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May 27, 2019

Crypto Custody and Crypto Assets – What Stands Behind the Announced Law Amendments?

Notice: This blog article refers to the first draft of the German Ministry of Finance dated 20th May 2019 which in this form has not been realized by the legislator.

On 20 May 2019, the German Ministry of Finance published its first draft for the transposition of the provisions of the 5. European AML Directive into national law. Beside the awaited change proposals for the German AML Act in order to transpose the rules from the 5. EU AML Directive into German law, the ministry came up with a real surprise: The German legislator wants to use the opportunity and not only change the provisions of the German AML Act, but additionally amend the German Banking Act by introducing a new financial service. In future, crypto custody shall be regulated as a financial service being subject to a permission requirement from BaFin. In addition to that, the Ministry of Finance plans to define crypto assets legally as financial instruments, probably also for the purpose of putting an end to the discussions about Bitcoins and comparable cryptocurrencies qualifying as units of account and therefore financial instruments in the sense of the German Banking Act, which finally came up after the ruling of the Criminal High Court of Berlin stating that Bitcoins were not to qualify as units of account.

WHICH ACTIVITIES SHALL BE QUALIFIED AS CRYPTO CUSTODY SERVICES IN THE FUTURE?

According to the ministries first draft the safekeeping, the management and the protection of cryptocurrencies or private keys that allow the access, the storing or the transfer of cryptocurrencies shall be considered a crypto custody service. This primarily affects providers of wallets that store the cryptocurrencies of their clients by transferring them to wallets of their own. But more interestingly, this regulation will also affect crypto exchanges that have to take the cryptocurrencies of their clients onto their own wallets in order to safely perform trades between their customers. Under current legislation, the mere custody of cryptocurrencies for customers does not require the service provider to hold a BaFin permission, as the custody regulations of the German Banking Act (KWG) are only applicable to securities right now. This would change if the draft became law.

WOULD CRYPTO CUSTODIANS NEED A PERMISSION FROM BAFIN IN THE FUTURE?

The inclusion of the crypto custody service into the German Banking Act (KWG) would mean that German blockchain businesses need a BaFin permission in order to – temporarily or permanently – store cryptocurrencies of clients in their wallets. According to this draft the requirements to obtain such a permission include a 125.000 euros minimum capital at all times, fit and proper directors as well as all the other general requirements that financial institutions have to meet. As an alternative to obtain a permission itself, the crypto custodian could also cooperate with an already licensed partner. It can be expected that several German FinTech banks will quickly create this option for crypto custodians to partner up with them.

WHAT EXACTLY WILL BE CONSIDERED A CRYPTO ASSET?

In addition to that, the Ministry of Finance plans to extend the catalogue of financial instruments in the German Banking Act (KWG) and include crypto assets. The 5th EU AML Directive compels the EU members to define “virtual currencies” in their respective national laws. The Ministry of Finance prefers the term “crypto asset” and plans to define it instead of “virtual currencies” in the German Banking Act (KWG). According to this definition crypto assets are digital representations of values that are not issued or guaranteed by a central bank or any other public authority and does not possess the legal status of currency or money, but is accepted by natural or legal persons as a means of exchange or payment on basis of an agreement or actual practice or which serves investment purposes and which can be stored, traded and transferred electronically. The ministry justifies the use of the term “crypto asset” instead of “virtual currencies” with the argument that it not only includes tokens with payment and exchange functions but also tokens that serve an investment purpose. The term “crypto asset” should therefore not only include currency tokens but also security tokens in the case that the security token in question is not already considered a security and therefore a financial instrument with regards to the German Banking Act (KWG).

SHOULD BLOCKCHAIN BUSINESSES START TO PREPARE FOR THE NEW REGULATION RIGHT NOW?

The Ministries of Finance proposal dated May 2019 is just a first draft. It is somewhat likely that this draft will be changed in the course of the now following discussion. At the same time, businesses providing crypto custody services should prepare for the new supervisory situation. It is unlikely that the German legislator abandons the idea to introduce the financial service of crypto custody. After the implementation of the final draft, providing custody services without BaFin license will no longer be possible.

Attorney Lutz Auffenberg, LL.M. (London)

I.  https://fin-law.de

E. info@fin-law.de

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    May 20, 2019

    Security Tokens Always Securities – What are the Implications of the New Administrative Practice of BaFin for STO Emitters?

    BaFin expressed its new, general administrative practice concerning the qualification of security tokens in an article in the BaFin journal of April 2019. Under this new administrative practice security tokens, meaning all tokens granting its owner membership or equity-like rights and that are freely tradable and transferable will be qualified as securities sui generis. This qualification by BaFin will lead to a supervisory handling of these tokens which is at odds with the wording of the law. The law differentiates between securities which are freely tradable and transferable on the capital markets on the one hand and investment products like GmbH shares, non-securitized participation rights or individual contractual subordinated loans which all lack this feature on the other hand. BaFins administrative practice does not make this differentiation. The ascertainment of this administrative practice is another example of BaFins dangerous tendency to exceed its authority as an executive organ and to create de facto obligations for emitters that have no legislative basis.

    WHAT ARE BAFINS ARGUMENTS?

    BaFin is right to the extent that new financial phenomena like STOs need to be regulated in a way that will continuously ensure the important purposes of regulation – primarily protecting investors and the stability of the financial markets – in the future. BaFin apparently felt prompted to quickly adapt its administrative practice in regard to security token offerings. The key argument for the creation of a new class of securities for security tokens is that the tradability of any capital market product is increased as soon as it is shifted to a blockchain solution because then it is easily transferrable between emitters, investors, exchanges and any other intermediary. BaFin further argues that the creation of a new form of securities is also covered by the European Securities and Markets Authority (ESMA) principle of “Substance over Form”. This principle means that not the naming of a capital markets product is the decisive factor for the regulatory categorization of that product but rather the way it is designed and its functions. Conversely the “Substance over Form” principle can of course not justify the qualification of a capital markets product as a security if it is designed as an alternative non-security investment product.

    IS BAFIN’S ADMINISTRATIVE PRACTICE APPROPRIATE?

    The new regulatory approach by BaFin has two major flaws. First of all, it violates the principle of separation of powers according to which public authorities like BaFin as part of the executive branch of government carry out the rules and regulations that are resolved by the legislative branch of government. They have a certain leeway when it comes to the interpretation of these rules and regulations, but they cannot form a legal interpretation that leads them to carry out their regulatory duties in a way that contradicts these very rules and regulations. In this respect ESMAs “Substance over Form” principle could not justify the administrative practice of BaFin, not even if it was just about the misleading naming of a capital markets product because ESMA as well is not a legislative body but an executive authority.

    Second of all, this practice by BaFin bears unpredictable legal risks for STO emitters. Civil courts that in the course of a prospectus liability litigation might have to decide if a security token is a security or an alternative investment asset could very well disagree with BaFin on this matter. The courts could use the aforementioned separation of power argument and the wording of the law to come to a different legal interpretation and qualify the security token as investment asset. The STO emitter would then be in danger of not having published the correct prospectus and therefore being liable.

    IS A TOKENIZED INVESTMENT ASSET NO LONGER POSSIBLE?

    The administrative practice of BaFin does not necessarily mean that designing a tokenized investment asset will be impossible in the future. The key argument of BaFin revolves around the free tradability and transferability of the token. There are legal means to restrict these features. Security tokens which e.g. cannot be transferred without the prior consent of the STO emitter have still to be qualified as investment assets, even according to the new administrative BaFin practice. A security token that is designed as a tokenized investment asset can be advantageous for STO emitters if they plan an emission that is limited to Germany and if the emitter wants to facilitate the distribution of the token via non-BaFin licensed investment intermediaries.

    Attorney Lutz Auffenberg, LL.M. (London)

    I.  https://fin-law.de

    E. info@fin-law.de

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      May 13, 2019

      Building a Crypto Exchange (Part IV) – The Crypto Broker

      Eine Krypto Tauschplattform kann auf vielerlei Arten ausgestaltet werden. Die sie ausmachende Kernfunktion ist das Zusammenbringen von Angebot und Nachfrage hinsichtlich der Anschaffung und Veräußerung von Kryptowährungen. Auch Plattformen, die kein automatisiertes Order-Matching-Verfahren bieten oder nicht selbst als Vertragspartner ihrer Kunden beim Kauf oder Verkauf von Kryptowährungen auftreten, sondern sich auf die grundlegende Aufgabe der Vermittlung von Handelsgeschäften über Kryptowährungen beschränken, betreiben in Deutschland nach der Verwaltungspraxis der BaFin erlaubnispflichtige Finanzdienstleitungen. Allerdings können sich solche Kryptobroker neben der Beantragung einer eigenen BaFin Lizenz auch unter ein regulatorisches Haftungsdach eines in Deutschland zugelassenen Instituts begeben, das die BaFin Erlaubnis für den Betrieb der Anlagevermittlung innehat. Der Kryptobroker agiert dann als sogenannter vertraglich gebundener Vermittler des lizenzierten Instituts.

      WAS GENAU IST DIE TÄTIGKEIT DES KRYPTOBROKERS?

      Der Kryptobroker beschränkt sich auf das Zusammenbringen von Angebot und Nachfrage hinsichtlich des Handels mit Kryptowährungen. Nutzer der Kryptotauschplattform bekommen die Möglichkeit, Angebote zum Kauf oder Verkauf von Kryptowährungen über die Tauschplattform zu publizieren. Interessenten können sich auf die eingestellten Inserate über die Kryptobörse melden und in Verhandlungen über den Abschluss eines Kryptowährungshandels mit dem Anbieter treten. Der Kryptobroker agiert hier als reiner Vermittler, der die auf seiner Plattform eingestellten Angebote passenden Interessenten zugänglich macht. In dieser Variante wird der Kryptobörsenbetreiber in Bezug auf den Kryptohandel selbst nicht Vertragspartner der Plattformnutzer. Das gilt auch, wenn er im Rahmen der Abwicklung der Tauschgeschäfte die zu transferierenden Kryptowährungen bis zur vollständigen Bezahlung des Erwerbspreis und aller Gebühren als zusätzliche, nicht erlaubnispflichtige Dienstleistung in Verwahrung nimmt. Kennzeichnend für die Anlagevermittlung ist zudem, dass die potenziellen Vertragspartner direkt miteinander in Kontakt gebracht werden und daher wissen, wer bei Abschluss des Geschäfts ihr Vertragspartner sein wird. Dies ist der entscheidende Unterschied zum Handel über multilaterale Krypto Handelssysteme.

      WELCHE KERNVORAUSSETZUNGEN MÜSSEN FÜR EINE BAFIN ERLAUBNIS ZUR ANLAGEVERMITTLUNG ERFÜLLT WERDEN?

      Die Zulassung als Anlagevermittler ist zumindest dann, wenn der Kryptobroker nicht selbst mit Finanzinstrumenten auf eigene Rechnung handeln und zu keinem Zeitpunkt Eigentum oder Besitz an Geldern oder Wertpapieren seiner Kunden haben wird, mit vergleichsweise geringen Anfangskapitalanforderungen umsetzbar. Gegenüber der BaFin ist ein frei verfügbares Eigenkapital von mindestens 50.000 Euro nachzuweisen. Alternativ zum Anfangskapital kann eine Vermögensschaden-Haftpflichtversicherung über eine Versicherungssumme von mindestens 1.500.000 Euro pro Versicherungsjahr und 1.000.000 Euro je Versicherungsfall nachgewiesen werden. Für Anlagevermittler, die gleichzeitig als Versicherungsvermittler zugelassen sind, gelten weitere Erleichterungen. Darüber hinaus muss der Kryptobroker insbesondere einen fachlich geeigneten und zulässigen Geschäftsleiter vorweisen sowie einen tragfähigen Businessplan vorlegen können, in dem die wirtschaftliche und bankaufsichtsrechtliche Geschäftsplanung und Unternehmenssteuerung schlüssig dargestellt werden. Solange der Kryptobroker ausschließlich Geschäfte über klassische Kryptowährungen wie Bitcoin, Ethereum oder Litecoin vermitteln will, die nach der Auffassung der BaFin nur als Rechnungseinheiten Finanzinstrumente nach deutschem Aufsichtsrecht darstellen, gelten für seine Tätigkeit die besonderen Anforderungen der MiFID II Regulierung nicht. Sollen über seine Plattform hingegen auch Security Token handelbar sein, müssen umfangreiche weitere aufsichtsrechtliche Pflichten betreffend den Wertpapierhandel eingehalten werden.

      WIE FUNKTIONIERT DIE ANBINDUNG AN EIN HAFTUNGSDACH?

      In Deutschland gibt es zahlreiche Finanzdienstleister, die sich auf die Bereitstellung ihres regulatorischen Haftungsdachs für Anlageberater und Anlagevermittler spezialisiert haben. Dabei ist eine Spezialisierung keine Voraussetzung, um vertraglich gebundene Vermittler anzubinden. Grundsätzlich kann jedes entsprechend lizenzierte Unternehmen Kryptobroker als vertraglich gebundene Vermittler aufnehmen, solange es gegenüber der BaFin bestätigt, dass der Kryptobroker fachlich geeignet und zuverlässig ist und dafür sorgt, dass die Geschäfte des Kryptobrokers im Einklang mit dem geltenden Bankaufsichtsrecht betrieben werden. Die aufsichtsrechtlichen Pflichten sowie die Haftung gegenüber den Kunden des Kryptobrokers treffen dann zunächst das das Haftungsdach gewährende Institut. Der Kryptobroker selbst muss als vertraglich gebundener Vermittler keine eigene BaFin Lizenz für den Betrieb seiner Kryptotauschplattform einholen.

      Rechtsanwalt Lutz Auffenberg, LL.M. (London)

      I.  https://fin-law.de

      E. info@fin-law.de

      Mehr lesen:

      Building a Crypto Exchange (Part I) – Welche Möglichkeiten gibt es?

      Building a Crypto Exchange (Part II) – Das Multilaterale Krypto Handelssystem

      Building a Crypto Exchange (Part III) – Die Krypto Wechselstube

      There are many ways to design a crypto exchange. In all variants, the defining feature of a crypto exchange is bringing together the buy and sell orders of the exchange users. Even platforms that do not feature any automated order matching or do not become direct contract party of their customers regarding the selling or buying of cryptocurrencies but rather focus on relaying those users to each other are operating a business which, according to the administrative practice of BaFin, offers financial services and therefore requires BaFin’s authorization. Besides applying for an own authorization from BaFin, crypto brokers also have the legal possibility to operate their business under a regulatory liability umbrella of a German financial institution possessing BaFin’ authorization to act as an investment broker. The crypto broker then acts as a tied agent of the licensed institution.

      WHAT EXACTLY DOES A CRYPTO BROKER DO?

      The crypto broker brings together the supply and demand regarding the trading of cryptocurrencies and is limited to this service. Users of the crypto exchange get the opportunity to publish offers to purchase or sell cryptocurrencies on the platform. Interested possible counterparties can answer these offers via the platform and engage in negotiations with the user that published the offer. The crypto broker therefore acts as an intermediary making the published offers accessible to suitable interested parties. In this version of a crypto exchange the operator of the exchange never enters directly into an agreement regarding the actual trading of cryptocurrencies. This holds true even if the operator stores the cryptocurrencies in question until all fees and the complete acquisition price are paid. The key characteristic of this exchange type is that the potential business partners are directly dealing with each other and therefore know about their identities. This is the main difference to the multilateral crypto trading facility.

      WHAT ARE THE MAIN REQUIREMENTS THAT HAVE TO BE MET IN ORDER TO OBTAIN A BAFIN APPROVAL TO ACT AS AN INVESTMENT INTERMEDIARY?

      BaFin’s authorization to act as investment broker is tied to a relatively small starting capital requirement as long as the applicant at no point in time has legal ownership of his client’s money or securities and as long as he does not engage in proprietary trading. BaFin demands the applicant to show 50,000 euros equity capital to be at the disposal of the applicant. Alternatively, a liability insurance that covers at least 1,500,000 euros in pecuniary losses per insurance year and 1,000,000 euros per insured event is also sufficient. Investment brokers that simultaneously are regulated insurance brokers benefit from further facilitations. Furthermore, the crypto broker has to submit a sustainable business plan which conclusively shows the economic and regulatory planning and the business management system of the crypto broker’s company to BaFin. At least one fit and proper company director is another requirement that must be met. As long as the crypto broker only offers his services in relation to classic cryptocurrencies like Bitcoin, Litecoin or Ethereum qualifying as units of account and therefore as financial instruments, the special requirements of MiFID II will not be applicable. If the exchange offers intermediary services also in regard to security tokens, the strict regulations regarding securities trading will additionally have to be fulfilled.

      HOW DOES THE CONNECTION TO A REGULATORY LIABILITY UMBRELLA WORK?

      There are numerous financial service providers in Germany that specialize in providing their regulatory liability umbrella to investment advisors and brokers. This specialization however is not necessarily required for connecting tied agents. Every licensed financial service provider can cooperate in this way with a crypto broker as long as he confirms towards BaFin that the crypto broker is professionally qualified and reliable. Furthermore, he has to ensure that the crypto broker conducts his business in accordance with banking regulatory law. The supervisory obligations as well as the liability towards the clients of the crypto broker then apply to the financial service provider providing the regulatory liability umbrella. In this scenario, the crypto broker as a tied agent does not need a BaFin authorization himself for operating his crypto exchange platform.

      Attorney Lutz Auffenberg, LL.M. (London)

      I.  https://fin-law.de

      E. info@fin-law.de

      Read more:

      Building a Crypto Exchange (Part I) – What are the Regulatory Design Possibilities?

      Building a Crypto Exchange (Part II) – The Multilateral Crypto Trading Facility

      Building a Crypto Exchange (Part IV) – The Crypto Exchange Bureau

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        May 06, 2019

        Passporting a Crypto License – Does That Work?

        Europe offers a lot of advantages, especially for financial service providers that are located within the European Union (EU) if it comes to the internationalization of their business model. The progressive harmonization of the legislation regarding financial supervision and the capital markets within the European Union allows supervised and regulated banks and financial service providers to offer their services in other member states without the necessity of an additional regulatory license in this country. If the targeted country is a member of the EU a relatively simple notification procedure is enough to provide a uniform regulation by the home authority of the expanding company. But does this also apply to crypto and blockchain based businesses or are there specificities for these businesses?

        EQUAL RIGHTS FOR ALL – BUT ONLY IF THE PREREQUISITES ARE THE SAME

        The principle “Equal rights for all” does apply. A business model that is the subject of authorization and ongoing supervision according to the European directives and regulations has to be regulated and supervised by the competent authority. A Spanish bank as well as a French financial portfolio manager for example have to acquire a permission to perform their services from their respective home authorities. If the business of e.g. a European bank or financial service provider is about to be expanded to Germany, the expending company can make use of the harmonized European passporting-rules by notifying its home authority that it will expand its business to Germany. The home authority then notifies BaFin which can only prohibit the market entrance of the company in question if the services that that company offers are not covered by the license from the home authority of the company and therefore are not supervised at all.

        INCONSISTENT EUROPEAN BLOCKCHAIN REGULATION AS AN OBSTACLE FOR EU-PASSPORTING

        When harmonizing the rules and regulations of financial supervision, the European Union primarily had in mind financial service providers and traditional banks. Blockchain-based business models on the other hand are not regulated uniformly by the member states. While Bitcoins and comparable cryptocurrencies are still classified by the German BaFin as units of account and therefore as financial instruments most other member states do not classify them as financial instruments. Therefore, business models with a connection to cryptocurrencies as e.g. the operation of a crypto exchange or a Bitcoin ATM require a BaFin permission in Germany while in other member states these businesses do not require a permission from the supervising authority. An Austrian investment advisor who is regulated with regards to his financial advisory business in Austria by the Austrian FMA still needs a BaFin license if he wants to advice his customers in Germany to invest in Bitcoin. The passporting of his Austrian FMA license fails because of the fact that advising someone to invest in Bitcoin is not an activity that needs FMA permission or supervision in Austria. If BaFin would allow him to offer that specific service without a German license the Bitcoin related investment advice would be unregulated.

        APPLYING FOR A BAFIN PERMISSION OR COOPERATION WITH A LICENSED PARTNER

        The German market still is an interesting target for Blockchain companies. The German economy is strong and potential customers are solvent. Therefore, entering the German market can be a lucrative move even if a BaFin license is necessary for the business model in question. Because the application process and the subsequent ongoing supervision impose an administrative and financial burden on the applicants, a cooperation with an already licensed and supervised partner – e.g. a bank or a financial service provider – can be a valid alternative in certain individual cases. In the last couple of years certain banks in Germany have specialized in those kinds of partnerships by providing the regulatory infrastructure for their customers. The question whether this kind of partnership is a viable solution for a specific blockchain-related business model depends on the details and has to be decided on a case by case basis.

        Attorney Lutz Auffenberg, LL.M. (London)

        I.  https://fin-law.de

        E. info@fin-law.de

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          Apr 29, 2019

          Building a Crypto Exchange (Part III) – The Crypto Exchange Bureau

          A crypto exchange platform does not always have to be designed comparable to professional stock exchanges for requiring the operator to obtain a BaFin permission. Platforms not automatically matching and executing the buy and sell orders of the users can also be required to acquire a BaFin permission prior to its launch if it is supposed to be accessible for German customers. The requirements of a successful license application in these cases are not necessarily lower than those for a multilateral crypto trading facility. An operator wanting to offer his customers the option to buy and sell cryptocurrencies from and to his own stockpile commercially or to an extent that requires professional structures can be, according to BaFin administrative practice, dealing in financial proprietary trading and is therefore offering financial services being subject to a prior BaFin permission. The key criteria for the classification of a crypto exchange platform as a crypto exchange bureau is that the operator of the platform enters into an agreement with his customers.

          WHAT IS FINANCIAL PROPRIETARY TRADING AND WHEN IS AN ACTIVITY QUALIFIED AS SUCH?

          Every time that financial instruments are traded for one’s own account it might be a case of financial proprietary trading. To trigger an obligation to obtain a license in accordance to the German Banking Act (KWG), certain further circumstances must accrue. One of these circumstances is e.g. a service character of the activity. If someone offers his customers to sell or buy cryptocurrencies from or to them out of or to his own stockpile as a service, he is operating a crypto exchange bureau. It does not make any difference if this service is offered via the internet or in a local shop. A service of this kind will generally be subject to a BaFin license requirement if financial instruments are traded to the account of the operator and that the offering is a service to the operator’s customers.

          CAN PRIVATE TRADING OF CRYPTOCURRENCIES ALSO QUALIFY AS FINANCIAL PROPRIETARY TRADING?

          The obligation to obtain a permission from BaFin in accordance to the German Banking Act is only triggered if banking services or financial services are actively offered to German customers and if those services are either offered commercially or to an extent which requires professional structures. Whether this commercial extent is given or not is a case to case decision which is made by BaFin as the competent authority. Generally, such extent can also be reached by private traders of cryptocurrencies. BaFin therefore developed a rule of thumb for financial proprietary trading according to which no approval is needed if the transactions made on average per month do not exceed 25 single transactions, even if the activity qualifies as financial proprietary trading and a license requirement would generally be given. So, whenever someone performs less than 25 trades on monthly average, he generally does not operate a business that would require BaFin’s permission. The final decision if a license is necessary or not always rests with BaFin because individual cases might deviate from the rule of thumb. A close coordination with BaFin is therefore always advisable.

          WHAT ARE THE REQUIREMENTS A CRYPTO EXCHANGE BUREAU MUST FULFILL IN ORDER TO OBTAIN A BAFIN LICENSE?

          As with other financial services BaFin issues the admission for financial proprietary trading only if the applicant is run by fit and proper managers that are professionally apt. Professional aptitude requires that the manager in question has sufficient theoretical knowledge and practical experience in the area of business in which the applicant wants to operate. If it comes to financial proprietary trading this means that the manager should be experienced in the trading of financial instruments e.g. from working in investment banking. Next to that he or she should have some management experience. A fundamentally solid business plan and budget figures for the first three years of business as well as all the sample contracts and internal manuals that are necessary to run the business are further requirements of the applicant by BaFin. On top of that a minimum starting capital of 730.000 euros has to be shown to BaFin and the applicant needs to be in free disposition of this amount at any time. The requirements for a BaFin license to operate a crypto exchange bureau are therefore relatively substantial. Small businesses only wanting to offer to their customers a limited or entry level access to cryptocurrencies should in most cases refrain from this design option. For companies willing to access the German crypto market with high trading volumes the requirements are manageable and a crypto exchange bureau might be a viable design option.

          Attorney Lutz Auffenberg, LL.M. (London)

          I.  https://fin-law.de

          E. info@fin-law.de

          Read more:

          Building a Crypto Exchange (Part I) – What are the Regulatory Design Possibilities?

          Building a Crypto Exchange (Part II) – The Multilateral Crypto Trading Facility

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            Apr 15, 2019

            STO Without Prospectus – What Are the Possibilities?


            Security tokens are blockchain tokens that are issued via smart contracts and that grant to their owner certain monetary rights like e.g. an interest rate or a participation right on the issuing companies’ profit. In this respect the security token differs from the utility token which grants its holder access to or benefits within the issuers’ business model and the currency token which in general is just an alternative means of payment and grants to the token holder no rights vis-à-vis the issuer at all. Within the German jurisdiction and therefore in all cases where German investors are targeted by the token issuing company as potential investors, BaFin will generally qualify the security token as a security if the token is tradable without restrictions and therefore is fungible and fits for capital markets. To those tokens the German Securities Prospectus Act and the EU Prospectus Directive are applicable. The public offering of these tokens in Germany can therefore only take place if the emitter has a securities prospectus created, approved by BaFin and published prior to the public offering.

            LEGAL EXEMPTIONS FOR BIG TICKETS AND SMALL OFFERINGS

            The obligation to publish a securities prospectus is generally in effect when offering a security token but there are exemptions. The German Securities Prospectus Act provides a couple of legal exemptions that lift the obligation to create a prospectus in certain cases from the emitter of security tokens. A security token offering that exclusively targets qualified and professional or institutional investors is subject to such an exemption. Likewise, emitters offering their security token either to not more than 150 non-qualified private investors within the European Economic Area or only allow minimum investments of 100.000 euros from each individual investor also do not need to create a prospectus for their security tokens. Banks and Emitters whose shares are already publicly traded are also exempted.

            PRIVATE PLACEMENT OF SECURITY TOKEN WITHOUT A SECURITY PROSPECTUS

            The obligation for emitters of securities respectively security tokens to create and publish an approved prospectus only applies when publicly offering the security or the security token. In case of offering those products exclusively to family and friends or to investors to whom a business relation had already been established before the offering, the creation and approval of a prospectus is unnecessary. When it comes to security token offerings this method may primarily be useful in the context of a presale to the actual token offering because through a private offering no new investors can be acquired. On the other hand, this possibility can be useful to finance and market the STO main sale if the issuer has a financially strong network that is willing to invest in his project

            STO WITH A VOLUME OF UP TO 8 MILLION EURO WITH AN INFORMATION SHEET INSTEAD OF A PROSPECTUS

            Another interesting exemption from the obligation to create a prospectus for a security token offering can be employed by emitters of STOs with a hard cap of 8 million Euro. For these types of STOs the emitter does not have to draft a full securities prospectus but rather an information sheet that includes information regarding the emitter, the security token to be offered and the risks associated with the investment. If the issuer wants to procure capital of in between one and up to 8 million euros, the token sale has to be performed by a BaFin licensed investment intermediary or a BaFin licensed investment advisor. The BaFin licensed sales company has to ensure that private investors with an average wealth profile do not invest more than 1,000 euros and that wealthy private investors do not invest more than 10.000 euros maximum if their financial situation allows it. The review of the financial situation of the individual investor and the determination of the maximum sum that he can invest is the responsibility of the BaFin licensed sales company. If the hard cap of the STO is less than one million euros, the STO can be conducted without a BaFin licensed distribution partner. This funding method can be a viable alternative to the classical sale of company shares for startups in the early business stages.

            Attorney Lutz Auffenberg, LL.M. (London)

            I.  https://fin-law.de

            E. info@fin-law.de

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              Building a Crypto Exchange (Part II) – The Multilateral Crypto Trading Facility

              Bitcoins and comparable cryptocurrencies are, according to BaFin, classified as financial instruments as defined in the German Banking Act (KWG). Therefore, a BaFin license is a mandatory prerequisite for operating a crypto exchange in Germany. What are the requirements to fulfil in order to obtain such license and what are the conceptual design options for companies to tailor a crypto exchange to their needs while matching the aforementioned requirements? The second part of FIN LAW´s blog series “Building a Crypto Exchange” tackles multilateral crypto trading facilities, shows essential features of this kind of crypto exchange as well as the most important requirements to legally operate such a facility in Germany.

              WHAT IS A MULTILATERAL CRYPTO TRADING FACILITY?

              According to the German Banking Act, the operation of a multilateral trading facility in Germany is a financial service that requires prior approval from BaFin. A multilateral trading facility is legally defined as a multilateral system that brings together its users buying and selling interests in financial instruments within the system and in accordance with preset, non-discretionary rules in a way that leads to a sales contract between the users. If the only tradable financial instruments in such a system are cryptocurrencies, it’s a multilateral crypto trading facility. The key difference between this type of crypto exchange and others is the anonymity of the paired users. The actual matchmaking and execution of the buy and sell orders between the users on these types of exchanges happens anonymously and automatically by the system itself. The users of a multilateral crypto trading facility do therefore not know with whom they are trading cryptocurrencies. The transfer of coins to the buyer and the transfer of the acquisition price to the seller are also automatically executed by the system, so the users need a sufficient balance of cryptocurrencies or fiat currency with the operator when placing a buy or sell order.

              WHAT ARE THE FINANCIAL MEANS NECESSARY TO ACQUIRE A BAFIN LICENSE?

              The granting of the license to operate a multilateral crypto trading facility depends on a multitude of requirements that have to be matched. The exact requirements depend on the details of the individual case. These details should therefore be diligently reviewed and defined prior to the license application. If the operator of the crypto exchange will not be entitled to hold customer funds or customer securities himself a starting capital of at least 50.000 euros has to be proven in the license application to BaFin. Otherwise a starting capital of 125.000 euros is the minimum. If the operator additionally wants to trade financial instruments on his own account and for own interests – in this case cryptocurrencies- the minimum starting capital is at least 730.000 euros. In order to keep the starting capital low a cooperation with a licensed bank for payment processing is often advisable.

              WHAT ARE THE REQUIREMENTS FOR THE EXECUTIVES OF THE CRYPTO EXCHANGE?

              The managers of a multilateral crypto trading facility need to be fit and proper. They should, if possible, have relevant and appropriate working experience in a managing position in a comparable project or company. They need to have the theoretical and practical abilities to lead a multilateral crypto trading facility. The needed reliability to manage such a project may be compromised if the manager has a previous criminal conviction or a negative entry into the commercial register. This kind of reliability is also required from every shareholder holding more than 10% of the company. Moreover, BaFin expects the managers to be sufficiently available so that they can manage the crypto exchange in a diligent and prudent way.

              WHAT OTHER DOCUMENTS ARE NECESSARY FOR A BAFIN LICENSE?

              A successful application requires the applicant to submit a viable business plan that not only shows the financial planning of the project for the next three years but also detailed information regarding internal control and monitoring procedures to fulfil regulatory obligations such as anti-money laundering prevention, IT-security and basic risk management. The owners and the managers need to submit CV´s, clearance certificates and a multitude of other documents to BaFin. Furthermore, the most important contracts as well as the terms and conditions and the cooperation contracts should be submitted if possible. Depending on the individual design of the multilateral crypto trading facility and the owners and designated managers, further documents and statements might be necessary to submit. A diligent planning of the whole project ahead of time is therefore absolutely necessary.

              DIFFERENCES IN CONTRAST TO CLASSICAL MULTILATERAL TRADING FACILITIES

              The stated requirements also have to be fulfilled by applicants wanting to operate a multilateral trading facility for other financial instruments than Bitcoin and other cryptocurrencies. Multilateral crypto trading facilities have the regulatory advantage that the strict provisions which are applicable to securities trading are inapplicable to units of account and therefore to Bitcoins and comparable cryptocurrencies. As long as the listed cryptocurrencies on the crypto exchange do not qualify as security tokens or other financial instruments according to the second EU Directive on Markets in Financial Instruments (MiFID II) but are rather qualified as units of account, the securities regulations as for example the German Securities Trading Act (WpHG) are not applicable to multilateral crypto trading facilities. Therefore, classical multilateral trading facilities are prohibited to allow private investors to trade on their platform whereas multilateral crypto trading facilities are not prohibited to do so.

              Attorney Lutz Auffenberg, LL.M. (London)

              I.  https://fin-law.de

              E. info@fin-law.de

              Read more:

              Building a Crypro Echange (Part I) – What are the regulatory Design Possibilities?

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                Apr 08, 2019

                Valid Transfer Mechanism for Security Tokens

                Besides of the regulatory qualification of security tokens as security, shares in investment funds or alternative investment assets quite a number of private law issues are raised when conducting securities token offerings. The most prominent pitfall when it comes to private law and security tokens is the fact that the German Civil Code BGB in its current form does not foresee electronic debt securities so far. Classical securities which must be freely tradable at the capital markets are therefore still issued in paper form in traditional manner so they are tangible assets that can be subject to property rights and be acquired on the secondary markets in good faith and free from encumbrances. Tangible assets however in German private law are only physical objects. For security tokens, being not more than virtual information in a smart contract on a blockchain, a different legal construction for transfer must be found. The only suitable alternative is probably a cession of the obligation represented by the security token by which the obligation against the emitter can be transferred to the acquirer of the security token. In this case however it must be made sure that the obligation will strictly be tied to the token because otherwise a separation of the token and the obligation and a confusion on the markets may happen.

                LEGAL CONSTRUCTION OF TRANSFER IS CRUCIAL FOR CAPITAL MARKETS ELIGIBILITY

                The necessity of a valid construction of the transfer of a security token is not at all only an academic problem. As the unlimited fungibility of a security token and therefore its’ eligibility for the capital markets can only be given, if the acquirer of the security token can be sure that he has not only acquired the token but also the obligation against the STO emitter. In case the token and the obligation can get separated, such security tokens being traded at the capital markets will not be standardized anymore. In such case the eligibility of the security token to the capital markets would have to be declined because the acquirer of such token could not be sure whether he has acquired only the bare token but also the obligation against the STO emitter. In addition to that, such token could not be qualified as a security from a regulatory law perspective. The token could at best be qualified as an investment asset according to the German Investment Asset Act (Vermögensanlagengesetz) as these instruments characterize by their limited fungibility in comparison to securities.

                SECURITY TOKEN TERMS SHOULD EXPLICITLY SET OUT RULES FOR THE TRANSFER MECHANISM

                With regard to the massive legal consequences that may occur in case of non-existent rules for the legal transfer of the security token, the security token terms should set out a clear legal mechanism for the initial acquisition of the security token during the STO as well as for the secondary acquisition after the STO. The security token terms should definitely regulate, how exactly the obligation of the STO emitter to repay the investment and/or the payment of interests will be transferred to the acquirer of the security token in case of a secondary acquisition. It is of utmost importance that these rules factor the technical peculiarities of the blockchain technology and of smart contracts to make sure that the security token and the associated obligation can never be separated. The legal conception of a security token therefore differs fundamentally from the legal conception of classical securities’ terms and requires a profound consideration of the peculiarities of blockchain technology and technical knowledge. FIN LAW combines the necessary technical understanding and the regulatory expertise and is therefore the right legal partner for security token offerings.

                Rechtsanwalt Lutz Auffenberg, LL.M. (London)

                I.  https://fin-law.de

                E. info@fin-law.de

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                  Apr 01, 2019

                  Building a Crypto Exchange (Part I) – What are the Regulatory Design Possibilities?

                  Since BaFin qualifies Bitcoins and comparable cryptocurrencies as financial instruments, the operating of a crypto exchange requires the operator to be BaFin licensed. But what are the requirements to fulfill in order to acquire such license and what are the conceptual design options that businesses have for meeting these requirements while at the same time tailoring their exchange to the performance of their business? The first part of FIN LAW´s “Building a Crypto Exchange” blog series discusses the three major possibilities for regulatory designs of crypto exchanges in Germany. In the upcoming weeks the follow-up blogs will go into greater detail regarding the regulatory prerequisites for obtaining the above-mentioned licenses.

                  ACTIVE ADVERTISING TO GERMAN CUSTOMERS REQUIRES BAFIN LICENSE

                  A common misconception is that BaFin is only competent for exchanges that are registered in Germany. In reality, BaFin, as the German financial watchdog, is also the competent supervisory authority for all crypto exchanges that act from outside of Germany but actively target German markets and customers. The authority interprets its competence very broad and intervenes e.g. in case a service provider operates a German website, hosts roadshows in Germany or gives interviews in German magazines presenting the businesses’ services to the German public.

                  1. VARIANT: THE MULTILATERAL CRYPTO TRADING FACILITY

                  The most common way of running a crypto exchange outside of Germany is to operate trading platforms that work by an automated matchmaking system pairing the users’ buy and sell orders. Characteristic for these exchanges is that the matchmaking process does not reveal the parties’ identities which is why they do not know who they enter into an agreement with. The German Banking Act (KWG) defines a multilateral trading facility as a system that brings together two parties’ buying and selling interests in financial instruments within the system and in accordance with preset, non-discretionary rules in a way that leads to a sales contract between the two parties. The execution, meaning the transfer of coins or tokens to the buyer and the transfer of the acquisition price to the seller, is processed automatically by the operator of the facility. The users therefore must at all times dispose of a sufficient balance of cryptocurrency respectively fiat currency with the operator of the trading facility so that the trade can be settled.

                  2. VARIANT: THE CRYPTO EXCHANGE BUREAU

                  A comparatively easy way to design a crypto exchange is the sale of cryptocurrencies from the operators’ own stockpile. In this case the operator of the exchange becomes the contracting partner of the customer and owes him fulfillment of the contract meaning either the transfer of cryptocurrencies to the customer in exchange for fiat money or vice versa. From a regulatory point of view this constitutes either proprietary trading or a financial commission business. A financial commission business can be given if the operator only buys or sells the cryptocurrency in question from or to the international markets on basis of a customer’s order.

                  3. VARIANT: THE CRYPTO BROKER

                  A version of a crypto exchange already tested in Germany is the crypto broker design. Users of these exchanges can issue offers to buy or sell cryptocurrencies via the platform. The users then interact and enter into contracts with each other directly. The operators of these exchanges are not contractual partners of the customers but rather act as an intermediary to them bringing together the potential contractual partners. In contrast to the multilateral crypto trading facility the users know the identity of their contractual partner in this version of a crypto exchange.

                  LISTED CRYPTOCURRENCIES INFLUENCE THE REGULATORY REQUIREMENTS AS WEL

                  Additionally, the nature of the listed cryptocurrencies on the exchange influences the regulatory requirements that have to be met. Generally spoken, the requirements tend to be lower if the exchange lists “classic” cryptocurrencies such as Bitcoin or Litecoin and they get higher if the exchange lists e.g. security tokens.

                  The regulatory conception of crypto exchanges is complex and any detail can potentially influence the requirements that have to be met. A competent legal advisory is therefore the basis of every successful project. In the upcoming weeks FIN LAW will publish further parts of the blog series “Building a Crypto Exchange” illustrating the supervisory details of the specific variants of crypto exchanges.

                  Attorney Lutz Auffenberg, LL.M. (London)

                  I.  https://fin-law.de

                  E. info@fin-law.de

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                    Mar 25, 2019

                    What are the Regulatory Requirements for Operation in Germany?

                    Probably one of the oldest Bitcoin based business models since Bitcoin became popular is the operating of Bitcoin ATMs. ATM is the abbreviation for Automated Teller Machine while a Bitcoin ATM is a machine that changes Bitcoin into bank money and vice versa. In other European countries like Austria, Switzerland or the Netherlands Bitcoin ATMs can be operated without the need to fulfil any specific regulatory requirements. In contrast to that in Germany a prior approval from BaFin (German Federal Financial Supervisory Authority) is necessary in order to operate such machines. But what exactly is the subject of approval and what are the requirements which must be fulfilled to obtain a BaFin permission for operation of a Bitcoin ATM?

                    BITCOINS ARE CONSIDERED FINANCIAL INSTRUMENTS IN GERMANY

                    To a great extent, the financial regulations are harmonized within the European Union. In regard to Bitcoin and comparable cryptocurrencies there are some points that differ from member state to member state and that have to be kept in mind. In the Federal Banking Act (KWG) the German legislator chose to not only qualify the instruments listed in the second Markets in Financial Instruments Directive (MiFID II) but additionally units of account as financial instruments. Examples for units of account are the euro’s predecessor European Currency Unit (ECU), the special drawing rights of the International Monetary Fund or Goldfranken which were formerly used in the international post and transportation industry. BaFin also qualifies Bitcoin and comparable cryptocurrencies as units of account and accordingly as financial instruments as defined in the Federal Banking Act (KWG). Even though the qualification for Bitcoin as a unit of account has been ruled unlawful by the Berlin Court of Appeal in a criminal judgement dated 25 September 2018, BaFin holds on to the qualification and argues that a criminal judgement has no binding effect for a supervisory authority like BaFin. As long as the administrative courts that are competent for BaFin’s administrative practices do not confirm the legal opinion of the Berlin Court of Appeal, Bitcoins must be considered units of account and therefore as financial instruments in the sense of the Federal Banking Act and therefore the license requirements set out in the Federal Banking Act are applicable to all Bitcoin related businesses as well.

                    WHICH ACTIVITIES MUST BE PERMITTED BY BAFIN FOR THE OPERATION OF BITCOIN ATMS?

                    Providing a Bitcoin ATM service means that on the customers’ demand Bitcoins get transferred from a wallet owned by the operator to a wallet that is owned by the customer in exchange for a payment in fiat currency or vice versa. Simply put, a Bitcoin ATM can be seen as an automated exchange office for Bitcoins. Acquiring or selling financial instruments as a service for customers from an own stockpile in a commercial extent is considered as proprietary trading. The service provider must therefore obtain a permission from BaFin in accordance to the German Banking Act (KWG). If those financial instruments are not delivered from the operators’ stockpile but are purchased by the operator on behalf and on account of the customer before delivery to the customer, the operator is required to be licensed for financial commission business by BaFin in advance.

                    WHAT ARE THE REQUIREMENTS THAT NEED TO BE FULFILLED TO OBTAIN A BAFIN LICENSE?

                    A successful BaFin application for proprietary trading and/or financial commission business requires the applicant (the Bitcoin ATM operator) to have a starting capital of at least 730.000 euros at his disposal. Furthermore, BaFin requires the directors of the company to be fit and proper and – if possible but that is not a necessity – to have experience in the fields of proprietary trading respectively financial commission business. For a successful application a sustainable business plan with key figure estimates for the first three business years, a comprehensive description of the planed compliance processes and internal monitoring and controlling procedures as well as detailed information on the key shareholders of the operating company must be shown to BaFin.

                    FIN LAW supports its clients with the preparation of BaFin license applications and specializes in the legal specifics of business models that are related to cryptocurrencies.

                    Attorney Lutz Auffenberg, LL.M. (London)

                    I.  https://fin-law.de

                    E. info@fin-law.de

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                      Mar 18, 2019

                      E-Money on a Blockchain: What Serives can a Cypto E-Money Institution Offer?

                      Blockchain tokens that are issued by the emitter in exchange for money and that can be exchanged back to a legal tender and that are accepted as a means of payment by others than the issuer can be e-money from a regulatory perspective. But what are the advantages of blockchain based e-money and who would be legally allowed to provide it?

                      Who would be Allowed to Offer Blockchain Based E-Money?

                      Within the European Union the issuing of e-money requires the emitter to be licensed as an e-money institution. These licenses are issued by the banking regulator of the country in which the service is originally provided. Once the license is acquired in one of the EU-countries it can then be “exported” via the so called EU-Passporting process and be used in all the other EU member states without the need of another approval and licensing process. The EU-Passporting procedure is a relatively simple notification process that is initiated by the banking regulator of the originally licensing member state upon application of the e-money institution. Next to licensed e-money institutions banks with a full banking license and certain government institutions are also allowed to issue e-money.

                      What are the Advantages of Crypto Based E-Money?

                      The most exiting feature of blockchain based e-money would be that fully digitalized units of value could be transferred directly between the users. The physical handover of an electronic or magnetic data carrier from the buyer to the seller would be as obsolete as the involvement of the issuing e-money institution in the transaction. Documentation and confirmation of transactions would be processed on the blockchain itself. The double spending problem would not occur with blockchain based e-money because the ownership of a value unit would be forgery-proof documented within the blockchain itself and therefore blockchain based e-money could circulate fully automated and digitally.

                      What Services would Crypto E-Money Institutions be Allowed to Offer?

                      E-Money institutions are not limited to the issuing and re-exchange of e-money. The permission to issue e-money and conduct an exchange business with it additionally enables e-money institutions to provide other interesting activities which usually require a separate permission. Next to the e-money business a crypto e-money institute could additionally offer e.g. fiat payment accounts and money remittance. Furthermore, licensed crypto e-money institutions could, within strict regulations and boundaries, even grant credits to customers, as long as the credit is related to a payment process. Even foreign exchange transactions would be possible, as long as they are related to the e-money business of the company.

                      What are the Requirements for an E-Money Institute to Get BaFin Approved?

                      As shown above blockchain based e-money institutes could have access to numerus business models that can connect traditional payment activities with the crypto world. But there are also regulatory requirements that have to be fulfilled in order to acquire the necessary e-money license. To name a few, a sustainable business model, sufficient and adequate security precautions, two fit and proper directors and at least 350.000 euros as starting capital will have to be shown to BaFin. FIN LAW supports its clients from the project planning phase to the preparation and submission of the license application and represents them vis-a-vis BaFin in the permission process.

                      Atty. Lutz Auffenberg, LL.M. (London)

                      I.  https://fin-law.de

                      E. info@fin-law.de

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                        Mar 10, 2019

                        How Should a Security Token be Legally Designed?

                        Since a few weeks the German crypto community celebrates the first BaFin approved securities prospectus, being fully compliant with German regulatory laws and statues. With this approval BaFin really displayed an innovative and progressive attitude towards blockchain based funding methods. At least three more STO prospectuses are currently awaiting BaFin’s approval and more will follow. The security token now being offered through the first approved STO prospectus is legally designed as a registered bond and therefore, according to German capital markets regulatory law as an asset investment. Nevertheless, BaFin categorizes the token as a security and not as an asset investment. This stems from the legal view of the BaFin that because the registered bond is embodied in the (transferable) token it is tradable just like a security. But what should be the legal design of a security token from the issuer’s perspective so that the Security Token Offering can be conducted without any problems?

                        The Administrative Practice of BaFin Regarding Blockchain Tokens.

                        On the 20st of February 2018 BaFin pointed out that tokens having been issued via an Initial Coin Offering, depending on the actual token design, may classify as either securities as defined in the German Securities Trading Act (WpHG) or an asset investment as defined in the German Asset Investment Act (VermAnlG) or even as shares of a investment fund as defined in the German Capital Investment Code (KAGB). According to BaFin, this regulatory qualification cannot be generalized but instead has to be considered on a case to case basis. For a token’s classification as security the following four criteria have to be fulfilled: (1) The token is not meant to be a mere means of payment, (2) it embodies corporate and/or participation rights, (3) it must be transferable and (4) it must be tradable on the financial or capital markets. BaFin actually considers crypto exchanges as financial markets in this sense. A token can be classified as a share of an investment fund as defined in the KAGB if it represents a share of an entity that makes collective investments for a number of investors. If a token neither qualifies as a security nor as a share of an investment fund while granting patrimonial rights to the investor it will most likely be classified as an asset investment. In 2012 the German legislator passed the Asset Investment Act with the intention to regulate those capital market products that where neither a security nor a share of an investment fund and therefore were at that time unregulated. All three of those regulatory regimes differ from each other and the creation and approval processes for creating prospectuses and further legal documents for their public offering have different prerequisites.

                        Security Tokens have to be Designed Coherently in regards to Supervisory Law as well as Private Law

                        A risk for emitters of security tokens lies in the fact that the approval of the prospectus is granted by BaFin, being an administrative authority while claims that arise from a missing or wrong prospectus in the form of prospectus liabilities are decided by civil courts. Due to the principal of separation of powers the civil courts are not legally bound to the classification decision of BaFin regarding the legal nature of a token. They will assess if a token is a security, an asset investment or a share of a capital fund themselves on basis of the law. It therefore is possible that a civil court might qualify a token as an asset investment while BaFin qualified the same token as a security. That might lead the deciding court to the conclusion that a required asset investment prospectus has not been published by the emitter. For the issuer of an STO this poses a major liability risk. The consequences of a missing prospectus are usually that the emitter has to refund the original investment to the investor plus any transaction fees. In return the emitter will get back the tokens . The legal conception of a security token therefore must be designed with the highest diligence and professional competence. FIN LAW specializes in the legal conception of Security Token Offerings and offers its clients the highest advisory quality in all relevant legal aspects.

                        Attorney Lutz Auffenberg, LL.M. (London)

                        I.  https://fin-law.de

                        E. info@fin-law.de

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