Digital Securities - Game changer or flash in the pan?

Traditional avenues such as equities and corporate bonds have historically served as the primary tools of companies seeking funding. Getting buried in costs, bureaucratic hurdles, and complicated processes, however, can leave even the most seasoned entrepreneurs scratching their heads. New technologies could provide the means to streamline this process presenting a promising solution that could reshape the landscape of capital acquisition for businesses of all sizes.

But is the infrastructure modern, secure and regulated enough to potentially mount a challenge against the long-trusted financial giants' tight grasp on the methods of traditional capital raising?

A new era

Over the past few years, the rise of digitisation has ushered in a wave of technologies like blockchain aimed at simplifying access to capital markets, starting with Initial Coin Offerings (ICOs) in 2017, which later evolved into Security Token Offerings (STOs).

Unfortunately, an initial lack of regulation led to a flood of scams and fraudulent projects in the ICO market, leaving many investors empty-handed. A justified outcry for investor protection and increased regulatory oversight to ensure compliance with securities laws resulted in tightened regulations and clarity on the market. Today, every crypto exchange in Europe requires Know Your Customer (KYC) and Anti-Money Laundering (AML) procedures for each user.

This was also the primary driving force behind German regulators wanting to create an environment of trust and security for issuers and investors. They have defined the safest way to offer securities on a blockchain-based infrastructure with a new law. The government laid the foundation for this new law on June 10, 2021, with the adoption of the German Electronic Securities Act, or “eWpG” for short. 

Since then, companies have had the opportunity to issue bonds and fund shares in the form of electronic securities. In practice, an environment of trust and security is created by:

• Comprehensive property protection, especially in the event of insolvency and foreclosure, as well as special regulations for dispositions including the transfer of ownership and for purchases in good faith.

• The holders of the securities are entered in the register by a regulated financial institution or crypto securities registrar and can only be transferred to persons who have also been KYCed by a registrar.

Navigating regulatory waters: Germany's eWpG

Let's take a look at how this new securities standard is actually defined by German law to gain a better understanding of the differences from regular securities.

According to the definition of the eWpG, a crypto-security is an electronic security registered in a crypto-security register. It is defined as being registered in an electronic securities register rather than being issued in the form of a paper certificate. 

The registry must be maintained by a regulated crypto-securities registrar entity that guarantees the confidentiality, integrity and authenticity of the data at all times. It must be maintained on a tamper-resistant record-keeping system in which data is logged in chronological order and stored in a manner protected against unauthorised deletion and subsequent modification.

While the eWpG does not yet cover traditional equities such as shares, it is poised for expansion in the near future. 

Understanding the difference (Security Token Offering vs Crypto Security)

Before the eWpG came into force in Germany, companies were already able to issue securities digitally in the form of tokens, known as security tokens. The newly introduced law streamlined the regulatory requirements in the form of a license (crypto securities registrar license), which is granted by the Federal Financial Supervisory Authority (BaFin) if all requirements are met. 

• Greater legal certainty for issuers and investors due to strict regulatory requirements and prescribed standards such as KYC and AML data 

• Extended liability for the administrator of the crypto securities registry

• Improved liquidity as physical certificates are no longer required, making secondary market trading (currently OTC only) more accessible

• Access to a new capital market for institutional investors

Growing pains while navigating evolving terrain 

Large-scale technology adoption is always accompanied by growing pains. Shedding the technological burdens of an outdated financial system is never easy. Crypto securities emerged as a disruptive force within the market, showing a glimpse of the huge potential already. 

However, as the industry grapples with the complexities of an evolving terrain, the current state of the market remains hard to predict. The lack of a unified technology standard among security registrars has contributed to the chaotic nature of the industry. Each registrar operates with its own set of technology, which makes it difficult to interoperate with other parties like regulators, exchanges, marketplaces, etc.

As a result, the integration of new technologies is hampered by outdated traditional financial infrastructure, making a rapid expansion of digital securities difficult.

A potential solution is currently in the works by a German association, founded in 2022 called “Bundesverband der Kryptowertpapierregisterführer”. They aim to find and provide a common token standard to support interoperability. This new token standard is similar to the T-Rex (ERC 3643) standard and proposed to the Ethereum Foundation as an EIP (Ethereum Improvement Proposal). 

A hurdle that remains in the digital securities space, is the continued reliance on fiat money transfers for transactions. The digital state of the security needs to synchronise with the real-world state of the ownership transfer.

A comparable example of this would be withdrawing funds from your bank account instantly, while the actual transfer of physical money may take place at a later, scheduled time. This makes only the transfer process of the security entirely digital and instantaneous, not the entire transaction.

The solution is most likely only a matter of time as stablecoins gain prominence. Utilising a euro stablecoin as payment for a crypto securities transaction would make it possible to enable a seamless and instantaneous exchange of both securities and funds, entirely on the blockchain. By leveraging smart contracts for settlements, the potential for more efficient and streamlined processes becomes apparent. 

Pioneers paving the way

The introduction of the eWpG in Germany has paved the way for progressive regulation and a conducive environment for blockchain technologies to flourish. Notably, significant players such as Siemens have already embraced this transformative shift, participating in the issuance of approximately €165 million worth of crypto securities by July 2023.

Despite the prevailing sentiment surrounding blockchain-based offerings and the challenges posed by the existing financial infrastructure, the innate resilience of the market is expected to overcome these obstacles in time. Just as in any downturn, the quiet times serve as the ideal opportunity to conduct comprehensive research, experiment with use cases, and continue to build out the essential infrastructure.

As the market continues to mature, the prospect of a more decentralised financial landscape, unencumbered by the inefficiencies of traditional systems, calls out to all stakeholders.

So, if you're ready to embrace the future of finance and delve into the possibilities presented by crypto securities, our team at Tangany is here to guide you through every step of this exciting journey. 

Contact us today at info@tangany.com!