The hype surrounding ICOs has cooled down a bit of late, but now Germany is seeing its first Security Token Offering from Bitbond Finance GmbH. What is behind it? How is it different to an ICO? In order to answer these and other questions, let’s take a closer look at the topic.
A Security Token Offering is a public offer of a security that is tokenized. The owner of the token obtains rights in a company or contractual claims to assets as promised by the security. In contrast, an ICO is usually not backed up with assets, but it mostly involves the issuance of a cryptocurrency or a utility token. With a cryptocurrency token, the token can be used as a means of payment. The utility token entitles the owner to purchase goods or services from a company. They both have in common, however, that they are not secured by assets. The risk of an empty promise is therefore very high. With the Security Token Offering, however, there is a right to a share of an asset and there is also a stricter legal framework. Some risks are, of course, still involved, but we will provide further details on those below.
Legal framework for a Security Token Offering in Germany
According to BaFin, Security Token Offerings are subject to the provisions of securities law (for further details on BaFin’s classification see Frank’s entry on “Regulators mount up – BaFin provides further guidance on ICOs), if the token is a security. This is the case if it is (a) transferrable, (b) can be traded on a financial or capital market (BaFin also includes crypto exchange platforms in this), (c) the token represents legal rights such as shareholder rights or contractual rights and (d) it does not constitute a payment instrument. If the token constitutes a security, this means, for example, that a securities prospectus needs to be prepared.. This provides investors with increased security but also results in more work as well as potential liability for any errors in the prospectus.
A concrete example: The Bitbond Finance GmbH Security Token Offering
The securities prospectus of Bitbond Finance GmbH as approved by BaFin details what the token represents. The security is a subordinated bond. This means that each investor grants the company a loan of the amount paid by each investor. In the terms and conditions of the bond, the company promises to repay the amount at the end of the term and to pay interest during the term. In this specific case, there is a fixed interest rate of 4% p.a. on the investment sum and a variable interest on the company’s proceeds. The subordinate nature of the bond means that the other creditors of the company are satisfied before the bondholders. Up to this point, this mechanism does not differ from other corporate bonds. However, while those are usually securitised by way of a global certificate which is held in collective custody at a central depository (Clearstream), in a Security Token Offering, no global certificate is issued but the security is tokenised, i.e. each investor receives a token (smart contract) which represents their rights. For the Bitbond Security Token Offering, the token is created on the Stellar Blockchain.
Risks of a Security Token Offering
The risks of investing in a corporate bond or share remain pretty much the same at first glance; they arise from the risks of the company and its business model (it is no coincidence that the term “junk bond” was created). However, the prospectus must present these risks truthfully so that investors can make an informed decision. In the case of a Security Token Offering, however, there are additional, blockchain-specific risks. For example, anyone losing the key to their private wallet will lose access to their investment and will be unable to restore it any other way. An advantage and at the same time also a risk is the fact that there are no intermediaries. Who will guarantee that all investors will actually receive a token? In the case of a “regular” bond, it is purchased and sold by banks that are subject to regulation. For Security Token Offerings, the company itself ensures that investors receive their tokens. What if the company fails to ensure this or if the smart contract has been tampered with?
Additionally, any payments in cryptocurrency are risky as cryptocurrencies tend to be very volatile, resulting in increased currency exchange risks.
One advantage of Security Token Offerings is the ease with which tokens can be transferred. For some it may also be important that an anonymous transfer appears to be possible. However, this may not be possible to this extent for much longer due to the increased regulation of crypto exchanges, which will in future be subject to stricter anti-money laundering obligations (for more information, please see Bernd Fletzberger’s entry on the 5th Anti-Money Laundering Directive).
From cutting coupons to tokens: can the law still keep up?
Historically, bonds were securitised in individual bonds (also known as shells) and the right to interest in interest coupons was also known as coupon. Additionally, dividend coupons are also referred to as coupons. Bonds and coupons can be traded and redeemed like money. Upon presentation of the coupon, the holder received the interest due from the bank. The individual interest coupons are cut from the shell in order to redeem them. The right to the certificate follows the right in the certificate (Section 793 German Civil Code, BGB). Therefore, the bond itself and the rights securitised therein are transferred by handing over the certificate.
Today, this type of individual securitisation has become unusual. The standard is securitisation in a global certificate, which is held collectively at a central securities depository. However, the transfer here is also effected in accordance with applicable property law. The central securities depository that holds the certificate in its safe, is the direct third-party holder. It holds the certificate (or a co-ownership share) in safe custody for the depositor’s custodian bank. The custodian bank of the depositor is the first rank indirect possessor, the depositor itself is the second rank indirect possessor. The transfer is effected by the central securities depositary acknowledging that it possesses the certificate for the new owner’s custodian bank. Legally, however, this is a transfer under property law pursuant to Section 929 sentence 1 BGB.
In actual fact, no document is presented or even moved in this case anymore, but there is still a reference to a piece of paper. However, this is different in the case of a Security Token Offering. There is no “piece of paper” and therefore no clear legal basis for how the transfer of a tokenised bond works from a legal perspective.
In order to bridge this lack of legal rules, the terms of the bond can also contain rules regarding their transferability, e.g. that a transfer is only possible via the blockchain and not outside of it. However, it is not entirely clear whether such a condition would hold if it were challenged in court.
Legal certainty could be ensured by the legislator in this area if token-based securities were treated in the same way as securitised securities. The German Federal Ministry of Finance and the Federal Ministry of Justice and Consumer Protection thought along the same lines when publishing their key points for the regulatory treatment of electronic securities and crypto tokens. In it, they propose to solve this problem with the help of a blockchain-based register, in which electronic securities are created by entering them in the register. They also propose to use a legal fiction to declare them as property for the purposes of the law. Anyone with an interest in this area and who belongs to an interested group of experts can submit a statement to the relevant ministries by 12 April 2019.
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