Cryptocurrencies, which represent a new form of a digital asset based on a network that is distributed across a large number of computers, has been in the limelight for some time now but regulation around digital assets is somewhat lacking.
Experts explain that this decentralised structure allows them to exist outside the control of governments and central authorities. Meanwhile, blockchains, which are organisational methods for ensuring the integrity of transactional data, is an essential component of many cryptocurrencies.
Some in the industry suggest that blockchain and related technology is a disruptor, while others see it as evolutionary rather than revolutionary.
Cryptocurrencies have come under fire a few times with critics saying they can be used for illegal activities, exchange rate volatility, and vulnerabilities of the infrastructure underlying them.
Meanwhile, others have given them praise for their portability, divisibility, inflation resistance, and transparency.
Despite the mixed bag of opinions, there is movement going on with market players introducing new platforms, and existing firms partnering with smaller fintech firms within the digital asset space to expand on their existing services.
One country that has experienced further movement on legislation and regulation in the digital assets space is Germany.
On 1 August the Germany Finance Ministry proposed legislation to modernise German securities law and the associated supervisory law.
With the establishment of digital securities, the German Finance Ministry noted that one of the central components of the Federal Government’s blockchain strategy and the joint key issues paper of the BMF and the BMJV on electronic securities will be implemented.
According to the current legal situation, financial instruments that are classified as securities under civil law must be securitised in a document. The proposed regulation also creates regulatory clarity.
It was noted that the Federal Financial Supervisory Authority will monitor the issuance and the maintenance of decentralised registers as new financial services under the eWpG, the KWG and the central securities depository regulation.
The ministry of finance said the draft differentiates between the maintenance of a central electronic securities register by a central securities depository and the maintenance of registers for issuing electronic bonds made possible by distributed ledger technologies, among other things.
The ministry explained: “Adapting the legal framework to new technologies, especially blockchain technology, serves to strengthen Germany as a business location and increase transparency, market integrity and investor protection.”
Deutsche Boerse Group, among others, welcomed the draft law on the introduction of digital securities.
Gerd Hartung, head of new digital markets at Clearstream, says: “Digital asset servicing in this context bears great potential to drive automation e.g. via smart contracts, but we expect that this will only fully unfold over a longer period of time because of significant integration efforts for the distribution channels in today’s markets.”
Meanwhile, a spokesperson from the Federal Financial Supervisory Authority (BaFin) explains that since the proposed legislation aims to introduce the issuance of dematerialised debt securities in accordance with German civil law, BaFin expects the following two items to be the key driver with regard to the potential impact on the asset servicing market:
- Firstly, traditional market participants and issuers will be allowed to issue dematerialised debt securities (in particular, bearer bonds). In doing so, the draft proposal promotes digitalisation for both, capital markets and at the level of each individual market participant while they can rely on existing processes for trading and post-trade services.
- Secondly, the proposed legislation will also foster innovation and the potential use of distributed ledger technology (DLT) for the issuance of dematerialised debt securities which are initially registered with a crypto-security registrar (Kryptowertpapierregister). Thereby, many start-up companies and fintechs located in Germany engage in competition to traditional players based on their expertise in terms of technology and digital processes.
Modernisation
The modernisation in German securities law and the associated supervisory law is something that industry participants are particularly looking forward to.
Clearstream says they appreciate the dematerialisation of German securities and have been promoting it for years previously.
The broad and technology-neutral approach as formulated in the draft bill helps to digitise the whole market and not only niche markets.
“This focus on the whole industry and a regulatory framework for new types of securities (so-called “crypto securities”) should be kept and advanced to asset classes other than bearer bonds,” comments Hartung.
Meanwhile, BaFin in its role as the supervisory authority will focus on the associated supervisory law. Therefore, associated amendments to the supervisory framework such as the German Banking Act (Kreditwesengesetz) aims to introduce the new financial service (crypto security registrar) and to set prudential requirements which provide further regulatory clarity and guidance with regard to digital securities including crypto-securities.
“From a high-level perspective, BaFin also aims to support innovation and digitalisation. Furthermore, these amendments complement the overarching regulatory framework for crypto-assets,” according to a BaFin spokesperson.
New opportunities and challenges
The newly proposed legislation in Germany could create the potential to spur an increase in the number of new digital custody firms, or create a rise in the number of existing custodians expanding their services. However, BaFin highlights that the proposed new financial service (crypto security registrar) should be clearly distinguished from custody services, including crypto-asset custody in accordance with the German regulatory framework.
With reference to Article 7(4) of the proposed legislation, the registrar function as such does not qualify as custody service in the meaning of the German Custody Act.
“Therefore, BaFin expects new firms emerging to apply for an authorisation to provide services as crypto security registrar,” comments the BaFin spokesperson.
At the same time, BaFin has also noticed that many traditional asset servicing companies argued in favour of an extension to also provide services as a central registrar for electronically issued securities (Zentrales Register).
Hartung highlights that the proposed legislation brings opportunities for the whole industry: be it new entrants, existing custodians or new partnerships between different market participants.
According to Hartung, the legislator has to create a level playing field with clearly defined rules and responsibilities for everybody to have the chance to contribute to the new setup.
“Roles might change in a distributed world, but tasks and responsibilities will still have to be fulfilled in a reliable, scalable and efficient manner. Lots of different solutions in the back office, for example, for custody it might lead to fragmentation in the market and ultimately a lack of scalability and reduced efficiencies,” Hartung adds.
Although opportunities are at hand there are still some barriers that could get in the way if the legislation is passed. For example, different laws across Europe would pose additional work for market participants and could prevent real market adoption.
The European Commission published a legislative proposal on Markets in Crypto-assets (MiCA), which would regulate crypto-assets that fall outside the scope of current EU financial market regulation.
The EC suggested special rules for stablecoins. If adopted, MiCA will replace existing regulatory frameworks applicable to crypto-assets in the EU member states.
The proposal builds on advice received from the European Banking Authority (EBA) and the European Securities and Markets Authority (ESMA).
MiCA, which aims to be technology, asset class and jurisdiction agnostic neutral, allows for the use of both permission-less and permission-based distributed ledger technology (DLT).
“We see explicitly a possible overruling by the proposed EU legislation on MiCA and the pilot regime for decentralised market infrastructure. Mismatches in the positions might hinder or delay investments in infrastructure, as regulatory overruling is a business risk for building new infrastructures,” affirms Hartung.
Problems could also arise on the supervisory and applicant side based on the variety of possible and technical implementation of the new crypto securities registrar function.
As a result, the authorisation process could lead to additional questions or information requests especially with regard to the technical implementation and the interaction with the decentralised ledger and the management of operational risks, according to experts.
A waiting game
While industry experts are optimistic about this new legislation there is still no clear answer on how long this could take to implement.
While the implementation of the law is planned for Q1 2021, it will take time for real and broad market adoption.
Clearstream’s Hartung stressed that the broad market adoption of this new legislation will require efforts from all players within the overall financial market ecosystem.
Generally, the adoption of the proposed legislation follows the legislative procedure in Germany.
This means that market participants will have to wait for the final details of the transitional provision with regard to the authorisation in accordance with the German Banking Act.
But could this movement in Germany give other European countries a nudge to update and modernise existing legislation?
Taking into account the digital finance package adopted and published by the European Commission at the end of September, BaFin said it generally supports the initiative to establish a regulatory framework for crypto-assets and the application of DLT in financial markets.
“Hence, BaFin appreciates to actively contribute to the ongoing discussion with other representative bodies of European member states,” the spokesperson comments.
Hartung weighs in on this saying that Luxembourg’s adoption of digital securities last year was a major impetus for the European financial markets.
“More countries embedding new technology in their financial markets in a sustainable manner will certainly cause others to follow. Germany has to ensure that it doesn’t lag behind in the EU whilst lobbying and working towards a common European framework for digital finance,” Hartung concludes.
