020

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

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

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

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

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

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

    WHICH VARIANT IS BETTER SUITED FOR CRYPTO TRADING?

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

    Attorney Lutz Auffenberg, LL.M. (London)

     I.  https://fin-law.de

    E. info@fin-law.de

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      Nov 16, 2020

      The Crypto Security – Overrated or the Next Big Thing?

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

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

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

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

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

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

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

      Attorney Lutz Auffenberg, LL.M. (London)

      I.  https://fin-law.de

      E. info@fin-law.de

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        Nov 09, 2020

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

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

        MACOMP IS NOT APPLICABLE TO CRYPTO CUSTODY SERVICE PROVIDERS

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

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

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

        MACOMP APPLICABLE TO DEALINGS WITH SECURITY TOKENS

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

        Attorney Lutz Auffenberg, LL.M. (London)

        I.  https://fin-law.de

        E. info@fin-law.de

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          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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                      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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