Blockchain-based Digital Collectibles – Are Those Financial Instruments?

(For German version click here)

 

More and more mid-sized companies consider blockchain-based capital markets issuances - so-called security token offerings (STO) - as an alternative. The new issuing-vehicle is quickly becoming a viable financing alternative not only for startups but also for SMEs. But blockchain has even more to offer. Stocks, bonds and shares of investment funds are not the only assets that can be tokenized. Specific values and objects can also be depicted on the blockchain through a token and thereby not only become immediately transferable between users but also traceable. The blockchain community calls these tokenized specific values “digital collectibles”. But in which fields of business can digital collectibles create value and moreover: are they financial instruments in the form of crypto assets which have been newly introduced into the German Banking Act (KWG)?

Tokenization of Art Pieces, Trading Cards or Other Individual Objects

Digital collectibles are especially interesting for the gaming industry. One of the most prominent examples are the CryptoKitties which rose to fame by the end of 2017 and at that point even made up most of the traffic on the Ethereum blockchain, thereby severely slowing down the whole network. In this online-game, players have the opportunity to digitally breed cats which are depicted by tokens of the ERC721 protocol on the Ethereum blockchain. The ERC721-protocol allows the creation of tokens with individual characteristics within a smart contract on the Ethereum blockchain, which is the essential contrast to the ERC-protocols that are used for capital markets issuances like ERC20, ERC1400 or ERC1404. While tokenized investment products necessarily need to be designed identical and interchangeable, smart contracts that run on the ERC721-protocol on the other hand can create unique tokens that each have individual properties. This characteristic makes these smart contracts very interesting when it comes to the tokenization of art or trading cards. Of course, they can also be used for the creation of a digital tokenized proof of ownership for objects in the real world, since practically every object can be connected to an individual token.

Is it Necessary to Create a Capital Markets Prospectus in Order to Issue Digital Collectibles?

Right now, the whole subject of tokenization is firmly in the grasp of the financial markets regulatory authorities. This is the reason why it is often assumed that the public issuance of tokens can only be executed with prior regulatory authorization or after the approval of a capital markets prospectus by BaFin. When it comes to digital collectibles, this assumption is in most cases erroneous. The mere tokenization of a real-world object does not necessarily mean that the corresponding token has to fulfil the legal requirements associated with a financial instrument. The individuality of digital collectibles will regularly mean that the issuance of the tokens does not qualify as a public offering of securities or shares of investment funds, because such products have to be identical and interchangeable by definition to even be suited for a capital markets issuance.

Are Digital Collectibles Also Financial Instruments in Accordance to the German Banking Act (KWG)?

Authorization obligations in accordance to the KWG may apply if the token in question qualifies either as a unit of account or as a crypto asset. BaFin qualifies tokens as units of account only if they are designed identically. If they are not, they cannot be used as a unit to define value and therefore they cannot be units of account. The legal definition of crypto assets requires that the token can potentially be used for either investment purposes or as a means of payment. While the usage of individualized tokens as a means of payment seems to be impossible, the usage of specific objects such as tokenized art also for investment purposes seems possible. However, in most cases the prime function of digital collectibles will not be investment but rather the proof of ownership or a traceability via the blockchain.

 

Attorney Lutz Auffenberg, LL.M. (London)

 

I.  https://fin-law.de

E. info@fin-law.de

Our Blog Articles in a Monthly Newsletter?

The FIN LAW Newsletter provides you with all blog articles of the month via monthly e-mail. Our newsletter is published regularly at the beginning of every month. Feel free to sign in to the FIN LAW Newsletter by clicking the button below. Of course can can sign off at any time if you do not wish to receive our newsletter anymore.