Germany: The unexpected leader of the digital asset revolution
- Dec 14, 2023
- 18 min read
Updated: Mar 17
Digital Asset Custody Guide
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Germany is unexpectedly ahead of Singapore, Luxembourg and Switzerland in creating a hospitable environment for securities and funds to be tokenised
The keys to the German success were separate domestic legislative measures that encouraged issuance and custody of tokenised securities
However, much of the activity in Germany to date is better understood as digitisation of the issuance process rather than tokenisation of securities and funds
Singapore has a good claim to be the jurisdiction that is leading the digital asset revolution. The Monetary Authority of Singapore (MAS) has certainly earned universal admiration for its dense and practical engagement with the private sector and the State at home and with its regulatory counterparts abroad to progress the development of digital asset exchanges and other infrastructures in Singapore and to build the support that cross-border activity requires.
In Europe, Switzerland – again with conspicuous levels of mutual support between the central bank, the private banks and the vertically integrated stock exchange – has emerged as the leading jurisdiction Finanzplatz Schweiz has built infrastructure and made some progress in re-shaping securities laws and regulations to accommodate digital assets, though it is not yet completely clear what counts as a security token.
Luxembourg might argue it has achieved that clarity but, unlike Switzerland, it is a member-state f the European Union (EU), where uncertainty over securities tokens persists. The flagship Markets in Crypto-Assets (MiCA) Regulation, which came partially into force on 29 June 2023 and will not be fully in force until December 2024, explicitly excludes securities (as opposed to cryptocurrencies, Stablecoins and e-money). Instead, the EU is testing future possibilities via its so-called Pilot Regime for financial market infrastructures interested in developing digital assets services.
True, this has left the field open for national governments and regulators in EU member-states to set their own pace of reform. And Luxembourg is right to consider itself a contender for leadership. After all, the government has passed a succession of three “Blockchain Laws” that enable tokenised securities and funds to be issued, registered and used as collateral. These laws have persuaded a number of digital asset businesses – notably those in the funds sector - to establish themselves in the Grand Duchy.
What nobody had expected to find is that Germany – by the admission of its own leadership, a digital laggard in most areas – is leading both Switzerland (see Box 1) and Luxembourg in getting digital securities and funds issued into the marketplace, as opposed to being experimented with and merely talked about. By November 2023, Germany had hosted the tokenisation of no less than 56 bonds and funds. So the explanation of that success, whether it is more apparent than real, and how Germany might build upon it, is worth exploring.
Box 1
A comparison of digital asset developments in Germany and Switzerland Switzerland has built a reputation as a magnet for FinTechs in general and cryptocurrency and digital asset talent and investment. It has certainly promoted that image and introduced policies designed to encourage the development of the market. Germany, on the other hand, has pursued a quieter strategy. [1] But quietness has not made it any less effective. A FINTECH Global survey of deal activity in FinTechs in the third quarter of 2023 put London far ahead (with 85 deals) but Germany (41) ahead of both France (30) and Switzerland (13). [2] Similarly, in the AI Rankings prepared by Tortoise Media, Germany is only one place (eighth) ahead of Switzerland (ninth) overall but third in terms of scale – behind only Singapore and Israel - while Switzerland is in 16th place. Where the two countries are closely matched is in terms of legal infrastructure. Both are civil law jurisdictions that must pass new laws to make securities compatible with on-chain activities. Both adopted the same basic solution of an omnibus act plus amendment of multiple related laws. [3] In Switzerland, the Federal Act on the Adaptation of Federal Law to Developments in Distributed Electronic Ledger Technology (known colloquially as “the DLT law”) amended four core laws and six others. In Germany, the Gesetz zur Einführung von elektronischen Wertpapiere (eWpG) also not only introduced electronic securities to Germany but made changes to existing laws. Structurally, where Germany and Switzerland part company is that the Swiss emphasise the integration of security tokens with regulated trading markets under the DLT law. Custody, on the other hand, is not integrated with the legal reforms because the Swiss Financial Market Supervisory Authority (FINMA) deals with custody of digital assets as part of its overall supervision of banks and securities firms. In short, if a bank offers digital asset custody, it must have FINMA approval. The German approach, by contrast, is to treat custody of cryptocurrencies and digital assets as an explicitly separate activity, with no pre-approval for banks looking to provide a service. That said, the transitional arrangements in Germany for switching from conducting an unregulated custody activity to acquiring a licence to do so seem to be generous in terms of timing. The German strategy recognised that “crypto securities” – “native,” non-asset backed tokens that have no life outside the blockchain onto which they are issued - are a desirable end-state, but also emphasised practicability. Most importantly, Germany had to accept that under EU law “crypto securities” issued on to decentralised blockchain networks rather than into a CSD are not eligible to trade on regulated marketplaces. This is a major point of difference with non-EU Switzerland, where the goal was to drive security tokens on to regulated exchanges. Overall, what is the outcome in the two markets and how do they compare? Switzerland has SDX, a fully regulated digital asset exchange with a digital CSD attached. SDX works with Aktionariat, an exchange that specializes in issuing native shares of private companies in tokenized form. It lists more than 40 equity tokens, issued under the DLT Law, for purchase. Switzerland also has Organised Trading Facilities (OTFs) run by regulated securities firms. They include OTFs controlled by Sygnum (a digital bank) and Taurus (a technology firm with a broker-dealer arm). Neither has a large volume of securities listed or traded. SDX has three digital bonds listed, one of which was issued by its parent company. Given the effort that the Swiss authorities have put into crafting rules for a regulated, blockchain-based trading venue it is ironic that none of the current trading venues fall within their scope. SDX, for example, is licensed under the traditional rules but allowed to trade blockchain-based securities. Likewise, the OTFs remain alternative trading facilities. Germany hosts digitally native “crypto securities” but on a small scale, with securities “digitised” at the issuance level only achieving much higher volumes. The German market is developing a supportive eco-system of registrars and advisors but secondary market trading is not yet considered, let alone expected. The custody licensing structure, on the other hand, is working, though licences are being issued at a glacial pace. A comparison with Singapore is instructive. Singapore now has seven Regulated Market Operators (RMOs) running digital asset trading venues, including a DBS Bank subsidiary, and a separate capital markets custody licence available in addition to approvals granted through normal bank regulatory channels. This model is achieving more success, in terms of volume and value, than either Germany or Switzerland. |
How the German token market developed
The proximate causes of the unexpected emergence of Germany as a major host of tokenised security and fund issues were two separate actions taken by regulators and legislators as component parts of a broader strategy laid out by the German finance ministry (Bundesministerium der Finanzen) in a 2019 paper on electronic securities and codified in a formal “blockchain strategy” adopted by the government in 2020.
The first action was the publication in March 2020 by the Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin), the German financial markets regulator, of a Guidance Notice to financial institutions on the custody of “crypto-assets.” [4]
The Guidance Note codified the requirements necessary to obtain a digital asset custody (Kryptoverwahrgeschäft) licence in Germany – essentially, capital of €125,000 plus demonstrable competence to safekeep digital assets - from BaFin under the German Banking Act (KWG) (see Box 2). Importantly, the licence is not “passportable” within the EU and so cannot be used to provide services in other member-states.
Box 2
Digital asset custody in German law Under section 1 (1a) sentence 2 no. 6 of the German Banking Act (Kreditwesengesetz – KWG), digital asset custody is defined as:
Institutions authorised to conduct either type of custody are also authorised to provide “crypto-securities” registration services within the meaning of section 1 (1a) sentence 2 no. 8 of the KWG. Companies can apply separately for a “crypto-securities” registration licence. |
The Guidance Note was followed in June 2021 by a second action. This was a new “Act to introduce electronic securities” (Gesetz zur Einführung von elektronischen Wertpapiere – eWpG [5]) that, as the name suggests, enabled the issuance of electronic securities.
Under previous German law, securities needed to be represented by a physical certificate (Urkunde) that provided the foundation for the ownership and transfer of the security under German property law. The eWpG made it possible to issue bearer bonds, mortgage bonds (Pfandbriefe) and certain fund units in purely electronic formats. Importantly, securities in electronic form also included “crypto securities.”
The eWpG also introduced the concept of a digital asset ownership registration function (Kryptowertpapierregisterführung) (see Box 3). Any firm providing such registration services must obtain a licence from BaFin, which is contingent on showing capital of €730,000. This sum, being nearly six times that required of a digital asset custodian, testifies to the importance German regulators attach to the security and integrity of the register of holders of tokenised securities.
Box 3
How the digital asset registration function works under the eWpG Under historic German securities law, securities needed to be represented by a physical certificate. The certificate proved ownership of the security and enabled it to be transferred under German property law. The eWpG, by enabling the issuance of electronic securities, required a different proof of ownership and transferability akin to that when bearer securities are dematerialised – namely, a register. That register can take one of two forms. The first is a centralised registry, used to record (as the name suggests) electronic central registry securities). Its operation is straightforward. Under section 4 (1) of eWpG, a “central registry” must be established and maintained by a company licensed as a central securities depository (or CSD, which in practice in Germany means Clearstream Banking Frankfurt). If central registry securities are entered in the central register of the CSD in the name of that CSD, the securities automatically become book-entry securities of that CSD under section 12 (3) of the eWpG. This means that the requirements of Article 3 of the European Central Securities Depository Regulation (CSDR), permitting them to be traded on regulated exchanges within the meaning of the Markets in Financial Instruments Directive (MiFID), are met. The second form a register can take is a decentralised one, used to record issuance, ownership and transfers of “crypto-securities.” Under Section 4 (1) no. 2 of eWpG, a “crypto securities registry” is a registry kept on a tamper-proof recording system in which data is logged in chronological order and stored in a manner that protects the entries against unauthorised deletion and subsequent modification. Although the law is intended to be technology-neutral, the term “crypto-securities registry” clearly refers to blockchains or distributed ledgers that make use of blockchain technology. In simple terms, a crypto securities register is therefore a register for electronic securities based on distributed ledger technology within the meaning of section 16 of the eWpG. Decentralised registers of this kind do not meet the requirements of section 12 (3) of the eWpG, which means in turn that “crypto-securities” do not meet the requirements of Article 3 of the European Central Securities Depository Regulation (CSDR) and so cannot be traded on a regulated exchange within the meaning of the Markets in Financial Instruments Directive (MiFID). Operators of “crypto-securities” registers, which are responsible for its proper functioning, can be either the issuer or an entity operating on behalf of the issuer. Both types are subject to specific supervisory requirements. Under section 1 (1a) sentence 2 no. 8 of the German Banking Act (Kreditwesengesetz – KWG), crypto securities registration is a financial service requiring authorisation, and it is subject to requirements regarding business organisation and the conduct of business. So an issuer acting as its own registrar needs to obtain a licence from BaFin to do so – in practice, the issue of licences is likely to be restricted to “crypto-securities” registrars that also provide the service as a business to other companies. |
Considered more broadly, the two actions taken - the custody guidance from BaFin and the electronic securities legislation - represented the culmination of three underlying trends.
The first was growing interest among market participants in issuing and investing in tokens. After the Initial Coin Offering (ICO) boom and bust of 2017-18, BaFin created a format that allowed security tokens to be issued in a form which were clearly securities under the existing securities regulations - and indeed followed the German Securities Prospectus Act. This legitimised a fundamentally different form of securities from the then-prevailing system of physical certification in global form, but the format never gained traction.
Secondly, BaFin, in discussion with the banks, realised that the “wet ink” system of issuing global certificates for securities was slow, risky and costly. These costs and risks were largely invisible to investors, since once the global certificate was lodged with Clearstream Banking Frankfurt as the central securities depository (CSD), trading and settlement could continue in a purely digital environment. Had this not been the case, pressure to dematerialise all securities and funds – as France did in 1984 - would have been intense. But physical certification remained a problem for German issuers, which generate circa five million new listings a year.
Thirdly, the customer losses associated with the ICO boom and bust, and the accompanying need for Germany to comply with the then-upcoming Fourth EU Anti-Money Laundering Directive, persuaded BaFin to focus on providing a properly defined custody regime for cryptographically based assets, whether they were cryptocurrencies or payment, utility, security or fund tokens.
The intention was that all regulated financial providers must comply with a single custody regime for “crypto-assets” on a clearly defined basis. The BaFin Guidance Notice of March 2020 still provides a clear and formal framework for firms to become licensed providers of digital custody services and act as crypto-asset registrars as well, if they wish. As it happens, the registration function is at the heart of the reforms of German law to accommodate digital assets.
The market since eWpG came into force in June 2021
The combination of the Guidance Note on custody plus the eWpG accelerated issuance activity in digital assets in Germany. The German market has seen security tokens issued and custodied, and a similar trend is now occurring in the funds industry. Although the eWpG enabled German investment funds (Sondervermögen) to issue digital fund units without physical global certificates, - as with bonds, the certificate can be replaced by a central electronic register – the law did not provide for issuance of digital fund units recorded on a decentralised blockchain-based ledger.
A new Regulation on Crypto Fund Units (Verordnung über Kryptofondsanteile – KryptoFAV), issued under the eWpG in September 2022, covers this gap. It provides a legal foundation for issuing fund units that are not centrally registered. In effect, it means that German asset managers can now issue investment fund units in digital form only on the blockchain-based ledgers. The first fund units governed by the KryptoFAV have already been issued by Metzler Asset Management Gmbh. [6]
But most of the issuance activity has taken place in securities rather than funds. At 23 November 2023, the BaFin database recorded 62 [7] security tokens in issue. These are not “asset-backed” tokens with links to an equivalent traditional security but genuine “crypto securities” (see Box 4) that are issued on to and remain on a blockchain-based ledger.
Box 4
The difference between electronic centrally registered securities and “crypto-securities” Thanks to the eWpG, securities in electronic form now have the same legal standing in Germany as securities represented by a physical certificate. Further, securities in electronic form include “crypto securities.” Quite how these concepts translate into the mundane activities of issuance, investing and trading can be confusing, so it is helpful to summarise the three routes an issuer can now take to market: First, the issuance of bearer bonds via a (“wet ink”) placement of a physical global note with a CSD (namely, Clearstream Banking Frankfurt) persists. Post-issuance trading and settlement take place in a purely digital - a de facto dematerialised - way.
Secondly, the issuance of securities in electronic form (under the eWpG) can take place in either of two forms:
In short, any electronic security that is not called a “crypto-security” is an electronic central registry security, whatever name issuers and their advisers choose to apply to it. |
This means they are not fungible with any traditional assets and are not traded in a secondary market (EU law forbids this unless the security tokens are issued into a CSD). As a result of their non-tradeability, and the lack of connectivity between blockchain networks and traditional infrastructures, the tokens cannot be used conveniently for traditional market purposes such as, say, collateralising an exposure. They exist, in effect, in a separate universe.
62 is scarcely a large number. The collective value of the “crypto security” issues, at circa €200 million [8], is not high either. In fact, the biggest issue (€60 million), managed by Hauck Aufhäuser Lampe Privatbank AG on behalf of Siemens AG in February 2023, accounts for a third of the total. So “crypto securities” (see Box 4) are as yet a fraction of the German capital markets.
Greater scale is being achieved through “digitisation” rather than “tokenisation” under the eWpG. Digitisation creates a digital twin of a traditional or real-world asset at issuance into the CSD - which in this case is D7, the digital asset CSD owned by Clearstream Banking Frankfurt. But issuance in digital form is the only digital aspect of the process.
After issuance, the digitised security can still be processed and used in the same way as a traditional security. It can settle in central bank money via the T2 payments system of the European Central Bank (ECB), for example, and be serviced and reporting by a global custodian. It can even be pledged as collateral. Any investor can buy the instrument, because its basic nature remains in line with that of traditional securities.
The question is why issuers bother to issue digitised securities at all if so little changes. The answer is that digital issuance is much cheaper and faster than the traditional method and does not require issuers to master new technologies and processes. Nor does it cut issuers off from investors, by forcing investors to adopt new technology and techniques to gain access to blockchain networks of the kind where “crypto-securities” live.
D7 says it has hosted 7,000 digitised securities issues on to its (non-blockchain) platform, most of them structured notes for retail investors that are terminated quickly: the 4,000 still outstanding at end-November 2023 were worth €3.3 billion. 7,000 is more than 100 times the total number of “crypto security” issues and €3.3 billion 17 times the €200 million valuation of “crypto-securities.”
It is nevertheless also a fraction of the total volume of securities being issued in Germany in the traditional way. An average of 400,000 traditional securities are issued in Germany every month - or five million a year, which is 714 times the total number of digitised securities issued in total so far.
Nevertheless, 62 “crypto security” issues and 7,000 digitised securities are still significant by comparison with the levels of issuance activity in other digital asset-friendly markets in Europe such as Switzerland and Luxembourg. And they provide a foundation on which the German market can build an incremental transition to a tokenised future, including the construction of a scalable (and possibly blockchain-based) platform powerful enough to accommodate 400,000 issues a month.
D7 is working on increasing the capacity of its platform to accommodate larger flows of data between its digital issuance engine and the infrastructure and service providers of the traditional market already. A new application programme interface (API) was installed in June 2023, and a further upgrade capable of processing tens of thousands of issues a month is due to go live in March 2024. A purely blockchain version of the digitisation engine, using Ethereum on the Polygon network, is also planned for 2024.
In another encouraging sign for the future, the digital asset ownership registration function which is at the heart of the eWpG has prompted the emergence of specialist service providers. Judging by the registrars recorded in the BaFin list of 62 token issues, three independent providers – Cashlink, Smart Registry and E-SEC – currently dominate the market for licensed registration services, with an 80 per cent market share between them. [9] The biggest, Cashlink, accounts for just over 41 per cent of appointments.
Two registrars (Hauck Aufhäuser and Tangany) double as custodians. However, in the provision of custody services, the surge in token issues in 2023 has led to an increase in applications to BaFin from major German banks, and custody licences are being granted and expected to be granted. The first – granted to Commerzbank on 14 November 2023 – was so new at press time that it had not shown up in the BaFin database at month-end (see Box 5).
Box 5
“Crypto” custodians listed in the BaFin Database at 30 November 2023
Source: https://portal.mvp.bafin.de/database/InstInfo/sucheForm.do |
In fact, the eight names recorded in the BaFin database bear witness to the growth of initially unregulated custodial businesses catering to cryptocurrency investors even before BaFin issued its Guidance Note in March 2020. Several banks and brokers not in the BaFin database say they have a digital asset custody licence, which suggests the database has not yet completely caught up with the progress being made.
This lack of alignment between market participants and regulators is predictable. The transition to a regulated service is inevitably untidy, as firms custodying cryptocurrences already are allowed to continue on a temporary basis while applying for full licence. BitGo, for example, was granted transitional approval in 2019 and a licence in October 2023. But a system is in place to license digital asset custodians.
There is also an expectation that equities, which currently remain entirely confined to the traditional world, will be brought within the scope of eWpG in 2024. The Financing for the Future Act (Zukunftsfinanzierungsgesetz), whose purpose is to increase the attractiveness of Germany as a capital market, rests on the supposition that digitisation is crucial to the achievement of that objective. It will free companies to issue shares on to blockchain networks, instead of in certificated form, in the same way as the eWpG has made it possible to issue bonds and funds on to blockchain networks.
The benefits of eWpG lies primarily in the issuance function – and in Germany equities are a modest part of the capital market (which is why the Financing for the Future Act aims to recruit start-ups and small to medium sized companies (SMEs) as issuers and to incentivise equity ownership with tax breaks).
But bringing equities within the scope of the eWpG alongside debt and funds makes obvious sense. If issuers and investors can interact with a unified digital assets platform across equity as well as debt and funds, they are more likely to use it. Lower cost and complexity should also accelerate the transition from digitised securities to “crypto securities.”
There remain two major hurdles to that transition. The first is that “crypto securities” are presently downloaded by the registrar to the issuer into a variety of blockchain protocols and blockchain networks, some of which are public and some of which are private. Clearly, if volumes grow, and especially if secondary market trading commenced, interoperability will become a serious problem. At this point a handful of firms dominate the registration process but a lot of major banks are looking at developing registration services, so fragmentation is a possibility. Either way, the industry or BaFin will need to resolve the inter-operability challenge if the business is to scale.
Secondly, “crypto securities” dispense with the need to issue securities into a CSD. Instead, the registrar manages an on-chain register of tokens in issue, and of holders of them. However, issuance into a CSD remains a requirement for admission to listing to trade on a trading venue within the meaning of the Markets in Financial Instruments Directive (MiFID), the principal piece of EU law governing the securities markets.
This means “crypto securities” cannot trade on regulated exchanges, multilateral trading facilities (MTFs) or organised trading facilities (OTFs), which in turn means equity issuers - and especially those with large, frequently traded market capitalisations - will be deterred from issuing “crypto securities.” Corporate bonds, by contrast, remain relatively illiquid anyway, and already trade OTC rather than in highly regulated markets.
[3] The laws affected by the omnibus eWpG are extensive. They include the German Safe Custody Act (Depotgesetz – DepotG); KWG, the German Banking Act (Kreditwesengesetz – KWG); the Securities Prospectus Act (Wertpapierprospektgesetz – WpPG); the German Securities Trading Act (Wertpapierhandelsgesetz – WpHG); the German Bond Act (Schuldverschreibungsgesetz – SchVG); the German Pfandbrief Act (Pfandbriefgesetz – PfandBG); the Investment Firm Act (Wertpapierinstitutsgesetz – WpIG); and the German Investment Code (Kapitalanlagegesetzbuch – KAGB).
[4] Federal Financial Supervisory Authority (BaFin), Guidance notice – guidelines concerning the statutory definition of crypto custody business (section 1 (1a) sentence 2 no. 6 of the German Banking Act (Kreditwesengesetz – KWG), 2 March 2020.
[6] Press release, Metzler issues first DLT-based fund shares under cryptoFAV with Cashlink and fundsonchain, 5 September 2023.
[8] The value of issues is not disclosed by BaFin, so this number is an estimate made by a market participant.
