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Category: blog EN

Apr 13, 2020

Tokenized Convertible Bonds – A Compromise on the Road to Equity Tokens?

The interest in token-based capital markets issuances increases notably. Not only blockchain startups and tech companies, but also well-established businesses with more traditional business models increasingly consider this new and innovative means of refinancing through the tokenized capital markets. So far, German businesses limit themselves to the issuance of tokenized, subordinated participation rights, but it just seems to be a matter of time until the next step in tokenization will be taken. The issuance of tokenized stocks is seldomly an option for stock companies, even though there is a considerable market-interest for alternatives to tokenized debt products. Hardly anyone wants to be the first one to issue blockchain-based stocks especially because the German legislator announced that there will be changes to the legal basis for these types of issuances in close future as a result of the legislators blockchain strategy. This leads to the question if there is an alternative to the issuance of tokenized stocks for businesses already available that might pave the way for tokenized equity products.

CONVERTIBLE BONDS AS A HYBRID OF DEBT AND EQUITY PRODUCTS

This is where so-called convertible bonds come into play. The idea of convertible bonds is not new but rather a tried and tested one. Convertible bonds are bonds that give the investor at the end of the duration the option to receive e.g. stocks instead of the repayment of the invested capital. The duration of a convertible bond can be set without restrictions by the issuer, just as the interest rate and the other associated rights and obligations of the investor and the issuer. In the new market of tokenized financial instruments, convertible bonds have the advantage that they can be designed as tokenized participation rights at first and thereby give the issuer the option to wait and see if the announced legal changes for tokenized stocks actually are suitable for his needs. Issuers could design a convertible bond in a way that it would give the investor the option to choose stocks as a repayment at the end of the duration, but could also reserve the decision on how those stocks (securitized, unsecuritized or tokenized) would be issued to the investor. The design of the specific stock could therefore be postponed to a later point in time when the legal basis for tokenized stocks might already be implemented, if the duration of the bond is long enough.

ALTERNATIVES TO TOKENIZED SUBORDINATED BONDS INCREASE

Tokenized convertible bonds could therefore be a valid alternative to tokenized participation rights for issuers wanting to offer investors the option of a real stake in the company without being the first company that actually issues tokenized stocks. Tokenized convertible bonds give the option of a blockchain-based capital markets issuing to these issuers. It is interesting to see that and how the market for tokenized capital markets products rapidly expands and that alternative product designs such as e.g. tokenized stocks, tokenized asset investments and tokenized shares of investment funds are being developed. Tokenized participation rights will of course stay as a viable alternative and not only be remembered as a pioneer design when it comes to digital financial products. But already today it is a good idea to think outside the box when designing a tokenized financial product to find the financial instrument that best suits the issuers needs.

Attorney Lutz Auffenberg, LL.M. (London)

 I.  https://fin-law.de

E. info@fin-law.de

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    Apr 06, 2020

    The Authorization Process for Crypto Custodians – The New BaFin Guidelines

    Companies that offer their customers the storage of crypto assets and/or private keys that are used for the transfer of crypto assets had to notify BaFin of their intention to apply for authorization as a crypto custodian until the 31st of March 2020. Companies that used this option are now obliged to submit a complete application to BaFin until the 30th of November 2020. In the Meantime, the companies that made use of the aforementioned option are allowed to legally continue to offer crypto custodian services thanks to a legal fiction. But this so-called “Grandfathering” option should not obscure the fact that the affected companies are considered financial institutes in the sense of the KWG already since the introduction of the crypto custody service in the German Banking Act (KWG) on the 1st of January 2020. They therefore already have to fulfill certain supervisory obligations. BaFin offered more guidance last week with the publication of the “Guidelines on application for authorization for crypto custody business” to companies that now have to prepare the application process.

    DO ALL CRYPTO CUSTODIANS HAVE TO FULFILL THE SAME REQUIREMENTS FOR A SUCCESSFUL BAFIN AUTHORIZATION APPLICATION?

    In general, the principle “equal law for all” applies to all market participants. Two companies having exactly the same business model and offering exactly the same services would therefore have to fulfill exactly the same requirements in their authorization application. Differences could arise if the business models of two crypto custodians would differ in detail. In this context the most important distinguishing criteria is the portfolio of crypto tokens for which the crypto custodian intends to offer custodian services. Applications from businesses that intend to offer crypto custody services exclusively for crypto tokens that qualify solely as crypto assets and not additionally as another financial instrument – e.g. as bonds, stocks or shares of investment funds in the sense of the AIFM-Directive – must meet the requirements of sec. 32 para. 1 KWG and the corresponding ordinance. Crypto custodians that intend to offer their services for crypto assets that also qualify as securities in the sense of the MiFID II regulation of the European Union have to apply on basis of the Delegated Regulation (2017/1943/EU) and the corresponding implementing regulation (2017/1945/EU). Additional difference in the application process of two crypto custodians can arise from the specific design and conduction of processes within the individual business.

    WHAT ARE THE SPECIFIC CHARACTERISTICS OF AN AUTHORIZATION PROCESS FOR CRYPTO CUSTODIANS?

    In the recently published guidance, BaFin points out that crypto custody business is first and foremost a tech service. The authority therefore emphasizes that it will focus within the authorization process of a crypto custodian on the technical handling of customer private keys for crypto assets. Therefore, applicants will have to provide in-depth and detailed information about the technical processes regarding the safeguarding of customer crypto assets and how the storage of these will be done. This includes information about the storage of cryptographic keys in so-called hot wallets and cold wallets and if the customer keys are kept in collective or individual wallets. All business processes have to comply with the “Supervisory Requirements for IT in Financial Institutions” (BAIT) and with the “Minimum Requirements for Risk Management” (MaRisk), both published by BaFin. With regards to the professional competence of the managing directors BaFin will focus also on the technical abilities and credentials of the proposed candidates, making these positions available for candidates with tech job and managing experience. BaFin will also consider that the crypto custody business is a completely new regulated activity and that at this point there ishardly anyone who could proof his or her professional competence through relevant experience in this field of work. Regarding the obligations of crypto custodians in the field of anti-money laundering prevention, a specific guidance with relevant information for crypto custodians will shortly be published.

    Attorney Lutz Auffenberg, LL.M. (London)

     I.  https://fin-law.de

    E. info@fin-law.de

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      Mar 30, 2020

      Digitalization and COVID-19 – Temporary Simplifications for German Stock Companies

      Digitalization was on the rise even prior to the SARS-CoV-2 outbreak but the German legislator so far struggled to introduce the legal framework that was necessary to foster the further development of digitalization. With the outbreak of COVID-19 into a world-wide respiratory pandemic and the subsequent pressure on the German economy, the German legislator thankfully reacted quickly. Even though it cannot be a permanent status for a healthy democracy that the political opposition rests its job, in this case the reluctance of the opposition made fast legislative responses possible that are absolutely necessary in order to contain this pandemic. The German legislator passed a law (Gesetz über Maßnahmen im Gesellschaftsrecht zur Bekämpfung der Auswirkungen der COVID-19 Pandemie) within just a few days that went into effect on the 28th of March 2020 and will stay in effect until the 31st of December 2021. This legislation is supposed to lessen the impact that COVID-19 has on the German economy and includes the possibility for German stock companies to hold the annual shareholder meeting in a digital manner, even if the company’s statute does not set out this possibility. The regulation initially is only applicable to shareholder meetings that take place in 2020, but the law includes the option to extend this possibility up to the 31st of December 2021.

      DIGITAL SHAREHOLDER MEETINGS AS A SUITABLE SOLUTION FOR THE FUTURE

      According to the transitional regulation, the executive boards of German stock companies as of 28th of March may decide that the participation and voting in the annual shareholder meeting takes place by means of electronic communication. According to the old law – or more precisely: the temporarily suspended law – the executive board of a German stock company only had this option if it was explicitly stated in the company´s statute. Naturally, this option was basically never included in the statutes of long running, older companies. Even though such companies may also be interested in the digitalization of their annual shareholder meetings and the subsequent voting with regards to the indisputable cost-efficiency, the actual implementation of this into the company´s statute and the correct technical execution of digital meetings and votes are initially associated with investments in both cost and effort. Because of the COVID-19 pandemic and the current contact ban that practically leads to a ban on any form of assembly, the digital conduction of this year’s annual shareholder meetings seems to be the only option. Stock companies will therefore now have the possibility to gather experience with digital annual shareholder meetings.

      DO THESE SIMPLIFICATIONS ONLY APPLY TO STOCK COMPANIES?

      The German legislator also implemented simplifications for GmbHs, namely the possibility of digital shareholder resolutions. Throughout the duration of the temporal law, shareholder resolutions may be passed in text form (e.g. via e-mail) without the generally necessary consent to this form of all GmbH shareholders. The transitional provisions regarding annual shareholder meetings of stock companies also apply accordingly to partnerships limited by shares, European companies (SE) and for the most part to mutual and mutual-type associations. 2020 will show if and how companies can handle digital annual meetings and voting. The legislator might implement a permanent option for digital meetings and voting after the pandemic is finally over, if the experiences that are now gathered are positive.

      Attorney Lutz Auffenberg, LL.M. (London)

       I.  https://fin-law.de

      E. info@fin-law.de

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        Mar 23, 2020

        Business Models with Crypto Assets – What is the Correct Legal Basis for the BaFin Application?

        In Germany, business models that are based on cryptocurrencies require prior approval by BaFin if their activity qualifies as a banking business or a financial service. This was already the case prior to the introduction of crypto assets as financial instruments into the German Banking Act (KWG) at the beginning of this year. BaFin qualifies Bitcoins and comparable blockchain tokens as units of account and therefore as financial instruments already since 2011. Business activities in Germany such as e.g. investment brokerage or investment advice, the operation of an exchange platform, proprietary trading or financial brokerage with cryptocurrencies therefore practically always required a corresponding BaFin license. Applications for authorization that were submitted to BaFin until the end of 2017 had to fulfil the provisions of the KWG and the corresponding reporting ordinance (AnzV). Since 2018, investment firms have to submit their permission applications in accordance with the Delegated Regulation (2017/1943/EU) and the corresponding implementing regulation (2017/1945/EU). In light of the above, the question arises which legal basis is the correct one for businesses with regards to crypto assets?

        BUSINESS MODELS WITH “TRADITIONAL” CRYPTOCURRENCIES APPLY IN ACCORDANCE WITH THE KWG

        The Delegated Regulation (2017/1943/EU) and the corresponding implementing regulation (2017/1945/EU) are based on the Second Markets in Financial Instruments Directive (MiFID II). They therefore only apply to businesses that are subject to the provisions of MiFID II. Business models with regard to cryptocurrencies are special in the way that “traditional” cryptocurrencies such as Bitcoin, Litecoin, Ether or Ripple are not (yet) considered financial instruments in the sense of MiFID II. The directive comprehensively defines in appendix I, section C which products are financial instruments in this sense. This catalogue lists neither cryptocurrencies nor units of account. Therefore, business models that are based on “traditional” cryptocurrencies are not subject to the MiFID II provisions. These businesses are not considered investment firms in the sense of the Delegated Regulation (2017/1943/EU) and the corresponding implementing regulation (2017/1945/EU). Approval applications for these business models therefore continue to be subject to the provisions of the KWG and the AnzV.

        BAFIN APPLICATIONS FOR BUSINESS MODELS WITH REGARDS TO SECURITY TOKENS FOLLOW THE NEW RULES

        BaFin applications for business models that are not (entirely) based on “traditional” cryptocurrencies differ from the aforementioned rules. Business models operating with blockchain tokens that are considered financial instruments in the sense of MiFID II are considered investment firms and therefore have to adhere to the new regulations. According to appendix I section C of MiFID II, this is the case with tokens that qualify as e.g. transferable securities, shares of investment funds, options such as futures, swaps, CFDs or derivatives businesses. This makes a considerable difference especially for the preparation of BaFin applications of future crypto custodians. Depending on the tokens that the crypto custodian intends to safeguard for his customers, the BaFin application would have to be prepared in accordance to the KWG (for “traditional” cryptocurrencies) or the Delegated Regulation (for security or investment tokens).

        WHAT DIFFERENCE DOES THE LEGAL BASIS MAKE FOR THE APPROVAL APPLICATION?

        With regards to the requirements the national (KWG) and the European (Delegated Regulation) legal basis differ only marginally from each other. While the approval application in accordance to the KWG can be made without any formal requirements, the Delegated Regulation and the corresponding implementing regulation require the usage of forms that are set out in the appendix of the implementing regulation.

        Attorney Lutz Auffenberg, LL.M. (London)

         I.  https://fin-law.de

        E. info@fin-law.de

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          Mar 16, 2020

          Blockchain-based Digital Collectibles – Are Those Financial Instruments?

          More and more mid-sized companies consider blockchain-based capital markets issuances – so-called security token offerings (STO) – as an alternative. The new issuing-vehicle is quickly becoming a viable financing alternative not only for startups but also for SMEs. But blockchain has even more to offer. Stocks, bonds and shares of investment funds are not the only assets that can be tokenized. Specific values and objects can also be depicted on the blockchain through a token and thereby not only become immediately transferable between users but also traceable. The blockchain community calls these tokenized specific values “digital collectibles”. But in which fields of business can digital collectibles create value and moreover: are they financial instruments in the form of crypto assets which have been newly introduced into the German Banking Act (KWG)?

          TOKENIZATION OF ART PIECES, TRADING CARDS OR OTHER INDIVIDUAL OBJECTS

          Digital collectibles are especially interesting for the gaming industry. One of the most prominent examples are the CryptoKitties which rose to fame by the end of 2017 and at that point even made up most of the traffic on the Ethereum blockchain, thereby severely slowing down the whole network. In this online-game, players have the opportunity to digitally breed cats which are depicted by tokens of the ERC721 protocol on the Ethereum blockchain. The ERC721-protocol allows the creation of tokens with individual characteristics within a smart contract on the Ethereum blockchain, which is the essential contrast to the ERC-protocols that are used for capital markets issuances like ERC20, ERC1400 or ERC1404. While tokenized investment products necessarily need to be designed identical and interchangeable, smart contracts that run on the ERC721-protocol on the other hand can create unique tokens that each have individual properties. This characteristic makes these smart contracts very interesting when it comes to the tokenization of art or trading cards. Of course, they can also be used for the creation of a digital tokenized proof of ownership for objects in the real world, since practically every object can be connected to an individual token.

          IS IT NECESSARY TO CREATE A CAPITAL MARKETS PROSPECTUS IN ORDER TO ISSUE DIGITAL COLLECTIBLES?

          Right now, the whole subject of tokenization is firmly in the grasp of the financial markets regulatory authorities. This is the reason why it is often assumed that the public issuance of tokens can only be executed with prior regulatory authorization or after the approval of a capital markets prospectus by BaFin. When it comes to digital collectibles, this assumption is in most cases erroneous. The mere tokenization of a real-world object does not necessarily mean that the corresponding token has to fulfil the legal requirements associated with a financial instrument. The individuality of digital collectibles will regularly mean that the issuance of the tokens does not qualify as a public offering of securities or shares of investment funds, because such products have to be identical and interchangeable by definition to even be suited for a capital markets issuance.

          ARE DIGITAL COLLECTIBLES ALSO FINANCIAL INSTRUMENTS IN ACCORDANCE TO THE GERMAN BANKING ACT (KWG)?

          Authorization obligations in accordance to the KWG may apply if the token in question qualifies either as a unit of account or as a crypto asset. BaFin qualifies tokens as units of account only if they are designed identically. If they are not, they cannot be used as a unit to define value and therefore they cannot be units of account. The legal definition of crypto assets requires that the token can potentially be used for either investment purposes or as a means of payment. While the usage of individualized tokens as a means of payment seems to be impossible, the usage of specific objects such as tokenized art also for investment purposes seems possible. However, in most cases the prime function of digital collectibles will not be investment but rather the proof of ownership or a traceability via the blockchain.

          Attorney Lutz Auffenberg, LL.M. (London)

           I.  https://fin-law.de

          E. info@fin-law.de

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            Mar 09, 2020

            The New BaFin Leaflet for Crypto Custodians – Can Security Tokens be Stored by Crypto Custodians?

            BaFin published its long-awaited leaflet on crypto custodian services (German only) at the start of last week. Since the legislative process took almost till the end of 2019 and the crypto custodian service was however introduced on the 1st of January 2020 into the German Banking Act (KWG), BaFin had little time to develop an administrative practice on the new financial service. The leaflet offers an explanatory interpretation of the different criteria of the new legislation and thereby clarifies which activities of service providers are subject to authorization. In addition, the authority answers the question if security tokens, meaning tokenized securities, can be safeguarded by service providers that are authorized for crypto custody services. According to the wording of the new legislation, crypto custody is applicable to the safeguarding of crypto assets which were also introduced to the KWG on the 1st of January 2020 as a new form of financial instruments. According to the legal definition, crypto assets can be digital means of payment or exchange as well as digital investment products. Therefore, currency tokens as well as security tokens can be qualified as crypto assets depending on the case at hand. According to the new administrative practice that has now been published in the leaflet, the question if a security token can be safeguarded by a crypto custodian has to be answered for each case individually.

            UNDER WHICH CIRCUMSTANCES CAN SECURITY TOKENS BE SAFEGUARDED BY CRYPTO CUSTODIANS?

            The exact regulatory classification of a security token is essential for the answer to the question if the token can be safeguarded by a service provider with authorization for crypto custodian services. The term “security token” obviously relates to tokens that are designed as securities but tokens that are designed as e.g. asset investments in accordance to the German Asset Investment Act or as shares of investment funds in accordance to the AIFM directive can also be digital investment products. Depending on the specific design of the token, issuers and providers of such security tokens or investment tokens must abide by the applicable capital markets regulations and, if necessary, create a sales prospectus for them. In the newly issued leaflet, BaFin explicitly states that security tokens – in accordance to the current legal situation – are not securities in the sense of the Securities Deposit Act (DepotG) and that therefore the safeguarding of security tokens does not require an authorization in accordance to the DepotG but can also be offered on basis of an authorization for crypto custody business. The background of this administrative practice stems from the fact that, according to BaFin, the security depository business only applies to products that are securities in the sense of the DepotG. Since the regulations of the DepotG all relate to securities that are securitized in paper documents, it seems farfetched to apply these rules to securities that are embodied in a digital token. The KWG however does not make this distinction in its legal wording. Nevertheless, BaFin keeps up this interpretation with regards to security tokens even though the very same leaflet also cites the explanatory memorandum of the Federal Government for the introduction of crypto assets into the KWG which states that the custody of security tokens requires authorization in accordance to the DepotG if the tokens in question are securities in the sense of the DepotG. It would have been helpful if BaFin had also explained which requirements a security token has to fulfill to be considered a security in the sense of the DepotG, especially as the authority states in the same leaflet that security tokens are not securities in the sense of the DepotG.

            WHAT ARE THE CONSEQUENCES FOR THE SECURITY DEPOSITORY BUSINESS?

            BaFin’s new administrative practice regarding the custody of security tokens by crypto custodians could have a massive impact on the tokenization of the capital markets in general and especially on the market for depository business for securities. While securities that are securitized in single or global certificates can only be safeguarded by banks that are authorized in accordance to the DepotG, tokenized securities can now be safeguarded by crypto custodians for investors. The second option is not only more cost-efficient but also regulatorily privileged. These facts threaten the business-model of traditional depository banks and might even make them obsolete if the infrastructure of the capital markets continue to improve for tokenized financial products.

            Attorney Lutz Auffenberg, LL.M. (London)

             I.  https://fin-law.de

            E. info@fin-law.de

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              Mar 02, 2020

              Tokenization of the Capital Markets – Which Financial Instruments Can be Tokenized?

              Blockchain-based capital markets issuances are more and more becoming a viable alternative not only for blockchain startups but also for mid-sized companies when it comes to procuring funds at the capital markets. After the first security token offerings have already been realized by startups in very important pioneer work and the international capital markets supervisory authorities – including BaFin – are generally open to the idea of tokenized capital markets products, more and more mid-sized companies are working on blockchain-based, tokenized financial products and aim to procure fresh money from the capital markets. Even though the majority of the realized token issuances up to now was designed in a way that the issued token embodied a subordinated participation right, the tokenization of the capital markets is not limited to this kind of product. But which kind of financial products can already be tokenized according to German law and are therefore an option for companies intending to offer blockchain-based investments?

              TOKENIZED CORPORATE BONDS AS MOST COMMON PRODUCT

              The German legislator announced last year, as part of the government’s blockchain strategy, to lay the legal foundations for digital securities and publish a first draft with regards to the private as well as the regulatory law already in 2019. In a first step, it is planned to introduce laws that allow the issuance of fully digitalized bonds. Since the legislator is behind schedule on this project there is still the problem that according to German securities law an embodiment of rights and obligations can only be achieved in paper documents and not in digital tokens. The security tokens that already have been issued in accordance to German law achieve the necessary connection of the rights and obligations of the issuer and the investor with the tokens through the underlying token terms. These tokenized corporate bonds are usually designed as identical loan agreements that grant the investor a fixed or variable interest claim in exchange for the temporal transfer of money. As to the details, the issuers have a wide scope to offer within their terms with regards to the design of the investor rights. Loss options as well as subordination clauses and special termination rights or even option rights that grant the investor the right to choose company shares instead of a repayment in money at the end of the duration are all possible design options.

              TOKENIZATION OF STOCKS AND COMPANY SHARES

              The German legislator intends to introduce the legal foundations for digital stock shares after the legal foundations for digital bonds are introduced. Even though the tokenization of registered shares would already be possible in accordance to German law, there is no tokenized stock company in Germany yet. The tokenization of GmbH shares on the other hand proves to be way more difficult. Every transfer of GmbH shares needs a notarial certification to be effective. This fact does not necessarily preclude a tokenized GmbH share but it limits the tradability of such a token and moreover leads to a high cost intensity and complexity. Other company shares such as limited partner´s shares or shares of a general partnership could be tokenized but the statues for these company forms would require each and every token holder to be registered in the public company register. In contrast to the few moments a token transfer requires for being processed, the much longer processing time of the registry court makes this option rather impractical.

              TOKENIZATION OF FUND SHARES DEPENDING ON THE LEGAL NATURE OF THE INVESTMENT ASSET

              The possibility of the tokenization of fund shares depends on the legal design of the investment fund itself and the legal structure of participation options for the investors. If the investment fund would e.g. be designed as a limited partnership, the aforementioned problems regarding the registration of the investors would also apply to this situation. If the tokenized fund shares would be designed as claims, a tokenization of such fund shares could be realized in a comparable way as the tokenization of corporate bonds.

              Attorney Lutz Auffenberg, LL.M. (London)

               I.  https://fin-law.de

              E. info@fin-law.de

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                Feb 24, 2020

                Tokenized Financial Products and Deposit Business – Can Tokenization Exclude the Deposit Business?

                Companies that collect money from third parties which, according to the base agreement, shall be subject to an unconditional repayment clause, in most cases operates a depository business and therefore requires a banking license. The depository business is an activity that can legally only be provided by licensed banks. There are some exemptions from the general obligation to acquire authorization in order to operate a depository business that either evolved over the years from the administrative practice of BaFin or derive directly from the codified legal provisions of the German Banking Act (KWG). For example, BaFin acknowledges an exemption from the deposit business when it comes to the collection of unconditionally repayable money, if the repayment claim is secured by a standard banking collateral, e.g. bank guarantees or immediately realizable mortgages on real estate. Furthermore, BaFin also acknowledges an exemption from the deposit business in cases of collection of money, if the investor and the recipient contractually agree upon a qualified subordination clause in regard to the investor’s repayment claim, because in these cases the repayment is not unconditional. A legal exemption according to the wording of the law applies if the repayment claim is securitized in bearer or registered bonds. The legislator intended with this exemption to give businesses the opportunity to procure funds directly from the capital markets without the necessity of involving banks as intermediaries. But is this exemption applicable to tokenized bonds as well even though the wording calls for a traditional securitization of the bearer or registered bonds?

                EXEMPTIONS ARE OLDER THAN TOKENIZATION

                The legislator of the time in which the exemption was introduced obviously did not think about the possibility of blockchain-based bonds. The legislator rather assumed that bonds under German law would be regularly securitized in paper documents. BaFin interprets the exemption in a way that for the exemption, only financial instruments are suitable that qualify as bonds and that are either, if they are issued in accordance to German law, issued as identical bearer or registered bonds to the capital markets as part of a total issuing or, if they are designed in accordance to foreign law, are comparable to identical bonds from a total issuing under German law.

                THE KEY CRITERION IS THE CAPITAL MARKET ELIGIBILITY

                So far BaFin´s administrative practice does not address the question if the exemption is applicable to tokenized bonds without securitization in paper documents or not. The emphasis on “identical bonds from a total issuing” shows that the essence of the matter is the capital markets eligibility of the bonds. If the intention of the legislator of the time is taken into consideration according to which the legislator wanted to create an opportunity for businesses to procure funds at the capital markets without the necessity of the involvement of an institute that is authorized to operate a depository business, the relevant factor cannot be the securitization of the financial instrument but only the capital markets eligibility. Tokenized bonds are directly transferable between holders and therefore highly tradable which potentially leads to an increased capital markets eligibility. Therefore, there are not a lot of arguments that counter the applicability of the exemption for tokenized bonds, as long as they are designed identically and for the purpose of a capital markets issuing. However, it is not clear yet, if BaFin will actually adapt its administrative practice in this regard. As long as a decision on this matter has not been published by BaFin, every blockchain-based capital markets issuing should be coordinated with BaFin prior to the issuing or the token terms should include a qualified subordination clause in order to trigger the exemption for qualified subordination clauses.

                Attorney Lutz Auffenberg, LL.M. (London)

                 I.  https://fin-law.de

                E. info@fin-law.de

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                  Feb 17, 2020

                  Tokenized Asset Investments – What are the Advantages to Tokenized Securities?

                  Businesses that intend to procure funds in Germany have three basic regulatory frameworks regarding the legal design of the investment product they want to offer. This is applicable to traditional capital markets issuances as well as for the issuance of innovative tokenized financial products. Blockchain-based capital markets issuances nowadays are immediately associated with the public offering of tokenized securities better known as Security Token Offerings (STO). For this kind of capital market financing the European and national regulations such as the German Securities Prospectus Act, the European Prospectus Directive, the German Securities Trading Act and other, securities related laws are applicable. On the other hand, if the issued blockchain token has the legal properties of an investment fund share and is therefore qualified as such, the German Capital Investment Code (KAGB) respectively the European AIFM-Regulation is applicable. If the token qualifies as neither a security nor a share of an investment fund it most likely qualifies as an asset investment according to German capital markets regulatory law. If an issuer intends to publicly offer a tokenized asset investment, the rules and regulations of the German Asset Investment Act have to be observed. But can it be advantageous to design a token as an asset investment and not as a security?

                  BAFIN QUALIFIES TOKENIZED FINANCIAL PRODUCTS RATHER AS SECURITIES

                  When designing a tokenized financial product, it has to be considered that BaFin developed an administrative practice in the spring of 2019 according to which tokenized financial products are, when in doubt, more likely to be qualified as securities than as asset investments. BaFin justifies this practice with the argument that the blockchain technology substantially enhances the tradability of tokens and therefore the ability to be traded on the capital markets which is the main characteristic of a security. However, this administrative practice does not mean that tokenized asset investments are impossible in Germany. In order to design a token which would be qualified as an asset investment by BaFin, the tradability of the token has to be restricted. This can be achieved by e.g. contractual restrictions. As long as a restricted tradability and the other legal requirements, especially the subsidiarity of asset investments with regards to securities and shares of investment funds as well as to the deposit business according to the German Banking Act (KWG) are fulfilled, a tokenized asset investment is possible.

                  DISTRIBUTION OF ASSET INVESTMENTS WITH A LICENSE IN ACCORDANCE TO SEC. 34 F OF THE GERMAN INDUSTRIAL CODE

                  A massive advantage of tokenized asset investments over security tokens that are qualified as securities is the possibility to sell them via asset investment brokers that are licensed in accordance to sec. 34 f GewO. The sale of these products therefore does not require a BaFin authorized financial broker. This allows providers and issuers of tokenized financial products to utilize numerous new distribution channels.

                  CUSTODY OF TOKENIZED ASSET INVESTMENTS BY CRYPTO CUSTODIANS

                  It is still uncertain if BaFin will allow the commercial custody of security tokens by the newly introduced crypto custodians or not. According to the materials pertaining the introduction of crypto custodians into the KWG the German legislator intended to assign the custody of tokenized securities to securities deposit banks that are already licensed for the custody of traditional securities. The custody of security tokens would therefore require an authorization as a depository bank. The authorization as a crypto custodian would not be sufficient. This problem does not occur with asset investments. Asset investments are not securities, an authorization as a depository bank in order to safeguard them is therefore not required.

                  TOKENIZATION OPENS NEW TARGET GROUPS FOR ASSET INVESTMENTS

                  Traditionally, asset investments are financial products that are almost exclusive to the retail market, especially because of the restricted tradability and lack of a third-party custody option for these products. Typically, asset investments were designed as contractual agreements between issuers and investors with a relatively long duration without them being securitized in any form which made it impossible to hold them in custody. While private investors do not necessarily require an external custody option for their investments, institutional investors do. To fulfill their investment criteria, institutional investors need periodical deposit statements of trustworthy third-party custodians concerning their investments in order to enable auditors to audit these investments. Tokenization allows the commercial custody of asset investments by third-party custodians and thereby makes asset investments accessible to institutional investors. In a nutshell, tokenized asset investments have their advantages and can be an interesting choice for certain projects.

                  Attorney Lutz Auffenberg, LL.M. (London)

                  I.  https://fin-law.de

                  E. info@fin-law.de

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                    Feb 03, 2020

                    Let´s Build a Crypto Custodian (Part V) – Reporting Obligations of Crypto Custodians in Ongoing Supervision

                    ng Act (KWG) as well as the requirements of the legislative decrees that are based on the KWG, just like any other supervised bank or financial institution. One of the essential obligations of supervised institutes in the ongoing supervision is the reporting obligation to BaFin and the German Central Bank. The scope of the reporting obligations is determined by the type of services offered, while the German legislator regulated some privileges for crypto custodians. But what kind of reporting obligations do supervised crypto custodians have exactly according to German supervisory banking law?

                    WHAT HAS TO BE REPORTED DURING THE ONGOING SUPERVISION BY CRYPTO CUSTODIANS?

                    The obligation to continuously fulfill the legal reporting obligations is of highest priority to all banks and financial institutions. Missing, erroneous or late reports can lead to severe fines and may in addition lead to doubts regarding the reliability of the acting persons which can potentially provoke BaFin to revoke the license. Crypto custodians have to submit their financial information and a profit and loss offset every three months to the German Central Bank. If the crypto custodian is part of a group of institutions or a financial holding group, financial information concerning the respective groups must be submitted additionally. Additionally, crypto custodians have to immediately report certain events such as e.g. the appointment or release of a managing director or a deputy managing director, the decrease of the starting capital beneath the minimum of 125.000 euros, the intention to relocate the place of business or the intention to cease business operations altogether to BaFin and the German Central Bank. Crypto custodians also have to submit their approved annual financial statements with the associated annexes and audit reports immediately after receiving them to said authorities. Imminent insolvency or overindebtedness are other examples of events that have to be reported immediately. There are numerous other legally defined events that trigger reporting obligations for crypto custodians.

                    HOW DID THE GERMAN LEGISLATOR PRIVILEGE CRYPTO CUSTODIANS?

                    Due to the special characteristics of the crypto custody service in comparison to other financial services, the German legislator decided that parts of the KWG are not applicable to crypto custody service providers as long as they do not also offer any other banking or financial services in addition to the crypto custody service. As a result, the reporting obligations that are applicable to institutions concerning e.g. liquidity and the equity capital are not applicable to crypto custody service providers. Crypto custodians in contrast to other financial institutions are not obligated to regularly report on these matters to BaFin and the German central bank. The legal limitations concerning large exposures are also not applicable to crypto custody service providers. Since crypto custodians are regulated by national German law and not by European directives and regulations, the obligation to report the intention of founding a branch office in a member state of the European Economic Area (EEA) is not applicable to them. However, if a crypto custodian intends to open a branch office outside the EEA it has to report that intention to BaFin and the German central bank.

                    Attorney Lutz Auffenberg, LL.M. (London)

                     I.  https://fin-law.de

                    E. info@fin-law.de

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                      Blockchain-Based Central Bank Money – Which Effects Would that have?

                      Since last autumn and the announced massive resistance of international politics against Facebook´s Libra coin it has been relatively quite regarding the idea of stable coins that are issued by private companies. Nevertheless, the advance of the social media giant has been a true wake-up call for legislators and central banks of the major economies around the globe. According to information from the Chinese government, China is close to the implementation of a digital Yuan. The United States FED plans the introduction of a Crypto-dollar and the European Central Bank (EZB) discusses the possibility of a blockchain based form of the euro. Digital central bank money (CBDC) has a high chance of becoming reality in the near future, even though the exact design and scope of it cannot be asserted at this moment. The question that arises from this possibility is how CBDCs would have to be classified from a regulatory point of view and how their existence would affect the existing crypto market.

                      CBDC AS A DIGITAL NATIONAL CURRENCY – BLOCKCHAIN BASED FIAT MONEY

                      If individual central banks actually decide to issue blockchain based currencies, these units would most likely have to be qualified as national currency and therefore as legal tender. As a consequence, units of a hypothetical crypto-euro would be subject to the German Payment Services Act (ZAG). Service providers that e.g. offer their customers transactions of crypto-euros or crypto-euro wallets would then engage in payment services that are subject to prior BaFin authorization under the Payment Services Act. It is also worth noticing, that e.g. the exchange of crypto-euros to crypto-dollars would in all likelihood be considered foreign exchange trade and therefore be subject to the German Banking Act (KWG), because foreign exchange, according to the KWG, is a financial instrument. This will, in some cases, result in an additional mandatory licensing obligation in accordance to the KWG for providers of certain services. It is however certain that CBCDs could not be qualified as crypto assets. The newly added (1st of January 2020) definition of crypto assets to the KWG explicitly requires that crypto assets are digital values that are not issued by a central bank or any other public institution. Therefore, the custody of CBCDs cannot be a crypto custody service as defined by the German regulatory banking law.

                      WHAT EFFECTS COULD CBDCS HAVE ON THE CRYPTO MARKET?

                      Up to now the regulatory classification of cryptocurrencies was a legally controversial and highly interesting task. While in many nations Bitcoin, Litecoin and comparable decentralized digital currencies are neither classified as legal tender nor as financial instruments, in e.g. Germany they are classified as financial instruments in the form of either units of account or as crypto assets according to the KWG. Crypto payment tokens that are issued by a central emitter qualify as e-money provided that all other requirements are fulfilled and security tokens are potentially subject to the capital markets regulations. Blockchain based means of payment that are issued by a central bank could play an interesting role in the crypto eco system in the future. First and foremost they would render obsolete the need for most private stable coins because they would present a crypto compatible retreat asset without immense volatility which is the exact role that private stable coins play right now. At the same time, they would bring the established financial system closer to “traditional” cryptocurrencies. This could pose problems especially with regards to AML risks. Another crucial point would be the fact that the governments would have access to all economic data of the users of the CBDCs that it issued.

                      Attorney Lutz Auffenberg, LL.M. (London)

                      I.  https://fin-law.de

                      E. info@fin-law.de

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                        Jan 27, 2020

                        STO with a Security Information Sheet – A Chance for SMEs?

                        According to the requirements of the EU-prospectus directive, companies intending to procure funds from the European capital markets by offering securities to investors need to compile and publish a comprehensive security prospectus that must be approved by the competent capital markets supervisory authority. The same rules apply to the public offering of security tokens, that qualify as securities. Often, these prospectuses consist of more than 100 pages. These prospectuses have to contain not only comprehensive information regarding the financial situation, the history and the corporate structure of the emitting company but also details regarding the business model, the managing directors as well as the market situation of the issuer and competitors. Furthermore, these prospectuses have to explain the functionality of the offered security token as well as the rights and obligations of the issuer and the investor associated with the token and display the risks associated with the investment. Compiling and creating a security prospectus is therefore an expansive and complex project that may often be not cost efficient in case of smaller emission volumes. In order to give medium-size businesses and even start ups the opportunity to procure funds at the capital markets through capital markets issues, the European legislator allowed the member states to permit the public offering of securities respectively security tokens with a total equivalent of 8 million euros without the prior approval and publication of a prospectus within the European Economic Area (EEA). The EEA member states made use of this option but with varying requirements and maximums. In Germany for example, the exemption from the prospectus obligation is applicable to emissions with a total equivalent of up to 8 million euros. In Austria on the other hand these emissions are caped at less than 2 million euros.

                        WHAT ARE THE REQUIREMENTS FOR GERMAN STO ISUUERS IN ORDER TO BE EXEMPTED?

                        For the public offering of security tokens with a maximum equivalent value of up to 8 million euros the issuer is required to create a three-page Security Information Sheet (WIB) that contains all the base information regarding the emitter, the offered security token, the associated rights and obligations and the relevant risks of the investment. This WIB then must be approved by BaFin, just like a comprehensive security prospectus, for publication by BaFin. Naturally, the costs for creating a three-page WIB are substantially lower than those of a comprehensive security prospectus with 100 pages or more. In addition to the WIB, the German exemption requires that the security tokens are distributed only via a professional financial distributor that is licensed for investment advisory or investment brokerage. According to the exemption regulation, the financial distributor has to ensure that private investors adhere to certain maximum investment amounts. Issuers therefore cannot directly sell WIB regulated security tokens to private investors, e.g. via an own website. Institutional investors on the other hand are not subject to the aforementioned restriction of the exemption regulation.

                        CAN WIB BASED STOS THEREFORE ONLY BE NATIONAL CAPITAL MARKETS PROJECTS?

                        Since the EEA member states implemented the requirements of the EU Prospectus Directive differently from one another, a harmonized exemption regulation for all of Europe does not exist. This means that a WIB that has been approved by BaFin cannot be passported via a simple notification procedure in order to utilize it in another EEA country for the sale of the security tokens as it would be possible with a full prospectus. However, this does not mean that a specific security token cannot be offered simultaneously in more than one member state of the EEA at the same time. According to the EU Prospectus Directive it only has to be ensured that the total equivalent value of the offer within the EEA does not exceed 8 million euros over a 12-month period. It would therefore be possible to procure e.g. 1.5 million euros in Austria, 5 million euros in Germany and further 1.5 million euros in the Netherlands, as long as the respective requirements for the exemptions in each of these jurisdictions are fulfilled.

                        Attorney Lutz Auffenberg, LL.M. (London)

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