Digitalising securities in Germany – ministerial draft presented and consulted
The German legislator paved the way for Germany’s future as a financial and capital markets hub. The first step towards the issuance of electronic securities has been taken with the ministerial draft of a new “Electronic Securities Act” (Gesetz zur Einführung von elektronischen Wertpapieren – eWpG) (the “Draft Act”) which was presented in August 2020. The Draft Act is intended to enable the issuance of electronic securities – however initially only of debt securities in the form of bearer bonds (Inhaberschuldverschreibungen) – and to introduce a legally structured and safe securities trading market based on the existing blockchain technology. Considering the potential impact that electronic shares could have on the structure of a stock corporation, shares have not yet been included in the scope of the ministerial draft but may follow at a later stage, provided that the system has proven its functionality. Although there are calls requesting to include further non-complex instruments in the first round of eligible instruments, provided that their functionality is comparable to bonds, it is a wise decision to reduce the number of instruments in this pilot project to one, given the novelty of the approach.
It may seem surprising to investors that electronic securities are still unknown to German law, in particular as stock exchange trading is already entirely based on digital book entries between securities accounts without any settlement actions that would require the exchange of a physical note. However, the physical note (in the form of a global note) continues to be the legal basis for the issuance and transfer of securities, including the electronic settlement, as the German securities law is still based on in rem principles. These in rem principles distinguish between the right to own (Eigentum) and the right to possess (Besitz). The global note that is held in central custody for all investors by Clearstream Banking AG, a subsidiary of the German stock exchange Deutsche Börse AG, represents all in rem titles of the securities owners. The investors are co-owners (Miteigentümer) of fractional rights of the global note and at the same time co-holders (Mitbesitzer) of the physical global note, which they hold via their custodian banks which are associated with Clearstream, acting as intermediaries). This legal structure is commercially significant as it allows for the possibility of a purchase in good faith (gutgläubiger Erwerb), unlike in case of a mere acquisition of a legal title. Although there is only little scope for a purchase in good faith in practice, given the electronic sale, purchase and settlement of securities transactions, this means, however, that a party acquiring a security can be certain that the acquired securities really belong to it as a result of the transaction.
The Draft Act now differentiates between electronic securities (Sec. 2 of the Draft Act) and crypto-securities (Sec. 4(2) of the Draft Act). This approach is intended to guarantee technological neutrality between these two concepts and not to unilaterally privilege offerings based on blockchain technology. Furthermore, “traditional” securities issuances by means of a physical global note will of course continue to be possible alongside these two alternatives for the issuance of electronic securities, as well as for all other instruments not (yet) included in the scope of the Draft Act.
As a first step, issuers shall in future be able to issue bearer notes in the form of electronic securities. Instead of a physical global note, the securities will be issued via registration with an electronic securities register. In this context, it becomes obvious that the term “bearer” bonds (Inhaberschuldverschreibungen) would no longer accurately reflect the idea of an instrument that is electronically registered and not securitised in a physical note representing the rights of a “bearer”, i.e. the holder. Therefore, the question arises, which further impact the new system might have on existing civil law concepts.
The electronic registers are central registers to be maintained specifically for the purpose of electronic securities, and will be operated by an authorized central securities depository. The register takes over the documentation function of classic global note certificates that are currently issued and filed with Clearstream Banking AG, Germany’s only central securities depository, for central custody. However, as for physical securities represented by a physical global note, transfers are effected via the existing securities giro clearing and settlement system operated by custodian banks and Clearstream. As the current draft only allows the register to be maintained by a registered central securities depository, the registers could currently only be kept by Clearstream in Germany. However, there are good reasons to argue that other financial institutions should be included in the group of eligible providers as well, given their level of supervision by the German Federal Financial Supervisory Authority (BaFin).
The dematerialisation of securities is a long overdue adjustment in the law to reflect actual securities trading practices. Although there will be special statutory rules for the transfer of electronic securities, the existing in rem principles of the German Civil Code (Bürgerliches Gesetzbuch) will essentially continue to apply, as pursuant to Sec. 2(3) of the Draft Act, an electronic security is to be classified as an in rem right (Sache) in the meaning of Sec. 90 of the German Civil Code. This is meant to provide investors with similar protection as under property law applying to global notes and securities to date and to strengthen the new electronic security and make it capital markets eligible. From a mere legal point of view, this approach is revolutionary as German property law, which was generally designed for physical objects, shall, for the first time, apply to certain digital goods in the future. There is room for further development, considering that private keys as the legitimisation code for the disposal of electronic securities could be included in the scope of Sec. 90 as well, given that they are an essential aspect for the transfer of electronic securities.
The second idea of the Draft Act, the introduction of a legal framework for the issuance of crypto-securities, is conceptually even more interesting. The issuance of this new securities type by way of registration with a new type of securities registers for crypto-securities will be based on distributed ledger or blockchain technology. Unlike in case of regular securities with central securities depositories such as Clearstream, crypto registers to be used for electronic securities such as crypto-securities are decentralised registers. Financial services providers as well as issuers for their own securities will be able to register the securities with the electronic register. The intention is that the operator of the decentralised register will be liable to ensure the accuracy and safety of the register. BaFin will supervise the issuance of the securities and the operation of the registers.
The distributed ledger-technology promises benefits in terms of efficiency, costs and time: The parties to a capital markets-transaction would be able to conclude and execute transactions within the shortest possible time. The exact frequency depends on how often the underlying distributed ledger updates. For example, the bitcoin blockchain, which, however, was not specifically designed for securities, updates approximately every ten minutes. This alone would considerably speed up the settlement process of securities transactions, as compared to the settlement process via Clearstream, which currently takes about two banking days. Furthermore, transactions could become more cost-efficient as the settlement process does not require the involvement of the giro clearing and settlement system provided by the custodian banks and Clearstream anymore. It will also be possible to register the holders of the securities directly with the decentralised register (Sec. 8(2) and Sec. 3(3) of the Draft Act).
The anticipated competition for the operation of the decentralised registers may lead to a reduction in the cost of capital markets financing for issuers, rendering it more attractive, in particular for smaller issuers. However, with the maintenance of securities registers for crypto-securities and the assistance of issuers in crypto-securities issuances, new business opportunities will open up also for the established investment banking and securities trading banks. In this respect the technology-neutral Draft Act will allow them to develop tailor-made solutions for issuers.
Whether these developments and advantages will actually materialise and will ease the digitalisation of capital markets financing remains to be seen. There are still many unanswered questions, in particular whether issuers will opt for the new securities legislation or rather the security token offerings-model under existing law. But also practical aspects of securities trading still have to be clarified, such as how crypto-securities can be transferred between registers, if there is an option to convert electronic securities into crypto-securities and back and or how to ensure anti money-laundering prevention in the context of decentralised securities registers. The preliminary draft was opened to a consultation process during which interested groups had the chance to submit their opinions until 14 September 2020. Numerous market participants have responded to this call.
Any questions? Please contact: Dominik Kloka or Georg Langheld
Practice group: Capital Markets