In March 2019, the Swiss federal government published a draft law on distributed ledger technology (DLT Draft Law). The proposed rules aim to improve the legal framework for cryptoassets and DLT-based applications. Stefan Kramer and Urs Meier of Homburger take a look
The draft law was preceded by a report of the Swiss Federal Council on the legal framework for blockchain and DLT in the financial sector that was released in December 2018. The report was driven by an initiative to enhance innovation and allow Switzerland to evolve as a leading and sustainable location for DLT-based business models. The report concluded that Switzerland's legal framework is already well suited to deal with new technologies, including DLT, but also pointed out the need for selective action and improvements. The DLT Draft Law seeks to address a number of the points identified in the report.
Classification of cryptoassets
From a technical perspective, cryptocurrencies and other cryptoassets are ultimately tokens, i.e., pieces of information stored in a DLT-based register. In order to facilitate compliance with Swiss financial market regulations, the Swiss Financial Market Supervisory Authority (FINMA) in February 2018 published guidance on initial coin offerings (ICOs), which also included a classification of tokens. Using an economic approach and looking at the substance instead of the form, FINMA distinguishes three basic types of tokens:
- "Payment tokens" (according to FINMA, this term is synonymous with the term cryptocurrencies) are tokens, that are intended to be used, now or in the future, as a means of payment for acquiring goods or services, or as a means of money or value transfer. Generally, such tokens do not give rise to any claims towards an issuer or a third party and according to prevailing Swiss legal doctrine, they are therefore deemed to be purely factual, intangible assets. For example, cryptocurrencies such as Bitcoin and Ether fall into this category.
- "Utility tokens" are tokens that are intended to provide a DLT-based access to an application or service.
- "Asset tokens" represent assets such as a debt or equity claim on the issuer. They provide, for example, for a right to a certain part of a company's profits. In terms of their economic function, asset tokens therefore are analogous to equities, bonds or derivatives.
The three categories of tokens are not mutually exclusive. Rather, asset tokens and utility tokens may at the same time also qualify as payment tokens. In that case, they constitute so-called "hybrid tokens".
The above classification serves as a guideline for compliance with Swiss financial market regulations. In particular, the issuance and trading of tokens that are considered to constitute securities or derivatives may constitute a regulated securities dealing activity, thus triggering licensing requirements. In addition, a public issuance of tokens that are considered to constitute securities will typically be subject to prospectus or similar disclosure requirements. Whether or not a given token should be regarded as constituting a security needs to be determined on a case-by-case basis. In this respect, FINMA has provided the following guidance:
- Payment tokens, such as Bitcoin or Ether, are not treated as securities by FINMA.
- Similarly, mere utility tokens are not treated as securities by FINMA, provided: (i) their sole purpose is to confer digital access rights to an application or service; and, (ii) the tokens can actually already be used in the proposed way at the time when they are issued. If these two conditions are met, the typical "connection with capital markets" inherent to securities, according to FINMA, does not exist.
- In contrast, utility tokens that fully or partially serve an investment purpose and asset tokens will according to FINMA generally be treated as securities if they are: (i) issued under identical terms (i.e., as regards denomination, interest rate and maturity date); (ii) publicly issued or placed with at least 20 investors; and, (iii) suitable for mass trading.
Key aspects of the proposed DLT Draft Law
Facilitation of the tokenisation of financial instruments
One of the main goals of the proposed DLT Draft Law is to increase legal certainty in connection with the issuance and trading of "tokenised" rights and financial instruments, such as bonds and shares. The notion of tokenisation is generally defined as the linking of a real-world asset (for example, a claim) to a token in a way that the asset can only be transferred and enforced by the holder of the token. To that effect, the DLT Draft Law provides for the introduction of a new concept of DLT Rights (DLT-Wertrechte) and specific rules in the Swiss Code of Obligations for debtors looking to issue shares in tokenised form.
The purpose of the introduction of DLT Rights is to allow for a legally sound tokenisation of legal positions. With this new concept, legal certainty regarding the issuance and transfer of tokenised rights and financial instruments, such as shares or bonds, will increase substantially, since DLT Rights will have the same functionality and entail the same protection as traditional negotiable securities. The draft also contains provisions on how DLT Rights may be cancelled by a court and under what circumstances dispositions concerning DLT Rights are regarded irrevocable in a bankruptcy situation.
If the DLT Draft Law enters into force as envisaged, any uncertificated rights may in the future be issued as DLT Rights if, based on a registration agreement (Registrierungsvereinbarung) between the parties involved, such rights (i) are entered into a DLT-based electronic register (DLT Register); and, (ii) can exclusively be asserted and transferred via such DLT Register. The DLT Register will have to meet the following requirements:
- the content of the DLT Right (for example, the terms of the bond), the operating principles of the register, and the registration agreement must be recorded either in the DLT Register itself or in accompanying readable data that is hash-linked to the DLT Register;
- both the functional safety and the integrity of the data in the DLT Register need to be ensured in accordance with the latest state of technology at the time of issuance of the relevant DLT Right; and,
- the parties, i.e., the debtor and the creditor, must at any time be able to access both the register entries that concern themselves as well as the information mentioned in the first bullet point above.
There is no clear guidance in the draft law as to which of the existing blockchains will be deemed to be in compliance with the above requirements. In the view of the authors, the scope of the new rules should not be construed narrowly and should, for example, also capture "permissioned" blockchains, i.e., blockchains where only specific members can validate transactions. It is generally expected that this (important) question will be addressed in the final text of the law or in the accompanying report or an implementing ordinance of the Swiss Federal Council. In any event, according to draft legislation, there will be no requirement that a governmental agency review the satisfaction of these requirements. Instead, the draft law provides that the issuer of the DLT Right is required to inform investors of the mode of operation and the security and integrity of the register. It also provides that the issuer may be held liable for damages if the distributed electronic register does not satisfy the applicable requirements and the debtor or issuer is unable to prove that it applied due care. As regards the potential liability of the issuer of DLT Rights, the authors believe that the scope should be clarified in the final text of the law in order not to provide for an overly strict liability regime in the case of malfunction of the relevant DLT Register.
One of the main goals is to increase legal certainty in connection with the issuance and trading of tokenised financial instruments
Legal positions that may be tokenised, i.e., those that qualify as an admissible underlying of a DLT Right, will include any rights against counterparties, such as contractual claims, debt instruments (loans, bonds, etc.) and equity instruments (shares, participation certificates, etc.). Hence, as basic rule, if an asset, utility or payment token entails rights vis-à-vis a counterparty, it may be issued in the form of a DLT Right. Today, asset tokens are often issued in the course of so-called "security token offerings" (STOs). The new concept of DLT Rights will substantially increase legal certainty regarding STOs, mainly because the issuance and transfer of tokenised financial instruments, such as shares or bonds, will have a clear statutory basis in Swiss law. The same holds true, for example, for "stable coins" that entail a redemption right against the issuer or a third party. Conversely, native tokens, for example, "pure" cryptocurrencies such as Bitcoin or Ether, may not be issued in the form of DLT Rights, since they do not give rise to claims against an issuer.
Finally, it should be noted that the process of tokenisation does not necessarily need to occur directly, i.e., by creating DLT Rights, which are then held by the investors. Indirect forms of tokenisation are possible too. One example could be that DLT Rights are created and subsequently registered with a Swiss bank or central securities depository and booked to a regular securities account thereby converting into regular book-entry securities (Bucheffekten).
Trading in tokenised financial instruments
Another key element of the DLT Draft Law is the proposal to create a new licence category for financial market infrastructures for tokenised securities. This new licence category for "DLT Trading Venues" (DLT-Handelssysteme) will allow the offering of a wide range of services (primarily) with regard to "DLT Securities" (DLT-Effekten). DLT Securities are securities that are (i) suitable for mass trading; and, (ii) registered and transferred based on distributed ledger technology. The services offered may concern trading, clearing, settlement and/or custody of cryptoassets, and they may be rendered both to regulated financial market participants and unregulated market participants such as corporates or individuals, including retail clients.
The new licence category is available to trading venues allowing for the simultaneous exchange of offers between several market participants and the conclusion of contracts based on non-discretionary rules. Hence, the licensing requirements are largely modelled on the existing requirements for multilateral trading facilities (MTFs). Additionally, however, a DLT Trading Venue must provide for at least one of the following elements: (i) the admission of unregulated corporates or individuals; (ii) the custody of DLT Securities based on uniform rules and procedures; or, (iii) the clearing and settlement of trades in DLT Securities based on uniform rules and procedures. However, once a DLT Trading Venue has obtained a licence from FINMA, it may also permit the trading of payment tokens (for example, cryptocurrencies such as Bitcoin or Ether) as well as utility tokens.
Insolvency rules applicable to custodians of cryptoassets
Yet another key element of the DLT Draft Law concerns the question of how cryptoassets are treated in bankruptcy. When it comes to storing cryptoassets there are two basic options: either the owner of the cryptoassets stores the tokens him/herself, or the tokens are stored by a third-party custodian such as a wallet provider or a trading platform. There are various reasons why the owner may choose to store tokens with a third party, such as the facilitated handling of private keys or improved security. However, if a third-party custodian becomes insolvent, it needs to be determined which assets belong to the bankruptcy estate. This can, in particular, be difficult whenever the bankrupt custodian had control over assets to which a third party asserts (beneficial) ownership.
Under current Swiss law, it is not clear whether cryptoassets held by a custodian on behalf of a client may be segregated in bankruptcy, i.e., transferred back to the client. The DLT Draft Law therefore aims to introduce a new provision in the Swiss Debt Enforcement and Bankruptcy Act (DEBA). Under this new rule the cryptoasset owner may request segregation of its cryptoassets if the bankrupt debtor had the sole power to dispose over the cryptoassets, provided that the cryptoassets are individually attributed in the DLT Register to the relevant owner. The new segregation regime will apply to all custodians, namely also to banks and securities dealers. Therefore, the Swiss Banking Act (BA), which contains the insolvency regime for financial institutions, will be amended accordingly.
The proposals of the Swiss federal government are well balanced and at the same time innovative
The envisaged concept both under the DEBA and the BA is that the owner may request segregation of his cryptoassets if two conditions are met: (1) the bankrupt debtor had the sole power to dispose over the cryptoassets; and, (2) the cryptoassets are individually attributed in the DLT Register to the relevant owner. The proposed new segregation regime will apply both to "crypto-based means of payment" (kryptobasierte Zahlungsmittel), i.e., payment tokens, as well as other tokens, such as utility and asset tokens, provided the latter qualify as DLT Rights.
With regard to the condition (1), i.e., the bankrupt debtor (custodian) having the sole power to dispose over the cryptoassets, the key question is whether the debtor had "exclusive actual power of disposal" regarding the tokens in question. Usually, whoever has access to the private keys may initiate DLT-based transactions and therefore has such actual power to dispose over the tokens. Consequently, the decisive element is how the private keys are being managed. Four basic set-ups may be distinguished: either (i) only the owner may directly dispose of the cryptoasset and initiate a transaction in the DLT Register; (ii) both the owner and the custodian may initiate a transaction in the DLT Register; (iii) the owner and the custodian may jointly initiate a transaction in the DLT Register (a "multi-signature" setup); or, (iv) only the custodian may directly dispose of the cryptoasset and initiate a transaction in the DLT Register. Only in the last set-up (iv) is there exclusive actual power of disposal on the side of the custodian. Consequently, the cryptoassets fall into the custodian's bankruptcy estate and therefore, the proposed new insolvency rules would become relevant here, since the owner has no access of its own and the insolvent third-party custodian at the same time has all the keys to access the cryptoasset directly. Since in this set-up the cryptoasset would be included in the custodian's bankruptcy estate, the client would need to claim that it has the better right, i.e., is the owner of the cryptoassets in question.
With regard to the condition (2) mentioned above, the DLT Draft Law foresees that a segregation right will only exist if it is possible to unambiguously allocate the cryptoassets in question to a specific creditor. Accordingly, it is of importance whether the cryptoassets held by the bankrupt custodian can at all times be allocated individually to the entitled party, i.e., the owner. Here, the details of how the cryptoassets are stored are of utmost importance. If each client's credit balance can be tracked to a specific address in the DLT Register and is registered directly in the DLT Register, such cryptoassets are – according to the explanatory report of the DLT Draft Law – sufficiently attributed in the DLT Register to the relevant owner. In such cases it is possible at any time and without additional technical arrangements to allocate the cryptoassets to the individual client for whom the custodian holds the tokens.
The consultation period for the Draft DTL Law ended in June 2019. The effective date of the new law is not yet known.
Should the new rules enter into force as envisaged at the moment, they will further improve Switzerland's legal framework for tokenisation of financial instruments and cryptoassets in general. In the view of the authors, the proposals of the Swiss federal government are well balanced and at the same time innovative. In particular, the introduction of the concept of DLT Rights would likely become a cornerstone of the new Swiss legal framework and should help to further enhance the country's attractiveness as a jurisdiction, where tokenised financial instruments such as shares or bonds may be both issued and traded safely. That said, once the legal toolset is in place, it remains to be seen how the markets for cryptoassets will develop in the future.
|About the author|
Stefan Kramer is a partner in Homburger's banking and finance team and the firm's tech group. He was a member of a group of experts advising the Swiss Federal Government in relation to the new Swiss DLT legislation discussed in this article. Stefan regularly advises on DLT related regulations, asset-based financings (covered bonds and securitisations), banking regulation (including regulatory capital transactions) and derivatives markets regulations. Other areas of work include insolvency law and financial markets infrastructures. Stefan is also the head of Homburger's restructuring and insolvency team.
|About the author|
Urs Meier is a senior associate in Homburger's banking and finance team and the firm's tech group. His practice focuses on advising banks, securities dealers, funds and other financial intermediaries with regard to financing transactions and regulatory matters. His areas of work include in particular distributed ledger technology and other fintech-related topics.