Emerging blockchain ecosystems may be one of the most potent game-changers in financial and legal services over the next decade as some European countries have made substantial progress in terms of using and supporting distributed ledger technologies (“DLT”), today commonly known as “Blockchain”. Blockchain technology is applied in different sectors including the financial sector. In the context of blockchain technology, various legislative projects are currently being pushed forward in Europe. In this post, we focus on the imminent German blockchain legislation on digital securities that is expected to become law within the next 9 months.
On December 16, 2020, the German cabinet passed an official draft bill for a new statute allowing all-electronic securities to be recorded using blockchain technology: “Entwurf eines Gesetzes zur Einführung von elektronischen Wertpapieren” (“Draft bill on the introduction of electronic securities”). The government draft follows a draft bill from August 11, 2020 and implements some editorial smoothing and more importantly, recognizable points of criticism and encouragement from the industry and legislators, which became apparent during the commenting procedure. The new law comes at the same time as an EU‑wide legislative initiative on crypto–assets and is expected to take effect in 2021. The political background is that Germany, especially Berlin, is a major hub for blockchain developers and projects. Ethereum was partly developed by its Berlin-based members. Consequently, from 2016 on, the German legislature and government were learning about this new technology. When the new coalition government formed in 2017, the agreement among the governing parties mentioned blockchain technology as one of its main areas of focus.
Recent initiatives in Luxembourg, Liechtenstein, Switzerland and Poland
In general, when classifying the various initiatives, it is important to make a clear distinction between the dematerialization of securities (“Entmaterialisierung der Wertpapiere”) and the possibility of using distributed ledger technologies for the circulation of securities (“Mediatisierung des Wertpapierrechts”). Luxembourg took the first step in terms of providing legal clarity on the use of blockchain and DLT technologies. The law of March 1, 2019, on the use of new technologies for holding and moving financial instruments entered into force on May 5, 2019. Starting from the principle of technology neutrality, the Law explicitly recognized the possibility of using DLT for the circulation of securities. In continuation of the law of 2019, the Luxembourg government will take the issuance of dematerialized securities a step further. On July 27, 2020, it submitted a bill of law n°7637 to the Luxembourg Parliament that extends the scope of central account holders to include any credit institution or investment firm authorized in a member state of the European Economic Area, provided they meet certain organizational and technological criteria. Currently, only Luxembourg credit institutions or investment firms, or Luxembourg branches of credit institutions or investment firms authorized in another Member State can act as central account keepers. With the new law, issuers from around the world will be able to rely on a legal framework to issue and settle securities directly by using DLT.
The Swiss law, as well as the Liechtenstein law and the Polish law, deals exclusively with dematerialization. On October 3, 2019, the Parliament of Liechtenstein unanimously adopted the Token and TT-Service Provider Act (TVTG), a “comprehensive regulation of the token economy”. The Liechtenstein Blockchain Act came into force in January 2020 and allows straightforward tokenization of all kinds of assets and rights. The law is designed to enable crypto and blockchain projects to thrive, while at the same time providing consumers with a basis for trusting in these new technologies.
In late September of this year, the Swiss Parliament unanimously approved a Federal Act on the Adaptation of Federal Law to Developments in DLT (so-called “DLT Bill”), which amends several provisions in ten existing laws. The Swiss “blockchain act” will provide a clear legal framework regarding cryptocurrency trading and how it relates to securities laws. Under the new law, a well-defined legal basis for the trading of digital-only securities has been created. The reformed law also helps outline the legal processes for reclaiming digital assets from bankrupt companies. Switzerland currently houses about 900 blockchain companies with an estimated total staff of about 4,700. These figures will probably increase when the new bill comes into full effect. This Act is aimed to allow Switzerland to continue developing as a leading country for blockchain and DLT companies. The amendments to the Code of Obligations, the Federal Intermediated Securities Act and the Federal Act on International Private Law that are envisaged in the DLT bill will now enter into force from 1 February 2021. These provisions enable the introduction of ledger-based securities that are represented in a blockchain. The remaining provisions of the DLT bill will probably enter into force on 1 August 2021.
The Polish legislator has also recently dealt with the problem of dematerialization; as of March 2021, all share certificates of stock corporations will be replaced by an electronic register entry system. The resulting transfer mechanism for electronic shares, which is based on a legal entry in the shareholders’ register, will promote the efficiency and security of share trading. The Polish legislator has opted for a standalone solution that deals exclusively with the dematerialization of shares. This regulation is advancing Polish securities law into a regulatory patchwork. It fails to provide for a complex framework for electronic and crypto securities, perhaps because the Polish legislator is waiting for results at the EU level.
Digital Finance Package of the European Commission
On September 24, 2020 the European Commission (EC) launched proposals for a new EU-wide regime to regulate crypto-assets and DLT in the financial sector through a Digital Finance Package. The regulations are proposals of the EU Commission, which are being discussed in the European Parliament and Council. They are expected to come into force by 2024 at the latest. The intention is for the new regime to be directly applicable in all EU member states, replacing existing national frameworks applicable to crypto-assets such as the existing laws in Luxembourg and Liechtenstein.
According to the EC, the proposed “Regulation on Markets in Crypto Assets” (“MiCAR”) is supposed to “boost innovation while preserving financial stability and protecting investors from risks”. MiCAR aims to replace existing national frameworks on crypto-assets and has a very broad scope. The draft regulation defines the term “crypto-asset” broadly as “a digital representation of value or rights which may be transferred and stored electronically, using distributed ledger technology or similar technology”. According to initial estimates by the EC, this would currently include around 150 service providers, for example cryptocurrency trading platforms. The EC wants to implement MiCAR to “provide legal clarity and certainty for crypto-asset issuers and providers.” Operators authorized in one Member State shall be allowed to provide their services across the EU (this is called “passporting”). But this comes with a security net, the EC adds: “Safeguards include capital requirements, custody of assets, a mandatory complaint holder procedure available to investors, and rights of the investor against the issuer. Issuers of significant asset-backed crypto-assets (so-called global ‘stablecoins‘) would be subject to more stringent requirements (e.g. in terms of capital, investor rights and supervision).”
Crypto-assets that are already caught by existing financial services legislation will not be covered (e.g. financial instruments). Current crypto-assets that qualify as financial instruments or electronic money (except e-money tokens) still fall under the requirements of their respective directives (MiFID II, Electronic Payment directive, Prospectus and Transparency Directives, CSDR, etc.) and within the context and legal framework that is currently in force.
Furthermore, MiCAR is not intended to establish civil law rules for crypto-assets, in particular their transfer as provided for in the recent German legal initiative. The basic civil law treatment of crypto-assets is generally subject to national law and may not be harmonized at a European level.
Germany’s Blockchain Strategy
Until now the German Civil Code forced issuers and holders of securities to document transactions with a paper certificate. The rules describe a certificate as a statement of thought embodied in writing in which the issuer promises to render performance to the bearer, making a physical certificate mandatory. In the way of market developments in the digital world, this presents a major hurdle to digital innovation and the use of DLT.
Last year the German government released its 24-page blockchain strategy, showing a commitment to supporting the use of the technology. The document outlines the national approach to blockchain project funding, sustainability, and digital identity. The strategy broadly aims to exploit the opportunities offered by blockchain technology and its potential to mobilize for digital transformation. The blockchain strategy includes the goal of modernizing German securities law, focusing on financial applications and making the German market more attractive to issuers and investors looking to do deals.
In implementing this strategy the legislator has drafted a proposal for digital securities that could trigger a revolution in German capital markets. When Chancellor Angela Merkel’s cabinet passed the new legislation in December 2020, Finance Minister Olaf Scholz said: “The paper certificate may be dear to some for nostalgic reasons, but the future belongs to its electronic version. Electronic securities cut costs and administrative burdens.”
A blockchain entry in a central securities depository will replace the requirement for a (global) note in paper form. In the future, there will be other registers that perform the same function in addition to the central securities depository Clearstream. The legislator also makes it possible for issuers themselves – possibly even major industrial corporations – to operate a registry for their own securities. The new law differentiates between the central register of electronic securities and the register of crypto securities. For regulatory purposes (including MiFID and prospectus requirements), electronic securities and crypto securities are treated the same way as traditional securities. As far as crypto securities are concerned the new law regulates the dematerialization of securities as well as the use of DLT for the circulation of securities.
Dematerialization of physical securities: Electronic Securities
The core of the draft law is the opening of German law for electronic securities. Electronic issuance of securities will also be made possible outside the use of blockchain technology and comparable distributed ledger technologies. This means that the current mandatory certification of securities will be abandoned. In the future, issuers will have the right to choose whether they want to issue securities by means of a certificate or electronically. The main difference from traditional securities will thus be the change of data medium for the statement, from paper to digital.
The draft addresses a step-by-step digital transformation and initially opens doors only for electronic bearer bonds (plural “Inhaberschuldverschreibungen”) and fund units. While this law creates a legal fiction of a digital bond, ownership is controlled by the registry and not something in possession of the investor. Since no costs will be incurred to keep physical certificates in safe custody, decreased transaction costs are expected. Shares and other assets will still be subject to the old paper regime.
Issuance will occur via registration of the electronic securities in a register that may be a central register operated either by a regulated central register of securities (CSD) or a custodian bank. The registering agency must ensure the initial registration of electronic securities, and document changes to the recorded content of rights. Issuers can start conversion from paper certificates to electronic securities without the consent of investors. Electronic securities can be exchanged for traditional securities. They can also be consolidated with traditional securities of the same series.
Two frequently criticized points regarding the draft bill from August 11, 2020 concerned the unclear wording- the draft bill used the term electronic securities as both a generic term and a subordinate term – and the fact that only licensed central securities depositories were allowed to maintain a central register for electronic securities. The government draft now introduces the term central register security for such electronic securities that are registered on a central register. This means that the term electronic security can now serve as a generic term without causing confusion.
In addition, under the new draft, central registers may be maintained by all other custodians licensed to conduct custody business in Germany. This opens up the keeping of registers to custodian banks.
The use of blockchain technology will not be privileged in any way. The government draft leaves it up to the market to establish and maintain the central register. The market will be free to decide if, and to what extent, new structures for the central register should be created, or whether the existing structures suffice. The rules on electronic securities are supposed to be technology neutral.
The draft bill’s main achievement will be the legal option to register crypto securities. A special feature here is that, in contrast to a central register of securities, no licensed central securities depository or custodian will be required. In order to permit holding and moving blockchain-based crypto securities, they may be registered. For reasons of investor protection, market integrity and ensuring a functioning and transparent market exchange, the entities maintaining a crypto securities register are to be placed under the supervision of the Federal Financial Supervisory Authority (“BaFin”). For this purpose, crypto securities registry management will be structured as a financial service. The issuer can maintain the register itself or assign a service provider to do so; thus, industry groups may maintain their own registers of securities. This is expected to yield efficiency gains.
However, not all crypto securities issued using blockchain technology or comparable technologies are intended to be electronic securities in the civil and regulatory sense. This is because there are high regulatory requirements and significant civil law consequences associated with property rights in securities. Therefore, the questions which crypto securities shall be within the property law provisions of securities will be determined with legal certainty.
Investor protection similar to rights in rem protection
Electronic bonds are defined in the draft as something that counts as property (“Sache” in German, i.e. a tangible object, a right in rem) granting them property rights and providing a level playing field in terms of legal status. This means that investors in electronic securities will generally benefit from the same ownership protection as in the case of traditional securities issued in the form of certificates. This is, for civil law dogmatists, treacherous territory because you cannot touch an electronic bond. But German law does have a tradition in this way, as it also states for animal protection that animals are not things in a legal sense but that the law of rights in rem apply to animals, unless the nature of an animal or animal protection laws prohibit this. Moreover, and importantly, the German law of tangible objects as rights in rem has been applied to bonds as deeds issued on paper for a long time, together with well-refined and longstanding case law, creating market stability and market trust. This is the reason why the German legislature wants to extend this tried and tested approach from old-fashioned bonds to electronic bonds. The official explanation for this historic background and the legal contortions of German law that draft tries to address is very explicitly mentioned in the draft and excerpts of this part should therefore be quoted in full.1
When it comes to the digital transformation of the law, it is important to note the law still follows the power of the beaten path. It is too simple to say that you should just allow digital processing of all legal transactions and securities in order to attain 100% digital transformation. If you digitize an area of law, new risks may arise. The legislature always needs to consider whether the people and rights that are supposed to be protected by any legislation will still be protected in a similar way.
Overall, the new German law introducing electronic securities is expected to make German financial markets more competitive, allowing issuers and investors to benefit from efficiencies and lower transaction costs.
Even though the draft law aims to be technology-neutral, it is expected that once implemented, DLT and blockchain technology will receive a boost and become more established in capital markets. Creating a civil law on the treatment of electronic securities and crypto-assets will significantly contribute to fostering Blockchain/DLT technologies in Germany.
U.S. capital market participants assert that a full dematerialization of securities will contribute to a more cost-effective, efficient, secure, and competitive U.S. marketplace. Germany follows a gradual and smooth approach in this context. Germany’s strategy behind the draft legislation is to take advantage of electronic securities’ benefits with as little transformation risk as possible and fit it into existing civil and supervisory laws as smoothly as possible. This is why the reform is encapsulated in a new separate statute and not yet inserted into the core of German civil law, the German civil code – that would happen later. Germany has a record of enacting major reforms of civil law in separate statutes in the beginning, in order to let the market and the legal community work with the reform as a whole. Once practical experience and case law has accumulated, the statute is integrated into the German civil code. This happened with major reforms as to general terms of trade and other consumer protection laws.
When it comes to blockchain technology, cryptocurrencies, and the tokenization of things, Germany is in a dichotomous position: the wealth of developers and funders is busily working in Germany on cutting-edge projects. Meanwhile, the German judicial system, which has served traditional capital markets well, is challenged by this technology as it is dogmatically still based on paper documentation and slow intermediaries. The German government and legislature are aware of this, which is precisely why it is trying to push the German legal and judicial system into the digital era on many ends. This proposed law is one cornerstone of this. While some may say that the proposal is not ambitious enough, as it is a specific law for specific securities and not a general dematerialization of assets and paper formalities in the core of the German civil system, others might say that this is the best that is possible under the circumstances and something that cannot be turned back. With this proposed law, the German legal system embarks for real into the digital era.
*Dr. Julia C. von Buttlar, LL.M. (Duke) is Deputy Head of Division at the BaFin’s Directorate for Securities Supervision.
The views expressed in this post are those of the author and do not reflect the views of the BaFin.
**Tom Hinrich Braegelmann, LL.M., Attorney and Counsellor at Law (New York) at Schalast.
1. “The publicity function of holding paper certificates, which is important for the tradability of securities, has already been effectively replaced in the case of securities traded on the financial market by the publicity of electronic bookings on securities accounts. The global certificates commonly used in today’s securities giro transactions are no longer moved. The “reification” of subjective private law asset rights by means of paper certificates has grown historically in German law. A digitally networked data transfer between the participants in legal transactions, as exists in the modern financial world, was not foreseeable at the time of the codification of the German Civil Code [in the year 1896]. With the creation of paper documents as reference objects of rights, it was possible to take into account the interest of potential purchasers in the protection of their rights.
This protection of the rights of market participants still functions very successfully today. For this reason, this bill does not impose any restrictions on the existing practice of issuing or holding documents.
[The statute] merely opens up an additional option. This option allows the issuer to dispense with the intermediate step of issuing a paper certificate and to carry out the issue directly as an electronic entry. This is neither intended to substitute the classic issuance by means of a paper certificate, nor is the electronic security intended to create a security of its own kind (functional approach). It is merely an extension of the forms that can be used and not an extension of the “numerus clausus” of securities. (…) An electronic security differs from other securities only in the form of issue chosen. The document is not in a deed, but in an electronic register. The change in the “storage technology” used for the embodied content of the right from paper form to digital does not change the legal nature of the security.
However, the nature of the “storage technology” results in a significant difference between the digital form of issuance and the paper form. It lacks a physical reference object, a thing. In order to actually achieve the desired parallelism with securities evidenced by certificates, the rights in rem fiction [of the statute] is therefore necessary.
Since electronic securities do not differ from conventional securities in terms of their legal nature, there is no need for any further provisions on the creation, enforcement and cancellation of electronic securities. The general rules of civil securities law, which are often not codified, remain in place and are deliberately not interfered with so as not to create a “sui generis” right. Special regulations are only made where the nature of the electronic document requires it, because the regulations of the document script are not transferable for factual reasons and therefore cannot be applied accordingly.
(…) The draft law does not wish to make any normative stipulations in the area of theories on the issuance of securities, as an isolated regulation only for electronic securities could lead to a divergence between the normative stipulations and the prevailing issuance theories for securities issued by means of certificates. The draft law wants to avoid a “sui generis” issuance theory for electronic securities.
No new designation such as “uncertificated securities” [“Wertrechte”] is to be introduced for electronically issued securities; instead, the historically evolved designation “security” [“Wertpapier”] will be retained even for “paperless” securities. This is also intended to avoid that, if securities are possibly only issued electronically in the future, established terms would also have to be renamed (…) The term “security” [“Wertpapier”] is a normative legal term, as illustrated in particular under regulatory law, which has even so far not required any documentary/physical embodiment.
(…) In order to avoid misunderstandings, [the draft statute] contains the explicit clarification that, due to the documentation used, there are in principle no differences to the legal nature and the legal effect of “paper securities”. (…) [T]here is therefore no room for interpretations that determine the legal nature of an electronic security differently from that of securities issued by means of a paper deed.”
(…) In order to maintain the connection to property law applicable to securities for electronically issued securities, a legal fiction is required which normatively qualifies the electronic security embodied in the register entry as a physical thing.
This fiction is necessary because only a new mode of issuance is to be introduced, but the legal nature of the security is not to be changed. This is because, not least in the event of insolvency, legal transactions rely on the legal effects in rem that they have hitherto known from securities. These legal effects have proven their worth. By virtue of fiction, they will apply in full to electronic securities.
The draft law combines the property law approach of German securities law with a register solution and, in doing so, goes beyond what is provided for in the current legal situation for securities issued by means of a deed in some respects, such as protection of good faith.
The fact that this fiction of rights in rem is not intended to put an end to the discussion as to whether it would make sense to make securities – along the lines of the Swiss intermediated securities law – a new sui generis right. This decision should be made in the context of a comprehensive reform of German securities and custody law. It would not make sense to make only electronic securities a new sui generis right, while traditional securities held in collective custody would continue to remain things; rather, the legal nature should be regulated uniformly.
(…) As the discussions on the EU Commission’s proposals (which are currently not being pursued) for harmonizing substantive securities law have shown, this would require an elaborate synchronization with the booking procedures of the current custody system in order to keep the resulting conversion effort low for practitioners. The present draft law is not intended to anticipate such a reform. It is therefore impossible to say at this point in time whether the concept here represents a bridge solution in the direction of an accounting-based law for capital market securities.”