As recently reported, the Swiss parliament has passed the new DLT Act (Federal Act on the Adaptation of Federal Law to Developments in Distributed Ledger Technology) in its autumn session 2020. Yesterday the corresponding blanket ordinance was published and submitted for consultation. The consultation process with cantons, political parties and other interested parties will last until 2 February 2021. The entry into force of the amendments to the laws and regulations is expected to take place on 1 August 2021.
The new DLT Act, together with the blanket ordinance, entails various improvements to the Swiss legal framework in connection with the use of decentralised technologies and blockchain. The introduction of so-called ledger-based securities, which enable the digitization of shares and other rights, is certainly central to this. An overview of the innovations can be found here.
For many market participants, the most important innovation which the DLT Act brings is the introduction of the DLT / Security Token Exchange, a new form of licence for trading venues for digital assets. We are happy to provide details on the new licence category and explain why this licence will be central for many FinTech companies.
DLT Trading Facility as Trading Venue 2.0
The Swiss DLT trading facility is the trading venue of the future. Similar to existing trading venues, it enables multilateral trading, i.e. the simultaneous exchange of offers among several participants and the conclusion of contracts according to non-discretionary rules. However, instead of the assets of the old world, the DLT trading facility focuses on trading DLT securities. DLT securities include the ledger-based securities (Security Token) introduced by the DLT Act and their foreign equivalents. In addition to DLT securities, other digital assets, such as payment tokens (e.g. BTC, BCH, LTC, ETH) and utility tokens (e.g. ADA, WINGS, FIL) may also be used in DLT trading facilities.
DLT trading facilities differ from traditional trading venues in that they:
- Allow retail customers as participants;
- Hold DLT securities in safe custody; and/or
- Clear and settle transactions with DLT securities.
DLT trading facilities also differ from traditional token exchanges in that they
- Allow trading with security tokens
- Allow safekeeping of tokens and DLT securities
- Allow safekeeping of payment tokens and thus the keeping of accounts
By offering the trading of DLT securities – instead of conventional securities – the new licence type allows for a larger group of participants to be admitted. This extension of potential participants to retail customers is expected to lead to a partial disintermediation of banks, as customers can trade DLT securities themselves and, unlike in the current system, are no longer obligated to trade shares and other financial instruments exclusively via their bank or broker.
In terms of the activities covered by the new licence, the DLT trading facility is very different from current trading venues. In addition to trading, DLT trading facilities may offer the custody of DLT securities, a service which under current law required a licence as a central securities depository. DLT trading facilities may further provide the settlement and clearing of transactions in DLT securities. This is also a service which, under current law, requires an additional licence, namely as a central securities depository respectively as a payment system. However, the licence as a trading facility does not cover the clearing of transactions. The concentration of counterparty risks resulting from this may also in the future be assumed only by central counterparties. It should be noted, however, that clearing can be waived if the settlement takes place at the same time as the trading and not, as is the case on today's trading venues, two days later.
In summary, the new DLT trading facility is a one-stop-shop for the trading, custody and settlement of digitized assets (e.g. tokenised shares or other security / asset token that qualify as DLT securities), which is open not only to banks or brokers but also to retail customers.
Advantage over other Jurisdictions
With the entry into force of the DLT Act and the regulation of the DLT trading facility provided for therein, Switzerland will have a clear legal basis for the offering of trading and post-trading services by the same company. This innovation, together with the i) introduction of ledger-based securities, ii) easing of requirements for custodians of digital assets and iii) introduction of clear rules on the issuing of digital assets in the event of bankruptcy, also provided for in the DLT Act, will give Switzerland one of the most innovation-friendly legal basis for the safe custody, trading and settlement of security token like digital shares and other digitized assets.
The recently published draft of the Markets in Crypto-Assets (MiCA) Regulation, which is intended to ensure uniform rules for the handling of digital currencies and crypto-assets in the European Union, does not – unlike the DLT Act – cover tokens that represent financial instruments. The latter are to be regulated in the Markets in Financial Instruments Directive (MiFID). It is however not yet possible to make a definite statement with regard to both, the precise content and the date of entry into force of the MiCA or the adapted MiFID. Consequently, the legal certainty that the DLT Act provides will, at least until the entry into force of the MiCA and the adaptation of the MiFID, be unique in Europe.
In principle, the requirements for financial market infrastructures associated with licensing and prudential supervision, such as those relating to organization, guarantors, ancillary services, business continuity, etc. also apply to DLT trading facilities.
Furthermore, the requirements applicable to trading venues also apply to DLT trading facilities. These include requirements for self-regulation, organisation of trading, ensuring pre- and posttrade transparency, guarantee of orderly trading, supervision and suspension of trading etc. In order to take into account the different risks associated with business models, a distinction is made between large and small DLT trading facilities. Small DLT trading facilities must meet reduced licensing requirements (see below).
In addition, DLT trading facilities providing custody settlement and/or clearing services are also subject to the requirements applicable to central securities depositories. These include, for example, requirements for the custody, booking and transfer of securities, as well as requirements relating to collateral, capital adequacy, liquidity, procedures in the event of participant’s default and segregation.
Segregation of assets does not necessarily have take place on the underlying blockchain but may be conducted via the (central) system of the DLT trading facility. Omnibus custody solutions are thus possible under the new law.
The different requirements – depending on whether a DLT trading facilities provides custody, settlement and/or clearing services or not – are particularly evident with regard to minimum capital requirements:
- Minimum capital for large DLT trading facilities that do not provide custody, settlement and/or clearing services: CHF 1 million
- Minimum capital for large DLT trading facilities providing custody, settlement and/or clearing services: CHF 5 million
- Increase in minimum capital by FINMA: FINMA may increase the minimum capital requirements by a maximum of 50 percent in justified cases
- Minimum capital for small DLT trading facilities: at least CHF 500’000 (See details below)
Among other things, the Federal Council has specifically regulated the admission of DLT securities. As mentioned above, the DLT trading facility may also admit to trading assets other than DLT securities. However, derivatives structured as DLT securities, DLT securities and assets, which could significantly impede the implementation of the requirements of the Money Laundering Act or which could impair the stability and integrity of the financial system, may not be admitted. The latter category includes in particular so-called privacy coins, which specifically make transaction monitoring considerably more difficult (e.g. Monero or Zcash).
Lower Requirements for small DLT Trading Facilities
In contrast to the Financial Market Infrastructures currently established in Switzerland, the new authorization category of the DLT trading facility has the clear aim to be suitable for smaller market players. For reasons of proportionality and in consideration of the protective purpose of the Financial Market Infrastructure Act, the Federal Council was given the power to provide for relief from certain legal requirements for DLT trading facilities.
According to the blanket ordinance submitted for consultation by the Federal Council, a DLT trading facility is considered small if the following cumulative criteria are met:
- Trading volume: Max. CHF 250 million per year
- Custody volume: Max. CHF 100 million
- Settlement volume: Max. CHF 250 million per year
- Credit allocation: No credit allocation
The Federal Council's draft regulation provides in particular for the following easing of requirements for small DLT trading facilities:
The lighter regulatory regime for small DLT trading facilities as proposed by the Federal Council's draft regulation in particular relate to the organisational / governance structure of the trading facility as well as to lower capital requirements:
- Reduced minimum capital requirement: CHF 500,000 if no custody, clearing and settlement services are provided resp. 5 percent of the DLT securities held in safe custody, but at least CHF 500,000 if custody, clearing and settlement services are provided.
- No capital adequacy and liquidity requirements: The capital adequacy and liquidity requirements for central securities depositories that apply to other DLT trading facilities do not apply to small DLT trading facilities.
- Reduced governance requirements: The business management does not have to be strictly separated in terms of personnel from the overall management, supervision and control. Only a majority of the members of the management, supervision and control may not be members of the business management.
- Reduced requirements for business continuity: The requirements for business continuity can also be met by the fact that, in the occurrence of damaging events, the operation of the DLT trading facility is taken over by another licensee (Art. 13 para. 1 FinMIA).
- Reduced requirements for self-regulation: Self-regulation can also be carried out by a non-independent body (Art. 27 para. 2 FinMIA).
- No independent appeal body: An independent appeal body is not required (Art. 37 FinMIA).
- No internal audit: An internal audit is not required (Art. 8 para. 1 let. c FMIO).
Swiss stamp tax (SST) aspects are the most relevant tax aspects with regard to the new DLT Exchange License.
According to the current legislation, a SST liability arises if (1) a Swiss securities dealer within the meaning of SST legislation (SST Dealer) acts as (2) an (a) intermediary or (b) counterparty in (3) the transfer other than by way of a gift of (4) taxable securities (e.g. shares, fund units, bonds) and (5) no exemption applies. Further, Swiss banks, FINMA licensed Swiss security dealers and entities with the main business purpose to trade taxable securities for other parties qualify as SST Dealer (among others).
Security Tokens are generally considered as taxable securities for SST purposes.
The key aspect is whether a DLT Trading Facility qualifies as SST Dealer. Although this could be the case from a purely technical point of view, in practice it is considered that a DLT Trading Facility should not be SST Dealer in particular if transactions are on a peer-to-peer basis. However, further clarification on a case by case basis is necessary and depends in particular on the functions of the DLT Trading Facility (e.g. peer-to peer-transaction, retail customers as participants).
The introduction of the DLT trading facilities and provision in the regulation is very welcome. The current separation of trading and post-trading, i.e. the compulsory division of the two activities into several companies, is no longer appropriate, particularly in view of technological change. The new one-stop-shop brings together what belongs together and allows efficient and legally secure trading, including the settlement of assets.
The expansion of the circle of participants to retail customers is in keeping with the Zeitgeist of disintermediation and is also very encouraging. However, the associated obligations, particularly in the area of transaction supervision and the Money Laundering Act, which have so far primarily affected banks, should not be underestimated by the operators of DLT trading facilities.
The extent to which the requirements for DLT trading facilities are equivalent to the requirements for financial market infrastructures and trading venues, and if need be central securities depositories, is appropriate and creates a level playing field.
The easing of requirements for small DLT trading facilities appear to be a successful implementation of the principle of proportionality. However, as with the Fintech licence, it remains to be seen whether the low maximum custody volume will not lead potential DLT trading facility operators to forego a licence as a small DLT trading facility and apply directly for the more comprehensive licence.
Internationally, the introduction of DLT trading facilities, together with the other changes in the DLT Act, is unique and is expected to remain so for the next 2-3 years.