Bitcoin has become a popular investment following its rapid increase in value. In addition to Bitcoin, which is the largest cryptocurrency in terms of market capitalization, there are now over 10,000 different cryptocurrencies worldwide, creating a new asset class for investors. With the increasing number of cryptocurrencies, the current market capitalization of €2.584 billion (as of 22 October 2021) is also rising.

With the growing importance of crypto-assets, the regulatory framework is also being adapted continuously. The introduction of both the Amendment to the Money Laundering Act and the MiCA regulation, for example, represent a significant step in the regulation of these new forms of investment, which is likely to have a strong influence on the financial world in Europe. Furthermore, the technology behind cryptocurrencies — the distributed ledger technology — is increasingly influencing the regulatory environment. For example, since the law on the introduction of electronic securities was passed, it is possible to process the paper certificate, that was required as a part of the documentation of a securities transaction, optionally in digital form, e.g. via a decentralized crypto securities register.

Overview

In response to the global financial crisis of 2008/2009, a computer scientist or group of computer scientists who called themselves Satoshi Nakamoto published a white paper on a digital currency called Bitcoin. It was supposed to allow people all over the world to exchange monetary values without having to rely on banks, accounts, or credit cards.

Before the rapid rise of Bitcoin, the internet was mainly used for communication and as a source of information. It absorbed the previous sources of information such as radio, newspapers, and television and bundled them into an Internet of Information. Information could thus be exchanged and shared worldwide via the internet in a matter of seconds. Bitcoin follows on from this principle. Unlike a bank transfer abroad, which takes several days and incurs high fees, Bitcoin now also offers the possibility of exchanging values over the Internet almost instantaneously and at manageable costs, and has thus heralded the development of an Internet of Value.

Instead of relying on banks or other financial service providers as intermediaries, Bitcoin uses a network of computers distributed around the world to keep a common log, called a distributed ledger, of all past transactions. Due to the general accessibility of this ledger and the accompanying decentralization, the digital currency is completely independent of external third parties or central authorities.

Distributed ledger technology using the Bitcoin Blockchain as an example

The Blockchain is a form of a distributed ledger technology in which the respective transaction information, time stamps, and a random number, ‘number only used once’ (nonce), are stored in blocks. Each block also contains information from the previous block like a fingerprint, the so-called ‘hash’. The chaining of these blocks represents the blockchain:

Figure 1: Linking the information blocks to build the Blockchain

The mode of operation outlined refers to the Bitcoin Blockchain (other Blockchains may differ in their mechanism).

The hash of a block is derived from the information within a block — the input —using a hash function such as MD5²³ or SHA-25624. In simple terms, hash functions are mathematical operations that calculate a specific result of always the same size from the respective input based on an algorithm. For example, the SHA-256 hash of the word "Deloitte" is:

„f3f5cc986b466b373e36cd7ae0091abe13bcbb26b6fd79e520a66d7e2ef3758c“,

while the SHA-256 hash of "Deloitte DCE" is the following:

„d6c24f045e89265a3cbd855acb0b04d93bf95ab3fa0d7d2e6cc1a595273f9905“.

Although the changes to the input were marginal, the results are completely different. As a result, even the smallest changes from past transactions would trigger a domino effect and therefore cannot be carried out unnoticed.

In order for the transactions to actually be attached in a block to the blockchain, confirmation by the network participants is required. This confirmation is done by generating the hash of the new block that has to be confirmed. However, the hash to be calculated must meet certain criteria specified in the Blockchain protocol. Since the nonce is the only variable input, it must be selected so that the new hash of the block to be confirmed meets this criteria. From a technical point of view, it is currently impossible to infer the input of the hash function from the output in a reasonable amount of time, so the correct nonce must be found by trial and error:

Figure 2: Confirmation of new blocks

This process is called mining. Guessing the correct nonce is extremely time and energy consuming but is rewarded with a certain number of Bitcoins. The incentive is not to do this for blocks with invalid transactions since the confirmation process for the next block to be confirmed would expose them as invalid and thus the Bitcoins received for guessing the correct nonce would also become invalid. This mechanism is called proof-of-work (PoW) and helps to find a consensus between all participants in the Blockchain network about the transactions.

Digital signature on the Bitcoin blockchain

For every transaction that takes place between two participants on the Bitcoin blockchain, it is precisely documented which path the transferred cryptocurrencies take. This ensures that the entire system remains reliable and trustworthy. This is achieved with a unique so-called pair of keys for every participant, which consists of a private key and a public key. Both keys are mathematically related which ensures that encryptions done with one key can only be decrypted with the other key and none of the two keys can be derived from the other one. The key pair allows each participant to sign his or her transactions clearly verifiable by all other participants.

For example, if Alice wants to make sure that she is sending a transaction to Bob and no one else in Alice’s name, Alice encrypts her transaction with her private key. Bob then verifies this transaction by decrypting it with Alice’s public key which is – as the name says – publicly available. The decryption only works with Alice’s public key, if it was encrypted by Alice’s private key and so Bob can be sure that Alice send this transaction.

Figure 3: Digital Signature

Types of token

A token can be defined as a unit of value in an ecosystem based on a technological platform. It can be equated with a kind of container for the most diverse use cases. Depending on the properties and characteristics of the respective token, a more granular classification is made. The technical application possibilities of a token are almost unlimited. For example, rights or real objects can be securitized in the form of a token and made tradable via the technological platform using the distributed ledger technology. This process is called tokenization. Depending on the design of the token, it is categorized as a fungible or non-fungible token (NFT). The following categorization of tokens is based on the discussion paper of the European Financial Reporting Advisory Group, "Accounting For Crypto-Assets (Liabilities)".

Fungible tokens

Fungible tokens are identical in their design and are fully interchangeable. Similar to fiat money, a 50 cent coin always has the same value as another 50 cent coin. Fungible tokens can in turn be divided into the categories of payment, asset-backed, and utility.

• Payment tokens: While a payment token, such as Bitcoin, exists independently on its own blockchain, other token types each operate on a dependent blockchain or more generally distributed ledger. The payment token is the most original form of cryptocurrency and is not backed by any value. Similar to gold or cash, the payment token is intended to serve as a medium of exchange and enable all kinds of purchases, sales, and other financial transactions without involving a third, regulating party. A special form of payment token is the so-called stablecoin, which aims to mirror as closely as possible the value of a corresponding fiat currency, such as the US dollar, and is often backed by it as an underlying asset. They are used to counteract the volatility of the crypto markets.
• Security tokens: Security and utility tokens are each located on a dependent distributed ledger platform. The best-known example on which such tokens operate is the Ethereum blockchain, on which a large number of tokens exist and use the existing infrastructure of the Ethereum blockchain as so-called Ethereum Request for Comments (ERC)-20 tokens.
  
  A security token represents e.g. equity, debt or a real asset on a distributed ledger platform and thus making it virtually tradable. This describes the so-called process of tokenization, whereby the newly created tokens are comparable to traditional securities. Depending on the underlying asset, the security token can be further divided into equity, debt or real assets.

• Utility tokens: A utility token is linked to a specific use and is therefore also called a usage token. The utility token is similar to those used in earlier arcades, where certain coins were required to use the machines. It can also be used as a voucher to be redeemed in a certain shop. At the same time, there must be no financial incentive to hold the corresponding token.
• Hybrid tokens: A hybrid token combines the characteristics of the aforementioned tokens. Depending on the design, it can embody certain rights similar to security or utility tokens or, if accepted, be used as a means of payment like a payment token. This is particularly the case for some utility tokens if the issuers also aim to use the token as a payment or means of payment over time.
• Pre-functional tokens: A pre-functional token is the preliminary form of another token. This is issued before the start of the respective network or service and can already be traded, but not yet used, for the intended purpose. Accordingly, they offer no benefit in this form. Pre-functional tokens are usually, but not necessarily, converted into utility tokens when the network or service is launched.
   

Non-fungible tokens

Unlike fungible tokens, each NFT is unique. This means that a NFT can represent the ownership of an asset with certain characteristics, such as a work of art or a patent, and can be made tradable via distributed ledger platforms. On the Ethereum blockchain, these types of tokens can be found as ERC-721 and ERC-1155 tokens. One of the best-known use cases of the ERC-721 standard for creating NFTs is the game CryptoKitties, in which the purchase of ownership and trading of unique ‘crypto-cats’ is available. The ERC-1155 standard goes one step further by allowing the creation of both fungible tokens and NFTs. For example, it makes it possible to use an NFT as collateral for taking out a loan in non-fungible tokens.

Regulatory framework of crypto-assets in investment management

Due to the increasing number and importance of crypto-assets, the regulatory framework is also being continuously adapted and expanded. The EU's proposal to regulate the crypto market and the subsequent MiCA as part of the package for the digitalization of the financial sector, are intended to create uniform, EU-wide rules for dealing with digital currencies and crypto-assets. With the introduction of the Electronic Securities Act (eWpG) at national level, a step has also been taken towards the digitalization of securities law, and further regulatory measures will have to follow. For example, associations such as the German Investment and Asset Management Association (BVI) have recently criticized that too little is currently being adopted to create a ‘level playing field’ in existing laws.

Nevertheless, various laws relevant to crypto-assets must already be applied. An overview of the applicable regulations can be found in Figure 4.

Figure 4: Overview of applicable regulations in the context of crypto-assets

MiCA

With the Markets in Crypto-Assets regulations (MiCA), a proposal for an EU-wide regulation of crypto-assets was published on 24 September 2020. The MiCA is to apply equally to crypto issuers and service providers from the end of 2022.

The aim of the regulation is the homogeneous treatment of crypto-assets in the European economic area in order not to create any locational disadvantages through a common basis in the emerging market worth billions. With this regulation, the European Commission is trying to capture and categorize the diversity of the crypto landscape. For this purpose, it provides detailed rules that are integrated into the existing financial market regulations. In this way, market manipulation and insider trading can be punished accordingly in the future. The aim is to protect trading in cryptocurrencies against accusations of money laundering and terrorist financing and thus gain further trust among investors.

MiCA will be accompanied by further legislative proposals in the future. For example, the Commission proposes that the term "financial instrument" according to MiFID II should also include such financial products based on DLT. A pilot regulation for DLT market infrastructures is also being discussed. The pilot regulation would enable a test phase in a secure environment and is intended to provide indications for possible further changes. This should drive the further use and exploitation of the potential of crypto-assets.

The Electronic Securities Act (eWpG)

In addition to EU-wide regulation via MiCA, existing laws are also being changed and new regulations created at the federal level. The eWpG was passed by the German Bundestag on 6 May 2021 and opens up new possibilities for issuers with the introduction of digital securities. In the future, as an alternative to the traditional securitization in a certificate, bearer bonds can also be issued digitally as crypto securities using an electronic securities register. According to the eWpG, electronic securities are treated as property in the sense of civil law (§ 2 para. 3 eWpG). This leads to legal certainty in the transfer of electronic securities and makes them negotiable. According to the eWpG, a distinction must be made between two types of electronic securities and registers:

• Electronic securities and a central electronic register managed by a CSD authorized in accordance with Article 16 CSDR; or
• Crypto securities and crypto securities registers managed by a licensed crypto-custodian or a licensed issuer.

In order to ensure a harmonized integration of electronic securities into the existing regulatory framework, the eWpG introduces amendments to, among others, the KAGB, the KWG, the Securities Prospectus Act, the Custody Act, and the Stock Exchange Admission Ordinance.

The KAGB

On the German level, crypto-assets are not permissible assets for UCITS according to §§ 193-198 KAGB. Consequently, UCITS are not allowed to invest in crypto-assets. For public AIFS, there is generally increased flexibility in terms of permissible assets when compared to UCITS. However, crypto-assets are not permissible assets under sections 219, 221, 261 of the KAGB either. As a result, private investors are currently unable to invest indirectly in crypto-assets via funds. An exception here are the electronic securities which were issued according to the eWpG described above (§95 KAGB). However, there are already some funds, generally based on synthetic solutions, that offer private investors the opportunity to invest in cryptocurrencies. For professional investors, however, there is now a corresponding change in the KAGB. With the enforcement of the Fund Jurisdiction Act, cryptocurrencies have been added to the investment catalogue as a permissible asset for open domestic special AIFs with fixed investment conditions in accordance with §284 KAGB.
 

The KWG

A further step was taken in the regulation of crypto-assets within Germany with the Gesetz zur Umsetzung der Änderungsrichtlinie zur Vierten EU-Geldwäscherichtlinie, which stated that crypto-assets were incorporated into the KWG and MiFID/MiFIR. This law expanded the circle of obligated parties and had an impact on the KWG, among other regulations.

According to Section 1 (1a) Sentence 2 No. 6 of the KWG, crypto custody business is now defined as the custody, administration, and safeguarding of crypto-assets for others, as well as for the safeguarding of private cryptographic keys used to hold, store, and transfer crypto-assets.

Furthermore, crypto custody is now considered a financial service for the purposes of the KWG, as crypto-assets are digital representations of value. This value is not issued or guaranteed by any central bank or public body and does not have the legal status of currency or money, but can be accepted by natural or legal persons on the basis of an agreement as a means of exchange or payment. They can serve investment purposes and be transferred, stored, and traded electronically.

Figure 5: Regulatory roadmap at national and EU level

Possible applications for investment managers

1. Investment

For investment managers, cryptocurrencies as a new asset class offer new investment opportunities. Cryptocurrencies are currently en vogue and market capitalization of the best-known coins has risen sharply in recent quarters. The interest of investors in cryptocurrencies, or products that invest in cryptocurrencies, offers investment managers the opportunity to expand their business. Furthermore, investing in digital securities potentially offers additional benefits such as increased speed, liquidity, transparency, and security.

2. Tokenization of assets and funds

In addition, assets and funds can be tokenized. In particular, tokenization of illiquid alternative assets tends to have the greatest impact on price and market efficiency due to higher liquidity and trading volumes and thus lower spreads. When tokenizing funds and issuing digital tranches, issuers benefit from higher transaction speed through faster settlements and generally enable a reduction in fees. Thus, it would be conceivable that in the future smart contracts automatically check and validate the rules before each transaction (e.g. whether the investor is allowed to invest in this asset class up to this amount).

3. Crypto custody

There is also the possibility of profiting from the custody of crypto-assets. This business can take several forms. First, by building an infrastructure, tokenization and digital trading can be supported. By setting up a custodian for digital assets, these can also be used for the custody of one's own assets or offered as a service to others.

4. Further application possibilities

DLT also offers many other potential areas of application. All business activities in which an investment manager currently relies on a third party for the settlement of client transactions can be mapped via a distributed ledger. It is conceivable, for example, that securities clearing through a central entity could be eliminated, similar to the concept of the Australian Stock Exchange. Through decentralized clearing, an investment manager could have a direct business relationship with each client and save the costs of intermediaries, while being able to rely on an immutable distributed ledger.