SAFE Finance Blog
24 May 2019

Time of upheaval for the legal framework of securities trading

Roland Broemel: the emergence of digital securities raises many technical, civil law and regulatory issues

Digitization is leading to far-reaching changes in securities trading law as well. In March, the German Federal Ministry of Finance and the Federal Ministry of Justice and Consumer Protection presented backgrounds and options for the design of electronic securities register in a key issue paper in preparation for the introduction of a legal framework for the blockchain-based issuance of promissory notes.

If securities trading is digitalized, this also means that a physical stock certificate is not required. That raises some questions: under civil law, the principles of the protection of expectations in commercial transactions, i.e. the protection of the trust in the legitimacy of the contracting party, are linked to the possession or handover of the tangible certificate by transfer as well as by payment. The legal arrangements such as possession constructions are common in practice to enable central custody of the physical documents to act as an outsourced service. This aims to meet the requirements of the protection of expectations in commercial transactions and to increase the marketability (i.e. the ability to be traded) of the securities. The civil-law model of ownership of a physical document thus becomes a legal fiction in practice.

A blockchain-based securities register may, depending on its design, fundamentally change the background and functioning of expectations in commercial transactions. Comparable with other jurisdictions, German civil law provides two simplified models of the protection of legal transactions. A regime for movable property is based on the possession; the change of ownership and the right of possession form the starting point for the protection of bona fide legal transactions. A regime for immovable property (as well as ships and aircraft) relies on entries in a public register to protect bona fide legal transactions. By contrast, blockchain-based applications do not protect legal relations by normative rules of good faith: the deciding factor is the design of the algorithm. The distribution of blockchain to several decentralized nodes or methods of asymmetric cryptography and various mechanisms for coordinating the nodes offer the participants reliability independent of normative protection. Accordingly, virtual currencies such as Bitcoin compete with the self-conception that they can do without sovereign recognition. Other applications continue to regulate the design of corporate governance and decision making on blockchain-based decision-making rights. From this perspective, the law merely traces the results of the blockchain transactions: everything that the blockchain allows is within the legal framework (under company law). Not least because of these differences in the approaches of law and blockchain to provide the protection of expectations in commercial transactions, their connection in the blockchain-based trading of electronic securities raises a number of fundamental issues on how it could be designed.

Constraints of the network limit the innovation potential

One of the central points of a new regulatory framework for electronic securities concerns the circle of actors authorized to issue and trade securities. For technical reasons, it may be beneficial to design a register as a restricted network with access only to selected actors. This kind of restrictions may centralize registry administration and facilitate coordination of the nodes involved in the ongoing management of the blockchain. At the same time, this provides a regulatory interface for the approval and ongoing supervision of intermediaries.

However, this constraint also limits the innovation potential. On the one hand, blockchain-based applications have efficiency advantages due to the possibility of renouncing the performance of intermediaries. On the other hand, the choice of a specific form of a network with limited access and mechanisms to control and coordinate certain nodes implies a commitment to only one specific technological option from a variety of evolving approaches.

The authors of the key issues paper call for technology neutrality. Taking this matter seriously, it means, on the one hand, the parallel marketability of physical and electronic securities, including certain conversion options. On the other hand, such a register would have to remain open for the competition of different, also commercially developed blockchain concepts. This kind of a guarantee of openness to development stands in latent tension with the aim to introduce an electronic register as soon as possible.

The question of shaping the relationship among the involved nodes leads to another central point: the internal governance of the blockchain-based register. There are many different approaches to blockchain-based virtual currencies and platforms. Open systems that provide manipulation safety over the decentralized nature and design of the algorithm are challenged when external circumstances or unforeseen developments require adjustments of the code. For example, in the case of the bitcoin as a virtual currency, a cross-node validation mechanism of transactions (proof of work) may reach capacity limits by being coupled to the creation of new bitcoins. In other, platform-based blockchains, gaps have occurred in supposedly tamper-proof systems which made conceptually unscheduled corrections in the algorithm necessary.

By contrast, closed systems with defined, selected actors offer more space, including the reshaping of governance and corrections of the algorithm. However, they limit the innovation potential as a result of the determination.

The draft hides other securities such as shares

It quickly becomes clear that the introduction of blockchain-based securities is more than the digitalization of the tangible instrument and the consequences for civil law related to movable property. The authors of the key issues paper suggest linking the blockchain-based securities to the electronic register stated in the German Federal Government Debt Management Act. This is obvious insofar as bonds are already electronically listed there.
However, such a link between an electronic database with the protection of expectations in commercial transactions modeled after the land register and the rules for immovable property may still not address all the issues concerned with a blockchain-based register. On the one hand, the draft is limited to the issue and transfer of debt securities – it excludes other securities, in particular, shares, but also other forms of disposal, such as pledges. On the other hand, the standards of the German Federal Government Debt Management Act are based on a conventional database. Consequently, these rules neither provide the requirements of blockchain-based coordination, i.e. the governance of ongoing operations nor use the potential of a decentralized application by a large number of actors.

The questions of consumer protection also arise in setting up the legal framework for the issuing of blockchain-based units (Initial Coin Offering, ICO). On the one hand, these tokens issued on behalf of different items are in a legal gray area. They thus raise a need for regulation, above all on how to ensure a sufficient level of consumer protection. On the other hand, their cross-border nature encourages evasive action in less regulated areas. For example, against this background, the French legislative body has chosen an optional model for issuing so-called visas for certain regulated issuers.

In sum, the developments outlined in the regulatory framework of securities trading mean times of upheaval – the opening up to digitalized securities is foreseeable; the modalities of the technical, civil law and supervisory arrangements are not yet there.

Roland Broemel is Professor of Public Law, Economic and Currency Law, Financial Markets Regulation and Legal Theory at the Institute for Monetary and Financial Stability at Goethe University Frankfurt.