This article provides an overview of the regulations that need to be taken into account when issuing and transferring security tokens in Europe with a focus on Germany, Austria, Switzerland, and Liechtenstein.
As security token offerings are classified as securities, regulations applicable to securities will typically apply to Security Token Offerings (STOs) in addition to regulations specific to issuing tokens or other crypto assets.
Technically, the digital representation of an asset on a blockchain can easily be created. The asset is digitally represented by a set number of tokens that exist within a single blockchain such as Ethereum or multiple blockchains. For example, the Swiss-based Mont Pelerin security token exists on the Ethereum, Matic, and Binance Smart Chain blockchains. In order to create these digital tokens, a blockchain developer can create a smart contract that manages the desired number of tokens on each blockchain. Although this technical step can be done within minutes, the difficult part is linking the digital and real worlds.
Token holders need to be able to enforce the rights associated with their security token in the real world. The EU and Switzerland have taken different approaches to regulation of distributed ledger-based security issuance and trading. In September 2020, the Swiss Parliament adopted the Federal Act on the Adaptation of Federal Law to Developments in Distributed Ledger Technology (DLT). In the same month, the European Commission adopted several legislative proposals as part of its Digital Finance Strategy.
Switzerland: Switzerland’s new regulation enables the issuance of securities using DLT as of 1 February 2021. This new form of securities is named “ledger-based securities”.
- The Swiss ledger-based security (Registerwertrecht) is a new type of uncertificated security, which can serve as an alternative to the existing intermediated securities (Bucheffekten). Both types are immaterialised securities, but intermediated securities require a regulated institution such as a bank, securities firm, or a Central Securities Depository (CSD) for issuance and transfer of the security.
- The new Swiss ledger-based security (Registerwertrecht) can be issued and transferred without an intermediary. The parties involved must enter into a registration agreement, and the registration agreement must be recorded in a securities ledger (Wertrechteregister). The securities ledger has to fulfil the following requirements
- Creditors, but not the obligor, have the power of disposal over the rights reflected on the register.
- The ledger’s integrity is ensured by technical and organisational means such as joint management by several independent participants in order to protect it from unauthorised modification.
- The rights of the registration agreement and the functioning of the ledger are recorded in the ledger.
- Creditors can view relevant information and ledger entries and check the integrity of the ledger contents relating to themselves without intervention of a third party.
European Union: The European Commission adopted four proposals: The Market in Crypto-Assets Regulation (MiCA), the Pilot DLT Market Infrastructure Regulation (PDMIR), the Digital Operational Resilience Regulation (DORA), and a directive to amend existing financial services legislation. These proposals do not govern whether securities may be issued based on DLT but leave this to the national law of the EEA member states. The proposed legislation is expected to take effect 12 to 24 months from now.
However, the specific laws that apply depend on which country the issuer is in, which country the investors are in, and what type of investment contract is being tokenised. There are eight main types of security tokens:
- Tokenised profit participation rights
- Tokenised revenue participation rights
- Tokenised subordinated loans
- Tokenised commitments to use
- Tokenisation of a limited liability company (GmbH)
- Tokenisation of a stock corporation
- Tokenisation of real assets such as precious metals or apartment buildings
- Tokenisation of voucher entitlements
For example, in Austria shares of limited liability company must be transferred with a notarised piece of paper, therefore, a GmbH cannot be tokenised directly. However, there are ways around this. For example, tokenised commitments to use or profit can be used to redirect earnings from the GmbH to token holders. Attorneys such as Stadler Völker in Vienna specialise in setting up trustee structures that can ensure the promises made to token holders are enforced.
In contrast with Austria, Germany published a draft of their Electronic Securities Act in August of 2020, which introduces the possibility to transfer digital securities with a physical stock certificate. This legislation was approved in December, and it also enables the issuance of electronic bearer bonds using either a distributed ledger, named crypto securities register, or a CSD maintaining an electronic securities register. If the electronic bearer bonds are issued using the crypto securities register, the issuer must appoint an entity as operator of the distributed ledger. This entity is subject to a financial market license requirement. This law also clearly defines electronic securities as “goods” under German property law, meaning that existing civil law principles apply.
DLT Trading Facilities, DLT Market Infrastructures, and Digital Asset Marketplaces Are Synonyms
Switzerland’s 2020 draft also proposed new regulations that enable DLT trading facilities called “DLT trading facility” (DLT-Handelssystem). A DLT trading facility is a commercially operated institution for multilateral trading of DLT securities. Its purpose is the simultaneous exchange of bids between several participants and the conclusion of contracts. This regulation is expected to enter into force on 1 August 2021. Companies interested in becoming DLT trading facilities will need to apply for a new infrastructure license unless they already have a pre-existing financial market license. Startups with trading volume below certain thresholds qualify for a regulatory sandbox that has less stringent requirements.
The EU is also working on similar legislation. Companies interested in issuing or selling tokens in the EU/EEA should monitor the PDMIR, which introduces a pilot regime for DLT market infrastructures. According to this legislation, a DLT market infrastructure is either a DLT multilateral trading facility or a DLT securities settlement system. Operators of DLT market infrastructures must report their activity every six months to the European Securities and Markets Authority (ESMA) and the national competent authority. In order to operate a DLT market infrastructure, permission must be granted by the national competent authority, which is first required to consult ESMA before deciding on an application. A permission is valid for no longer than six years. Only investment firms or market operators according to MiFID II are eligible to operate a DLT multilateral trading facility, while only CSDs according to the CSD Regulation can operate a DLT securities settlement system.
The big difference in trading facility legislation is that Switzerland’s sandbox makes it easy for new competitors to enter the market whereas the EU’s requirement to be an approved MiFID II investment firm, market operator, or CSD means that DLT market infrastructures are expected to be largely operated by incumbents.
We expect the increasing recognition and support of STOs will continue to lead to a growth in digital asset intermediaries, market infrastructure providers, issuers and promoters. The most crucial factor that can hold back the adoption of STOs is regulatory uncertainty. Given that security token trading activity can be borderless, it is essential for global regulators to cooperate in a more consistent approach and method in regulating and supervising STOs.
 Excerpts from this article are taken from the upcoming Cointelegraph Security Token Report with research contributed by Martin Liebe and Silvan Thoma from PwC in Zurich and Oliver Völker and Bryan Hollman at Stadler-Völker Rechstanwälte in Vienna. To learn more about legislation in Switzerland, please contact email@example.com and firstname.lastname@example.org. To learn more about legislation in the EEA, please contact email@example.com and firstname.lastname@example.org.