A few days ago, a new milestone was reached in the blockchain-based bearer bond issues field. The technology group Siemens issued a crypto security in the form of a bearer bond with a volume of EUR 60 million via the public blockchain Polygon. Previously, there were similar issuances carried out by DekaBank, Hauck Aufhäuser Lampe, and Deutsche Bank, among others. The German Electronic Securities Act has already set a valid legal framework for such issues in 2021, which means that not only can blockchain-based securities be issued, but the issuance process must also be adjusted, which also requires the participation of new players.
Author: Sandra Sohn
See German version here.
The Electronic Securities Act as a valid legal framework
The Electronic Securities Act (eWpG) already came into force on June 10, 2021, and regulates the issuance and trading of digital securities. In the case of digital securities under eWpG, the physical global certificate, which previously had to be held in custody at a central securities depository (CSD), is replaced by an entry in an electronic (blockchain-based) register. In this context, the eWpG defines two forms of digital securities, which differ directly in the technical and operational presentation of the register management:
1. Electronic central register securities (§4 Abs. 2 eWpG):
- Electronic central register securities are kept in a central, electronic securities register. The law was formulated as technology-neutral, i.e., using a blockchain as infrastructure is possible.
- The register can be maintained either by a central securities depository (stock exchange trading according to CSDR possible) or a custodian (license custody business)
2. Crypto securities (§ 4 Abs. 3 eWpG):
- Crypto securities are electronic securities registered in decentralized crypto securities register. Although the law is formulated in a technology-neutral way, the requirements for the decentralized crypto securities register correspond to the characteristics of blockchain technology.
- The issuer either appoints a crypto securities registry administrator or is deemed the registry administrator. The crypto securities registry requires a corresponding license, which is issued by BaFin. Exchange trading is currently ruled out due to conflicting European legal requirements (Art. 3 CSDR).
The new division of roles in securities issues
Various parties are involved in traditional financing on the capital market via a bearer bond. Depending on the size of the issue (usually from EUR 200 million), a so-called banking syndicate must be selected in addition to law firms and consultancies. Depending on the financial product, the bank consortium is selected according to placement strength, research competence, regional position, experience, etc.
The main focus is on the investor approach and the network of the banking syndicate to institutional investors. Institutional investors include banks, insurance companies, foundations, pension funds, asset management companies, etc.. They can often invest in high volumes, which is particularly preferred by issuers in capital market issues.
The roles played by the banking syndicate, auditors, law firms, and consultancies in the run-up to the actual issuance will not necessarily change in the issuance of crypto securities or a blockchain-based bearer bond. This is because the due diligence, rating, preparation of research, equity story, marketing presentations, securities prospectus, and pre-sounding/investor education up to the investor approach will, for the time being, take place separately from the technical infrastructure of the actual issue. The added value created by introducing crypto securities only becomes clear in the technical issuance or in the settlement phase and trading. This is because a redistribution of responsibilities occurs here, and the current intermediaries, such as the CSD, are replaced, and new parties are added to the process. In particular:
Registrar: Within the legal framework of the eWpG, regardless of the type of digital security, a registrar is required to replace the CSD[1] and regulate the transfer of digital securities. In addition, the registrar is responsible for providing the terms of issue and investment and for the complete documentation of the registry data.
Wallet provider/Securing private keys: Since the legal right of a crypto security is securitized in digital form and stored on a blockchain in the form of a token, so-called wallets are created for the issuance and the investment. A wallet comprises a public key (which corresponds figuratively to the deposit number) and a private key (access key to the deposit). The private key must be secured because it gives access to the corresponding crypto securities assigned to a public key (“deposit”). Unlike crypto assets such as Bitcoin and Co., the custody of crypto securities is subject to the custody business and not crypto custody. However, banks with the appropriate license require a corresponding technical infrastructure to secure the private keys or can, in turn, outsource this to a licensed crypto custodian who stores the private keys.
Paying agent: The paying agent is a credit institution that is also part of the banking syndicate and acts as a contact and coordinator for external entities and is also responsible for processing dividends (shares) and interest payments (bonds). The paying agent is the only entity authorized by the issuer to execute payments for a class of securities on its behalf and for its account in accordance with the order. Due to the absence of a blockchain-based digital Euro, a paying agent in the traditional sense is also required to issue crypto securities, as payments must still be made traditionally. Depending on the structure, the registrar may also have paying agent functions.
Benefits for financial institutions and issuers
The shift to blockchain-based issuance of crypto securities opens up new business opportunities, cost savings, and revenue potential for financial institutions, especially those already involved in the traditional securities issuance process. Depending on the design, the registration and issuance of crypto securities can also be handled by different units of an organization to bring the entire value chain in-house (eliminating costs for the physical global certificate and custody at the central securities depository). In addition, crypto securities registry management can be added to the product offering as a new service for third parties. Furthermore, by digitizing and dematerializing the issuance and settlement process, various existing processes (e.g., calculation of withholding tax and commissions, corporate actions, etc.) can be automated, and previously necessary reconciliation efforts can be minimized. By establishing blockchain-based infrastructure (e.g., the technical setup for crypto securities registry management) early, credit institutions can establish a holistic product offering (crypto securities registry management, wallet provider + paying agent).
Costs can also be reduced on the issuer side due to the elimination of the global certificate and the efficiency gains at the custodian banks/registrars. Depending on the design, direct sale to (institutional) investors without intermediate sale to banks is also possible (depending on the placement power of the issuer). In the future, new distribution channels will also emerge, e.g., by connecting new digital trading venues, especially to reach retail customers as well as target groups Y, Z, and younger with blockchain-based securities.
Secondary market and DLT Pilot Regime
However, these advantages predominantly relate to primary market issuance. One remaining obstacle quickly becomes apparent regarding the secondary market: there is still no legally permitted trading on the organized market for crypto securities. So far, these can only be traded OTC, i.e., over the counter, which severely limits the securities’ liquidity.
However, this obstacle can be overcome when the DLT Pilot Regime comes into effect on March 23, 2023. The DLT Pilot Regime will enable and regulate the trading and settlement of blockchain-based securities across the European Union. The DLT Pilot Regime will introduce a “regulatory sandbox” that will allow authorized entities to operate blockchain-based trading systems and/or settlement systems (blockchain-based market infrastructure). To this end, temporary exemptions from some requirements that operators of such marketplaces normally have to comply with will apply. The DLT pilot regime will apply for three years from March 23, 2023, with the option to extend for another three years.
The concept of blockchain-based market infrastructure includes:
· A DLT multilateral trading facility (DLT MTF)
· A DLT settlement system (DLT SS)
· A combined DLT trading and settlement system (DLT TSS)
Companies that are not already regulated as central securities depositories (CSDs) or investment firms can apply for a corresponding authorization and, at the same time, a special authorization under the DLT Pilot Regime. The national authority then does not check whether the requirements for CSDs or investment firms are met but whether the blockchain-based market infrastructures are operated in accordance with the DLT Pilot Regime. In this way, the DLT Pilot Regime enables both established and new market participants to establish and operate blockchain-based market infrastructure.
Conclusion
As of February 20, 2023, 23 crypto securities have already been issued and registered with BaFin. Recently, the market for blockchain-based securities issues has become very professionalized. This is particularly evident in the latest crypto securities issue by Siemens in the form of a bearer bond on a public blockchain.
There is a lot to consider for such issues, especially in the selection of the appropriate setup (crypto securities registrar, wallet provider (technology provider and setup), platform, paying agent, blockchain (public, private, permissioned), execution of corporate actions, etc.). Financial institutions should also focus on modifying their own business model and strategically positioning themselves in this evolving market environment because although elements such as a regulated secondary market are still missing, there is already an opportunity not only to build up a setup that fits their own business model but also to establish the corresponding service offering.
We are happy to help with the strategic evaluation of the various use cases and positioning options as well as the implementation of a technical proof-of-concept with our cooperation partners to become familiar with the new infrastructure as a first step and to evaluate the impact on internal process flows and IT infrastructures.
About intas.tech
intas.tech focuses as a consultancy for financial institutions and asset managers on the strategic assessment of blockchain deployment opportunities as well as the integration of digital assets into existing business models and IT infrastructures. As a joint venture of Frankfurt School and Plutoneo Consulting, intas.tech combines blockchain know-how and expertise in the traditional financial sector.
Sandra Sohn is Chief Strategy Officer at intas.tech and has over five years of experience in the private banking sector, incl. responsibility for the development of investment solutions in the field of blockchain & digital assets as well as the development of blockchain-based infrastructure considering the legal situation in Germany. You can contact her via mail or LinkedIn.
[1] The CSD can become a registrar in the meaning of the eWpG itself for electronic securities within a central electronic registry.
