The market since EQPG came into force in June 2021
- Future of Finance
- Dec 15, 2023
- 8 min read
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. (1)
But most of the issuance activity has taken place in securities rather than funds. At 23 November 2023, the BaFin database recorded 62 (2) 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 represent-ed 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 dematerial-ised - 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 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 (3), 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.
62 “crypto security” issues is 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. (4) 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
1. BitGo Europe GmbH 2. Bitpanda Asset Management GmbH 3. Blocknox GmbH 4. Coinbase Germany GmbH 5. Finoa GmbH 6. Hauck Aufhäuser Digital Custody GmbH 7. Tangany GmbH 8. Upvest GmbH |
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 before being awarded 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 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.
(1) Press release, Metzler issues first DLT-based fund shares under cryptoFAV with Cashlink and fundsonchain, 5 September 2023.
(3) The value of issues is not disclosed by BaFin, so this number is an estimate made by a market participant.