How the german token market developed
- Future of Finance
- Dec 15, 2023
- 5 min read
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.” (22)
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: • Business conducted for others that involves the custody, management and safeguarding of “crypto-assets” or pri-vate cryptographic keys that serve the purpose of holding, storing or transferring crypto-assets for others; or • The safeguarding of private cryptographic keys that serve the purpose of holding “crypto- securities” for others. 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 “cryp-to-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(23)) 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 the 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 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 issu-ance of electronic securities, required a different proof of ownership and transferability akin to that when bearer securi-ties 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) elec-tronic 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 unauthor-ised deletion and subsequent modification. Although the law is intended to be technology-neutral, the term “cryptosecuri-ties 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 (Kreditwesenge-setz – 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 the 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, the 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, the 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 the 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.
(1) 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.