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5 July 2019

Cryp­to to­kens and dis­tribut­ed ledger tech­nol­o­gy – a fi­nan­cial mar­ket per­spec­tive

  • Distributed ledger technology (DLT) is emerging as a basic technology of the digital age.
  • The issuance of crypto tokens could become a new form of financing for start-ups and small and medium-sized enterprises.
  • The German Ministry of Finance is working together with other ministries to create a national regulatory framework for crypto tokens. The aim is to unlock the potential of DLT and crypto tokens while also preventing misuse.

Introduction

The German government has set out to shape the advance of digital technologies in business, work and society in such a way that everybody benefits. This includes the goals set out in the coalition agreement of March 2018: to unlock the potential of blockchain technology, prevent possible misuse, and consolidate Germany’s role as one of the world’s leading digital technology and fintech locations.

Under the leadership of the Federal Ministry for Economic Affairs and Energy and the Federal Ministry of Finance, the German government is currently developing a comprehensive blockchain strategy that goes far beyond the financial market-related aspects outlined in this article. In a first step, the Federal Ministry of Finance and the Federal Ministry for Economic Affairs and Energy set up an online consultation process, which met with a very positive response. The consultation process covered a broad range of possible applications. In addition to the financial sector, it encompassed the energy industry, the health care sector and the mobility sector, as well as transportation and production in complex supply chain and value chain systems. Associations, companies, organisations, research institutions and civil society stakeholders submitted more than 150 statements. These will feed into the final blockchain strategy, which is to be completed over the summer of 2019. There will also be a careful review of the capabilities of blockchain technology and how they compare to those of other digital technologies. In addition, it is being examined whether and how blockchain technology is compatible with or conducive to achieving other policy objectives, such as ensuring maximum data protection and sustainable resource utilisation.

DLT, and blockchain technology in particular, is seen as an emerging basic technology of the digital age. It allows for the tamper-proof storage, processing and transfer of information, assets and rights. Germany – and Berlin in particular – has become a globally recognised centre for this technology, with a high degree of creative potential.

Distributed ledger technology (DLT)

DLT allows information to be recorded on a decentralised database across multiple computer systems. DLT is usually based on public-key cryptography, a cryptographic system that uses pairs of keys: public keys which are publicly known and used for identification, and private keys which are kept secret and used for authentication and encryption.

Blockchain

A blockchain is a type of distributed ledger in which information is grouped into blocks. The blocks are linked in chronological order using cryptography and are saved on distributed databases.

The first practical application of blockchain technology was bitcoin, which was released in 2009. It was originally developed to facilitate online payments without the need for a “trustworthy third party” – usually a financial services provider – to act as an intermediary. Since 2015, Initial Coin Offerings (ICOs) have emerged as a new, DLT-based form of financing. ICOs are a process by which project initiators or companies (usually very young businesses) raise capital for their projects by selling virtual currencies or other crypto tokens. In 2018, the amount raised through ICOs worldwide was in the low double-digit billion euro range. At the beginning of 2018, the market capitalisation of virtual currencies and crypto tokens stood at approximately €700 billion. Over the course of 2018, however, there was a sharp market contraction, leading to significant losses for investors. Nevertheless, the issuance of crypto tokens has the potential to become a new form of financing, especially for start-ups and small and medium-sized enterprises (SMEs), provided that sufficient levels of investor protection and confidence can be achieved.

Crypto tokens

Crypto tokens or crypto assets are a digital, cryptography- and DLT-based representation of an intrinsic or perceived value. This value can be based on a wide range of functionalities, properties or rights associated with the token. In simplified terms, there are three categories of crypto tokens, although many tokens have characteristics associated with more than one category:

  1. Payment tokens (virtual currencies): These tend to fulfil the function of a private means of payment (either exclusively or as one of several functions). They generally have no intrinsic value and are not issued by a central bank.
  2. (Quasi-)security tokens (equity and other investment tokens): These tokens give investors membership rights or contractual claims on assets (similar to those associated with shares and debt securities).
  3. Utility tokens (app tokens or user tokens): Utility tokens can be used to purchase goods or services, but only within the network of the issuing institution. Utility tokens tend to have very complex legal structures.

Supervision of crypto tokens and DLT

Since the early days, the Federal Financial Supervisory Authority (BaFin) has played an active role in the emergence of DLT and of the market for crypto tokens. In 2011, BaFin classified bitcoin and comparable tokens that were intended to function as private means of payment as financial instruments in the form of units of account (see section 1 (11) sentence 1 no. 7 of the Banking Act (Kreditwesengesetz)). As a result, commercial transactions (or transactions conducted on a commercial scale) involving payment tokens can be classified as banking and financial services requiring authorisation. Having been classed as institutions, the issuers are obliged entities under the Money Laundering Act (Geldwäschegesetz). This in turn means that, thanks to its Money Laundering Act and its Banking Act, Germany has been addressing some of the main risks associated with crypto tokens since 2011, including the risks of money laundering and terrorist financing as well as risks for investors.

The relative anonymity of payment tokens means that they can be misused for criminal and terrorist purposes. However, Germany’s money laundering legislation limits this anonymity by imposing obligations on the banking and financial services sector. Service providers operating within the scope of the Money Laundering Act are obliged to identify their customers, including those using payment tokens, and to report suspicious transactions to the Financial Intelligence Unit.

The obligation to obtain permission for banking transactions and financial services involving payment tokens also protects customers and investors, as the institutions concerned must comply with the relevant rules under the Banking Act. As numerous investor scandals at international crypto exchanges in recent years have shown (e.g. MtGox in Japan and Quadriga CX in Canada), investors face considerable risks, particularly with regard to services involving crypto tokens. Rules on proper business organisation would be a means of counteracting these risks.

BaFin warned of the risks of ICOs as early as November 2017.1

In addition to addressing the risks associated with new financial technologies, creating legal certainty is crucial to the development of these technologies. To complement various earlier publications, BaFin therefore issued an advisory letter on the supervisory classification of tokens underlying ICOs in February 2018.2

Electronic securities and ICOs

As the first measure to be implemented as part of the German government’s blockchain strategy, the Federal Ministry of Justice and Consumer Protection and the Federal Ministry of Finance jointly published a “Key-issues paper on the regulatory treatment of electronic securities and crypto tokens – Allowing for digital innovation, ensuring investor protection”3 on 7 March 2019. A hearing on this paper was held on 7 May 2019. The key-issues paper is intended as a preparatory step for draft legislation that will (a) allow for the electronic issuance of securities via DLT systems and (b) regulate public offerings of certain crypto tokens.

Electronic securities

Under current law, securities must be represented by physical certificates in paper form. The key-issues paper cited above proposes that German legislation should be opened up to electronic securities. The option of issuing securities electronically will be introduced as an alternative to the tried-and-tested system of securities certificates. The rules will be technologically neutral, meaning that they will cover but not be limited to DLT. To begin with, the change will be restricted to electronic securities; rules on electronic shares will be introduced at a later stage. The option of issuing electronic securities without the need for certificates will save issuing houses time and money. The proposed change will also boost Germany’s competitiveness in the financial sector, given that other EU member states and Switzerland already allow “paperless” securities. At the same time, the possibility of issuing securities without certificates is a prerequisite for DLT-based securities.

Following the model of the Federal Debt Management Act (Bundesschuldenwesengesetz), electronic securities will be created by means of an entry in a register. This register will take on the documentation function currently fulfilled by the security certificate. The register will preserve the core elements of a security – first, the legitimation function (meaning that a legal presumption in favour of the creditor is linked to the holding of the security), second, the release effect (meaning that payment to the holder of the security frees the debtor from his/her obligation unless he/she has positive knowledge of ineligibility), and third, the transfer function (meaning that the right arising from the security follows the right to the security). For this reason, rigorous standards must be imposed with regard to the reliability of register maintenance and the accuracy of the register’s contents in order to ensure the securities’ authenticity (i.e. the identity of the originator) and integrity (i.e. that they have not been altered since they were drawn up).

To prevent any possibility of manipulation, the paper proposes that the issuing institution should generally not be permitted to maintain the securities register itself. Instead, the register should be kept by a central government agency or an agency that is under government supervision. If the use of DLT systems eliminates the possibility of unauthorised changes to entries in the securities register – in other words, if the technology guarantees the authenticity and integrity of securities to the same extent as tried-and-tested systems and procedures – the paper suggests that the issuing institution itself or a third party instructed by the issuing institution should also be permitted to maintain the register.

Public offers of crypto tokens

Many of the crypto tokens issued through ICOs in recent years cannot be classified under supervisory law as securities, capital investments or other financial instruments, even though they essentially serve the purpose of investment vehicles and are traded on trading venues. Public offers of such tokens are therefore not subject to existing capital market rules (in contrast to the future issuance of electronic securities). There is currently no legal obligation to publish a prospectus or information sheet prior to a public offer of such tokens. So-called “white papers” are routinely published nevertheless, but these are not comparable information and liability documents. They tend to contain only insufficient information about the project, the risks, and the rights associated with the tokens and any potential conflicts of interest. As a result, they do not normally help investors to make an informed investment decision. However, investing in crypto tokens involves substantial risk. The need to create adequate risk-disclosure obligations was also highlighted by the European financial regulator ESMA in its advice to the European Union institutions on initial coin offerings and crypto-assets, which was issued on 9 January 2019.4

Against this background, the key-issues paper proposes the possibility of regulating public offers of such tokens. For example, before ICOs, issuers could be legally required to publish an information sheet that meets certain legal requirements and whose publication has been authorised by BaFin.

Transposition of the Directive amending the Fourth EU Anti-Money Laundering Directive

As virtual currencies and other crypto tokens have become more widespread, the risk of abuse has increased. As part of their efforts to combat money laundering and terrorist financing, the members of the G20 agreed in early December 2018 to regulate crypto tokens. The amending directive to the Fourth EU Money Laundering Directive (EU) 2018/843 follows the same objective. In order to combat money laundering and terrorist financing, certain service providers will be obliged to comply with money laundering requirements and will be monitored by the competent authorities.

Under the directive, service providers who exchange virtual currencies for fiat currencies and vice versa as well as custodian wallet providers are obliged to comply with money laundering provisions. The term “custodian wallet provider” is defined as any entity that provides services to safeguard private cryptographic keys on behalf of its customers, to hold, store and transfer virtual currencies. The term “virtual currency” is broadly defined in the directive. According to the recitals, it is intended to cover all potential applications of virtual currencies. Their use as means of investment is specifically mentioned as an example.

In Germany, service providers who exchange virtual currencies for fiat currencies and vice versa, but also – and this goes beyond the EU directive – those who exchange virtual currencies for other virtual currencies, are already generally classified as financial services companies and thus obliged entities under section 2 (1) no 2 of the Money Laundering Act. However, Germany’s money laundering and supervisory legislation does not currently cover commercial trading in crypto tokens that do not have the characteristics of payment tokens and do not fall under the other categories of financial instruments set out in section 1 (11) sentence 1 of the Banking Act, nor does it cover custody of cryptographic keys and virtual currencies.

On 20 May 2019, the German Ministry of Finance initiated a consultation of associations on the draft law transposing the amending directive to the Fourth EU Anti-Money Laundering Directive. In order to implement the requirements of the directive with respect to virtual currencies, the draft legislation introduces the new term “crypto assets” to cover all uses of virtual currencies. Under the legislation, a “crypto asset” is a digital representation of an asset that has not been issued or guaranteed by any central bank or public body and does not have the legal status of a currency or money, but is accepted by individuals or legal persons as a means of exchange or payment or serves investment purposes on the basis of an agreement or actual practice, and that can be transmitted, stored and traded electronically. This covers not only payment tokens, but also crypto tokens used for investment purposes, regardless of whether they qualify as securities or investments, for example. Furthermore, the draft legislation classifies the crypto custody business as a new financial service and crypto assets as new financial instruments.

This, in conjunction with the existing provisions in section 1 (1a) of the Banking Act and section 2 (1) no 2 of the Money Laundering Act, means that certain service providers will be classified as financial service institutions requiring authorisation and be subject to money laundering obligations specifically on account of conducting business with crypto assets.

Tax treatment of crypto tokens

As well as introducing capital market rules relating to crypto tokens, the German Finance Ministry is also tackling the associated tax challenges. A Finance Ministry circular on the VAT treatment of virtual currencies5 was published on 27 February 2018. The German Finance Ministry is currently working on a set of administrative instructions on the tax treatment of various scenarios involving virtual currencies. This is intended to provide practical guidance for all parties involved. Prior to publication, the draft needs to be coordinated with the highest revenue authorities of the Länder.

Summary

By international standards, Germany is well positioned in the area of DLT and crypto tokens. Berlin in particular has established itself as a globally recognised centre of technological development in this area. In contrast to other countries, Germany already has rules – specifically, the obligation to obtain permission to provide commercial financial services involving payment tokens – that largely address the need to protect investors and mitigate the risk of money laundering. Germany’s draft legislation transposing the amended EU Anti-Money Laundering Directive makes further improvements to its existing systems combatting money laundering and terrorist financing and protecting investors and customers, not least in the area of crypto tokens. At the same time, the planned introduction of electronic securities creates the legal framework that is needed to enable further DLT innovations in Germany. The proposal to regulate public offers of certain crypto tokens currently under discussion also aims to further increase the level of protection. With these implemented and planned measures in the area of crypto tokens, the German Ministry of Finance is making an important contribution to ensuring that Germany continues to play a leading role when it comes to DLT-based innovations, while at the same time protecting consumers.

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