The Swiss legislation initiative to accommodate blockchain and distributed ledger technology (DLT) is well underway. After the consultation phase initiated this spring (see our earlier report), the Swiss Federal Council has now adopted the dispatch (Botschaft) on the amendments of various federal laws to further improve the legal framework for blockchain/DLT companies and published the draft bill of these amendments (Blockchain/DLT Draft Bill).
The main topics of the Blockchain/DLT Draft Bill are:
Creation of the possibility of an electronic registration of rights with the features of negotiable securities;
Specific regulation of the segregation of crypto-based assets in the event of bankruptcy;
Creation of a new authorisation category for "DLT trading facilities" (i.e. crypto exchanges).
Instead of a new specific act on blockchain/DLT, the Swiss Federal Council suggests punctual amendments to ten legal statutes to address these and further topics. The Blockchain/DLT Draft Bill aims at increasing legal certainty and reducing barriers to application. In addition, the risks of misuse will be minimised. The following article highlights the major features of these amendments.
Uncertificated Register Securities
The Swiss Federal Council introduces a specific category of tokenised rights called "Uncertificated Register Securities" (Registerwertrechte), thereby providing for a legally robust mechanism for the tokenisation of rights and their transfer. This cornerstone of the new legal framework is laid down in art. 973d – 973i of the Swiss Code of Obligations (CO).
Uncertificated Register Securities have features largely analogous to traditional certificated securities. Any right that can be securitised also qualifies as an underlying right for Uncertificated Register Securities, including asset tokens and utility tokens (but not payment tokens such as Bitcoin).
In order to create an Uncertificated Register Security, the parties must (i) enter into an agreement (Registration Agreement) that the securitised right can only be claimed or transferred through a DLT-based electronic register (Register) which (ii) meets the technical requirements described below. The Register takes over the functions traditionally attributed to securities:
Transfer function (Transportfunktion): an Uncertificated Register Security will be transferred by a transaction on the Register. Thus, once the relevant requirements are fulfilled, the transfer of Uncertificated Register Securities is no longer subject to a written declaration of assignment, which is still required for the transfer of ordinary uncertificated securities (art. 973c(4) CO) and according to some scholars currently also for the transfer of tokens concerning equity of Swiss companies.
Legitimising function (Legitimationsfunktion): by way of the Blockchain/DLT Draft Bill, the parties shall be in a position to agree that the Uncertificated Register Securities can be transferred on and claimed through the Register only. Those identified in the Register as rightful beneficiaries can thus be deemed the rightful beneficiaries, and the debtor can rely on the Register in performing his obligations to the creditors accordingly identified.
Good faith protection (Verkehrsrechtsschutz): the parties must be able to rely on the entitlements indicated by the Register and be protected in such reliance within the limits of the principle of good faith.
The proposed art. 973d(2) CO lays down the technical requirements that a Register must meet:
The Register will guarantee the creditors' full power to dispose of the right (token) as if it was a physical object, which means that the debtor cannot have any power to dispose of the right (token) (Verfügungsmacht).
The Register must meet certain security standards providing protection against unauthorised changes by way of appropriate technical and organisational measures. The Blockchain/DLT Draft Bill emphasises the variety of potentially possible technical means for ensuring such protection considering the fast developing environment. Hence, it does not detail the required measures. It rather names a few currently existing systems that would meet the standard, stressing that such a list is not exhaustive. The list contains examples of different types of systems, such as proof-of-work systems (e.g. Bitcoin), proof-of-stake systems (i.e., for instance, where Ethereum is aiming at), and permissioned systems (e.g. Corda).
The Register must allow for publicity of the rights. The features of the given Uncertificated Register Security, the Registration Agreement, and the operating principles of the Register must be made available through the Register. It is, however, not required that all details are recorded on the Register itself. The required publicity can also be ensured by means of accompanying data (e.g. a white paper) as long as a technical link exists between the Register and such data (e.g. through a hash value).
As mentioned, the parties must enter into a Registration Agreement in order to create Uncertificated Register Securities. Such agreement can be entered into in several ways, including by virtue of general terms and conditions (e.g. if an investor accepts the issuing conditions when it purchases a token). The details regarding the technical requirements of the Register also depend on the contractual agreement of the parties and will not be provided in an implementing ordinance as suggested in the pre-draft back in Spring 2019. It is expected that industry standards will develop in this regard.
The person primarily liable to the purchasers of Uncertificated Register Securities is the debtor (e.g. a company issuing its shares by way of Uncertificated Register Securities). Under art. 973i(1) CO, the debtor is obliged to disclose to the purchasers information on the features of the particular Uncertificated Register Security, the operating principles of the Register, and the measures taken to protect the functioning and integrity of the Register. Art. 973i(2) CO stipulates the liability of the debtor once a purchaser of Uncertificated Register Securities suffers damage as a result of incorrect or misleading information provided by the debtor. Such liability is, for instance, conceivable if a debtor chose a Register that does not meet the legal requirements described above and misinformed the purchaser on that. The debtor may free himself from liability if he proves that he has taken necessary care in providing the information, but is not allowed to limit or exclude this liability towards the purchaser. On the other hand, the debtor may seek indemnification from the provider of the Register or other third parties or otherwise contractually shift the liability to them.
DLT Trading Venues
Blockchain technology/DLT has innovation potential which is not yet reflected by today's financial market infrastructure regulation, such as providing financial market infrastructure services directly to private customers (and not exclusively via intermediaries regulated under financial market law) and combining trading and post-trading services. Therefore, the Blockchain/DLT Draft Bill proposes to create a specific new licence category for DLT trading facilities or – more plainly – crypto exchanges (DLT Trading Facilities) which accommodates this innovation potential. DLT Trading Facilities are entitled to offer services in the areas of trading, clearing, settlement, and custody of crypto-based assets.
The proposed amendments concern namely the Swiss Financial Market Infrastructure Act (FMIA). The following provisions are particularly noteworthy:
According to the legal definition, a DLT Trading Facility is (i) a commercially operated institution for (ii) the multilateral trading of so-called "DLT Securities" (DLT Effekten), with (iii) the purpose of simultaneous exchanges of offers between several participants, (iv) allowing for the conclusion of contracts in accordance with non-discretionary rules, that (v) admits unregulated companies or individuals as participants, holds DLT Securities in safe custody on the basis of uniform rules and procedures, and/or settles and processes transactions with DLT Securities on the basis of uniform rules and procedures.
A license as a DLT Trading Facility presupposes that DLT Securities are traded (respectively taken into custody, cleared and/or settled). This includes Uncertificated Register Securities once they are standardised and suitable for mass trading. Utility tokens that grant token holders the embedded digital use rights (and do not merely serve investment purposes) do not qualify as DLT Securities, and neither do payment tokens. However, in addition to DLT Securities, also utility and payment tokens can be traded on a DLT Trading Facility.
The licensing requirements of DLT Trading Facilities are, apart from some specific rules, shaped after the existing licensing requirements for trading venues (Handelsplätze). However, numerous details of the licensing requirements – concerning topics such as equity and liquidity requirements, risk diversification, ancillary services, insolvencies, etc. – will have to be determined by the Swiss Federal Council or, as the case may be, the Swiss Financial Market Supervisory Authority (FINMA). On the other hand, the Swiss Federal Council or FINMA are entitled to stipulate facilitations for small DLT Trading Facilities. Small DLT Trading Facilities are facilities which present low risks for the financial market participants and the functioning and stability of the financial system, in particular due to a small number of participants, or a small trading, custody, or clearing and settlement volume.
Fully decentralised "financial market infrastructures" (i.e. financial market infrastructures without direct and clearly identifiable operators) will not be able to benefit from the new DLT Trading Facilities license.
Considering the above, many details relevant for DLT Trading Facilities will be contained in rules to be enacted by the Swiss Federal Council or FINMA, whereby also international standards such as those of the International Organization of Securities Commissions (IOSCO) shall be accounted for. Until these rules are known, the regulation of DLT Trading Facilities remains a moving target.
With their increasing significance, crypto-based assets (kryptobasierte Vermögenswerte) will also play an increasingly important role in insolvency situations. The term "crypto-based assets" includes all assets where the power of disposal is exclusively conferred via a cryptographic procedure, including payment tokens and the new Uncertificated Register Securities.
The Blockchain/DLT Draft Bill creates a clear legal framework for segregating the crypto-based assets from third-party custodians in case of bankruptcy proceedings against them. The requirements under which crypto-based assets can be segregated are provided for in the amended art. 242a of the Swiss Debt Enforcement and Bankruptcy Law (DEBL). They can be summarised as follows:
At the time of the opening of bankruptcy proceedings, the custodian must have the actual power of disposal over the assets (tatsächliche Verfügungsmacht). If only the client has the key for direct access to the crypto based-asset (i.e. the "private key") or if both client and custodian can, independently from each other, access the assets by way of the respective key, there is no third-party custody and the assets do not fall within the bankruptcy estate of the custodian in the first place.
The custodian must undertake to keep the assets of a third-party client available for this client at all times. On the other hand, if the parties have agreed that the custodian can conduct proprietary business with the assets, such as own-account transactions, the segregation is not possible. In this situation, the assets may be considered public deposits, triggering licensing requirements under the Swiss Banking Act (BA).
In addition, it is required that the assets can be allocated to an individual client or a community of clients. This provision is among the significant adjustments compared to the pre-draft. In contrast to the pre-draft, it is no longer required that this allocation must be accomplished on the distributed ledger itself. Rather, it is only required that the assets can be allocated to the client at the moment of the opening of the bankruptcy proceedings. This is, for instance, possible if the tokens are placed on a separate account allocated to a customer through an internal registry kept by the debtor. Where it is technically possible to individualise the token itself (e.g., through a serial number), the token may also be allocated to a client through an allocation table kept by debtor. Eventually, it is sufficient for the purposes of segregation that the assets can be allocated to a community of clients rather than an individual client. This is particularly important in case the crypto based assets are stored on collective accounts. However, if the assets are allocated only to a community, it must be evident which share of these assets the given client is entitled to.
The rules in the BA on the segregation of crypto-based assets in case of bank insolvencies will be amended in line with the rules provided for in the DEBL and, in addition to the rules on segregation, art. 242b DEBL will create a statutory claim for the access to data in the custody of a bankruptcy estate (i.e. after the bankruptcy of a company in possession of this data, such as a cloud provider).
Beyond these main topics of the Blockchain/DLT Draft Bill, the Swiss Federal Council proposes further amendments, including the following:
Swiss Stock Corporation Law: Swiss stock corporations (Aktiengesellschaften) may issue their shares in the form of Uncertificated Register Securities under the proposed new legislation. This will require the articles of association to provide for a respective basis. The Stock corporation is furthermore responsible for choosing the technology on which the Register operates and the quality and security of the Register. Eventually, the existing corporate law requirements must also be complied with, including – for instance – the transparency requirements regarding beneficial ownership (art. 697j CO).
Organised Trading Facilities: Crypto exchanges merely catering for discretionary multilateral and bilateral trading of tokens with securities quality do not necessarily require a specific approval as DLT Trading Facility. Rather, they might qualify as an organised trading facility (OTS) and thus operate on the basis of a license as a bank, a securities dealer / securities house (Wertpapierhaus), or trading venue already under current laws. However, if a company wishes to operate an OHS and applies to FINMA for a licence as a securities house only for this purpose, it is doubtful whether it is eligible for a licence under current laws. Thus, the Blockchain/DLT Draft Bill clarifies – by way of new provisions in the Swiss Financial Market Institutions Act (FinIA) – that it will be possible to apply for a securities house licence exclusively for the purpose of operating an OTS. Unfortunately, the Blockchain/DLT Draft Bill offers such possibility only to own-account dealers which restricts the scope of the amendment.
Banking Law/FinTech License: As separable assets are not considered deposits from the public, the above mentioned amendments to the DEBL/BA could result in a situation in which custodians of crypto based-assets could to an unlimited extent perform their custody services without having to obtain a banking license or another relevant Swiss financial market law license. According to the Swiss Federal Council, this situation would entail substantial risks considering the purposes of Swiss financial market law, such as investor and creditor protection. For these reasons, the FinTech license (art. 1b BA) will be extended to include situations in which specific types of crypto-based assets are accepted as deposits. Furthermore, a provision will be introduced which grants FINMA the power to state a limit on the amount of crypto-based assets that can be held as deposits by a specific bank or holder of a FinTech licence.
Swiss Anti Money Laundering Law: The Federal Council intends to amend the Swiss Money Laundering Ordinance whereby issuers of payment tokens and decentralised trading platforms will be explicitly subject to the duties under Swiss anti money laundering law (unless an exception is available).
Conclusion and Next Steps
The proposed creation of Uncertificated Register Securities and the new license for DLT-trading facilities represent important steps to serve the needs of Blockchain/DLT businesses in Switzerland.
The Blockchain/DLT Draft Bill could, in particular, facilitate raising capital on the primary market through security token offerings, and enable issuers to trade their tokens on licensed exchanges on the secondary market. Combined with the new prospectus regime introduced by way of the Swiss Financial Services Act (FinSA), including clear-cut exceptions, Switzerland could thus become a "securities token hub". Once tokens will be offered outside of Switzerland, the foreign offering rules will however also have to be taken into account.
The market will furthermore appreciate the legal certainty provided by the proposed amendments addressing the bankruptcy of custodians of tokens and the clarifications catered for by the further amendments, such as those regarding anti money laundering.
The next steps in the legislation process are the discussions on the Blockchain/DLT Draft Bill in parliament which could start in Spring 2020. If these discussions go smoothly, the new laws could enter into effect already in early 2021.