The German Federal Financial Supervisory Authority (BaFin) has issued a notice letter reflecting its pragmatic approach to regulating initial coin offerings. In the absence of specific European and German laws, BaFin’s approach has led to uncertainties in how crypto-token offerings should be regulated. Legislative intervention by European and German lawmakers would be necessary to eliminate such uncertainties.
Initial coin offerings (ICOs), i.e., the offer of tokens by means of the blockchain technology against payment of money or cryptocurrency, have become increasingly popular internationally. In 2018, more than $20 billion was raised through ICOs, which were enthusiastically described as the “hottest game in town.”
This trend has not remained unnoticed by the German Federal Financial Supervisory Authority (BaFin) which calls for regulation. However, even though the European Banking Supervisors (EBS) and the European Securities and Markets Authority (ESMA) have both published reports on crypto-tokens in January 2019 and recommended regulation, no regulation on ICOs or crypto-tokens has been enacted on the European level so far. The same is in principle true for Germany where the legislator until now has made no attempt to react on this development.
Against this background, the BaFin published in February 2018 a notice letter on its approach to the regulation of ICOs. The BaFin explained that it will review on a case-by-case basis whether the respective token should be considered as a financial instrument pursuant to the Securities Trading Act (Wertpapierhandelsgesetz – WpHG) which will be assessed by analyzing which rights a specific token provides. Consequently, pursuant to the BaFin argumentation issuing tokens may require a prospectus under the Securities Prospectus Act (Wertpapierprospektgesetz – WpPG) and trading ICOs may require a license under the German Banking Act (Kreditwesengesetz – KWG). In addition, licensing requirements under the Payment Services Supervisory Act (Zahlungsdiensteaufsichstgesetz – ZAG) or the Capital Investment Act (Kapitalanlagegesetzbuch – KAGB) may be relevant depending on the type of tokens offered or the services provided in connection with such offering.
The Berlin Court of Appeal (Kammergericht) decided in its judgment of 25 September 2018 that contrary to the BaFin interpretation, the operation of a trading platform for bitcoins does not constitute a financial service for which a license is necessary because bitcoins do not constitute financial instruments under the WpHG. The court argued that bitcoins lack general recognition and stability of value so that they do not qualify as unit of account. With respect to the opposite opinion of the BaFin, the court stated that the BaFin has no competence to amend the scope of application of statutory laws.
Despite this judgement, the BaFin on 18 August 2019 published a second notice letter in which it confirmed its previous position on ICOs and again stated that tokens depending on their specific use may qualify as financial instruments under the KWG and the WpHG. In particular, the BaFin specified when it will consider an ICO to constitute a securities offering with the consequence that a prospectus under the WpPG will be required.
Legal Qualification of Tokens
An instrument will qualify as a security if it is transferable and tradable on the financial markets and embodies certain rights of the holder against the issuer. According to the BaFin, the basic transferability of tokens can be assumed. In order to be tradable on the financial market, the tokens would have to embody standardized rights. If tokens are traded on crypto exchanges in the internet, this criterion will also be fulfilled. There is no need for a securitization of the token. Rather, the prerequisite for a token to be regarded as a security within the meaning of the WpPG is the embodiment of asset rights or membership rights in the token, e.g., if the token entitles to certain payments at the end of its term or to regular payments. If the token is structured as an instrument that can be traded on a financial market, it can be classified as a security sui generis.
In order to answer the question about the securities characteristics, it is crucial to determine which rights are associated with the respective token. The BaFin distinguishes between different types of tokens:
- “Utility Token” which allow access to certain services or products and are similar to vouchers or access cards
- “Payment Token” which works as a virtual currency or payment method
- “Security Token” which embody membership rights or payment claims
In addition, there are hybrid forms of these tokens (“hybrid tokens”).
Typically, Utility-Tokens do not qualify as securities or financial instruments and, therefore, fall outside the scope of regulation under the KWG or WpHG. On the other hand, payment tokens may qualify as financial instruments as they represent alternative means of payment. Finally, Security Tokens work as securities and are, therefore, legally treated as securities. In particular the use of the blockchain technology for the creation of the tokens has the consequence that tokens which represent a certain asset investment reach a degree of standardization and tradability which is sufficient to qualify such token as security.
Prospectus and Licensing Requirement
The legal qualification as a security token has the consequence that a public offer of such tokens in German requires a prospectus pursuant to the WpPG. Further, the qualification of a token as financial instrument may trigger a licensing requirement under the KWG, ZAG, or KAGB for the person brokering or trading such tokens or offering payment services in connection with token offerings.
The BaFin’s approach to ICOs has been criticized for not staying within the borders of admissible interpretation of the law because the BaFin tries to fit an entirely new phenomenon into an existing legal framework that has not been designed for today’s virtual reality. On the other hand, there is no doubt that token offerings call for regulation and in the absence of specific laws the BaFin has taken a pragmatic approach by regulating ICOs according to their economic use. In order to eliminate the current legal uncertainties in this area, the European or national legislator will have to pass specific laws.