What does the term tokenization mean

BaFin - Navigation & Service

Traditional investments according to the Asset Investment Act (VermAnlG) are generally not considered securities under the Securities Prospectus Act (WpPG) and the Securities Trading Act (WpHG).1 This is because they cannot be compared with securities in terms of transferability, standardization and tradability (marketability). But that is changing due to blockchain technology (see info box and BaFinPerspektiven 1/2018), which can go so far that the two different financial instruments merge with one another.

The background to this is as follows: If a financial instrument, which in terms of content is designed or designated as an investment in accordance with Section 1 (2) VermAnlG, is digitized in the form of a freely transferable and tradable token (see info box), the result is not an investment in the sense of this of the VermAnlG, but a security within the meaning of the WpPG and the WpHG. This at least if the instrument contains equity-like or membership rights or a property right of a contractual nature and is freely transferable.

At a glance: digital cross-border commuters

Blockchain: This means an unchangeable digital database that only allows additions (see BaFinPerspektiven 1/2018).

Token: A token is a digitized form of assets. A certain function or a certain value is assigned to him. Far-reaching uses and manifestations are conceivable.

Tokenization: This is the digitized representation of an (asset) value including the rights and obligations contained in this value as well as the transferability made possible by this.

Token as a separate security class

Such tokens are a type of security of their own (sui generis), because due to the tokenization (see info box) they are assets that can be traded on the financial market and that must be classified as securities. This becomes clear when one considers the principle of “Substance over Form” coined by the European Securities and Markets Authority ESMA. According to this, the material components of an instrument are always decisive, not the purely formal designation.

This administrative practice applies in particular to shares that grant a share in the results of a company or that represent profit participation rights and registered bonds. So far, these instruments have come under the VermAnlG and not the WpPG, as they could not be traded on the financial markets. If they are not digitized in the form of a freely transferable token that can be traded on the financial markets, the classification as an investment within the meaning of the VermAnlG remains.

Criteria for classification as a security

In general, the following applies: For a financial instrument to be classified as a security within the meaning of Section 2 No. 1 WpPG, transferability, tradability on the financial market and security-like rights are required. A securitization in the form of a certificate, which ensures the marketability of financial instruments in the case of classic securities, is not required for a token to be classified as a security.

On the one hand, the concept of securities must be interpreted uniformly due to the desired EU-wide supervisory convergence, with both WpHG and WpPG transposing the concept of securities from the second European financial market directive (Markets in Financial Instruments Directive II - MiFID II) into national law (Article 4 Paragraph 1 No. 44 MiFID II). On the other hand, a token that maps the rights enables the marketability to be reduced through simplified transferability and increased tradability (but without necessarily being a document in the legal sense).

Transferability

Transferability means that, from a technical point of view, the tokens can be transferred to other users at all. A security that is transferable by its type also requires that the security remains unchanged in terms of its legal content or its technical nature in the context of the transfer to another purchaser. This usually works without problems with common token standards.

Tradability

It is crucial for tradability on the financial markets that a token is sufficiently standardized and designed in the same way. With regard to the “tradability” criterion, the type of transfer is not important. The token must simply not convey different rights and it must be possible to determine the type and number of pieces in business transactions. A standard such as the statutory protection of good faith (see info box) is not necessary for the acceptance of the property of a security - at least for the regulatory concept of tradability on which the WpPG and WpHG are based. When it comes to the concept of securities, crypto trading platforms are also viewed as financial markets, since the concept of “financial market” has to be interpreted broadly under European law.

Definition: protection of good faith

The protection of good faith is a legal institution that theoretically makes it possible to acquire a right from an unauthorized person. It is sometimes argued that the possibility of such a bona fide purchase is important in order to affirm the security status of an asset, since only in this way an orderly process and trading on the financial market is possible. The second European financial market directive (Markets in Financial Instruments Directive II - MiFID II), the Securities Prospectus Act (WpPG) and the Securities Trading Act (WpHG) do not presuppose this, but merely state the requirements for transferability, tradability on the financial market and rights similar to securities.

The pivotal point are the rights linked to the tokens, which, according to the provisions of the WpHG and MiFID II, must basically be membership and / or property rights. This means that a token must either embody a membership right similar to a share or another property right that must be comparable to the examples for transferable securities (e.g. debt instruments) mentioned in Section 2 WpPG.

At this point, it should be expressly pointed out that the assessment by BaFin only relates to the property of securities in the regulatory sense according to the requirements of the WpPG and other relevant supervisory laws. In addition, it is incumbent on the issuer to observe any legal requirements that result from this along the value, transfer and trading chain for the corresponding security. This includes custody in accordance with the German Securities Account Act as well as clearing and settlement in accordance with the European Central Securities Depositories Regulation (CSDR)

Security Token: First securities prospectus approved

The legal paradigm shift outlined above is already having an effect in operational supervision: At the beginning of 2019, BaFin approved the first securities prospectus for a security token offering in Germany. The underlying instrument was originally designed as a registered bond, i.e. as an investment, and would have been subject to the VermAnlG. However, the transfer to the blockchain has significantly increased tradability on the financial market. The investment tokenized in this way was to be classified as a sui generis security and assessed according to the WpPG. Therefore, the issuer did not have to prepare a sales prospectus under the VermAnlG, but a securities prospectus under the WpPG. Securities prospectuses for further security token offerings are still being examined.

author

Hagen White
BaFin Department of Fundamental Issues, Prospectuses and Monitoring Securities Analysts Department

Note

The article reflects the status quo at the time of publication in the BaFinJournal and is not updated retrospectively. Please note the general terms of use.

Footnote:

Further information

BaFinJournal 04/2019 (Download)

Did you find the article helpful?