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Category: blog EN

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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          Jul 20, 2020

          Acceptance Feature for Security Tokens – What is it and Why is it Important?

          [et_pb_section fb_built=”1″ _builder_version=”4.9.10″ _module_preset=”default” global_colors_info=”{}”][et_pb_row _builder_version=”4.10.6″ _module_preset=”default” global_colors_info=”{}”][et_pb_column type=”4_4″ _builder_version=”4.10.6″ _module_preset=”default” global_colors_info=”{}”][et_pb_button button_text=”for German version click here” _builder_version=”4.10.8″ _module_preset=”default” custom_button=”on” button_text_size=”13px” button_border_width=”1px” button_border_radius=”0px” hover_enabled=”0″ global_colors_info=”{}” button_url=”/acceptance-funktion-bei-security-token-was-ist-das-und-warum-ist-sie-wichtig/” sticky_enabled=”0″][/et_pb_button][/et_pb_column][/et_pb_row][et_pb_row _builder_version=”4.9.10″ _module_preset=”default” global_colors_info=”{}”][et_pb_column type=”4_4″ _builder_version=”4.9.10″ _module_preset=”default” global_colors_info=”{}”][et_pb_text _builder_version=”4.9.10″ _module_preset=”default” global_colors_info=”{}”]

          Since the approval of the first security prospectus for a security token offering on the German market, the issuance of tokenized securities has become an interesting alternative to the issuance of traditional, paper-based securities. Security token offerings are a technical milestone for the capital markets. They eliminate e.g. the need for depository banks, which are a mandatory requirement for traditional security offerings in Germany. Furthermore, they bring the investment product closer to the investor by allowing him or her to directly take custody of the tokens by storing them in a self-controlled wallet. In addition, security token offerings also allow trading and transferring the tokenized investment product without the need of an intermediary. The needs of investors that either prefer their tokens being safeguarded in professional custody or that are obligated to take that route are also satisfied since the introduction of crypto custody services as a financial service at the beginning of this year. Nevertheless, tokenization in general is still in its early stages in Germany. It will take time and pioneering projects until the infrastructure of the capital markets truly open up to adopt these new products. For example, there is still no regulated trading segment for tokenized securities at an authorized security exchange. Security token trading therefore takes place outside of security exchanges. This circumstance potentially leads to massive problems with regards to trading security tokens which can be solved by an acceptance feature.

           

          WHAT IS THE ACCEPTANCE FEATURE?

          The long-established, Hamburg based shipping company Vogemann issued the Greenshiptoken (GST) this month. GST is a security token that includes an acceptance feature according to its token terms. The acceptance feature solves the problem that arises from the fact that GST tokens will not be transferred on the secondary market via a security exchange or any other centralized marketplace, but instead immediately and directly between investors. The problem with this arrangement from a civil law point of view is that rights that stem from the security, especially the repayment and interest claims, will always have to be transferred collectively with the tokens. The German civil law ensures for paper-based debt securities that the right from the paper follows the right at the paper. The owner of a debt security in paper form is therefore legally always the owner of the claims that stem from that security as well. The German civil law currently does not allow a comparable legal fiction for tokenized debt securities.

           

          HOW ARE CLAIMS THAT STEM FROM SECURITY TOKENS TRANSFERRED TO THE PURCHASER OF THE TOKENS?

          Therefore, the transfer of security tokens and of rights that are connected to them has to be specifically regulated by the underlying token terms. Since the rights in question are claims, they can legally only be passed on from the seller to the purchaser via assignment to the purchaser. Legally this requires an assignment contract. According to German law, an effective contract requires two components, an offer and an acceptance related to the offer. At this point the decentral nature of blockchain solutions results in a technical problem. Even though the transfer of a blockchain token is actively initiated by the owner – in this case the seller – of the token, the recipient – the purchaser of the token – normally has no option to actively confirm the acceptance of the token. Blockchain tokens are simply added to the blockchain address of the recipient without the recipient being required to take any action whatsoever. Therefore, the offer to transfer a token and the rights connected to the token can be seen in the initiation of the blockchain transaction by the owner, but there is no visible action of the recipient that could legally be qualified as an acceptance of that offer. The acceptance feature solves this problem and ensures that the transfer of a security token will only be included in the underlying blockchain, if the recipient actively confirms the acceptance of the token and the connected rights.

           

          WHY IS THE ACCEPTANCE FEATURE IMPORTANT?

          The acceptance feature ensures that the rights connected with the security token will be passed on from the seller to the purchaser in the legally required form of an assignment contract. The absence of a legally effective acceptance of the offer poses the danger that the token could be transferred to the purchaser without the associated rights as set out in the token terms. These rights would then remain with the previous owner of the tokens while the security token would be transferred. The acceptance feature therefore enables the legally effective transfer of security tokens and their associated rights on the secondary market. Security tokens that can only be traded over centralized marketplaces do not necessarily need an acceptance feature, because the seller as well as the purchaser place a trading order which can be viewed as an offer respectively as an acceptance. But as long as such marketplaces do not exist for security tokens the acceptance feature is a valid way to ensure the legally effective transfer of security tokens and the associated investor rights.

           

          Attorney Lutz Auffenberg, LL.M. (London)

           I.  https://fin-law.de

          E. info@fin-law.de

           

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            Jul 06, 2020

            Buy or Build – Is the Acquisition of an Institute an Alternative to a BaFin Application?

            Business ideas in the blockchain sector in Germany can often not be realized without the appropriate authorization of BaFin. The obligation to obtain a BaFin authorization as a consequence of the extensive regulation of crypto assets and blockchain tokens often comes as a showstopper for startups if they cannot find a cooperation partner that offers the required regulatory framework as a Whitelabel solution or as a service. The authorization requirement can pose a serious obstacle even for well-funded projects, especially because the application process can take anywhere from six to twelve months depending on the specifics of the project. Many entrepreneurs therefore feel that the acquisition of an already existing and authorized bank or financial institute might be an elegant alternative to the rather time-consuming application process. But is the acquisition of an already authorized institute really faster than the aforementioned application process?

            COMPLEXITY OF A BAFIN AUTHORIZATION PROCESS DEPENDS ON THE SPECIFIC PROJECT

            Entrepreneurs should generally be aware of the fact that the specific business model and its realization and implementation as well as the ownership structure of the obligated company have a significant influence of the complexity of the authorization application. The authorization process for e.g. a GmbH with just one natural person as its shareholder intending to offer investment brokerage services related to cryptocurrencies will potentially be prepared and approved by BaFin and Bundesbank a lot faster than e.g. the application of a stock company which is part of an international group of companies intending to offer Market Making on an international crypto exchange, financial commission services for cryptocurrencies and financial portfolio management services for tokenized financial instruments. The preparation time for the application and the time required until authorization is granted is therefore much shorter for simpler, more focused business models than for more complex and versatile business models.

            BANK ACQUISITION AS AUTHORIZATION PROCESS IN A DIFFERENT FORM

            The acquisition of an existing institute is also subject to supervisory requirements. The purchaser of a bank or authorized financial institute must undergo a scrutinizing ownership control procedure, just as would be required in case of application for authorization directly. In this procedure, all of the intended owners that would hold substantial shares of the bank or institute to be acquired must provide information and documentation, such as e.g. certificates of good conduct and trade register excerpts. This might cause a similar workload as the preparation for an authorization process would, especially for purchasers that are part of an international group of companies. If additionally the business model of the to-be acquired institute must be changed or amended to suit the purchasers needs, a new and viable business plan must be submitted to BaFin as well. This business plan will be then be reviewed and checked in detail for economic and regulatory sustainability by BaFin and the German Central Bank. The internal processes also have to be adjusted, should the new business model trigger new compliance obligations for the institute. The creation of new documents such as report templates, ToS or customer contracts might also be necessary.

            ACQUISITION OF AN INSTITUTE FOR THE REALIZATION OF NEW BUSINESS MODELS IS SELDOMLY THE RIGHT CHOICE

            The acquisition of a bank or financial institute in order to realize a new business model is almost never worth it. The time-saving effect usually diminishes completely, because the acquisition of the institute can only become effective if the competent supervisory authorities approve the acquisition and they will only do so after a successful ownership control procedure. Furthermore, there is typically the risk that the acquirer also brings the institutes bad debts into his own books. For new crypto related business models, it is therefore usually preferable to directly apply for an own BaFin authorization.

            Attorney Lutz Auffenberg, LL.M. (London)

             I.  https://fin-law.de

            E. info@fin-law.de

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              Jun 29, 2020

              Crypto Business in Germany – In Which Scenario is BaFin Competent for Foreign Crypto Providers?

              Germany is taking on a special role in Europe and globally when it comes to blockchain regulation. The German Government decided last year that Germany would strive to become an internationally well-known hotspot for businesses with business models that are connected to or based on blockchain technology or cryptocurrencies. Germany tries to achieve this among other things by tailor-made regulations for blockchain related subjects. The transposition of the fifth European AML directive into German law for example went far beyond what was required by the European legislator. As a result, the custody of crypto assets for customers is a financial service that is subject to authorization since January 1st of 2020. But also other business models that are connected to crypto assets cannot be operated in Germany without the prior BaFin authorization. This applies to e.g. the operation of Bitcoin ATMs and crypto exchanges as well as to the offering of investment advice or investment brokering services for crypto assets. But at what point foreign services are subject to authorization?

              AUTHORIZATION REQUIREMENT WHEN BUSINESS SEAT IN GERMANY OR ACTIVE TARGETING OF GERMAN MARKET

              The German Banking Act is applicable to companies from the crypto industry that have their registered headquarter in Germany. These companies are therefore also obligated to obtain an authorization if they offer crypto related financial services. The obligation to apply for a BaFin authorization can alternatively also apply to foreign providers that neither have a registered place of business nor a branch office in Germany. BaFin states in its long-standing administrative practice that foreign providers of banking and financial services are subject to authorization, if they target the German market in order to repeatedly and commercially offer services that are subject to authorization to domestic enterprises and persons. The crypto providers are obligated to apply for a BaFin authorization in accordance to the German law in these cases. The option of EU-passporting an authorization for financial services that has been granted in another EU member state is not possible for this kind of crypto-related businesses. The reason is that the regulation of services in regard to crypto-related business models is not homogenously within the European Union.

              AT WHAT POINT IS THE GERMAN MARKET IS ACTIVELY TARGETED?

              The administrative practice of BaFin answers this question by giving numerous criteria by which the individual case can be assessed. The assessment whether a sufficient connection to Germany is given will always be decided by the circumstances of the individual case. The most important indications for BaFin that a sufficient “targeting” of the German market is given in case of a provider in order to justify an obligation to obtain an authorization are: the content of a website or of marketing tools that are used by the provider; whether the provider uses sales assistances that operate in Germany; whether German customers contacted via social media, messenger services, email, traditional print media or in any other way promoting the financial services. On the other hand, the administrative practice of BaFin accepts that a passive serving of German customers in a way that the customers initiatively demand the services from the crypto service provider instead of being actively targeted constitutes an admissible case of reverse soliciting. In such cases, a BaFin authorization in accordance to the German Banking Act will not be required.

              Attorney Lutz Auffenberg, LL.M. (London)

               I.  https://fin-law.de

              E. info@fin-law.de

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                Jun 22, 2020

                Trading Signals for Crypto Assets – Do Signal Providers have to register with BaFin?

                The international trade of crypto assets is becoming more and more attractive to professional traders. Even though the overall market capitalization of the crypto market is still extremely low in comparison to the market capitalization of the established capital markets, the independence from exchange trading hours and the volatility that are associated with crypto assets are potentially so profitable that more and more professional traders are entering this market. With the increasingly professional approach to investments in the crypto market, a likewise increase in the usage of modern investment tools which detect trends or even place buy and sell orders on the basis of artificial intelligence can be observed. A somewhat milder precursor to such investment-bots can be found in the sending of trading signals with attached buy or sell recommendations. These trading signals are often provided either via messenger services like Whatsapp or Telegram or via email or they are even made publicly available via a website. But is the provision of trading signals a regulated activity that the signal provider has to coordinate with the supervisory authorities?

                THE PROVISION OF TRADING SIGNALS IS TYPICALLY NOT INVESTMENT ADVISORY

                Financial services can be subject to an authorization requirement. This is the case with activities that include the offering of personalized investment advice to customers or their representatives with regards to certain financial instruments in consideration of the individual situation of the investor. According to the German Banking Act (KWG) financial instruments in this sense are also crypto assets such as Bitcoin, Litecoin or comparable cryptocurrencies. Global recommendations that are published by service providers via information distribution channels or that are intended for the public are not investment advice in the regulated sense. Trading signals that simply analyze general trends of the crypto market and provide buy or sell recommendations on this basis can therefore not be investment advisory in the aforementioned sense of the KWG. They always lack the personal reference to the investor.

                REGISTRATION OF INVESTMENT RECOMMENDATION SERVICE PROVIDERS WITH BAFIN

                Notwithstanding any authorization requirements, companies or individuals that are neither already authorized as securities service providers, financial investment management companies or as investment companies have a reporting obligation to BaFin if they offer investment recommendation services. However, this reporting obligation is only triggered according to the WpHG if the recommendations that are provided relate to financial instruments in the sense of the MiFID II. Crypto assets are qualified as financial instruments only according to the German KWG and not according to MiFID II. The reporting obligation therefore does not apply to signal providers that only provide their services with regard to the crypto market. This could of course be different in case of trading signals that relate to tokenized financial instruments that qualify as financial instruments in sense of MiFID II such as tokenized stocks or tokenized securities.

                Attorney Lutz Auffenberg, LL.M. (London)

                I.  https://fin-law.de

                E. info@fin-law.de

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                  Jun 15, 2020

                  Scaling Bitcoin via the Lightning Network – What Must be Considered by Crypto Businesses?

                  The Lightning Network promises to solve one of Bitcoin´s biggest problems: The Scalability. Due to its decentralized operation mode, the Bitcoin network itself can process and settle between seven and twelve transactions per second. In part this is due to the relatively small block size of just one Megabyte per block in comparison to other cryptocurrencies and in part to the fact that all transactions must be validated by the miners and then bundled in blocks be implemented into the current version of the Bitcoin blockchain. The Lightning Network, which is already active since 2018 tries to solve this problem with an off-chain solution.

                  HOW DOES THE LIGHTNING NETWORK WORK?

                  The Lightning Network is a very complicated construct from a technical point of view, which can hardly be described in a few sentences. It is a so-called Second-Layer protocol that even though it uses the Bitcoin networks infrastructure, it accumulates and resolves a certain number of Bitcoin transactions combined outside of the Bitcoin blockchain and will afterwards introduce them as just a single transaction into the Bitcoin blockchain. The core components of the Lightning Network are the so-called Payment Channels, which can be opened up between two users of the Bitcoin network. Payment Channels represent a current account relationship between two participants of the Bitcoin blockchain that opened them up, which are not managed on the Bitcoin blockchain but off-chain. If the two participants later decide to close the payment channel, their current account balance will be implemented as a single transaction in the Bitcoin blockchain. In addition, the Lightning Network enables its participants to also use already existing Payment Channels of other participants for their transactions so that transactions between participants not having a direct Payment Channel link can be processed indirectly through the Payment Channels of other participants. The usage of the Lightning Network relieves the Bitcoin network extremely with regards to the data amount to be processed as well as with regards to the computing power that miners have to spend for validation of transactions. Instead of validating each and every transaction on the Bitcoin blockchain separately, miners only have to validate a single transaction at the point in time in which the Payment Chanel is closed.

                  WHAT EFFECTS COME WITH THE UTILIZATION OF THE LIGHTNING NETWORK?

                  The most important effect of the utilization of the Lightning Network is the scaling of Bitcoin. The network is able to considerably increase the comparably low number of Bitcoin transactions per second. Transactions are also immediately valid without the necessity to wait for confirmation by the miners. Bitcoins appropriateness as an alternative means of payment is thereby substantially increased. In addition to this, the utilization of the Lightning network fosters financial privacy of the transaction parties on the Bitcoin network. While “traditional” Bitcoin transactions are directly and publicly included in the blockchain for everyone to see, transactions that are processed via the Lightning Network are not as such included in the Bitcoin blockchain but rather effectuated off-chain. Therefore, the amount, the involved parties as well as the origin of the transferred Bitcoins of an individual transaction processed via the Lightning network cannot be detected via the blockchain.

                  WHAT DOES THIS MEAN FOR CRYPTO BUSINESSES?

                  There is an increased demand for fast and cheap transactions, especially when it comes to the commercial handling of Bitcoins. Crypto exchanges and other service providers that handle a high quantity of Bitcoin transactions have a special interest in solutions like the Lightning Network. Crypto businesses that are obligated to observe AML obligations according to the applicable AML regulations have the problem that their auditing possibilities are substantially limited when using off-chain solutions such as the Lightning Network. They will not be able to determine the involved parties nor the transaction amount of an individual transaction. It is also virtually impossible to track the address, from which the transferred Bitcoin originate. Supervisory authorities will therefore probably be very critical with regard to the usage of the Lightning Network by supervised entities.

                  Attorney Lutz Auffenberg, LL.M. (London)

                   I.  https://fin-law.de

                  E. info@fin-law.de

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                    Jun 08, 2020

                    Capital Markets Union and Security Token – Which Country Should Be Chosen for a Security Token Offering?

                    The European commission intends to further develop and promote the free flow of capital within the Capital Markets Union. Numerus efforts have been made – and some have even been partially implemented – to reach this goal since 2015. The EU Prospectus regulation for example creates a uniform European framework for the creation and approval of security prospectuses for security issuances on the European capital markets. The requirements of security prospectuses regarding the content as well as the approval process have been harmonized by the new regulation. Furthermore, issuers of securities have the option to utilize a prospectus that has been approved in one European member state for the first public offering of a security via EU-Passporting in another member state for the same purpose. The regulation is obviously also applicable for the first public offering of dematerialized securities which are represented in the form of security tokens.

                    ISSUERS OF SECURITY TOKENS CAN FREELY CHOSE THE COMPETENT AUTHORITY

                    Issuers of security tokens are therefore always confronted with the question to which of the competent European authorities they should submit their security prospectus for approval. Issuers are generally speaking free to decide this matter. They can choose between the competent authority of their home state or any other supervisory capital markets authority within the European Union. Furthermore, security prospectuses can also be approved by supervisory authorities from one of the member states of the European Economic Area (EAA) and then be repassported via EU-passporting to other European countries in order to offer the security tokens to investors in the target country. But which supervisory authority is the right choice for STO issuers? Which criteria should be considered by issuers in the selection process?

                    THE RIGHT SUPERVISORY AUTHORITY DEPENDS ON THE PROJECT

                    The legal statues regarding the content as well as the approval and deposit process in all member states of the EEA are the same since the EU prospectus regulation entered into force. The European Securities and Market Authority (ESMA) published twelve guidelines on how the regulation has to be interpreted. These guidelines deal e.g. with the presentation of the risks in security prospectuses and they have to be observed by all European supervisory authorities during the approval process. Therefore, the selection of the right supervisory authority should be decided by criteria which take the actual project in account and not by legal criteria. It is probably cost efficient to apply for approval in the EEA member state in which the security tokens are offered, if the tokens in question are only offered to investors in this country. This way, the costs for an EU-passporting procedure and a translation of the prospectus summary into the official language of the target country, even though most will accept an English version – can be avoided. The widely shared supposition that the approval process for prospectuses takes longer in different states cannot be confirmed. The decisive factors for the question of how long the approval process takes are the complexity of the project and the diligence that the issuer and his advisers applied when creating the prospectus. The selection of a supervisory authority that has a certain amount of experience with the approval process of similar projects is however advisable when applying for approval of a security prospectus for security tokens.

                    Attorney Lutz Auffenberg, LL.M. (London)

                     I.  https://fin-law.de

                    E. info@fin-law.de

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                      May 25, 2020

                      Administration of Crypto Assets – What is Regulated by this Variant of the Crypto Custody Business?

                      The custody of crypto assets in Germany is an activity which is subject to authorization since the beginning of the year 2020. Rumors have it, that over 40 companies are interested in obtaining an authorization from BaFin to conduct crypto custody business in Germany. The newly introduced legal basis is not only applicable to the professional custody of digital customer assets. According to the wording of the regulation there are two additional activities that are also subject to authorization. The administration as well as the safeguarding of crypto assets and of private keys, which are required for the transfer of crypto assets are also activities that are subject to authorization according to the wording of the new law. But what exactly does the legislator refer to with the administration of crypto assets for a third party? Which specific activity is intended to be regulated by the wording of the law?

                      ADMINISTRATION OF CRYPTO ASSETS AS A SUBCATEGORY OF CUSTODY OF CRYPTO ASSETS

                      According to BaFin´s not yet fully developed administrative practice for the crypto custody business, crypto administration is a subcategory of crypto custody. According to the leaflet published by BaFin in early March of 2020, the supervisory authority assumes that a service provider conducts crypto administration in cases in which the service provider continuously exercises rights associated with the customers crypto assets. This may for example be the case when a service provider holds tokenized investment products for customers in custody, which yield a return to their respective bearers. Crypto administration may exist in the case that the custody service provider makes payment claims of the aforementioned kind on behalf of their customers vis-à-vis the issuer of the tokenized investment product or if the service provider receives the corresponding payments for these kinds of claims for their customers. The private keys and therefore the control over the tokenized investment products and the right to claim the corresponding yield will in most cases be held by the service provider. BaFin therefore expressly states in its leaflet that all three variations of the crypto custody business require the service provider to have custody of the private keys to the crypto assets. Even though the custody of the private keys is an essential requirement for the crypto custody business, crypto administration may be given even if the service provider does not have exclusive access to the crypto assets in its custody. According to the administrative practice of the supervisory authority, crypto administration is also given if the service provider knows the private keys in addition to the customer and exercises the customer rights for him.

                      CAN CRYPTO ADMINISTRATION BE GIVEN IN CASE OF DELEGATING?

                      It is questionable if crypto administration can exist in cases where crypto assets are delegated, meaning that these crypto assets utilize a consensus mechanism called the Delegated Proof of Stake (DPoS). Examples for crypto assets of this kind are EOS, Tezos and Cardano. In these blockchain systems new blocks are not created by miners that spend computing power in accordance to the Proof of Work consensus mechanism (PoW), but instead through the allocation of coins to so-called block validators. These block validators are chosen by the specific system on basis of the amount of coins (stake) that are allocated to them and they are rewarded for the validation of new blocks with the transaction fees that are paid by by the parties of the blockchaintransactions included in the block to be validated. Bearers of DPoS crypto assets can allocate their coins to block validators in order to improve the validators chances to be chosen by the system for validation of a new block. In return for the support, the validator will share the reward with his supporters should he actually be chosen by the system. However, delegating does neither require the delegated crypto assets to be actually transferred to a wallet of the staked validator nor does it require the block validators knowledge of the private keys to the delegated crypto assets. Crypto administration as a subcategory of the crypto custody business will therefore not be fulfilled by delegating crypto assets to block validators according to the administrative practice of BaFin.

                      Attorney Lutz Auffenberg, LL.M. (London)

                       I.  https://fin-law.de

                      E. info@fin-law.de

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                        May 18, 2020

                        Crypto Custodians and AML – What Applies to Crypto Custodians?

                        Last week BaFin published its long-awaited article concerning the AML obligations of financial service providers that intend to offer crypto custody services. The subject of crypto custody services therefore stays highly topical even during the corona crisis and BaFin continues its efforts to best inform the market participants with regards to the supervisory obligations of crypto custodians. Including its latest publication, the authority already published four leaflets addressing crypto custodians offering information concerning the interpretation of the Grandfathering regulation of sec. 64y of the German Banking Act (KWG), the authorization process for crypto custody service providers and its general interpretation of the definition of the new financial service of crypto custody business. Obviously, the authority intends to comprehensively inform market participants about the obligations before and under the ongoing supervision.

                        WHICH EXPLANATIONS DOES BAFIN OFFER TO CRYPTO CUSTODIANS?

                        Nevertheless, the current publication concerning AML obligations of crypto custodians is rather general in its approach. In the first part of the article, BaFin references its other publications regarding crypto custody services as well as its publications that are directed at AML obliged market participants in general. After that, BaFin points out that service providers offering crypto custody services are considered AML obliged financial institutes in the sense of the German Money Laundering Act since the introduction of the crypto custody service into the KWG and therefore must comply with the applicable AML regulations – companies only offering crypto custody services as of the amendment on 1st of January 2020 and companies that then already qualified as credit institutions or financial service institutions even before. Finally, BaFin offers a short summary of the following main obligations that derive from the German Money Laundering Act: The implementation of an adequate risk management system, the performance of customer due diligence procedures (KYC) as well as the implementation of a reporting system.

                        DOES THE BAFIN ARTICLE CONTAIN SPECIFIC NOTES FOR CRYPTO CUSTODIANS?

                        BaFins explanations concerning the performance of customer due diligence (KYC) and the implementation of a reporting system are rather general in this leaflet and only give a general overview of the obligations of AML obliged financial institutes. Only within the explanations concerning an adequate risk management system for crypto custody service providers, the authority highlights that this will also include the creation of a sophisticated risk analysis with regards to the specific business model of a crypto custodian. According to the authorities cautiously implied estimate, the risk analysis should probably focus on the specific product risks. According to BaFin, because of the complexity and novelty of the underlying technologies as well as the different designs of the potential anonymity features that are associated with individual crypto assets, the crypto custodians will at this point potentially have to apply higher analyzing standards than other financial institutes. As a matter of fact, the actual traceability of transactions ranges from very good to impossible, depending on the specific crypto asset.

                        MANY QUESTIONS REMAIN UNANSWERED

                        In summary, the new BaFin article on AML obligations of crypto custodians provides only little guidance for the preparation of a sufficient AML manual for crypto custodians. It would have been preferable if the authority would have provided more specific information on the issue of KYC and have stated which customer information will at least have to be collected and verified by the obliged crypto custodians, especially since the FATF (Financial Action Task Force) already released corresponding recommendations on this question. Since the FATF recommendations are very far-reaching in some aspects – they recommend to not only collect the personal data from the participating parties of a crypto transaction but also the collection of that data from a possibly involved service provider – a clear positioning of the German supervisory authority concerning the FATF recommendations would have been helpful.

                        Attorney Lutz Auffenberg, LL.M. (London)

                         I.  https://fin-law.de

                        E. info@fin-law.de

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