In June 2021, Germany transcended its conservative securities hinterland by departing from the paper-based securities realm. The new Electronic Securities Act strategically anchors Germany in the blockchain sphere, introducing a legal regime for digital securities, either in electronic or crypto forms, and officially opening the door to decentralized finance (DeFi).
Our recent article analyzes Germany’s Electronic Securities Act in light of Supervisory Technology (SupTech) expectations in the DeFi space. The act is not only a profound reform in Germany, but may even provide a model for digital transformation efforts worldwide. On the one hand, it paves the way for the digitalization of paper-based securities; on the other, it enables blockchain-based security issuance. The former is known as dematerialization of securities, which has become necessary for enhanced operational efficiency, digital financial supervision, market integrity, consolidated data collection, real-time market surveillance, multi-market and multi-asset monitoring, and, ultimately, investor protection. The latter represents a profound reform for financial market infrastructures and addresses a paradigm shift in Germany’s approach towards digital technologies; it officially welcomes DeFi in Germany.
Concurrently, digital transformation and the decentralized world of crypto assets present enormous challenges for financial market authorities. Market-driven innovative technological solutions and new instruments, particularly crypto assets, increase the technology gap between supervisors and supervised entities and markets, resulting in asymmetric technology: the pace of adaptation to new technologies in public sectors is neither equal nor symmetric to the pace of private sectors. Hence, the importance of SupTech geometrically increases. On the other hand, the success of SupTech solutions is tied to the infrastructures of the financial system. A fully dematerialized securities domain is a prerequisite and a core pillar for SupTech.
Asymmetric technology between financial markets or institutions and their supervisors is more dangerous than cyber-attacks and other well-known operational risks for which considerable vigilance and shields already exist. However, the lack of a well-functioning SupTech system leaves many doors wide-open for fraudulent technological transactions and their ensuing effects on financial stability. In other words, asymmetric technology between financial markets and the relevant supervisors is one of the most significant risks today. Therefore, having a digital financial supervisory system with a well-functioning SupTech configuration is one of the best risk management strategies.
Although the Electronic Securities Act profoundly reforms the German securities industry by introducing a regulated territory for digital securities, the act does not provide for the necessary SupTech infrastructure and seems to ignore BaFin’s digital transformation strategy. The act’s dematerialization rules result in a dual system: digital and paper-based securities can be issued or traded together, doubling the workload and challenges of financial supervisors in collecting consolidated (real-time) data and managing (near real-time) market surveillance, thus potentially undermining the SupTech capacity. Ideally, the parliament or the government and BaFin could have concurrently made an announcement to clarify and assist with some of the new challenges arising from the act, signaling the market a robust, integrated regulatory and supervisory strategy. In the current setup, the supervisory challenges increased and questions on how to address them have been left unanswered.
The reasoning behind the dual system assertion lies in the US securities industry. The US financial services industry has been grappling with physical certificates since the late 1960s, when it was overwhelmed by rising volumes on the exchanges that required paper certificates. The industry faced the ‘paperwork crisis’ in 1967–1968, causing an unprecedented number of intermediary firm failures. The industry’s initial solution was to immobilize stock certificates in a central location, and later to dematerialize them. Nevertheless, US capital market instruments have not been fully dematerialized yet. Instead, the industry has faced a new crisis: a dual system lets the circulation of physical securities and electronic securities together. In 2012, the Depository Trust & Clearing Corporation (DTCC) proposed steps to advance the full dematerialization of physical securities. The proposal came with a white paper, Strengthening the US Financial Markets: A Proposal to Fully Dematerialize Physical Securities, Eliminating the Costs and Risks They Incur , underscoring that ‘complete dematerialization will contribute to a more cost-effective, efficient, secure and competitive US marketplace’. The history of the US securities industry has vital takeaways for the recent electronic securities reform in Germany.
Evidence suggests that public sector innovations mostly happen through uncoordinated initiatives rather than strategic efforts. The development of a digital transformation strategy requires a combination of top-down and bottom-up approaches. As a cornerstone for digital transformation reform, the Electronic Securities Act has laid the legal foundation of decentralized finance and may be catalytic in changing the course of the securities market in Germany. However, Germany’s move towards electronic securities and DeFi confirms, once again, the evidence on uncoordinated public sector reforms, signaling limited SupTech considerations. Consequently, there are still many unanswered questions and unaddressed concerns up in the air, particularly in the context of SupTech.
Ibrahim E. Sancak is a Professor of Finance and an Associate Member of the ZWIRN-Research Center, Ostfalia University of Applied Sciences, Germany, and the former director at the Capital Markets Board of Turkey.