Already since the 1st of January 2020, the crypto custody business has been a regulated financial service in Germany. Companies intending to offer their clients the custody, management or safeguarding of crypto assets respectively of the associated private keys must obtain authorization from BaFin for the operation of the business prior to the start of the activity. Crypto custody is a service of utmost importance in the ever-evolving crypto market and it is an essential component at least for all crypto business models with centralistic design. As essential as the crypto custody service for the mass adaptation of cryptos may be, it is not the main focus of the market and remains a second-tier service. In this regard, crypto custody services remain somewhat of an accessory to services such as crypto exchanges or lending/staking business models. The profit margins for the actual custody of crypto assets are rather small. This raises the question, if crypto custodians may offer their clients an interest rate next to the custody service for the crypto assets they keep in custody.

Crypto Custody Authorization Covers Three Different Business Activities

The authorization of BaFin for the operation of crypto custody services allows crypto custody service providers not only to keep crypto assets and associated private keys in custody, but instead the authorization which is regulated in the German Banking Act (KWG) also allows for two additional services to be provided by the authorized service provider, being the management and the safeguarding crypto assets. BaFin and the German legislator define the management of crypto assets in the broadest sense as the execution of rights stemming from the managed crypto assets for others. The safeguarding of crypto assets relates to the custody of cryptographic keys on storage media, regardless if the storage media is of digital (cloud storage) or physical nature (USB stick or even written on paper). The safeguarding variation requires that the operator has actual access to the crypto assets of his clients via the custody of the private keys, just the same as in the two other variations. Since BaFin interprets the management variant rather broadly, the question arises, if allowing interest for managed crypto assets is also covered by a license for crypto custody services.

Crypto Management Only Possible in Triangular Setups?

Even though Bafin interprets the management variant of the crypto custody business rather broadly, the better argument can be made against the interpretation that allowing interest on crypto balances by the crypto managers can is covered by the license. The explanatory memorandums published in the administrative practice of BaFin and in the legislative proposal prior to the introduction of the crypto custody business require for the execution of rights for others that the crypto manager asserts the right of a client versus another party. Such assertion from a semantic perspective requires that the other party is a third party and not the custodian. The allowing of interest for the crypto balance kept in custody would be a claim of the client versus the custodian, which the custodian could not assert versus himself on behalf of the client. The allowing of interest for crypto balances would therefore not be considered to qualify as crypto management in the sense of the second variant of the crypto custody business as it is laid out in the KWG.

Can Interests on Crypto Balances then be Allowed without any Authorization?

Even if the allowing of interest for crypto balances is not qualified as crypto management, such an activity may nevertheless be subject to authorization by BaFin depending on the individual case. It is e.g. conceivable that the offeror of the interest would operate as a financial portfolio manager, if he would be allowed to utilize the crypto balance of his clients at his own discretion to generate profits to finance the interest to be paid to the custody clients.

Attorney Lutz Auffenberg, LL.M. (London)