The German Federal Ministry for Justice and Consumer Protection and German Federal Ministry of Finance recently published their draft for the proposed “act to introduce electronic securities”.
In the implementation of the fifth European Anti-Money Laundering Directive (AMLD5), the German Federal Government focused on the regulation of crypto assets. Following on from this, the federal ministries of justice and finance recently published a proposal to further digitalise the world of securities. The Electronic Securities Act (Gesetz über elektronische Wertpapiere – eWpG) would allow the issue of bearer bonds (Inhaberschuldverschreibungen) without a physical securities certificate. Along with some changes regarding crypto depository services, the eWpG would also introduce a new financial service, 'the crypto securities register management' (Kryptowertpapierregisterführung).
Electronic Security: What is covered?
The draft eWpG covers bearer bonds (Inhaberschuldverschreibungen) only. As according to the explanatory statement, demand in this particular market is the highest. This is the conclusion after measuring all Token emissions, meaning all Tokens classified as a security by German regulator BaFin. These Token represent claims under the law of obligations.
The proposed rules, however, are purposely left open to allow for a later adjustment of the scope of application. In regards to electronic stocks, amendments in corporate law would become necessary which is why this has currently been left out.
According to the draft eWpG, securities can be issued electronically. Such electronic securities are issued through a record in a newly established electronic securities register, instead of issuing a (paper-based) securities certificate. Electronic securities are supposed to carry the same rights and obligations as physical, certificate-based securities. It can be issued as “simple” electronic securities which are recorded with a regulated central securities depositary (CSD) in a central securities register or as crypto securities which are recorded with a crypto securities registry. The draft is insofar not technology exclusive.
Publicity through registry
The draft proposes a copy of the existing system to the digital sphere. So far, securities have been stored as a physical certificate with a CSD. The investors receive a ticket in their depot through their depot bank which facilitates possession and thus property. The physical certificate will now be omitted, but the ticketing process remains the same. The CSD is the holder of the electronic securities, and the investor remains the carrier of the corresponding rights and obligations.
In the case of crypto securities, the entry is done via a crypto securities registry. The management of a crypto securities registry is decentralized and may be provided by the issuer. The holder of crypto securities is the person whose name is registered with the crypto security in the crypto security registry. The 'Entitled' is the person who carries the rights and obligations corresponding with the securities.
The proposed eWpG-process corresponds with today’s standard of a paper-based certificate with a CSD or the management of a decentralised registry by the issuer (or a service provider) of a Security Token.
At the same time this means a radical change; the investor obtains property rights to an electronic security. It becomes an object in the sense of German civil law.
An electronic bond: an object
Electronic bonds are proposed to be full electronic securities, and generally, all rules regarding certificate-based bonds apply. The electronic bond becomes an object (in the sense of section 90 of the German Civil Code) by legal fiction. This is an essential quality needed to allow property rights.
The transfer of an electronic bond is done via a record or change in a record in an electronic securities registry. The proposal provides for bona fide purchases. A bona fide purchase shall be possible from the person recorded in the securities registry.
The difference to tokenised securities
BaFin approved the first securities prospectus for a tokenised bond some time ago, so, what is new in the eWpG?
All BaFin-approved tokenised bonds left many questions unresolved. Technically they have all been capital investments that were made negotiable via tokenisation, which led BaFin to qualify these as securities sui generis; however only in the case of supervisory law and prospectus regulation. This led to a split of supervisory law and civil law. According to German civil law, tokenised bonds have (so far) not been securities because civil law requires a certificate. The definition of securities is also not fulfilled under depot regulation. The main critique to BaFin’s practice was that Security Tokens were not transferred like classic securities and have therefore been non-negotiable. The draft eWpG seeks to remedy this through granting the same property and trading protection to electronic securities to paper-based securities.
The electronic securities that are covered by the draft eWpG do however represent a bearer bond. Bearer bonds are securities. All existing securities sui generis will not be covered as they are “only” tokenised capital investments instead of bearer bonds. It is possible to continue issuing tokenised capital investments as securities sui generis that are not covered by the draft eWpG. Those will continue to be qualified as securities only in the application of prospectus regulation, but not according to civil law or depot regulation. A lasting coexistence will depend on the attractiveness of the new legal framework.
A new financial service: Crypto securities registry management
The draft eWpG introduces a new financial service, the crypto securities registry management (Kryptowertpapierregisterführung), and anyone who manages a crypto securities register in the sense of the draft eWpG must obtain a licence as a financial services institution.
The issuer of a crypto security must name a crypto securities registry manager. The issuer who does not name such a manager, shall itself be a register managing entity. Whether this would trigger a licence requirement is currently unclear.
A crypto securities registry must be managed through a decentralised, tamper-proof recording system that records all data in a time series and, save these from unauthorised deletion or subsequent changes. The registry manager is obliged to fulfil the orderly entry of securities and the orderly change of entries. Consumers shall receive a register excerpt every time there is a change of the registration, or at least once a year. The registry manager is liable for any loss of data and unauthorised changes.
The registry management does not pose as a depository service of a crypto security.
Requirements for a licence are high. The initial capital must be at least EUR 730,000. In comparison, a crypto depository services requires initial capital of EUR 125.000. The liability as well as the public function are given as reasons to require this high amount of initial capital for registry managers. A crypto securities registry manager (that does not offer any other financial service) can, at the same time, expect the same simplifications and exemptions as a crypto depository service provider. This includes the exemption of additional provisions regarding the equity base (section 10 of the German Banking Act – KWG), capital buffers (sections 10c to 10i KWG), liquidity requirements (section 11 KWG), rules governing large-scale loans and loans to executives and staff (sections 13, 14, 15 KWG) as well as CRR provisions (Article 39,41,50 to 403 and 411 to 455 Regulation (EU) Nr. 575/2013).
Changes to crypto depository services
Crypto depository services were introduced as financial services in the German Banking Act (KWG) in January 2020. Transition periods still apply. Now the field of activity for crypto depository services providers shall be amended to cover electronic securities. In the future, the “safekeeping of private cryptographic keys, that are meant to store, save or dispose over crypto securities for others following section 4 paragraph 2 of this act via electronic securities” will be a crypto depository service.
The demarcation of crypto depository services and securities deposit business will be relevant. Electronic securities (which includes crypto securities) will be covered by the Securities Deposit Act. The storage of crypto securities shall, therefore, be a security deposit service instead of a crypto depository service. A crypto depository service may only offer the storage of cryptographic keys that enable the user to access crypto securities.
Crypto assets and their storage represent a catch-all element that is subsidiary to securities regulation. This means simplified rules for crypto assets do not cover crypto securities (or: crypto securities are securities, not crypto assets). Crypto depository services for crypto securities thus only applies to the storage of cryptographic keys, that allow access to crypto securities. In the case of crypto assets, however, the asset itself, (meaning private and public keys), may be stored in a way that allows generation and storage of both keys by the depositary. The practical application remains unclear.
The eWpG offers Germany the chance to boost both digitalisation and the German financial market. In contrast to the current handling of token emissions, it offers the advantage of a legal framework, and thus security, to issuers and investors. Whether electronic securities will be approved in this form and the type and scope of changes to follow in parliamentary proceedings will be eagerly awaited.