The stumbling block of crypto assets: why the capital market is still waiting for its revolution

Right from the beginning, blockchain technology was hailed as the technology of the future and a revolution of the financial market by the token economy was predicted. Hope was raised when the German Federal Government published its blockchain strategy last year and declared an ambitious motto: “We will set the standards for a token economy.”

However, hope quickly turned into disillusionment, with almost nothing having happened since then. So far, the only proof of life of the loudly announced blockchain strategy has been the regulation of the “crypto custody business” as a new financial service, introduced via back door of an implementation of the 5^th AML Directive, and the simultaneous introduction of “crypto assets” as new financial instruments. Due to its unbalanced effect, this cannot be called the most successful start of the crypto-regulation offensive (we reported here).

But where does the problem lie? If blockchain technology is in fact the technology of the future, then the capital market should be full of opportunities for investments in tokens. But the reality is a bit different. The numerous legal loopholes and uncertainties are slowing down the success of the “token economy” considerably on many levels. In fact, they are the reason for its absence.

Tokenisation

Like securities, Crypto Assets are merely a (digital) representation of assets which can be traded instead of these assets (similar to the new definition in Section 1 para. 11 sent. 4 German Banking Act (Kreditwesengesetz, KWG)). In contrast to securities (in their original form), however, Crypto Assets are not embodied in an object such as a piece of paper, but exist only virtually as a digital “entry” on a blockchain. Tokenisation describes the process of digitally transforming a real asset into a Crypto Asset.

Depending on the type of asset, the digital representations are referred to as:

• security tokens: securities-like tokens that represent what can also be represented by traditional securities, shares in companies or bonds;
• utility tokens (digital vouchers for goods or services);
• currency tokens (means of payment); or
• stablecoins (simplified: currency tokens with underlying asset).

Benefits

The idea is, as in securities trading, to make the asset positions behind the Crypto Assets as easy, uncomplicated and tradable as possible. Tokens can embody a variety of different assets, such as shares in companies – regardless of their legal form – or even commodities such as oil and precious metals.

In recent time, there has been a special focus on enabling uncomplicated trading of assets that are characterised by their illiquidity: real estate. However, tokenisation of real estate has so far only indirectly taken place by tokenisation of shares in a company which owns the real estate. This is probably due to the (non-existent) legal framework, which is probably the biggest obstacle to the establishment of crypto-assets on the capital market to date.

Legal questions

Numerous legal issues remain in relation to trading of tokenised assets.

Valuation and accounting

There are great uncertainties with regard to the valuation and accounting of Crypto Assets. Institutional investors such as funds and insurance companies must comply with mandatory valuation and accounting standards. However, due to the various forms of Crypto Assets, it is not possible to develop a general rule of application, leaving it largely unclear and up to an assessment on a case-by-case basis how a Crypto Asset should be valued. Given this legal uncertainty, it is not surprising that institutional investors have largely hesitated to invest in Crypto Assets.

„Numerus Clausus of assets“

Another problem is the so-called „numerus clausus of assets“, which determines the type of assets in which funds or other institutional investors like insurance companies may invest. If a Crypto Asset does not meet the asset specifications, investments are not allowed.

This applies in particular to mutual funds, where these requirements are intended, inter alia, to minimise the risk of loss for private and retail investors. An exception to the numerus clausus exists only in relation to special funds in which private investors may not invest. The range of potential investors is thus significantly restricted. Here, it would be up to the legislator to take into account further aspects of Crypto Assets in the German Capital Investment Code (Kapitalanlagegesetzbuch, KAGB) in a holistic approach and not to limit its view to a partially regulation of Crypto Assets in the German Banking Act.

Risk management

Particularly for institutional investors such as insurers, banks and fund managers, compliance with guidelines for proper risk management is a key factor.

For example, insurers must securitize their capital investments sufficiently with equity capital. Investments in real estate require less securitization than investments in shares. If, however, real estate is “tokenised” and made tradable like shares in the form of Crypto Assets, these indirect investments in real estate would probably have to be securitized in the same way as shares.

Investments in Crypto Assets offer additional possibilities for diversification of a portfolio. In the past, real estate was often included in a portfolio because it allowed investments in a long-term stable and thus rather low-risk asset. It is doubtful, however, whether the rising volatility of a real estate investment resulting from its “tokenisation” will lead (especially institutional) investors to increasingly invest in such Crypto Assets.

In addition, further legal issues such as the ability of Crypto Assets to attach or the handling of Crypto Assets in the event of insolvency are decisive for an accurate assessment of the risks associated with investments in Crypto Assets.

Civil law aspects

In particular, the question of the transferability of tokens under civil law remains unanswered.

Currently there are numerous approaches to how tokens can be transferred. These include a corresponding application of the rules on the transfer of movable property (§§ 929 ff. German Civil Code (Bürgerliches Gesetzbuch, “BGB”)), a corresponding application of the rules on the transfer of real estate (§§ 873, 925 BGB) and an application of the rules on assignment (§§ 398 ff. BGB).

It is also unclear whether all tokens are transferred under the same rules or whether they are to be distinguished depending on the embodied asset (e.g. in the case of GmbH shares or real estate). There is currently no clear legal regulation. The resulting legal uncertainty is also likely to have a negative impact on the decision of many investors to (not) invest in Crypto Assets.

With regard to real estate, further questions arise, such as whether Crypto Assets may only embody a claim under the law of obligations or even a position of ownership. And for the law specialists: if a position of ownership is embodied, is it joint ownership or co-ownership? One question after another…

Against this background, the efforts of the German Federal Financial Supervisory Authority (BaFin), which is trying to shed some light on the darkness of crypto-regulation through numerous publications (we reported here, German only), also seem to have faded. From a regulatory point of view, there may now be sufficient guidelines to enable a crypto-asset to be classified as a “security” with a reasonable degree of legal certainty. Nevertheless, this may not be the source of the problem of a missing will to invest. After all, what benefit does an investor derive from the fact that a prospectus has been published in accordance with regulatory law, if the rights that are to be embodied by the token are not effectively transferred to them under civil law?

The complexity of the answer to this question is shown by the huge struggles of the German Federal Government with such a (civil) law regulation. The intention was to present a legislative proposal for the introduction of electronic bonds by the end of 2019. This would necessarily have included civil law provisions. However, since no legislative proposal has been published to date (we reported here), the Federal Government’s goal in recent statements has been to submit a proposal for regulation by the end of the current legislative period (in other words, by (probably) the beginning of 2021).

Conclusion

Crypto Assets still have not been able to gain full acceptance despite their great potential. The main reason for this is the continuing legal uncertainty regarding the legal status of tokens – not so much in terms of regulatory law, but particularly in terms of civil law.

In principle, it is to appreciate that the legislator has recognised the potential of Crypto Assets and has already declared its support for regulation. However, this has been fragmentary and only relates to parts of financial regulatory law.

The fundamental problem of the civil law embodiment of assets in a token and thus also their transferability has not been addressed so far, probably due to the complexity of such regulation. In this respect, the regulatory proposal for electronic securities announced for 2021 (and due to the summer break and federal elections) and actually expected at the beginning of 2021 are eagerly awaited. The delay in the implementation of the German Federal Government’s blockchain-strategy so far thwarts the urgently needed legal certainty in dealing with Crypto Assets, but on the other hand gives rise to hopes of a more mature and comprehensive approach of a regulation.