German regulators are embracing digital securities
The German regulators continue to be at the forefront of regulatory innovation. With the release of its latest draft for the regulation of digital securities (“draft law on implementing digital securities”, which contains the draft law on digital securities called “eWpG-E”), German lawmakers add more detail to the previously introduced crypto custody license and generally provide more clarity surrounding the emerging digital asset ecosystem. Undoubtedly, digital securities will be a critical part in shaping the future of the capital market infrastructure and thus need to be regulated accordingly.
The aim of the draft is to provide a clear legal framework regarding the issuance, transfer, custody and distribution of purely digital debt instruments in the form of bearer bonds (“Inhaberschuldverschreiben”), as digital debt instruments have seen the broadest adoption so far. Below we have summarized the most important talking points after critically reviewing the draft:
- Digital securities (“Elektronische Wertpapiere”) are digital representations of ownership of a certain financial asset and thus are subject to the same securities laws as traditional securitized equivalents (§ 1 (1) Depotgesetz in the version of the draft law on implementing digital securities)). Furthermore, digital securities will be regulated pursuant to German property law (Sachenrecht (§ 2 (3) eWpG-E).
- The issuance of a digital security under the eWpG-E requires the registration of the security with an electronic securities register (“elektronisches Wertpapierregister”). An electronic securities register can either be a central register according to § 12 eWpG-E operated by a central securities depository (“CSD” such as Clearstream), or a decentralized crypto-securities register (“Kryptowertpapierregister”) according to § 16 eWpG-E. Among other information pursuant to § 17 eWpG-E, such crypto-securities register would need to contain information on the bearer (Inhaber) of a digital security, which could be a CSD, a custodian bank or the actual owner of the digital security itself. A regulated crypto custodian might provide the protection (“Sicherung”) of the respective private keys for an owner or as well for a custodian bank.
- A crypto-securities register is defined as a decentralized and immutable ledger system that records the ownership of digital assets and contains the information pursuant to § 17 eWpG-E. A crypto-securities register could be operated on a private or public blockchain infrastructure – for example the R3 Enterprise Blockchain and the Ethereum Blockchain, respectively. The operation of a crypto-securities register will require a license according to KWG. Issuers of digital securities are free to choose between the issuance via a central register or via a crypto-securities register. Crypto custodians might as well obtain a license to operate a crypto-securities register and could still make use of the exceptions already provided within § 2 (7b) KWG for crypto custodians, in case they do not provide any other financial or banking services.
- The administration and custody (“Verwaltung und Verwahrung”) of digital securities will qualify as regular custody business (Depotgeschäft) pursuant to DepotG and § 1 (1) sentence 2 No. 5 KWG. Whereas, the protection of private keys for holding, storing and disposing over digital securities can still be provided as a service of a crypto custodian. All qualified crypto custodians of digital securities fall under the regime of the new crypto custody license, which came into force on January 1st. The preliminary license will expire by the end of November, at which point all crypto custodians must have handed in the final application to the BaFin.
- In principle, crypto-securities registrars using a public, permissionless Distributed Ledger Technology (DLT) might not be considered a CSD and hence, would not require a CSD license (for the maintenance of the registers). A case by case decision must be made regarding crypto-securities registrars operating a private, permissioned DLT system, as the operating entity can have full decision making power over the participants in the register system and the settlement infrastructure.
- In general, for a specific DLT system to be a valid means of storing and tracking ownership of digital securities, the finality of transactions must be guaranteed, meaning transactions should not be reversible after they have been approved (§18 (4) sentence 2 eWpG-E).
- Lastly, there are no specific limitations regarding the use of public or private DLT systems as long as all legal and technical requirements are fulfilled. However, regulators express mild concerns regarding the possibility of previously approved transactions being invalidated in a public, proof-of-work based Blockchain.
The current draft describes exclusively the regulatory framework for the issuance of digital bearer bonds, however, the structure of the draft is designed to serve as a foundation for transforming and modernizing other German securities laws in the future, such as introducing regulations for digital shares and even digital fund shares.
As of now, any investment that is structured as equity or as an investment fund in the form of a “Sondervermögen” requires the issuance in a paper deed. In order to enable a purely digital issuance of shares in a stock corporation or an investment fund, the legislator would have to waive the requirement of securitization in a deed. Thus, at this point in time, it is legally not possible to tokenize shares of a company or shares of an investment fund (§1 (1) sentence 1 KAGB).
We appreciate the efforts of the regulators to provide and define clear guidelines surrounding the usage of the new and promising Blockchain technology. For us as market leaders in tokenizing debt instruments, the acknowledgement of DLT systems from regulators as a new means of managing securities is further confirmation of the work we have been doing so far and gives us greater confidence in our ability to disrupt the existing financial structures.