by Dr. Nick Wittek, Dr. Michael R. Fischer, Martin Schulte, Harriet Territt, Philippe Goutay, Stephen J. Obie, Mark W. Rasmussen
The Situation: The requirement for a paper‑based note for issuing securities under the German law has been an obstacle for the use of security tokens in Germany. With the release of a draft bill (the “Bill”) permitting the issuance of electronic bearer bonds under German law, Germany is paving the way for digitalizing its financial markets.
The Result: The Bill now proposes to remove the global note requirement. It sets out a legal framework for the issuance of electronic bearer bonds including those issued as security tokens on a blockchain. The Bill is another milestone in the provision of legal certainty for blockchain‑based securities in Germany after the introduction of the crypto custody license as of January 1, 2020.
Looking Ahead: The Bill will provide legal certainty to issuers and institutional investors and boost the use of distributed ledger technology (“DLT”) for the issuance of blockchain‑based security tokens under German law. Permitting the exchange of existing traditional securities into electronic securities (“e-Securities”) (and vice versa) and the consolidation of both types of securities will open up the market for institutional investors. This legislation comes ahead of an expected EU‑wide legislative initiative on crypto assets toward the end of 2020.
Under German civil law, the issuance of a bearer bond requires a paper‑based document with a wet ink signature (with the exception of certain government bonds). Even though a security issued as a paper‑based (global) note can be transferred electronically through the securities settlement system, the requirement of a paper‑based (global) note presents a major practical restriction on issuing German law securities in token form on a blockchain. Accordingly, security tokens under German law have, to date, taken the form of a subordinated participation right which is not subject to a paper note requirement.
The Bill permits the issuance of securities in electronic form. For the time being, these e-Securities are limited to bearer bonds, but the Bill is designed to permit other forms of securities, such as shares or fund units, to be issued in electronic form going forward.
The Bill provides that for e-Securities the requirement of a paper‑based note is replaced by the entry of the e-Securities into a register operated by a supervised entity. The register may be a central register that must be operated by a central securities depositary (“CSD”) under a CSD license. Alternatively, the register may also be a decentralized register, a so-called crypto security register (Kryptowertpapierregister), in order to permit the issuance of blockchain-based e-Securities as security tokens, which the Bill refers to as crypto securities and treats as a sub-category of e-Securities.
The crypto security register may be operated by the issuer or a third-party registrar appointed by the issuer. The crypto registrar will be subject to regulatory supervision by the Federal Financial Supervisory Authority, or BaFin, and will require a license for the provision of crypto security registration services (Kryptowertpapierregisterführung) with an initial capital requirement of EUR 730,000. That license is to be distinguished from the license for the provision of custody services for crypto assets (Kryptowerte) for others (including the custody of private keys for crypto assets and crypto securities). That is a separate license that only requires a capital of EUR 125,000.
Terms and Conditions and Transfers
The terms and conditions of e-Securities (and any amendment thereto) must be submitted to the registrar in electronic form. The issuance of e-Securities must also be published in the official gazette in Germany, the Bundesanzeiger. Transfers will be effected by an agreement between the buyer and the seller and an instruction by the buyer to the registrar to register the buyer as the new holder of the e-Securities.
Consolidation With Traditional Securities
The Bill also provides for an exchange and consolidation mechanism that will help kick-start the market for e-Securities. Issuers may exchange their existing securities into e-Securities and vice versa, and both can be consolidated into a single series. e-Securities can also be registered in the name of a CSD and can then be cleared and settled under the existing systems. For regulatory purposes, including the Markets in Financial Instruments Directive (“MiFID”) and prospectus requirements, they are treated the same way as traditional securities. The exchange and consolidation mechanism and the regulatory treatment in line with traditional securities will facilitate the generation of a meaningful volume and liquidity of securities needed for a functioning market and make it attractive for both, issuers and (institutional) investors.
Three Key Takeaways
- While to date, security tokens have been issued in the form of participation rights, the Bill proposes a new framework to provide legal certainty for issuing bearer bonds in electronic format, removing the requirement for a (global) note in paper form. These e-Securities may also be issued as security tokens on a blockchain as crypto securities. For regulatory purposes (including MiFID and prospectus requirements), e-Securities (including crypto securities) are treated the same way as traditional securities.
- Issuance will be by way of registration of the e-Securities in a register that can (i) either be a central register operated by a regulated CSD or (ii) in order to permit blockchain-based crypto securities, a decentralized register operated by the issuer or a third-party registrar appointed by the issuer. The operation of a decentralized register will require a license from the German regulator.
- Under the proposed framework, traditional securities can be exchanged for e-Securities and vice versa. e-Securities can also be consolidated with traditional securities of the same series. This will help to generate significant volume and liquidity of e-Securities which is required to kick-start the market for e-Securities (including crypto securities) and attract institutional investors.
The authors are lawyers at the global law firm Jones Day. The views and opinions set forth herein are the personal views or opinions of the authors; they do not necessarily reflect views or opinions of the law firm with which they are associated.