The so-called Crypto Valley, usually meaning the area covering Switzerland and Liechten-stein, is the home of 960 crypto-related companies with around 5,184 employees. In the midst of them, there are already 11 Unicorns – i.e. projects valued at more than US$1 bio.: Ethere-um, Cardano, Polkadot, Aave, Cosmos, Solana, Tezos, Dfinity, Near, Nexo and Diem (figures from CV VC Top 50 Report H2/2020). In fact, Crypto Valley came through the COVID-19 phase very well as digitalisation and tokenisation saw, in general, a hype during this crisis. Recently, Decentralised Finance (DeFi) is gaining more and more traction and popularity in Switzerland.
In view of all that, the Swiss Federal Council finally decided that the first part of the distributed ledger technology (DLT) law about register value rights (also known as ledger-based securities) should enter into force as of 1 February 2021. Further, as of 1 August 2021, the second part of the DLT Act will enter into force with numerous innovations. In particular, it will introduce a new DLT trading system licence, an extension of the FinTech licence to collectively held crypto-based assets, and a controversial extension of the scope of the Anti-Money Laundering Act (AMLA). Switzerland will therefore take a huge step forward in bringing full legal certainty to the crypto space.
1. Ledger-Based Securities
The new provisions in the Swiss Code of Obligations enable the electronic registration of rights with similar qualities as traditional securities in the form of a token – so-called ledger-based securities – and transferring them without the need for further written documents over the blockchain. The prerequisite is that the rights are mapped in an electronic register – i.e. a distributed ledger – that meets certain requirements and that the parties who are entitled and obligated by the right have consented to this registration.
The DLT Act thus introduces the possibility to transfer ledger-based securities exclusively by a technical transfer on a blockchain or distributed ledger, which will be recognised as legally valid even without physical transfer of a document or paper (required for certificated securities) and/or a written assignment (required for simple uncertificated securities) or a booking implemented by a central securities depository (required for book-entry securities). The latter requires, unlike the new ledger-based securities, a regulated institution such as a bank, securities firm or a central securities depository for creation and transfer.
All rights that can be certificated in securities up to now can also be structured as ledger-based securities, i.e. in principle, all contractual rights including, in particular, receivables as well as shares in corporations. Therefore, tokenisation has got a lot easier than before the introduction of the DLT Act in February 2021.
2. New Licence Type For DLT Trading Facilities
The Swiss Financial Market Infrastructure Act (FMIA) previously had three licensing categories for trading platforms: the stock exchange, the multilateral trading facility (MTF) and the organised trading facility (OTF). This universe is now expanded by the DLT trading facility which, similar to the MTF, allows trading between multiple parties without discretionary elements of the platform. In contrast to the MTF however, end customers can be directly connected for trading in so-called DLT securities (i.e. asset tokens according to the well-known Initial Coin Offerings (ICO)-Guidelines of the Swiss regulator Swiss Financial Market Supervisory Authority (FINMA) from February 2018) and the DLT trading facility may also provide clearing, settlement and custody services within the same legal entity in addition to the order matching. Trading with payment tokens is also permitted.
The licence requirements vary greatly depending on which of the aforementioned activities are to be performed and which DLT securities and payment tokens are to be traded. Depending on the trading, custody and settlement volume, so-called small DLT trading systems are defined, which may make use of authorisation easements. Only specific individual cases will be able to show whether the new instrument of DLT trading facility licence will prove itself in view of its variability, complexity and the rather high costs and requirements.
3. New FinTech License Category For Collectively Held Crypto-Based Assets
Until now, providers of custody wallets in which crypto-based assets of several clients were simultaneously held in collective custody generally required a banking licence under Swiss law unless they were able to take advantage of an exception such as a bank default guarantee or the sandbox regime up to CHF 1 million.
The Swiss Debt Collection and Bankruptcy Law now introduces a new provision, according to which crypto-based assets that are assigned individually or to a group of clients and it is evident which share of the pooled assets is due to the specific client, or can be reclaimed from the client in the bankruptcy of the custodian, provided that the custodian undertakes to keep these assets ready for the client at all times. The Swiss Banking Act (BankA) is consistent with this provision and treats such crypto-based assets as deposited assets that can be segregated in the bankruptcy of the bank.
In view of the fact that FIAT funds held in collective custody are subject to banking regulation, the legislator wanted to provide similar protection for investors in crypto-based assets held in collective custody (i.e. in pooled custody wallets), particularly at the request of FINMA, and therefore makes them subject to the FinTech licence requirement. In contrast to the conventional FinTech licence for public deposits, the licence for crypto-based assets held in collective custody does not have a CHF 100 million limit, but the catalogue of exceptions is explicitly restricted to settlement accounts, accounts of state-supervised companies, and institutional investors with professional treasury operations.
This new sub-category of the FinTech licence brings relief for the collective custody of crypto-based assets, but the relationship and delimitation of the two sub-categories of the FinTech licence from each other and from the banking licence becomes considerably more complex.
4. Expansion Of The Scope Of Application Of The Money Laundering Act And Implications For Decentralised Finance (DeFi)
Relatively inconspicuously, the catalogue of activities for payment services is expanded in the Swiss Anti-Money Laundering Ordinance (AMO). In particular, this is deemed to be the case if the financial intermediary helps to transfer virtual currencies to a third party, provided that he maintains a permanent business relationship with the contracting party or if he exercises power of disposal over virtual currencies for the contracting party, and he does not provide the service exclusively to adequately supervised financial intermediaries.
Until now, despite the similarly worded general clause in AMLA, the basic principle was that only those who have power of disposal over third-party assets are subject to Swiss money laundering regulation as financial intermediaries. However, since blockchain and distributed ledgers have entered our lives, and DeFi applications with decentralised trading platforms (DEX), for example, enable the transfer of virtual currencies by means of smart contracts without having the private key, conventional regulation has reached its limits and, from the point of view of FINMA and the international standard-setter Financial Action Task Force (FATF), investor protection and money laundering-related gaps are opening up.
In view of this, the aforementioned basic principle of power of disposal over third-party assets is now lifted and extended to cases in which the financial intermediary only ’helps’ to transfer virtual currencies to a third party, insofar as he maintains a contractual relationship with his client or insofar as he can otherwise exercise power of disposal for the client. This also includes, for example, custodians of private keys, which are encrypted and can only be decrypted by the client. Only pure software providers and licensors who do not enter into permanent business relationships with end customers are still clearly exempt from Swiss AML-regulations. Even the provision of partial services in the areas of payment initiation and execution or the implementation of a transaction fee that flows to the software provider/licensor are problematic. The current anti-money laundering regulations are thus being significantly expanded, which is also being driven internationally, in particular by the FATF, but whose usefulness is controversial.
The new DLT Act brings particularly more legal certainty in the tokenisation of rights and shares by introducing ledger-based securities. First experiences with this new instrument have been good, although there are still almost no financial market infrastructures ready for trading, clearing and settling such ledger-based securities. The introduction of the new DLT trading facility licence as of 1 August 2021 shall improve this situation. It is a very flexible, but also rather costly and complex instrument. Therefore, it remains to be seen if it will be successful. Another aspect of the new DLT Act will be to ease the burden of working with payment tokens within pooled custody wallets by introducing a new sub-category of the FinTech licence instead of the previously required full banking licence. This will certainly make the Swiss regulations more competitive regarding the European payment institutions licences because Switzerland was lacking similar licence types. Finally, the very aggressive expansion of AML-regulation to DeFi business models will force DeFi business models to leave only the unregulated software development in Switzerland and to locate the other parts of the DeFi business to an offshore jurisdiction with no regulations. It is doubtful whether this is really in the interest of FINMA and investor protection, or whether a new form of lighter regulation specifically adapted to DeFi-business model in Switzerland would make more sense. Hopefully, FINMA will soon change its stance on DeFi.
Dr. Reto Luthiger
Reto Luthiger is a Partner with MLL Legal and Co-Head of the Regulatory, FinTech & DLT Team. He is a financial market regulatory as well as a DLT/blockchain specialist. He advises and represents domestic and international clients in financial markets regulatory and civil law matters as well as proceedings before FINMA, self-regulatory organisations (SROs), supervisory organisations (SOs) other authorities and courts. He has wide-ranging experience in banking, securities brokerage, anti-money laundering, financial services, financial markets infrastructures and collective investment schemes as well as FinTech, InsurTech and DLT/blockchain.