On 11 August 2020, the German Ministry of Finance and the German Ministry of Justice and Consumer Protection published a draft bill introducing electronic securities (Entwurf eines Gesetz über elektronische Wertpapiere or eWpG-E). The eWpG-E aims to strengthen Germany’s position as a hub for financial technology and tap the potential of blockchain or other types of distributed ledger technology (DLT). Consultation on the eWpG-E is open until 14 September 2020 and adoption is expected later this year.
The eWpG-E deals with electronic debt securities as the first use-case (electronic equity securities and investment fund shares may be introduced at a later stage.) Electronic securities, commonly also referred to as digital securities or security tokens, are securities without a corresponding physical certificate. The eWpG-E introduces the option of issuing debt securities electronically via a register entry as opposed to the traditional paper-based issuance.
Germany’s new regulatory framework
In short, electronic debt securities are to be treated the same as paper-based debt securities. The newly introduced framework mirrors the existing regulation of German government bonds, which are issued as dematerialised securities by an entry in the federal debt register and treated as legal objects under the German Federal Public Debt Management Act. Electronic debt securities are fictionally declared to be a legal object so that German property law applies, along with its advantages in insolvency proceedings or bona-fide acquisitions.
Instead of being embodied in a certificate, electronic debt securities will be entered into a register. The eWpG-E introduces two kind of electronic securities registers:
- a central register maintained by a central securities depository (CSD); and
- a decentralised crypto securities register that may be based on blockchain or other types of DLT.
Electronic securities issued in a crypto securities register are defined as “crypto securities” while securities on a central register are referred to as “electronic securities”. Entities providing register management services are defined as “registry administrators”.
A registry administrator for a central register must be a CSD (ie an entity licensed as a CSD in the meaning of the Central Securities Depository Regulation or CSDR). Registry administrators for a crypto securities register require a newly introduced license under the German Banking Act (KWG).
Acting as registry administrator does not, by default, also constitute “custody business” in the meaning of the KWG. Since electronic securities shall be treated as paper-based securities, providing custody services for those securities qualifies as regular custody business rather than the novel “crypto custody business”. Depending on the type of services provided, both custody licensing regimes may apply.
Electronic debt securities may be created by entry in a central register managed by a CSD. Entries are only possible in the form of “collective entries” mirroring the current German system of collective safe custody. Once the new electronic securities are created, the CSD will transfer these into the existing securities settlement system and therefore avoid having two systems running in parallel.
This pathway also allows for the electronic debt securities to be traded on trading venues in the EU. To enable such trading, the CSDR requires issuers to ensure that securities are transferable via book entry. One way of achieving this – apart from placing physical securities in a CSD – is that the securities are dematerialised, which is contemplated by the eWpG-E.
The eWpG-E does not impose restrictions on the CSD using DLT or other innovative solutions to process and verify data streams. However, in this centralised environment, the final validity of the register solely depends on the CSD. Whether European legislation is also open for the use of such technologies by CSDs is a different question.
Crypto securities register
The eWpG-E proposes crypto securities registers as an alternative to central registers. Standards for such crypto securities register include decentralisation, protection against forgery and unlawful deletion or alteration, and saving data in the order received. The eWpG-E’s reasoning highlights that these standards can but don’t have to be fulfilled by current blockchain or other DLT solutions.
Crypto securities registers need a licensed registry administrator to ensure responsibility. However, in the end, an algorithm is the basis for trust which is why the registry administrator does not need to be a trusted CSD (in contrast to the administrator for a central register). Moreover, the issuer has the option to manage the register itself.
The eWpG-E requires a crypto securities register to state explicitly whether registered items are securities or simply private tokenised rights. These are distinguished essentially by the parties’ intentions, and the latter would be excluded from the eWpG-E. In contrast to the central register, the crypto securities register provides the additional option of having “single entries” for individual holders. While individual holders in a single entry may be registered by using a hash, the registry administrator needs to comply with anti-money-laundering regulation and, therefore, must remain able to identify every individual holder.
In contrast to central registers, the eWpG-E introduces further transparency and publicity obligations for crypto securities registers. Issuers using this type of electronic securities registers must publish the entry of a crypto security or changes to such crypto security in the German Federal Gazette and communicate such publication to the German Federal Financial Supervisory Authority.
Transfer of single entry electronic debt securities in a crypto securities register
The transfer of electronic debt securities in collective entries, either in a central register or a crypto securities register, is fully aligned and similar to the current market practice and the legal concept applied to paper-based securities held in collective safe custody. With regards to electronic debt securities in the form of single entries, the eWpG-E establishes the doctrine of “transfer transparency” and introduces a new clause for bona fide acquisitions.
Notwithstanding the usual requirements for transferring securities, the validity of any transfer of single entry electronic debt securities in a crypto securities register depends on a corresponding register change. The eWpG-E follows the principle that every change of ownership must be recorded, and a transfer not recorded is invalid. As a result, parties may generally execute a transfer by (1) reaching a mutual agreement, (2) the current holder instructing a change in the register, and (3) such change occurring as instructed.
This process allows for the legal assumption that the holder recorded in the register is the holder in fact. Consequently, the purchaser of a crypto security can acquire ownership in good faith from a third person that may have been wrongfully assigned ownership of the crypto security.
In conclusion, the eWpG-E maintains the traditional German approach of dealing with securities based on property law. At the same time, it introduces a new framework for decentralised registers. In providing more legal clarity for such decentralised environments, the eWpG-E is expected to encourage further innovation regarding the use of the blockchain and other DLT solutions and by regulating the registry administrators further professionalise the industry.
The Austrian government mentions in its programme for the legislative period 2020-24 that it wishes to introduce digital securities. Discussions are ongoing in Austria and it will be interesting to see how far Austria follows the new German model.