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Jan. 11th, 2022
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5 min read
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The financial world has seen immense technological advances in recent decades. One of the most notable developments is the gradual replacement of traditional paper securities with electronic alternatives. However, this electronic form of securities only marks the beginning of an even more profound transformation: the tokenization of stocks and other assets. Tokenized securities (also known as crypto securities), which are based on blockchain technology, promise not only more efficient processing of transactions, but also a significant expansion of opportunities for issuers and investors. By using distributed ledger technologies (DLT) and smart contracts, securities can be issued, traded and managed directly on digital platforms. This change could usher in a new era of financial markets, in which the lines between primary and secondary markets are blurred and assets are traded in real time and without intermediaries.
But these opportunities also come with challenges. The legal and regulatory landscape is evolving to meet new requirements, while at the same time market participants must overcome technical hurdles to fully exploit the market for tokenized assets. The introduction of laws such as the Electronic Securities Act (eWpG) in Germany and the DLT Pilot Framework Ordinance at European level are the first steps in this direction. They provide the necessary framework to enable and secure trading in tokenized securities and other digital assets. This white paper is dedicated to examining the secondary market for tokenized assets and highlights the regulatory, technical and operational challenges that still need to be overcome and are hampering further progress. Among other things, there is a particular focus on the role of market makers, the importance of stablecoins as a means of payment, the need for efficient order book management and tax implications. In addition, the effects of the immutability of the blockchain on legal security in trade are analysed.
With this overview, we want to offer a comprehensive insight into the current state of development and at the same time point out the open construction issues that need to be solved in order to reach market maturity.
The secondary market for digital assets is developing rapidly and is becoming increasingly important in Germany and Europe. This development is significantly influenced by a variety of legal frameworks and regulations that create the legal basis for trading and managing digital assets. In Germany and at European level, there are specific regulations that ensure the legally secure handling of digital assets and at the same time ensure the protection of investors.
Figure 1 Regulation of cryptoassets in Germany
In Germany, the Electronic Securities Act (eWpG) is a central element that defines the legal framework for issuing and trading electronic securities. The Electronic Securities Registers Regulation (EWPrV) clarifies the management of electronic securities registers. BaFin's regulations also play a decisive role, particularly with regard to crowd investing and the regulatory requirements for financial service providers.
At European level, the DLT pilot framework, the regulatory requirements from MiFID II and the upcoming Markets in Crypto Assets (MiCA) Regulation contribute to creating a harmonised and transparent market for digital assets. The DLT pilot framework is intended to promote innovations and experiments in the area of distributed ledger technology (DLT), while MiFID II already contains established rules for financial markets and their players. Finally, the MICA regulation aims to create uniform standards for cryptocurrencies and their providers within the EU and thus strengthen market integrity and investor protection. These legal and regulatory measures form the basis for a stable and trustworthy secondary market for digital assets that meets both the needs of investors and the requirements of regulatory authorities. They enable market participants to develop and offer innovative financial products while ensuring a high level of security and transparency.
Figure 2 Cryptoasset regulation in the EU
Market makers play an essential role in financial markets by continuously making offers to buy and sell (quotes) for financial instruments. Their main goal is to increase liquidity and minimize spreads, i.e. the difference between buy and sell prices. In doing so, they facilitate trade and contribute to market stability and efficiency. In traditional markets, a distinction is made between Regulated Market Markers (RMM) and Designated Sponsors.
Regulated market makers are institutional or individual traders who are responsible for ensuring a constant trading opportunity by continuously setting buy and sell orders. They act in accordance with regulatory requirements, such as MiFID II and Delegated Regulation (EU) 2017/578 (RTS 8). In order to operate as Regulated Market Makers, they must register and meet the specified requirements. Continuous quotation is an essential part of their work. Regulated market makers simultaneously submit buy and sell offers that are competitive in size and price and comparable with each other. These offers must be available for at least 50% of daily trading time to provide the market with sufficient liquidity. Designated Sponsors Designated Sponsors are a specialized form of market makers who assume extended obligations in addition to the duties of a regular market maker:
Similar to traditional secondary markets, market makers could also provide liquidity for tokenized securities on a blockchain. While order books are less common in native crypto space and so-called liquidity pools are used more frequently, market makers could become active for tokenized securities analogous to traditional markets and support the secondary market with liquidity and.
By defining the regulatory framework, service providers related to secondary markets for digital assets can now focus on the technical and procedural challenges that still need to be solved. These include:
The means of payment to be used must be between
All means of payment aim to be digital alternatives to traditional fiat currencies. However, the respective alternatives serve different purposes and are aimed at different market segments. CBDCs are primarily intended for interbank settlements and offer financial institutions a more efficient and secure way to make payments at scale. Stablecoins are often used by private customers and smaller companies who need a stable and accessible medium of exchange for everyday transactions. The following section deals exclusively with retail stablecoins as a means of payment.
A securities transaction on a secondary market usually requires at least two instruments, which are exchanged for each other (normally, a means of payment for a security). The blockchain enables so-called atomic settlements, i.e. immediate and simultaneous “delivery-vs-payment” procedures (see Figure 3). To do this, you need two different tokens on the blockchain (which represent either the security or a currency). In the crypto world, such transactions are carried out using cryptocurrencies (e.g. Ether (ETH)). For various valid reasons, traditional financial players do not want to process their transactions with cryptocurrencies. For example, you don't want to expose yourself to volatility risks or deal with operational changes (keywords taxes, security, and accounting).
Figure 3 Atomic Settlements as a Delivery-vs-Payment Method
So-called stablecoins exist as an alternative to volatile cryptocurrencies. Stablecoins should maintain a stable value and represent the monetary currencies known to us 1:1. For traders who process their exchange activities in US dollars, there have been opportunities to use US dollar stablecoins for a long time. The most renowned providers can be found in USDT (from Tether) and USDC (from Circle). Both providers already process daily trading volumes in the 2-digit billion range and are used by established financial companies worldwide. USDT (Tether) focuses on the less regulated, publicly accessible blockchain market, whereas USDC (Circle) focuses on regulated markets and traditional financial players.
For traders who transact their transactions in euros, on the other hand, there have only been very limited offers so far and those stablecoin providers that exist have not yet been able to provide enough liquidity that would justify the use of their product. This is also reflected in trading volumes. According to a joint published report by BitVavo and Kaiko2, the volume settled in EUR stablecoins in 2023 was only 0.3% of the entire stablecoin market. Without a liquid trading currency, a secondary market is barely operational. This is one of the reasons why we have not seen a EUR-based secondary market for digital assets in recent years. However, thanks to the regulatory clarity of recent months, there have been very encouraging developments involving various EUR stablecoin providers in the last 12 months.
Circle's first provider recently received a positive decision for their Euro stablecoin EURC with regard to the Markets in Crypto-Assets Regulation (MiCA). This means that the first regulated Euro-denominated stablecoin now exists. This creates trust among traditional financial players and a future increase in volumes settled in EUR stablecoin can be expected. Various providers who want to operate a secondary market for digital assets (DLT-TSS) as part of the DLT pilot project are being examined in more detail by the EU's national financial supervisory authorities. Additional positive decisions regarding license applications will have a positive impact on liquidity and developments for the secondary market.
An order book summarizes the various buy and sell orders from retailers (such as market makers). The order book scans the orders in milliseconds and as soon as a sell order and buy order match, the corresponding transaction is concluded and the transaction instructions are transmitted to the transaction parties involved.
This service is offered either by regulated exchanges or by companies with a so-called MTF license. Blockchain disciples would prefer to solve all processes using the blockchain. However, this is not the most pragmatic approach in all cases. In order to check and, if necessary, match the various buy and sell orders, as with a multilateral trading facility (MTF), a bot on the blockchain would have to pay network fees for each verification. If we scale this up with the frequency at which the traditional world scans the quotations (millisecond range), you can imagine that the costs of verifying on the blockchain would quickly rise immeasurably.
In addition to scanning the active order, simply creating an initial order on the blockchain also generates considerable costs without being able to guarantee that the order will be executed. Let's take a look at the OasisDex Protocol, for example. Here, a user paid over 7 USD (with the former ETH price) just to create an order (today it would already be 50 USD) (available via the blockchain explorer). It should be noted that the Ethereum network is notorious for its high network fees, and cheaper alternatives, such as Polygon, exist. Nevertheless, the Ethereum network is often used because it has many users who can be addressed.
The high costs are one problem, another is the public nature of the blockchain. Despite all the advantages of transparency, not every trader necessarily wants to be looked at and tell the world which orders are being placed. In order to maintain the challenges of the resulting costs and a certain level of privacy, the short to medium-term solution will probably not be found entirely on the blockchain, but will exist as a hybrid solution. Order placement and matching of various quotations will continue to take place in the traditional way for cost reasons alone until further notice. However, after a successful match, the transaction instructions are sent directly to the blockchain to exchange the payment currency for the financial instrument.
Figure 4 Hybrid order merging (off-chain) and transaction execution (on-chain)
As soon as trading takes place on a secondary market, traders will buy and sell tokenized securities in order to generate investment returns in the process. In the financial world known to us so far, capital gains taxes are usually withheld by a paying agent and the taxes are paid directly to the merchant's respective tax office. In the case of tokenized secondary markets, payment processing will take place using a stablecoin provider. The withheld capital gains tax will therefore exist in the form of stablecoin and not as the usual commercial EUR. It is very unlikely that German tax offices will accept stablecoins in the near future, as in addition to the legal basis, there are also no technical knowledge for them. Accordingly, there are two solutions that can be pursued:
A) The obligation to pay capital gains tax is completely passed on to users. This would be a simple solution for secondary market providers, as it would allow them to completely avoid the issue, but it would be a very unsatisfactory solution for secondary market users. In the end, no one is interested in a user-friendly solution, which means that this approach should not be pursued any further.
B) The paying agent withholds the tax to be paid (in the form of stablecoin) and converts it back into euros in order to transfer the taxes to the tax offices. This approach is the more pragmatic way for end users to participate in a tokenized secondary market. Direct withholding of tax to be paid ensures that end investors do not have to deal with the blockchain directly. One snag, however, would be that, contrary to the promise of blockchain experts, a new intermediary could come into play. If current payment agents do not yet have the technical know-how to handle digital assets, new service providers must come into play, which in turn could increase costs.
First payment service providers have already started to carry out stablecoin providers PoCs. It can therefore be expected that this issue will also have found a solution either at the start or shortly after the first secondary markets have been put into operation.
The blockchain has the characteristic of being immutable and thus increasing transparency. What is touted as an advantage can also be interpreted as a disadvantage. Incorrect entries cannot be overwritten directly and if a token is sent to an incorrect address, this transaction cannot be reversed.
This situation is impracticable for the financial world, as mistakes are human and it must be possible to correct them. The introduction of new legislation such as the Act on the Introduction of Electronic Securities (including the new financial service for crypto securities registry management) or MiFID II imposed obligations in this direction on financial service providers. Among other things, crypto securities registry administrators are required to be able to freeze tokens or even remove them from existing wallets in order to be able to apply the rules that prevail in the traditional financial world also in the tokenized world. This is also absolutely necessary, as securities traders must have complete legal security for their transactions.
Germany is playing an astonishingly positive pioneering role in this regard. As a result of regulation, financial players know exactly what can be tokenized and under what conditions. This provides clarity and encourages issuers to also offer tokenized securities. In other jurisdictions, such as the USA, this legal clarity is lacking and, accordingly, the major players are also more cautious when it comes to tokenization.
In addition to developments in Germany, there are also positive developments in the EU internal market. With the introduction of the DLT pilot regime in March 2023, the legal framework now also exists to trade tokenized securities on secondary markets. With confirmation via a letter from the European Commission in May 2024, it is now also unequivocally clear that the DLT pilot regime is here to stay. As of today, there are still no licensed secondary markets for tokenized securities. This is partly due to the fact that the entire infrastructure still needs to be built for it. However, according to the European Securities and Markets Authority (ESMA), four companies have already submitted a license application for the DLT pilot regime, which are currently being reviewed by national supervisory authorities. It can therefore be expected that the first tokenized secondary market will be available to investors this year.
As part of the white paper, we met with various decision makers and asked them why their companies are not yet tokenizing and how they face a tokenized secondary market. The reluctance on the subject can be summarized in the following points:
Figure 5 Crypto securities and registry managers in Germany
Through clever process implementations, wallets can be opened for end customers in a normal investment process without the end investor having to worry about private keys (the custodian provides this service). With the right choice of partner, securities can be tokenized by simply providing an ISIN. The tokenizer then takes care of the smart contracts and the correct token creation and distribution. Ideally, the tokenizer or a secondary market provider will then also take care of the user-friendly order placement and processing of trade transactions.
The beauty of blockchain solutions is that companies have the choice and can leave it up to their investors whether they should bring their own wallets and receive their interest income in the form of a stablecoin, for example. The costs saved as a result (due to the elimination of intermediaries) can either be withheld by yourself or passed on to the customer.
It would be premature to draw a final conclusion given the dynamic and fledgling nature of the tokenized asset market. The sector continues to develop rapidly, and the future is fraught with many unknowns. Nevertheless, we can give a well-founded assessment of which challenges still need to be overcome in order to reach market maturity and how far current developments in these areas have already progressed.
Figure 6 Exploiting progress in tokenized secondary markets
Our analysis shows that there is significant progress in certain areas, while others still need significant development. The regulatory framework is already well advanced. However, interoperability between traditional finance and blockchain solutions is another crucial field that needs to be further expanded to ensure smooth integration.
One area that remains particularly challenging is taxes. This requires innovative solutions to ensure that capital gains taxes can be paid efficiently and in line with existing regulations. The role of market makers and liquidity providers in tokenized markets is also still under development, with initial progress being seen. The regulation and application of stablecoins is also a key factor for the success of secondary markets for digital assets. While the regulatory framework for stablecoins is becoming increasingly clear, the practical application and broad acceptance of such currencies are still in their infancy.
After all, demand from market participants is already relatively strong, which shows that there is a growing interest in tokenized assets. This demand provides a solid basis for further market development as soon as the remaining technical and regulatory hurdles have been overcome. Overall, our assessment shows that although the path to full market readiness still poses some challenges, progress in various areas gives rise to optimism. The market for tokenized assets continues to evolve, and the coming years will be crucial to see how this new era of financial markets unfolds.
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