Legal framework and technical infrastructure: The structure of the digital security

Digital securities are a topic as complex as it is interesting. In this blog post you will learn how a digital security is defined and how it is structured, i.e. which important parts are essential. We will also discuss the process that is involved in setting up a digital security.

The drafting of contracts is usually complicated and lengthy, and few understand every step of the process, so you will have a comprehensive overview afterwards. However, because this process with all its small details is important, we explain all the details for you here. So after this article you will be prepared for all future contract discussions and know what to look out for.

How is a digital security defined?

First of all, a digital security has to be defined clearly.

  • EU capital market legislation defines a security as an equity or investment instrument that (1) is transferable and (2) by its nature can be traded on the capital market, (3) has a certain degree of standardization, and (4) is not purely a payment instrument
  • Consequently, a digital security is a security within the meaning of EU capital market law. In contrast to a conventional security, the digital security is represented by a distributed ledger technology / blockchain and is therefore not securitized

Digital securities consist of two parts: Legal framework and technical infrastructure

Digital securities consist of the following parts: First, there is the legal framework, which usually needs to be adapted to the situation. The contractual framework can be used in a standardized way, as is the case with our digital corporate investment. However, it can also be configured individually, as is the case with the structure of a profit participation right, a bond or a certificate. A vivid example of this is our cooperation with Bankhaus Scheich. 

The second part is the technical infrastructure, which includes the Smart Contract. Both parts are required to issue a digital security under German law and with the highest possible technical security.

Legal framework

The legal framework includes all contracts required for the issue of a digital security. It differs depending on the type of security. The structure of the contract is individual and therefore differs in many cases. It always depends on what kind of asset is involved. In particular, it depends on whether it is a profit participation right, a bond or a derivative and how the digital security is to be distributed. There is the possibility of placing it as a private placement or public offering. It is also decided whether it is aimed at institutional investors or consumers.

It is possible to set up an asset as a digital security if it has an investment or participation purpose. It is not considered a security if, for example, one euro would be taken as an asset, which corresponds to criterion four of the definition (not a pure payment instrument).

One can very roughly distinguish between two components of the legal framework: Firstly, a contract that contains the rights represented by the digital security. And secondly, a subscription contract which states that the issuing company has acquired the digital securities. The contract representing the rights is usually identical for all shareholders. The individual parameters, such as the price and how many digital securities are purchased, are set out in the subscription agreement. Thus, criterion three of the definition is also met, namely that digital securities should comply with a certain (3) standardization.

Technical infrastructure

In order to issue digital securities, a smart contract is required that belongs to the securities and maps them on the blockchain. So-called tokens represent the shares of the digital securities. The Smart Contract is a program that manages these tokens. Usually, each token represents a certain right to something, such as a certain share in a company. This right is defined in the legal documents.

With the Smart Contract, the tokens and therefore also the rights from the digital security can be easily transferred. This also meets the first and second criteria, i.e. (1) transferability and (2) tradability, from the definition of digital securities.

In what order is a digital security set up?

Here too, we distinguish between two cases: There is a standardized process for digital company participations as profit participation rights.

For other assets we proceed as follows: First, we structure the framework for the digital security. Here the issuers consider what the conditions for the security are. In the next step, the firm prepares the legal documents. Here, attention should be paid to important details, a guide to these can be found here. The last step is the tokenization. This means that a Smart Contract is set up on the blockchain and linked to the legal documents.

In the case of individual securities, the time period always depends on how long it takes the issuers to create the legal documents. It is therefore difficult to give an average or estimated value and the values vary from case to case.

Now you have the basic information you need to conduct successful contract negotiations on your digital securities. If you have any further questions, feel free to visit our website or contact our experts here.