It was a clear black night,
a clear white moon
BaFin is on the streets, trying to consume
Some ICOs for the eve, so it can get some funk
Just rollin’ in its ride, chillin’ all alone.
Some Background Information on Initial Coin Offerings (ICOs)
Before we go into the details of the BaFin information letter, I would like to give some background information on ICOs.
An Initial Coin Offering (ICO) is a method to raise capital with the help of so-called “tokens”. An ICO is also sometimes called an Initial Token Offering or a token sale. In the case of an ICO, a company or an individual issue tokens and sells them in exchange for regular currencies, such as Euros, or even more frequently in exchange for virtual currencies such as Bitcoin or Ether.
The characteristics and the purpose of the tokens can differ from one ICO to another. Some tokens allow for the usage or the purchase of services or products, which the issuer develops with the money received from the ICO. Others transfer voting rights or shares in future profits of the issuer. Some tokens do not have a concrete market value. Other tokens are traded and/or can be exchanged into regular or virtual currencies on specialised cryptocurrency dealing platforms after they have been issued.
ICOs are carried out online, i.e. on the internet or via social media. The tokens are usually generated and spread using the distributed ledger or blockchain technology (DLT). ICOs are used to generate means for a number of different projects, among others for transactions using DLT.
The need for regulation of the ICO market
Experts agree that the whole ICO market needs regulation in order to boost investor confidence, protect consumers more effectively, and ultimately advance this promising new method and alternative to venture capital. From a market perspective, regulation at a global level would be desirable, even though this is not an easy undertaking. For this purpose, it is necessary to categorize the underlying facts in a way that enables the lawmakers to develop a uniform set of rules that can be applied to a specific token. For this to happen, it is necessary to
(i) categorize the tokens available on the market from a technical/functional perspective
(ii) to develop a legally binding definition for each of these tokens, and
(iii) to specify regulatory requirements to be applied for each type of token.
At this point in time, the work on some of these points has only just started. As regards steps (i) and (ii), it appears that three categories of tokens have emerged by way of classification among the though leaders in the blockchain and DLT space. The following is an excerpt from “A Statement on Token Regulation with a Focus on Token Sales” – a very good piece of work and a must read for crypto geeks – by the German Blockchain Bundesverband:
“Cryptocurrency Tokens” means tokens that are meant to function as a means of payment for goods or services (inter alia) external to the platform or not only exclusively between the platform and its users but also between users.
“Utility Tokens” means tokens that are supposed to convey some functional utility to token holders other than/in addition to payment for goods or services, in the form of access to a product or service offered or at least intended to being enabled or created. These tokens come with particular rights, such as: (i) a right of access to a (future) service (once developed); (ii) a right to redeem the token for another token or service; (iii) voting rights which often are designed to shape the functionality of the product.
“Security Tokens” means tokens that are comparable to conventional instruments set out in Art. 4 (1) (44) MiFID, especially to conventional debt and equity instruments.”
Now, the BaFin stresses that the mere labelling of a token, e.g. a utility token, is not relevant to the legal analysis as to whether a token is subject to regulation. According to the BaFin, whether a token satisfies regulatory requirements can therefore not be answered in general but always requires an assessment of the characteristics of the token in each individual case. Thus, the classification of tokens as belonging to a certain category (as described above) is only a first step in developing a legal definition for the different types of tokens, which may then be used as the basis for a more advanced (and hopefully better) regulatory regulation of tokens.
Until this step has been completed, preferably on a global level, the supervisory authorities have to put the cart before the horse. This means they have to utilize the existing legal provisions on securities supervision as a starting point and apply them to describe scenarios that may result in a specific token being subject to regulatory oversight.
The BaFin information letter
Accordingly, BaFin describes the following scenarios, which may result in a token being subject to regulation:
Depending on their characteristics in each individual case, tokens can be regarded as (i) financial instruments, (ii) a security, (iii) a share in investment assets. In addition it can also constitute the basic value for a derivative transfer (for specifics, please refer to the Guidance Note on Financial Instruments (Derivatives)).
aa) Security: The requirements for a token to be regarded as a security in accordance with Sec. 2 para. 1 WpHG (German Securities Trading Act) or Art. 4 para. 1 No. 44 MiFID II, include in particular:
- it needs to be transferable;
- it needs to be able to be dealt on the financial market or the capital market, whereby cryptocurrency dealing platforms can generally be regarded as financial markets or capital markets in accordance with the securities definition;
- the token must embody rights, i.e. shareholders’ rights or contractual rights or rights comparable with shareholders’ rights or contractual rights that are embodied in the token; and
- the token must not fulfil the requirements of a payment instrument as stipulated in Sec. 2 para. 1 WpHG or Art. 4 para. 1 No. 44 MiFID II).
bb) Share in investment assets in accordance with Sec. 1 para. 1 KAGB (German Capital Investment Act) / Annex I Part C (3) MiFID II)
The BaFin has summarised what constitutes investment assets in its Interpretation Letter Regarding the Application of the KAGB and the Term “Investment Assets”.
cc) Asset investment in accordance with Sec. 1 para. 2 VermAnlG (German Investment Products Act)
This requires that the token must not constitute a share in accordance with the WpPG (German Securities Prospectus Act). Additionally, the token must not represent a share in investment assets and the acceptance of the monies must not be classified as a deposit.
Depending on the legal characteristics, a token can be regarded, among others, as a
- share in a company,
- shareholder loan or subordinated loan,
- participation right or as another form of investment.
b) Security in accordance with Sec. 2 No. 1 WpPG
Depending on their characteristics, tokens may also be classified as securities. With respect to the requirements to classify tokens as securities in accordance with the WpPG in each individual case, the same details as set for securities under the WpHG apply.
c) Consequences of classification as a financial instrument or as a security in accordance with the WpPG
If there are any regulatory questions regarding tokens, market participants that are affected should align with the relevant BaFin department well before any planned projects or transactions.
The relevant experts can be found on the BaFin Organisational Allocation Plan.
If applicable regulatory requirements are not adhered to, this may result in BaFin prohibiting the relevant projects or transactions. Additionally, such infringements may constitute administrative offences which may carry fines. To the extent there is any indication of offences being committed, the matter will be referred to the competent prosecution service.
aa. Banking licence or financial services licence
Depending on the circumstances, dealing with tokens as a
- bank business, namely principal broking services or underwriting business, or
- financial service, namely in the form of investment broking, investment advice, operating a multi-lateral or organised trading facility system, placement business, contract broking, financial portfolio management, own-account trading or investment management,
may be subject to the obligation to seek prior permission from BaFin.
One should note that operating a banking business or offering financial services without the relevant licence, may face imprisonment of up to five years or a fine.
bb) KAGB permission
In individual cases, tokens may also qualify as a share in investment assets. This may require prior permission in accordance with the KAGB.
cc) VAG licence
Further, tokens may constitute an insurance business if certain services are taken on for a certain price and in case of an uncertain event occurring. Carrying on insurance business requires a licence in accordance with the VAG.
dd) ZAG licence
If third parties are involved (e.g. an internet platform operating an exchange to convert the virtual money into legal tender), then not only the operation of a multi-lateral trading facility requires a financial services licence in accordance with KWG but a licence may also be required for offering payment services.
- If a third party transfers the real value of the token at the request of the acquirer to the exchange recipient via its own account, it is the third party that is operating the money remittance business and as such requires a payment services licence.
- If it acts at the request of the payment recipient, this may also constitute an acquisition business in accordance with the ZAG.
- A combination of both is also possible, for example if the payment services provider is acting for both sides of the exchange transaction, which can often be the case for internet platforms.
The key factors are the individual agreements between the relevant parties, as is always the case when evaluating whether or not an authorisation is required.
Please contact us if you have any questions on the BaFin information letter or the regulation of tokens, token sales or ICOs in general.
If you know like BaFin knows
you don’t want to step to this
It’s the ICO-Funk era
Funked out with a regulated twist
If you invest like a pro
Then you high like everyday
But if your ass is a buster
Than the BaFin will regulate
P.S. Sorry Warren G for twisting your lyrics in a geeky way.
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