A new German law introducing electronic securities is expected to take effect this quarter, modernizing German securities law and making the German market more attractive to issuers and investors looking to do deals. The Federal Ministry of Justice and Consumer Protection and the Federal Ministry of Finance published a joint draft bill for the law in August. The draft bill’s consultation phase ended in September.
The limits of current German law
The German Civil Code now describes bearer bonds as certificates in which the issuer promises to render performance to the bearer, making a physical certificate mandatory. Under the German Code of Civil Procedure, a certificate refers to a statement of thought embodied in writing. This presents an insurmountable obstacle to the issuance of securities via blockchain, and thwarts digital innovation.
Digitalization and innovative technologies, including blockchain and the electronic mass-production of securities, offer enormous benefits—for example, by eliminating the need for intermediaries or trustees and traditional clearing systems, saving time and money. As other countries already permit the electronic issues of securities, and to some extent also provide regulations for blockchain-based securities, the German financial market has been at a disadvantage.
A step toward digitalized financial markets
The draft bill abolishes the mandatory embodiment of securities in physical form, opening German law to electronic securities. Initially this digital form will apply to bearer bonds only. Rules related to electronic shares, fund units and other assets will be introduced later.
Physical data in the form of a paper document will be replaced with entry into an electronic securities register—only the storage medium will change, from paper form to digital. Electronic securities may also be issued via blockchain and similar technologies. German legislation on this point is deliberately technology-neutral.
Notably, the option to issue traditional securities in the form of paper certificates will not be abolished. Rather, the draft bill creates an additional option to issue securities. The full elimination of the physical, paper-based certificate system is not (yet) recommended.
Further, the draft bill will facilitate the change from the old to new world, and vice versa. Legislators will balance the retention of necessary existing structures with the promotion of newly emerging decentralized structures that may be equally attractive to large financial institutions and startups.
Despite digitalization, electronic securities will be securities for legal purposes. Pursuant to the draft bill, crypto securities will constitute a subtype of electronic securities. Crypto securities will only differ from traditional securities in that they will be registered in a crypto-securities register. The main difference from traditional issues will be the change of data medium for the statement of thought, from paper to digital.
Centralized and decentralized registers of securities
The draft bill differentiates between the central register of electronic securities and the decentralized register of crypto securities. The register of securities is critically important to create legal certainty. So, register maintenance must be reliable and register contents must be accurate to ensure authenticity (i.e., identification of originators) and integrity (i.e., no adulteration after origination). The maintenance of registers of securities will be supervised to safeguard investor protection, transparency, and to ensure the financial market functions.
Central register of electronic securities
Pursuant to the draft bill, the central register of securities must ensure the initial registration of electronic securities, and document changes to the recorded content of rights. Consequently, it will serve primarily as a medium for the creation of electronic securities, replacing paper certificates. As a result, decreased transaction costs are expected, since no costs will be incurred to keep physical certificates in safe custody. Further, the central register of securities will serve as a kind of collective securities depository, and make the necessary publications.
The draft bill leaves it up to the market to establish and maintain the central register as it only stipulates the formative framework. The market will be free to decide if, and to what extent, new structures for the central register should be created, or whether the existing structures suffice.
However, since great trust must be placed in the relevant institutions, a license as a central securities depository pursuant to the high regulatory standards of the Central Securities Depository Regulation will be required to maintain such a register. In addition, the Federal Financial Supervisory Authority (BaFin) will supervise the maintenance of registers, effectively minimizing potential manipulation. The central securities depository in Germany could expand its service portfolio to include the maintenance of securities registers, but other enterprises are also free to operate in this market segment, encouraging competition.
Decentralized register of crypto securities
The draft bill’s main achievement is the decentralized register of crypto securities. To safeguard trust in the integrity and authenticity of the register contents and the related protection of good faith, certain minimum technical standards will be required. The recording system must have decentralized data structures where data are recorded in chronological order and protected from unauthorized deletion and subsequent alteration. This structure will ensure the integrity of bond issues via distributed ledger technologies such as blockchain.
Here, the technology-neutral approach is useful, as it also covers alternatives to blockchain to the extent they guarantee minimum standards. Thanks to the decentralized register used in the blockchain system, practically all types of data can be shared and traded in a peer-to-peer network by electronically creating, updating, and coordinating encrypted data blocks simultaneously on several computers almost in real time. Every transaction or change is registered, verified, confirmed and documented by all computers on a network, making the system efficient, transparent, and almost forgery-proof. User identities are protected through encryption.
A special feature here is that, in contrast to a central register of securities, no licensed central securities depository will be required—the register can be administered and updated automatically based on algorithms. The issuer can maintain the register itself or assign a service provider to do so; thus industry groups may maintain their own registers of securities. This is expected to yield enormous efficiency gains.
Maintaining a register of crypto securities is considered a financial service, therefore, the registrar will be required to obtain a permission from BaFin. Thus, investor protection and market integrity, as well as transparency and the protection of capital market functions, will be ensured in connection with securities issued via blockchain.
Investor protection will mainly be safeguarded by the fact that the government will supervise the electronic register of securities. Government supervision will help ensure that investors are better protected, for example by reducing the risk of manipulation by issuers maintaining registers of crypto securities.
Additionally, the investment process should become more transparent, and digitizing investor information and data collection should speed up the issue process. Risk is reduced further as all transaction records during the investment process through to the transfer of securities can be stored digitally, and these records protect both the investor and issuer. Investors can be assured their data was securely and accurately collected, and data relating to the transaction will be available to issuers for reporting any regulatory purposes. Furthermore, administrative processes such as lockup periods, investor count, and other requirements or regulations can be embedded in digital securities.
Finally, the draft bill clearly stipulates that electronic securities are to be treated as property under German property law. So, investors in electronic securities will benefit from the same ownership protection as in the case of traditional securities issued in the form of certificates. This means that electronic securities will, for instance, be covered by the constitutionally protected fundamental right to property. In addition, electronic securities may be subject to defense and removal claims under property law, and damage claims under tort law.