The following blog post was written by Dr. Thomas Nägele, Managing Director of Nägele Attorneys at Law, for our whitepaper “Secondary Markets for Security Token”. The whitepaper is part of a series titled “STO 101: Anatomy and Context of Security Token Offerings”. More information on this series can be found here.
The secondary market for Security Tokens is currently in the process of formation. How it is organized depends to a large extent on the supervisory law. The trading, clearing, and settlement of Security Tokens through the use of DLT systems raises many new questions from a regulatory perspective. For example, it is important that technical innovations are not hindered by regulatory circumstances. The attractiveness of Security Tokens as a financing instrument (primary market) also depends on whether they can be exchanged for conventional or virtual currencies on a regulated secondary market.
Secondary markets are all stock exchanges and over-the-counter markets that are used for the circulation of securities already issued – on the primary market – through repeated securities issued on the primary market sales transactions. The most relevant markets are still the stock exchanges. They fulfill important economic functions by providing liquidity, raising capital, valuing the securities traded, and acting as a barometer for economic activity and industry.
Since Security Tokens are classified as securities, and thus as financial instruments according to Annex I, Section C of MiFID-II they are subject to the same rules as traditional financial instruments. The regulatory framework surrounding securities issuance and trading, however, was established long before the development of DLT systems for the traditional financial market. For Security Token service providers, these hurdles are usually (too) high and not appropriate given their business model, as there are regularly other or fewer risks to be addressed by regulation. In the following, it is, therefore, necessary to describe the process of a financial market transaction on the basis of three phases:
- Conclusion of the transaction (“trading”)
- Clearing of the transaction (“clearing”)
- Settlement of the transaction (“settlement”)
Today, securities are usually no longer physically handed over for the transfer of ownership, but the transfer is completed by electronic account postings.
The sequence of a classic securities transaction
Customer A gives his Bank A (custodian bank) an order to purchase a security. Bank A, as a commission agent, forwards the order to exchange in its own name. The trading venue looks for a suitable counterparty or a suitable order and brings them together (trading). The transaction successfully completed at the trading venue is settled (cleared) and reported to the central securities depository. Since the seller has his securities account at Bank B and the security in question, therefore, changes hands from the CSD’s point of view, the CSD posts the security in the account posting system from Bank B’s account to Bank A’s account (settlement). Bank A issues securities account credit to the buyer corresponding to his securities holdings, and Bank B issues securities account debit to the seller. If the buyer and seller are customers of the same depository bank, the bank can execute the securities transaction without the intervention of the central securities depository.
Settlement by means of central counterparties (clearing)
Clearing is understood by Art 2 No. 3 EMIR as the process of creating positions, including calculating net liabilities, and ensuring that financial instruments, cash, or both are available to hedge the risk arising from these positions. Clearing includes all technical processes for settlement: the transmission and reconciliation of trade data, the netting of offsetting delivery obligations and delivery entitlements, and the determination of collateral obligations. To minimize counterparty risk (especially insolvency risk), central counterparties often take over the clearing process in securities trading (phase 2).
The settlement phase of the transaction (settlement)
Phase 3, called settlement, plays a major role in the secondary market for Security Tokens. In this process, the trades concluded in phase 1 and settled in phase 2 are fulfilled. The actual delivery of the trades takes place in the classic secondary market by means of the corresponding custody account transfers. The custodian banks involved receive data from the central counterparty in the form of electronic lists of the trades to be settled, check the customer custody accounts, and release the transaction for settlement. The central securities depository makes the necessary transfers and prepares an actual delivery report or settlement list.
In the post-trading phase, therefore, CSDs – in addition to central counterparties – play an essential role. This should be seen against the background that, according to the considerations of the Central Securities Depository Regulation (CSDR), central securities depositories (CSDs) and central counterparties are supposed to safeguard the financial markets and give market participants confidence that securities transactions will be executed in an orderly and timely manner. For the trading of transferable securities – thus also Security Tokens – the CSDR standardizes the obligation that these securities are booked in the securities giro. As of 01.01.2023, this obligation applies to transferable securities issued after 01.01.2023. From 01.01.2025 it will apply to all transferable securities. The entry has to be made – also for Security Tokens – by immobilizing the securities or from the outset by issuance in dematerialized form. This obligation to book-entry securities in book-entry form is arguably the biggest challenge facing the secondary market of Security Tokens. Currently, there are no central securities depositories in the EEA that offer their services for Security Tokens. The question is whether this will be the case in the future, or, whether this central depository function will be provided by the DLT system itself, especially since the posting obligation, in contrast to the classical world, would not bring any increase in efficiency, but – on the contrary – would rather destroy the potential for efficiency gains.
Role-based regulatory approach
The systems of regulated intermediaries are shaped by the regulatory objectives of capital market law: functional protection, investor protection, and financial market stability. Since each of the centrally organized intermediaries maintains its own data pool and operates mainly bilaterally, attempts are being made at the European level to improve efficiency in (cross-border) settlement. DLT technologies, on the other hand, are based in particular on the fact that users can directly access the DLT system (the same database) using the same standards. If all participants use the same system, matching in the true sense of the word is no longer necessary.
In any case, the roles in settlement and custody will change. However, FIAT currencies in tokenized form would be a prerequisite for exploiting the potential for efficiency gains or minimizing risks through the use of DLT systems: Only in this way would trading pairs with FIAT currencies be possible without the involvement of intermediaries. Whether these FIAT tokens are issued by central banks or e-money institutions is of secondary importance. This necessary function is already possible in the legal framework. In addition, new roles would be needed in a secondary market for Security Tokens, in particular for the “custody of tokens” and the assignment of the identity of users of the DLT system.
DLT systems are mostly pseudo-anonymous, so with regard to combatting money laundering and terrorist financing, the identity of the natural or legal person acting on the DLT system must be traceable. So, what needs to be ensured by an additional function is the connection of the legal entities to the rights assignment system of the DLT system. Each party must identify itself in advance. This could also take the form of electronic proof of identity in accordance with the eIDAS Regulation.
In addition, it is conceivable that central securities depositories for the secondary market will now take on special token custody tasks. Each regulated CSD would, for example, be responsible for Security Tokens registered with it and could thus also book these Security Tokens for other CSDs (CSD links).
Against the backdrop of the obligation to book Security Tokens in the securities clearing and deposit system as of 2023, the question arises as to how the secondary market for Security Tokens will be organized and what role central securities depositories will play.
EU Pilot Regime for DLT-based Market Infrastructures
The problem just described of the obligation to book in the securities giro at the central securities depository has also been recognized by the European Commission and has been solved by a proposal within its Digital Finance Package, even if only as a pilot regime. For this reason, the so-called DLT-MTF pilot regime is very welcome. Particularly with regard to the development of a secondary market and to promote the dissemination of DLT in the trading and post-trading sectors, the pilot regime is intended to enable regulated institutions to establish a DLT-based infrastructure for trading, custody, and settlement of securities.
The goal of this regulation is precisely to remove barriers to the implementation of blockchain and distributed ledger technology (DLT) in financial market infrastructures. The pilot regulation is a “sandbox” (or controlled environment) approach that allows for deviations from the rules governing the trading and settlement of MiFID financial instruments. Among other things, the following exceptions are possible:
- Transferable securities traded on DLT-based multilateral trading facilities would not need to be recorded at a central securities depository (“CSD”), i.e., booked into the securities account.
- Investors can be admitted to DLT market infrastructures without intermediaries.
- Transactions can be made using DLT-based payment systems such as e-money tokens. The transfer of money and securities at the same time (delivery vs. payment).
The hurdles of the regulatory framework created for the classical regulatory framework are not appropriate for the token economy. The obligation to book in the securities giro of the central securities depository is the biggest obstacle to the development of a secondary market for Security Tokens. A solution to this challenge has already been envisaged by the European Commission.
About the Author
Dr. Thomas Nägele, founding partner of NÄGELE Rechtsanwälte GmbH, holds a Master of Laws and Financial Markets and a PhD from the University of Liechtenstein, as well as law degrees from the Universities of Vienna and Sankt Gallen. He has been involved with cryptocurrencies, bitcoin, tokens, and all legal issues related to blockchain technology and has also been providing related legal advice since founding the firm in 2015. The wide scope of application of this technology raises numerous new legal issues. As president of the CRYPTO COUNTRY ASSOCIATION, he supports crypto and blockchain projects in the country of Liechtenstein. In 2016, Dr. Thomas Nägele was appointed to the government’s working group on the TVTG (Token and VT Service Provider Act). Since 2017, he has also been a lecturer in IT law at the University of Liechtenstein. Dr. Thomas Nägele has published various papers, including the book “Blockchain rules” in collaboration with Piska and Völkel, “Secondary Market for Security Token” and “The Legal Nature of Tokens under the Liechtenstein TVTG with Special Consideration of the Token Container Model (TCM)”.
About the Company
The law firm NÄGELE Rechtsanwälte GmbH, Vaduz specializes in business law issues in private and public law, in particular blockchain/DLT, IT, internet, telecommunication, corporate, capital markets, labor, contract, and property law. NÄGELE Rechtsanwälte’s clients include international companies, banks, SMEs, and family businesses from the region, as well as private individuals and public institutions. NÄGELE Rechtsanwälte GmbH has extensive experience in the analysis of token-based business models and has assisted numerous clients in the preparation of an STO, in particular with regard to the legal structuring or the preparation of an Offering Memorandum or securities prospectus in accordance with the European Securities Prospectus Regulation (Regulation (EU) 2017/1129).
 Cf. Buck-Heeb, Kapitalmarktrecht, 2019, Rn. 74.
 Cf. G. Leser/G. Leser/Habsburg-Lothringen, Finanzinstrumente – Aktien, Anleihen, Rohstoffe, Fonds und Derivate im Überblick. inkl. virtuelle Währungssysteme (Blockchain, ICO, Bitcoin, Ethereum und andere Kryptowährungen), 2019, S 7.
 Cf. RL 2014/65/EU des Europäischen Parlaments und des Rates vom 15. Mai 2014 über Märkte für Finanzinstrumente sowie zur Änderung der Richtlinien 2002/92/EG und 2011/61/EU Text von Bedeutung für den EWR, ABl. EG 2014/173, 349.
 Therefore, for example, in the case of public offerings of such tokens, esp. the prospectus requirements are to be examined. Cf. Langer/Nägele, Blockchain- und tokenbasierte Unternehmen in Liechtenstein, IWB 2018, 1 (4).
 Cf. Kumpan in Schwark/Zimmer, Kapitalmarktrechts-Kommentar. Börsengesetz mit Börsenzulassungsverordnung, Wertpapierprospektgesetz, Wertpapierhandelsgesetz, Wertpapiererwerbs und Übernahmegesetz (KMRK),2019 § 21 BörsG, Rn. 3.
 Schwarz Globaler Effektenhandel. Eine rechtstatsächliche und rechtsvergleichende Studie zu Risiken, Dogmatik und Einzelfragen desTrading, Clearing und Settlement bei nationalen und internationalen Wertpapiertransaktionen, 2016,29f.
 Cf. Patz, BKR 2019,441.
 Cf. Kumpan in KMRK § 21 BörsG, 4.
 Cf. Kumpan in KMRK5 § 21 BörsG, Rn. 7.
 Cf. Zur Entwicklung eines buchungsgestützten Effektensystems Schwarz Globaler Effektenhandel. Eine rechtstatsächliche und rechtsvergleichende Studie zu Risiken, Dogmatik und Einzelfragen des Trading, Clearing und Settlement bei nationalen und internationalen Wertpapiertransaktionen 2016, 27ff.
 Cf. Kumpan in KMRK5 § 21 BörsG, Rn. 6.
 Cf. ErwG 1 CSDR.
 Cf. Patz, BKR 2019, 435 (440).
 Cf. Art 3 Abs 1 iZm Art 76 Abs 2 CSDR.
 Cf. Art 3 Abs 1 CSDR.
 Cf. Buck-Heeb Kapitalmarktrecht, 2019, 7 ff.
 Cf. Patz, BKR 2019, 435 (441).
 Cf. SET 20.12.2019 – Digital Asset Programme, 13.
 Cf. Nägele, Der Sekundärmarkt für Security Token, 2020, 48.
 Cf. SET 20.12.2019 –Digital Asset Programme, 16f.
 Cf. Nägele, Sekundärmarkt für Security Token, 51.
 Cf. Kumpan in KMRK5 § 21 BörsG, Rn. 6.
 Cf. ErwG 1 CSDR.
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