German legislator loosens rules on the use of distributed ledger technology DLT

Speedread:

• Germany has published a new regulation on crypto fund shares (KryptoFAV), which allows the issuance of fund units via decentralised crypto securities registers, typically based on DLT
• KryptoFAV results from a regulation passed last year allowing special investment funds to invest directly into crypto assets
• New and existing funds can take advantage of this regulation

The German Regulation on Crypto Fund Units (Verordnung über Kryptofondsanteile – KryptoFAV) came into force on 18 June 2022. The KryptoFAV results from the Electronic Securities Act (Gesetz über elektronische Wert¬papiere – eWpG) which was adopted in 2021. The eWpG allows issuers for the first time to issue 'dematerialised' securities exclusively in electronic form, as these previously had to be securitised by a physical document. With the eWpG, issuers now have the choice of issuing securities in electronic or certified form.

The KryptoFAV now introduces the option of issuing electronic fund shares via decentralised crypto securities registers, which are usually based on distributed ledger technology (DLT). However, this shall only apply to shares in investment funds in contractual form (Sondervermögen). As a result, shares in special funds such as securities can now be issued in full or only in part as crypto fund shares.

The KryptoFAV adopts a flexible approach, allowing units to be issued either for individual share classes or for only fractions of these classes. This means that both new and existing funds can take advantage of this regulation, as the latter do not have to exchange all their shares.

Fund management companies can therefore weigh up the respective operational advantages and disadvantages and issue crypto shares for individual funds while retaining traditional shares. The KryptoFAV follows a regulation passed last year that allows special funds to invest directly into crypto assets.

The law levels the path to a fully digitised fund

Both the fund shares and the assets to be acquired can thus exist on a new (blockchain) technology, which offers exciting options when considering a fund product's value chain, distribution channels and investor reporting. The new regulation allows the depositary of a fund, for the first time, to appoint a licensed third-party provider to maintain a crypto securities register instead of obtaining the licence itself.

The German legislator is thus enabling cooperation between established credit institutions that act as custodians and new fintech service providers. This may level the playing field and help new market participants to enter into the German market.

This current regulatory development has advantages from a risk perspective in terms of reducing settlement risk with the potential for atomic settlement using DLT. This will also help investors better understand their settlements in the future as the timing differences in settlement should be eliminated.

Nonetheless, there is still potential for performance losses as investors' funds cannot be used immediately, while investment markets have longer settlement times. For the full benefits to be realised, the entire investment trading cycle would have to be switched to atomic settlement. In addition, the regulation lacks any provision on a cash settlement leg.