The various currently known and potential future applications of Blockchain and Distributed Ledger Technologies (DLT) relate to Swiss financial market law in many different ways. As part of our series regarding the Swiss Federal Council report of 14 December 2018 we outline in our second blog article potential issues and any need for action with regard to the Financial Institutions Act (FinIA) and the Financial Services Act (FinSA). Authors: Darko Stefanoski, Ricardo Schlatter, Orkan Sahin, Dennis Herth
On 15 June 2018, the Parliament adopted the FinIA together with the FinSA. Both regulations have a broad impact on Switzerland’s regulatory landscape and will become effective as of January 2020. On 24 October 2018, the Federal Council started the consultation on the three ordinances which contain the implementing provisions for FinIA and FinSA. The consultation procedure will last until 6 February 2019 and the final versions of the three ordinances are expected to be published in the third quarter of 2019.
Based on the currently available regulatory guidance, this blog briefly analyzes the impact of Blockchain DLT based business models of financial institutions.
Legal situation of Blockchain- and DLT-based business models in accordance with FinIA
FinIA sets out the requirements applicable to the organization and the activities of financial institutions, namely to portfolio managers, managers of collective investments, fund management companies and securities firms. One may ask to what extent FinIA is applicable to Blockchain – and DLT- based business models and whether such application is appropriate. In particular, it should be clarified whether issuing tokens or trading with tokens requires an authorisation as a securities firm. Further, token management services are ultimately conceivable, which raises the question of whether an authorisation as a portfolio manager might be required.
In general, the introduction of FinIA will not lead to any material changes of the current regulation of Blockchain- and DLT-based business models. However, companies involved in Blockchain technology should consider the following FinIA-related points before the act comes into force:
- Issuing tokens and professional trading with tokens
The FinIA provisions on securities firms essentially correspond to the current provisions on securities dealers in the Federal Stock Exchange Act (SESTA). In accordance with these provisions, any party that trades with securities professionally in its own name for the account of clients is to be considered a securities firm and needs FINMA authorization. Own-account dealers and market makers are also deemed to be securities firms.
The creation of tokens itself does not require an authorization as a securities firm, even if the tokens have the characteristics of securities according to FinSA. The same applies to publicly offering self-issued securities. By contrast, any person that professionally creates derivatives in the form of securities and offers them to the public in the primary market – i.e. derivative firms – requires authorization as a securities firm or as a bank. It must be determined on a case-by-case basis whether tokens are to be classified as derivatives in the form of securities. Further, also a person that professionally underwrites securities issued by third parties and offers them to the public in the primary market needs authorization as a bank or a securities firm.
- Management of tokens
Token management may constitute an activity subject to authorization if the tokens qualify as “assets” and if the portfolio manager manages these assets on a “professional basis”. FinIA does not explicitly define the term “asset”. Based on the wording of the Federal Council’s dispatch regarding FinIA/FinSA, assets encompasses not just the financial instruments according to FinSA, but also all other financial investments, such as sight or time deposits and debt instruments without the character of securities. This may also include tokens. Hence, this point should be clarified upfront (incl. discussion with FINMA). Further, portfolio managers are acting “professionally”, if they:
- earn gross income of more than CHF 50,000 per calendar year,
- take up business relationships with more than 20 contractual parties per calendar year that are not linked to a one-time activity or maintain at least 20 such relationships per calendar year,
- have permanent power of disposal over third-party assets that exceed CHF 5 million at any point in time, or
- carry out transactions whose total volume exceeds CHF 2 million per calendar year.
Legal situation of Blockchain – and DLT-based business models in accordance with FinSA
FinSA mainly aims to protect consumers in the financial services sector, to create a level playing field for financial service providers and to ensure access to the European market. There are thus points of reference to crypto-based assets and Blockchain applications. Blockchain-companies should assess together with a legal business advisor to what extent their services are subject to FinSA and whether there is any need for action to comply with the consumer protection requirements.
The scope of FinSA encompasses financial service providers, client advisors and the issuers of financial instruments. FinSA sets out new organizational requirements and conduct rules for these institutions.
With regard to Blockchain and DLT, the following activities may be relevant from a FinIA/FinSA perspective:
- Mining of tokens itself does not constitute a financial service according to FinSA. By contrast, if tokens are mined which constitute financial instruments, the classification of a Miner as a financial service provider depends on how close and concrete the client relationship is in terms of a contractual relationship (mandate). The mandate must focus in practical terms on the purchase or sale of financial instruments or the acceptance and brokering of orders that involve financial instruments. However, as Miner typically act independently for their own advantage, such contractual relationship seems rather unlikely in practice.
Pure wallet app developers
- Developing software that allows users to manage their tokens does not constitute a financial service according to FinSA, even if the tokens are financial instruments. This is also true when using a wallet app as long as the private key is owned and managed by the client itself.
- The custody of assets, be it tokens or assets in the analogue world, does not in itself constitute a financial service according to FinSA, even if the tokens are considered financial instruments. Accordingly, FinSA does not apply to providers of custody services, provided that their service is restricted exclusively to custody. On the other hand, if the sale of tokens that are classified as financial instruments is only possible via an account at the provider of custody services, for example, because the private key is located there, the activity constitutes a financial service according to FinSA.
Crypto trading platforms
- Crypto trading platforms or crypto exchanges allow clients to buy and sell tokens directly (i.e., without the involvement of an intermediary). According to the Swiss Federal Council report, the operator of a crypto exchange should be considered as a financial service provider according to FinSA, if retail clients can purchase tokens via the crypto exchange without pure matching and if these tokens qualify as financial instruments. In our view, the operator may also qualify as a financial service provider if the tokens are purchased by professional clients. However, certain exemptions apply with regard to the FinSA conduct rules for any service provided to professional clients.
- Companies that purchase or sell tokens in the secondary market on behalf of clients meet the conditions to be deemed financial service providers according to FinSA, provided that the tokens can be classified as financial instruments within the meaning of FinSA.
- Consequently, crypto brokers are required to comply with the FinSA conduct rules. In particular, the are obliged to:
- divide their clients into segments,
- fulfill certain information duties,
- check appropriateness and suitability.
- Certain exceptions apply to execution-only transactions (e.g., duty to supply a key information document and duty to check the suitability and appropriateness).
FinSA in the context of an Initial Coin Offering (ICO)
To determine the relevance of FinSA in the context of ICOs, it must be clarified whether:
- the token issuer is a financial service provider according to FinSA , or
- the token issuer is an issuer and/or manufacturer according to FinSA , and
- the prospectus requirement applies in case of a public offering.
Initially issuing tokens in an ICO in the primary market does not fit the definition of a financial service according to FinSA, because it does not meet the condition of being an activity provided for a client. Initially issuing tokens itself in the form of an ICO and the prior creation of the token are not financial services within the meaning of FinSA either, which means that the conduct rules do not apply. However, other duties in FinSA do apply, namely the prospectus requirements in accordance with art. 35 et seq. FinSA.
In case of a public offer of tokens which encompass securities, the issuer has to publish a prospectus. Ass in other jurisdictions (e.g., EU member states), the prospectus is subject to approval by an authority (see art. 51 et. seq. FinSA). An offer is considered as public, if the issuing company issues a notification to the public that contains sufficient information about the offer conditions and the token itself for a purchase or subscription of tokens as securities.
If the tokens are classified as financial instruments according to FinSA, the issuing company is also considered as a manufacturer. Manufacturers of financial instruments must produce so-called key information documents for each of their products, unless a certain exemption applies.
Find out more details about the general FinSA/FinIA requirements here.