Digitization has led to significant changes in many areas. The financial markets cannot ignore these new developments either. One of these innovations in recent years has been the development of blockchain-based technologies. These enable stock rights with any content („tokens“ or „coins“) to be transferred electronically from the seller to the buyer without having to involve third parties. The first relevant use case of a blockchain technology took place in 2009 with the development of Bitcoin. The Bitcoin should enable online payments directly between the contracting parties without a financial service provider’s involvement, which is necessary with current online payment systems. More and more startups discovered the potential of virtual currencies or other crypto tokens as a quick and unbureaucratic form of financing in the years that followed. However, due to the possible anonymity when using cryptocurrencies, they also became interesting for an illegal business of all kinds. As a result, the legislator increasingly focused on the need to create statutory regulatory mechanisms. In this regard, the first step was the Bitcoin’s qualification and other crypto tokens used as private means of payment as units of account within the German Banking Act (KWG).
But now Germany is about to move five steps ahead with legal digital securities and shares
The development described was already characterized by the fact that other countries enable the electronic issuance of securities and, in some cases, also provide regulations for blockchain securities. In this context, there is a risk that Germany’s attractiveness as a financial center could be reduced if there are no corresponding regulations in Germany. The Federal Republic of Germany now wants to modernize its securities law. For this purpose, a ministerial draft of a proposal to introduce electronic securities has been submitted.
Takeaway 1: Germany is dead serious about blockchain. Period.
The draft law’s primary goals include the modernization of securities law and the financial center’s strengthening. In doing so, investor protection should be considered. Simultaneously, the creation of legally secure regulatory frameworks and supervisory structures is intended to protect and improve the integrity, transparency, and functionality of the financial markets. Likewise, by lawfully creating legally reliable solutions, technological innovation’s security is to be increased, and the conditions for changes in the financial sector are to be improved.
The message is clear: Germany takes blockchain seriously. After a very optimistic bockchain strategy was published by the German government as early as 2019, things are now – despite Covid-19 – continuing. As a financial player, Germany also wants to play a significant role in decentralized finance. However, this requires one thing for all blockchain users: a secure legal framework. It’s the most fertile ground for new technologies to flourish. At the beginning of 2020, a law already came into force that allows German banks to sell cryptocurrencies to their customers. Now the next step – shares and other digital assets on the blockchain. The German government shows: We are committed to the blockchain as the technology of the future.
Takeaway 2: Germany will treat electronic and physically securitized securities equally
The draft law is based on the legal situation in other countries that have already made progress in this regulation area. An entry in a securities register can replace the currently mandatory physical security certificate for bearer bonds.
In electronic bonds, the security certificate is to be replaced by an entry in a securities register. Such a securities register can be kept „classically electronically“ and crypto-based via DLT, especially in the blockchain. Collective entries in the name of a securities depository bank can also be made in the securities register. It links the old and the new world and allows electronic securities to be booked in a deposit. The electronic securities registers’ management is to be monitored by the Federal Agency for Financial Market Supervision (BaFin). At the same time, there should be a central register for electronic securities. A fundamental point for the acceptance of securities is their legally secure simple transfer. Accordingly, it is provided in the law that the transmission of ownership of electronic security is possible on the holder’s instructions to the purchaser by an appropriate agreement and that the securitized right is also transferred. At the same time, it is regulated that acquisition in good faith is always possible as long as the acquirer did not know positively at the time of his entry or was unknown to him as a result of gross negligence that the contents of the securities register were incorrect or that the owner was not authorized or the seller was authorized to dispose of. The legislature thus maps the classic transfer in securities trading. There is no difference in handling between electronic and physically securitized securities from a practical point of view.
Germany is a country where caution plays a significant role. Where people stick to regulations and are often sceptical about change. My history teacher once said: When German revolutionaries want to occupy a station, they first buy a train ticket. It is, therefore, almost a sensation that Germans are now digitizing a system of physical shares that has proven its worth for decades.
Takeaway 3: The transition to digital securities is much softer than you think
What particularly fascinates me about the draft law, however, is its approach. When I speak at conferences with other lawyers from all over the world, with software developers or entrepreneurs, people tell me: We have to rethink the law. We have to change systems so that blockchain and bitcoin are accepted worldwide. Our code is outdated. And what is Germany doing? The very gentle rapprochement. The connection between the old and the new world with just a few new rules.
According to the previous legal situation, the German (private) law still missed a prepared legal framework for the Federal government’s digital security issue. German civil law did not provide that securities could be issued purely electronically based on a blockchain. According to the Blockchain Strategy adopted by the Federal government in September 2019, the current mandatory requirement of a paper form of securities (documentary embodiment) for securities should no longer apply without restrictions. First, the planned opening is to be limited to electronic bonds. How are electronic securities regulated in the draft law? What are their unique features and differences?
Still, there is one difference from the nature of the technology that can be used, in which the legislature is welcome to be neutral and not only limited to blockchain technology. There is no physical reference object, „one thing“. To achieve the desired synchronization with securities securitized by means of documents, property law fiction is, therefore, by law necessary. The general, (often) not codified rules of civil securities law remain, which are deliberately not interfered with in order not to create a new law construction „sui generis“. This fiction is necessary because only a new issuing modality is to be introduced, but the security’s legal nature is not to be changed. Because of legal transactions, trust, not least insolvency, on the real legal effects, they have known from securities. These legal effects have proven themselves. Under fiction, they will apply in full to electronic securities. Special regulations are only made where the type of electronic script requires it because the document script regulations are not transferable for actual reasons and, therefore, cannot be applied accordingly. The legislature also wants in a consistent way to avoid the creation of the theory (issuance) for electronic securities. The draft law provides „crypto securities“ as a sub-form of electronic securities. In the case of crypto securities, the ownership must be noted in the register. Only then is a legal certificate available through the registered owner, who enables an acquisition in good faith.
Even if the electronic form of issuance only opens an additional option for issuing, which should not affect the existing structure of issuing using paper certificates, questions arise about the analog and digital issuing systems’ coexistence. The legislature answered these questions with the general claim individual securitization for electronic securities (change of form from entries in documents and vice versa).
What sounds technical shows the direction that legislation should take for new technologies like blockchain: the soft evolution instead of the hard revolution. Bitcoin enthusiasts and supporters of decentralized finance often preach the great rebellion: the dissolution of classical financial structures, the elimination of all middlemen, the economic revolution. It’s not going to happen. It also only leads to conflicts with legislation, government, and jurisdiction, which are often marked by thoughts of preservation and caution. What we need at the level of law is a kind of update, an addition to what already exists: The extension of the traditional structures for new technologies, for blockchain and digital values. It’s precisely the path Germany is taking, and in my view, it is a model for other countries as well.
New chances for blockchain technology in Germany?
In any case, with these new variants, the legislature creates the balancing act between the necessary preservation of existing structures and the promotion of new emerging decentralized structures that can be equally attractive for large financial institutions and startups. Although the draft law is designed to be technology-neutral without restriction to blockchain technology, this draft law undoubtedly represents the further development possibilities of blockchain technology acceptance in Germany. It is confirmed by the fact that, since the adoption of the Blockchain strategy by the Federal Government last year and the published Instructions on the crypto custody business as Leaflet by the Federal Agency for Financial Market Supervision (BaFin) at the beginning of spring this year, the path towards a technology-specific draft law. The legislator indicates that the digital securities’ issue does not necessarily have to occur on a private blockchain system. Instead, it would also be possible to be done on public blockchains. With it, the legislature would create the possibility that securities, according to German law, could also be issued on an Ethereum basis. And even more – if the regulations are established, the procedure could be transferred to stocks or investment funds.
The legislator is aiming for the new regulation to be passed in 2020. The draft law also provides several changes to the prospectus law, the custody account law, and other rules, so that all electronic securities are treated like securities everywhere. We can enthusiastically expect the regulations to be established so that the planned transfer of the envisaged approach to shares and investment fund shares can take place in the next step to strengthen Germany as a financial center.
If you want to learn more about blockchain or its regulation, join The Blockchain Lawyers Network. It’s a free social media style site with a community that only cares about blockchain and how we can create the law to empower it. If you like to keep track of blockchain and regulation, find my Podcast The Blockchain Lawyer on all major podcast platforms.