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Zentrum fr wissenschaftliches, interdisziplinres Risikomanagement und Nachhaltigkeit Implications of Germanys Draft Electronic Securities Regulation for RegTech and SupTech Prof.Dr.Stefan Zeranski Prof.Dr.Ibrahim E. Sancak 14 September 2020 Copyright 2020 The views expressed in ZWIRN Working Papers are those of the author(s) and do not necessarily represent the views of the ZWIRN, or the Ostfalia University of Applied Sciences. Zentrum fr wissenschaftliches, interdisziplinres Risikomanagement und Nachhaltigkeit zwirn.de / zwirnostfalia.de Salzdahlumer Str. 46/48 38302 Wolfenbttel, Germany 2 Implications of Germanys Draft Electronic Securities Regulation for RegTech and SupTech Stefan Zeranski Ibrahim E. Sancak Professor in Business Administration with Focus on Financial Services and Financial Management Brunswick European Law School (BELS) Director, ZWIRN-Research Center Ostfalia University of Applied Sciences Visiting Professor for Banking Regulation at the Savings Banks Finance Group - University of Applied Sciences - Bonn Professor of Finance Associate Member, ZWIRN-Research Center Ostfalia University of Applied Sciences Founding (E) Director, Market Oversight and Enforcement Division, Capital Markets Board of Turkey E-mail: st.zeranskiostfalia.de E-mail: i.sancakostfalia.de September 2020 Abstract This paper documents implications of Germanys draft regulation on electronic securities for RegTech and SupTech. Regulation of electronic securities or a dematerialized system should not only serve the development of the private sector, FinTech and RegTech for regulatory compliance but also serve the public sector, namely support RegTech for regulators and SupTech for financial supervisors. Electronic securities have the potential to increase operational efficiency and accuracy both in compliance and supervision, namely, corporate governance, audit, and surveillance by deploying RegTech and SupTech systems. Digital transformation in the financial sector should include considerations in line with the digital finance requirements, such as closing the technology gap between the private and public sectors and managing asymmetric technology risks. Germanys draft regulation is a strong signal for digital transformation in Germany; however, it does not foresee a fully dematerialized system, a prerequisite for well-designed RegTech and SupTech systems. JEL Classification: G23, G28, G30, G38, K22, O31, O32, O38 Keywords: Asymmetric Technology, BaFin, Blockchain, Crypto Securities, Cyber Risk, Dematerialization, Digitalization, Digital Transformation, DLT, Electronic Markets, Electronic Securities, FinTech, Germany, Green Blockchain, RegTech, Regulatory Risk, SupTech, Sustainable Finance. 3 Table of Contents Acronyms and Abbreviations . 4 Highlights . 5 Introduction. 6 I. From the Paperwork Crisis to Electronic Securities . 7 II. Characteristics of Digital Transformation . 13 2.1. Content of Digital Transformation. 13 2.2. Risk Implications of Digital Transformation . 14 2.3. Digital Transformation on the Governmental Side . 16 III. Dimensions of Germanys Electronic Securities Reform and Comparisons with Implementations of Turkey and the U.S. . 20 3.1. Different Approaches in Digitalization of Securities. 20 3.2. Digitalization of Securities in Germany . 22 3.3. Dematerialization in Turkey . 24 3.4. New Concerns about Physical and Electronic Securities in the U.S. . 26 Conclusion . 29 References . 30 4 Acronyms and Abbreviations BaFin: German Federal Financial Supervisory Authority BIS: Bank for International Settlements BMF: German Federal Ministry of Finance, in German “Bundesministerium der Finanzen” BMJV: German Federal Ministry of Justice and Consumer Protection, in German; “Bundesministeriums der Justiz und fr Verbraucherschutz” BMWi: German Federal Ministry of Economic Affairs and Energy, in German; “Bundesministerium fr Wirtschaft und Energie” CAT: Consolidated Audit Trail CDS: Credit-default Swap CMB: Capital Markets Board of Turkey CSD: Central Securities Depository DLT: Distributed Ledger Technology DRS: Direct Registration System DTC: Depository Trust Company DTCC: Depository Trust in German “Gesetz ber elektronische Wertpapiere” FinTech: Financial Technology FMI: Financial Markets Infrastructure FREP: Financial Reporting Enforcement Panel, in German; “Deutsche Prfstelle fr Rechnungslegung”, or “DPR” GHG: Greenhouse Gas IOSCO: International Organization of Securities Commissions IT: Information Technology KWG: German Banking Act, in German; “Kreditwesengesetz” RegTech: Regulatory Technology SDGs: Sustainable Development Goals SEC: U.S. Securities and Exchange Commission SupTech: Supervisory Technology U.S.: United States of America 5 Highlights The draft initially opens doors for electronic bearer bonds. It is an implementation of the German governments digital transformation plan set out in 2018. As a rule, the conversion from paper certificates to electronic securities is not obligatory. In a special case, issuers can start conversion without the consent of bond investors. The draft does not foresee a full dematerialization per asset class. It introduces blockchain bearer bonds, which is (1) a strong signal for digital transformation in Germany, (2) a revolutionary step considering the German laws systematic. The draft addresses a step-by-step digital transformation, starting with only one securities class, which signals a rational perspective in managing transformation risks. The regulation intends to be technology-neutral, which means electronic bonds or blockchain-based bonds are not intentionally privileged to one another. Electronic bonds are defined as property (“Sache” in German) to entitle them directly property rights and provide a level playing field in terms of legal status. Digital finance reforms should consider all stages and segments of a financial system, including the regulatory and supervisory landscape (RegTeh and SupTech). Voluntary-based or partly dematerialization neither meets the digital reform requirements nor provides a sound base for RegTech and SupTech. A fully dematerialized securities system is a prerequisite and one of the main pillars of SupTech systems. With more than 20 years of electronic security experience, the U.S. securities industry participants demand a full dematerialization system and define the current system as ineffective. Turkey has a fully dematerialized system, which provides a robust infrastructure for RegTech and SupTech. If the draft passes as it is, two critical aspects might hurt the overall German financial system: 1) The draft is not conducive to RegTech and SupTech. 2) It does not foresee a parallel development for the SupTech projects of financial supervisors; instead, it overloads the supervisory system; hence, it increases asymmetric technology risks. Even though it is a convention, the draft does not include an impact analysis, which raises questions about probable effects. In light of the EU Green Deal, it is indispensable to ensure that the new approach is green- blockchain compliant with the Paris climate targets. 6 Introduction Digitalization of securities, converting physical securities to electronic form, touches on many aspects of a financial system. In addition to the well-known benefits, electronic securities have the potential to increase the efficiency and accuracy in auditing, compliance, and supervision by deploying RegTech and SupTech systems. In many countries, paper-based securities are not actively in play anymore. However, electronic securities are also not the main form. Instead, immobilization is a common industry practice. Immobilized securities are physical but treated as if they were electronic securities. Transaction and custody rules of immobilized securities are mainly tied to physical security practices. Some countries, such as India, Turkey, and the U.S., have been dematerialized securities, which means the countries converted securities to electronic form. However, dematerialization practices are not the same. A fully dematerialized system lets the audit firms, compliance structures, and financial supervisors carry out their functions and responsibilities timely and properly. As data is considered the new oil, digital transformation policies should always include data aspects of digital transformation reforms. For example, how will the draft affect the data infrastructure of the German financial system? Going one step further, how will supervisors be positioned in terms of data arising from the new regulation, specifically blockchain-based bonds? Will the reform increase market integrity and investor protection? In this regard, Germanys draft raises more questions in the digital world. We will underscore some questions around RegTech and SupTech and try to answer them utilizing evidence from the U.S. and Turkey experiences. This paper does not approach the draft from legal quality or legal aspects; instead, it considers the probable effects of the draft on the digital financial world, focusing on RegTech and SupTech dimensions. Since Germanys radical movement might have a ripple effect in other countries, this paper might also shed light on other countries electronic securities reforms. This paper has three sections. In the first section, we introduce three key concepts: Electronic securities, immobilization, and dematerialization. The first section also touches on the paperwork crisis. Section two discusses the characteristics of digital transformation. The third section compares three countries; Germany, the U.S., and Turkey, in terms of the digitalization of securities or dematerialization. 7 I. From the Paperwork Crisis to Electronic Securities In the securities industry, securities can be either in physical or electronic form. Since securities transactions occur in a high-speed world, in some markets in microseconds1, it is impossible to deliver and take securities physically in return for every transaction. The push to eliminate physical securities originated in the “paperwork crisis” of the late 1960s when trading volumes surged, and the back offices of banks and brokerages were inundated with stock certificates and the associated paperwork in the U.S. (DTCC, 2012). In the late 1960s and early 1970s, the U.S. securities markets experienced a back-office crisis caused by increasing volumes and back-office inefficiencies in processing securities transactions (Bergmann, 2004). During the paperwork crisis, a brokerage firm used approximately 33 different documents to execute and record a single securities transaction (Bergmann, 2004). Since operational deficiencies caused fail rates and customer complaints to soar, losses in 1967- 1968 caused an unprecedented number of broker-dealer firm failures; for example, roughly 160 New York Stock Exchange member firms went out of business while others either merged or liquidated (Bergmann, 2004). In response to the paperwork crisis, the industrys initial solution was to “immobilize” stock certificates in a central location, recording ownership changes with bookkeeping entries (DTCC, 2012). The second solution was the concept of substituting paper certificates with book-entry securities, a process called “dematerialization” (DTCC, 2012). Today, immobilization and dematerialization are two solutions in response to the paperwork crisis as well as other developments in the securities industry worldwide. The following figure shows three main forms of securities. Figure 1: Three Forms of Securities. 1 One million microseconds are equal to one second (1 s = 10-6 s). Printed (Physical in reality), or, Not Printed Physical by definition of law Physical Securities Centralized Book-entry form Physical by definition of law Immobilized Securities Dematerilized Book-entry form Electronic by definition of law Electronic Securities 8 Electronic securities, or digital securities, are the financial instruments that exist only in electronic form and kept via a book-entry system. A central securities depository (CSD) keeps records of electronic securities and, where necessary, carries out related services. Investors do not have physical securities in this case; instead, they might have ownership statements issued by a CSD. If securities are in electronic form or dematerialized, they do not exist in physical form. However, they have the same properties as the physical ones. In other words, in principle, the digitalization of physical securities does not change the functions of securities. As a rule, immobilization and dematerialization should not imply any loss of rights for securities holders (European Parliament, 2014). The shareholders have the same rights without regard to electronic or physical ones. However, electronic securities enable market participants practical solutions, like faster transfer, clearing and settlement, easy and continuous access to the holdings, hassle-free issuer-investor relations, practical corporate action solutions, and so forth. Even though securities can be physical either printed or not printed, they are not subject to physical delivery rules. Industry practices force the securities industry to follow a market practice known as immobilization. Immobilization enables securities to be transferred, bought, and sold without moving physically by a book-entry system. In practice, immobilization is in between the physical securities system and the electronic securities system. A further step away from physical securities is the full dematerialization of a securities issue (BIS the institutions were called “Kassenvereine” (Chan, Fontan, Rosati, they can be stored anywhere by owners or intermediaries. More importantly, paper certificates are not easily trackable by issuers, auditors, and supervisors. Therefore, it is not conducive to the efficient protection of financial consumers, auditing, and financial supervision. Digitalized and centralized securities have strong implications for audit firms and supervisory authorities, which means a stronger infrastructure for RegTech and SupTech. Moreover, the dematerialization of securities is a dimension of sustainable finance in the financial sector. The Principles for Financial Market Infrastructures suggest that securities should be immobilized or dematerialized and transferred by book entry in CSDs to the greatest extent possible (BIS less cost for corporate actions such as stock splits, spin-offs, and dividends Easier to track records Easier to hold formal meetings, even virtual company meetings possibility, less costly and practical Stronger corporate governance capacity Stronger investor relations capacity Better investor rights protection capacity More liquidity capacity at securities markets More accurate and quicker clearing and settlement (from T+2 to T+0) Better and quicker refinance capacity Easier to track shareholder rights and benefits, like bonus shares and dividends Innovative technology application capacity,
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