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Category: blog EN

Feb 17, 2020

Tokenized Asset Investments – What are the Advantages to Tokenized Securities?

Businesses that intend to procure funds in Germany have three basic regulatory frameworks regarding the legal design of the investment product they want to offer. This is applicable to traditional capital markets issuances as well as for the issuance of innovative tokenized financial products. Blockchain-based capital markets issuances nowadays are immediately associated with the public offering of tokenized securities better known as Security Token Offerings (STO). For this kind of capital market financing the European and national regulations such as the German Securities Prospectus Act, the European Prospectus Directive, the German Securities Trading Act and other, securities related laws are applicable. On the other hand, if the issued blockchain token has the legal properties of an investment fund share and is therefore qualified as such, the German Capital Investment Code (KAGB) respectively the European AIFM-Regulation is applicable. If the token qualifies as neither a security nor a share of an investment fund it most likely qualifies as an asset investment according to German capital markets regulatory law. If an issuer intends to publicly offer a tokenized asset investment, the rules and regulations of the German Asset Investment Act have to be observed. But can it be advantageous to design a token as an asset investment and not as a security?

BAFIN QUALIFIES TOKENIZED FINANCIAL PRODUCTS RATHER AS SECURITIES

When designing a tokenized financial product, it has to be considered that BaFin developed an administrative practice in the spring of 2019 according to which tokenized financial products are, when in doubt, more likely to be qualified as securities than as asset investments. BaFin justifies this practice with the argument that the blockchain technology substantially enhances the tradability of tokens and therefore the ability to be traded on the capital markets which is the main characteristic of a security. However, this administrative practice does not mean that tokenized asset investments are impossible in Germany. In order to design a token which would be qualified as an asset investment by BaFin, the tradability of the token has to be restricted. This can be achieved by e.g. contractual restrictions. As long as a restricted tradability and the other legal requirements, especially the subsidiarity of asset investments with regards to securities and shares of investment funds as well as to the deposit business according to the German Banking Act (KWG) are fulfilled, a tokenized asset investment is possible.

DISTRIBUTION OF ASSET INVESTMENTS WITH A LICENSE IN ACCORDANCE TO SEC. 34 F OF THE GERMAN INDUSTRIAL CODE

A massive advantage of tokenized asset investments over security tokens that are qualified as securities is the possibility to sell them via asset investment brokers that are licensed in accordance to sec. 34 f GewO. The sale of these products therefore does not require a BaFin authorized financial broker. This allows providers and issuers of tokenized financial products to utilize numerous new distribution channels.

CUSTODY OF TOKENIZED ASSET INVESTMENTS BY CRYPTO CUSTODIANS

It is still uncertain if BaFin will allow the commercial custody of security tokens by the newly introduced crypto custodians or not. According to the materials pertaining the introduction of crypto custodians into the KWG the German legislator intended to assign the custody of tokenized securities to securities deposit banks that are already licensed for the custody of traditional securities. The custody of security tokens would therefore require an authorization as a depository bank. The authorization as a crypto custodian would not be sufficient. This problem does not occur with asset investments. Asset investments are not securities, an authorization as a depository bank in order to safeguard them is therefore not required.

TOKENIZATION OPENS NEW TARGET GROUPS FOR ASSET INVESTMENTS

Traditionally, asset investments are financial products that are almost exclusive to the retail market, especially because of the restricted tradability and lack of a third-party custody option for these products. Typically, asset investments were designed as contractual agreements between issuers and investors with a relatively long duration without them being securitized in any form which made it impossible to hold them in custody. While private investors do not necessarily require an external custody option for their investments, institutional investors do. To fulfill their investment criteria, institutional investors need periodical deposit statements of trustworthy third-party custodians concerning their investments in order to enable auditors to audit these investments. Tokenization allows the commercial custody of asset investments by third-party custodians and thereby makes asset investments accessible to institutional investors. In a nutshell, tokenized asset investments have their advantages and can be an interesting choice for certain projects.

Attorney Lutz Auffenberg, LL.M. (London)

I.  https://fin-law.de

E. info@fin-law.de

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    Feb 03, 2020

    Let´s Build a Crypto Custodian (Part V) – Reporting Obligations of Crypto Custodians in Ongoing Supervision

    ng Act (KWG) as well as the requirements of the legislative decrees that are based on the KWG, just like any other supervised bank or financial institution. One of the essential obligations of supervised institutes in the ongoing supervision is the reporting obligation to BaFin and the German Central Bank. The scope of the reporting obligations is determined by the type of services offered, while the German legislator regulated some privileges for crypto custodians. But what kind of reporting obligations do supervised crypto custodians have exactly according to German supervisory banking law?

    WHAT HAS TO BE REPORTED DURING THE ONGOING SUPERVISION BY CRYPTO CUSTODIANS?

    The obligation to continuously fulfill the legal reporting obligations is of highest priority to all banks and financial institutions. Missing, erroneous or late reports can lead to severe fines and may in addition lead to doubts regarding the reliability of the acting persons which can potentially provoke BaFin to revoke the license. Crypto custodians have to submit their financial information and a profit and loss offset every three months to the German Central Bank. If the crypto custodian is part of a group of institutions or a financial holding group, financial information concerning the respective groups must be submitted additionally. Additionally, crypto custodians have to immediately report certain events such as e.g. the appointment or release of a managing director or a deputy managing director, the decrease of the starting capital beneath the minimum of 125.000 euros, the intention to relocate the place of business or the intention to cease business operations altogether to BaFin and the German Central Bank. Crypto custodians also have to submit their approved annual financial statements with the associated annexes and audit reports immediately after receiving them to said authorities. Imminent insolvency or overindebtedness are other examples of events that have to be reported immediately. There are numerous other legally defined events that trigger reporting obligations for crypto custodians.

    HOW DID THE GERMAN LEGISLATOR PRIVILEGE CRYPTO CUSTODIANS?

    Due to the special characteristics of the crypto custody service in comparison to other financial services, the German legislator decided that parts of the KWG are not applicable to crypto custody service providers as long as they do not also offer any other banking or financial services in addition to the crypto custody service. As a result, the reporting obligations that are applicable to institutions concerning e.g. liquidity and the equity capital are not applicable to crypto custody service providers. Crypto custodians in contrast to other financial institutions are not obligated to regularly report on these matters to BaFin and the German central bank. The legal limitations concerning large exposures are also not applicable to crypto custody service providers. Since crypto custodians are regulated by national German law and not by European directives and regulations, the obligation to report the intention of founding a branch office in a member state of the European Economic Area (EEA) is not applicable to them. However, if a crypto custodian intends to open a branch office outside the EEA it has to report that intention to BaFin and the German central bank.

    Attorney Lutz Auffenberg, LL.M. (London)

     I.  https://fin-law.de

    E. info@fin-law.de

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      Blockchain-Based Central Bank Money – Which Effects Would that have?

      Since last autumn and the announced massive resistance of international politics against Facebook´s Libra coin it has been relatively quite regarding the idea of stable coins that are issued by private companies. Nevertheless, the advance of the social media giant has been a true wake-up call for legislators and central banks of the major economies around the globe. According to information from the Chinese government, China is close to the implementation of a digital Yuan. The United States FED plans the introduction of a Crypto-dollar and the European Central Bank (EZB) discusses the possibility of a blockchain based form of the euro. Digital central bank money (CBDC) has a high chance of becoming reality in the near future, even though the exact design and scope of it cannot be asserted at this moment. The question that arises from this possibility is how CBDCs would have to be classified from a regulatory point of view and how their existence would affect the existing crypto market.

      CBDC AS A DIGITAL NATIONAL CURRENCY – BLOCKCHAIN BASED FIAT MONEY

      If individual central banks actually decide to issue blockchain based currencies, these units would most likely have to be qualified as national currency and therefore as legal tender. As a consequence, units of a hypothetical crypto-euro would be subject to the German Payment Services Act (ZAG). Service providers that e.g. offer their customers transactions of crypto-euros or crypto-euro wallets would then engage in payment services that are subject to prior BaFin authorization under the Payment Services Act. It is also worth noticing, that e.g. the exchange of crypto-euros to crypto-dollars would in all likelihood be considered foreign exchange trade and therefore be subject to the German Banking Act (KWG), because foreign exchange, according to the KWG, is a financial instrument. This will, in some cases, result in an additional mandatory licensing obligation in accordance to the KWG for providers of certain services. It is however certain that CBCDs could not be qualified as crypto assets. The newly added (1st of January 2020) definition of crypto assets to the KWG explicitly requires that crypto assets are digital values that are not issued by a central bank or any other public institution. Therefore, the custody of CBCDs cannot be a crypto custody service as defined by the German regulatory banking law.

      WHAT EFFECTS COULD CBDCS HAVE ON THE CRYPTO MARKET?

      Up to now the regulatory classification of cryptocurrencies was a legally controversial and highly interesting task. While in many nations Bitcoin, Litecoin and comparable decentralized digital currencies are neither classified as legal tender nor as financial instruments, in e.g. Germany they are classified as financial instruments in the form of either units of account or as crypto assets according to the KWG. Crypto payment tokens that are issued by a central emitter qualify as e-money provided that all other requirements are fulfilled and security tokens are potentially subject to the capital markets regulations. Blockchain based means of payment that are issued by a central bank could play an interesting role in the crypto eco system in the future. First and foremost they would render obsolete the need for most private stable coins because they would present a crypto compatible retreat asset without immense volatility which is the exact role that private stable coins play right now. At the same time, they would bring the established financial system closer to “traditional” cryptocurrencies. This could pose problems especially with regards to AML risks. Another crucial point would be the fact that the governments would have access to all economic data of the users of the CBDCs that it issued.

      Attorney Lutz Auffenberg, LL.M. (London)

      I.  https://fin-law.de

      E. info@fin-law.de

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        Jan 27, 2020

        STO with a Security Information Sheet – A Chance for SMEs?

        According to the requirements of the EU-prospectus directive, companies intending to procure funds from the European capital markets by offering securities to investors need to compile and publish a comprehensive security prospectus that must be approved by the competent capital markets supervisory authority. The same rules apply to the public offering of security tokens, that qualify as securities. Often, these prospectuses consist of more than 100 pages. These prospectuses have to contain not only comprehensive information regarding the financial situation, the history and the corporate structure of the emitting company but also details regarding the business model, the managing directors as well as the market situation of the issuer and competitors. Furthermore, these prospectuses have to explain the functionality of the offered security token as well as the rights and obligations of the issuer and the investor associated with the token and display the risks associated with the investment. Compiling and creating a security prospectus is therefore an expansive and complex project that may often be not cost efficient in case of smaller emission volumes. In order to give medium-size businesses and even start ups the opportunity to procure funds at the capital markets through capital markets issues, the European legislator allowed the member states to permit the public offering of securities respectively security tokens with a total equivalent of 8 million euros without the prior approval and publication of a prospectus within the European Economic Area (EEA). The EEA member states made use of this option but with varying requirements and maximums. In Germany for example, the exemption from the prospectus obligation is applicable to emissions with a total equivalent of up to 8 million euros. In Austria on the other hand these emissions are caped at less than 2 million euros.

        WHAT ARE THE REQUIREMENTS FOR GERMAN STO ISUUERS IN ORDER TO BE EXEMPTED?

        For the public offering of security tokens with a maximum equivalent value of up to 8 million euros the issuer is required to create a three-page Security Information Sheet (WIB) that contains all the base information regarding the emitter, the offered security token, the associated rights and obligations and the relevant risks of the investment. This WIB then must be approved by BaFin, just like a comprehensive security prospectus, for publication by BaFin. Naturally, the costs for creating a three-page WIB are substantially lower than those of a comprehensive security prospectus with 100 pages or more. In addition to the WIB, the German exemption requires that the security tokens are distributed only via a professional financial distributor that is licensed for investment advisory or investment brokerage. According to the exemption regulation, the financial distributor has to ensure that private investors adhere to certain maximum investment amounts. Issuers therefore cannot directly sell WIB regulated security tokens to private investors, e.g. via an own website. Institutional investors on the other hand are not subject to the aforementioned restriction of the exemption regulation.

        CAN WIB BASED STOS THEREFORE ONLY BE NATIONAL CAPITAL MARKETS PROJECTS?

        Since the EEA member states implemented the requirements of the EU Prospectus Directive differently from one another, a harmonized exemption regulation for all of Europe does not exist. This means that a WIB that has been approved by BaFin cannot be passported via a simple notification procedure in order to utilize it in another EEA country for the sale of the security tokens as it would be possible with a full prospectus. However, this does not mean that a specific security token cannot be offered simultaneously in more than one member state of the EEA at the same time. According to the EU Prospectus Directive it only has to be ensured that the total equivalent value of the offer within the EEA does not exceed 8 million euros over a 12-month period. It would therefore be possible to procure e.g. 1.5 million euros in Austria, 5 million euros in Germany and further 1.5 million euros in the Netherlands, as long as the respective requirements for the exemptions in each of these jurisdictions are fulfilled.

        Attorney Lutz Auffenberg, LL.M. (London)

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          Jan 20, 2020

          Crypto Assets – What is that Exactly?

          [et_pb_section fb_built=”1″ admin_label=”section” _builder_version=”3.22″ global_colors_info=”{}”][et_pb_row _builder_version=”4.10.6″ _module_preset=”default” global_colors_info=”{}”][et_pb_column type=”4_4″ _builder_version=”4.10.6″ _module_preset=”default” global_colors_info=”{}”][et_pb_button button_text=”for German version click here” _builder_version=”4.10.8″ _module_preset=”default” custom_button=”on” button_text_size=”13px” button_border_width=”1px” button_border_radius=”0px” hover_enabled=”0″ global_colors_info=”{}” button_url=”/kryptowerte-was-ist-das-eigentlich-genau/” sticky_enabled=”0″][/et_pb_button][/et_pb_column][/et_pb_row][et_pb_row admin_label=”row” _builder_version=”3.25″ background_size=”initial” background_position=”top_left” background_repeat=”repeat” global_colors_info=”{}”][et_pb_column type=”4_4″ _builder_version=”3.25″ custom_padding=”|||” global_colors_info=”{}” custom_padding__hover=”|||”][et_pb_text admin_label=”Text” _builder_version=”3.27.4″ background_size=”initial” background_position=”top_left” background_repeat=”repeat” global_colors_info=”{}”]

          Since the beginning of the year, Germany has a new regulated financial instrument. With the regulation of crypto assets the German legislator regulates digital representations of value that are neither issued nor guaranteed by a central bank nor any other public authority and that do not possess the legal status of currency or money, but are accepted by natural or legal persons as a means of exchange or payment on basis of an agreement or actual practice or which serves investment purposes and which can be stored, traded and transferred electronically. Commercial activities on the basis of or in relation with such instruments may, as of this year, be subject to authorization for the providers of such services in accordance to the German Banking Act (KWG). But which products and services exactly are the subject of this rather wordily definition? Are now all blockchain units in Germany regulated can and possibly trigger BaFin authorization obligations when being subject to financial services?

          DEFINITION OF CRYPTO ASSETS WITHOUT A SPECIFIC RELATION TO BLOCKCHAIN

          The major example for crypto assets is Bitcoin. The legislator had in mind the most successful cryptocurrency and comparable blockchain units when he decided to introduce the new category of financial instruments into German banking regulatory law. Even so, the definition does not only apply to blockchain based units of value and mentions neither blockchain technology nor any other distributed ledger technologies as a mandatory technical prerequisite for crypto assets. In the spirit of a technology neutral approach the wording of the definition is sufficiently abstract to also cover representations of value that are based on new and future, nowadays not even existing technologies. A decentralized operating mode is also not required by the definition in order to define a product as a crypto asset. It is therefore possible for centralized issuers to generate and distribute crypto assets as long as the issuer is not a central bank nor a public authority and as long as the specific design of the digital representation of value does not qualify as e-money.

          ARE CURRENCY TOKENS CRYPTO ASSETS?

          Cryptocurrencies with a decentralized design that are designed to be used as an alternative means of payment are, according to the definition, in principal crypto assets. To the extent however that currency tokens being represented by a smart contract are designed as e-money meaning that the issuing and the transfer of the tokens are executed on a blockchain but the issuer of the currency tokens offers the exchange of the tokens against legal tender at all times and that the tokens are accepted by others than the issuer as a means of payment, the KWG precludes in sec. 1 subsection 11 sentence 4 the classification of the tokens as crypto assets. These tokens are classified as e-money and are therefore regulated as such under the Payment Services Act (ZAG).

          CAN UTILITY TOKENS BE CRYPTO ASSTS?

          An interesting question is, if utility tokens which were extremely popular at the height of the ICO-hype in 2017 can also be classified as crypto assets under this definition. Utility tokens grant their bearers no monetary or shareholder rights but instead can be used as payment for services and goods exclusively within the business model of the issuer or as a voucher in a comparable way. According to sec. 1 subsection 11 sentence 4 KWG, these units are also not crypto assets if for example they can only be used for the purchase of goods and services of a single provider or a specific network of providers (e.g. shopping center) or for a very limited range of goods and services. These exemptions basically correspond with BaFins administrative practice that was in place prior to the introduction of crypto assets as financial instruments. BaFin, under the previous legal situation, did not qualify utility tokens as units of account and therefore not as financial instruments.

          WHAT ABOUT SECURITY TOKENS?

          Security tokens, meaning digital units of value of which the ownership is connected to investor rights, such as e.g. claims for repayment or for an interest payment, pose a difficult special case. The first explanatory memorandum of the Federal Ministry of Finance for its draft legislation for the introduction of crypto assets stated that crypto assets are subsidiary to other financial instruments of the KWG so that digital representations of value that meet the requirements of any other financial instrument would not be qualified as crypto assets but as the other financial instrument instead. The wording in the draft legislation included an according subsidiary clause for crypto assets. The subsequently following governmental draft, according to its explanatory memorandum wanted to keep the legal effect of crypto assets to be subsidiary vis-à-vis other financial instruments. However, the wording of the proposed legislation did not include it anymore. Therefore, it is questionable if security tokens can now be e.g. debenture bonds and crypto assets at the same time. The only thing that is for sure is that security tokens are, in one way or another, financial instruments according to the KWG.

          Attorney Lutz Auffenberg, LL.M. (London)

          I.  https://fin-law.de

          E. info@fin-law.de

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            Jan 13, 2020

            Let´s Build a Crypto Custodian (Part IV) – What do Foreign Crypto Custodians have to Consider?

            With the introduction of crypto custody services as a financial service that is subject to authorization, Germany positioned internationally as a location with clear and definite laws for the blockchain-business. Even though the German solo effort led to a still inconsistent crypto regulation throughout the continent which in terms of market harmonization within the EU is not beneficial, German crypto custodians, as of 1st January 2020, at least profit from a clear legal situation. Crypto assets are now clearly defined as financial instruments according to the German Banking Act (KWG) and the offering of crypto custody services for customers is a financial service that is subject to authorization. Not only German but also foreign businesses that intend to offer crypto custody solutions for crypto assets to German customers are interested in obtaining a BaFin license for crypto custody services. Therefore, it is highly relevant for these businesses to know if BaFin places additional requirements on non-German businesses in order for them to obtain a license for crypto custody services and how the BaFin application process can be conducted.

            NO EU PASSPORTING: GERMAN CORPORATION OR A BRANCH OFFICE?

            Since there is no legal basis in the EU directives and regulations for defining crypto custody services as financial services that are subject to authorization but the German legislator still opted to do so, a passporting of the license for crypto custody services neither to nor from Germany is possible. Therefore, businesses that intend to offer such services have to apply for BaFin authorization. The KWG stipulates that BaFin cannot approve an application of non-German companies that apply for authorization to offer a financial service in Germany if the company in question does not have its central administration in Germany. Non-German businesses are left with only two options. They can either establish a German company as a subsidiary which then, as a German company with a central administration in Germany, applies for authorization or, as an alternative, they can establish a branch office in Germany. A branch office is a subsidiary of a non-German company that operates without a German GmbH or AG or any other German corporation form. The branch office therefore is legally dependent and not a legal entity itself. According to the KWG, branch offices are however considered to be institutes in the sense of the German banking regulations if they intend to offer crypto custody services or other financial services that are subject to authorization. In this constellation the branch office would file the application.

            WHAT ARE THE DIFFERENCES FOR THE BAFIN APPLICATION PROCESS?

            If a German subsidiary corporation is founded for the purpose of applying for a license to offer crypto custody services, the application requirements are basically comparable to those of a “regular” application. A special requirement however must be fulfilled if the foreign parent company is a credit institution that is regulated and authorized in its home country. In that case, an authorization can only be granted if the foreign supervising authority accepts the founding of the branch in Germany. The branch office has to prove the consent of the supervisory authority of the parent company to BaFin. If the business instead chooses to apply for the license through a German branch office, additional requirements have to be met. This includes that the branch office has to keep special record of the ongoing business activities in order to report to BaFin and the Bundesbank for the ongoing supervision. Keeping one single record with the parent company is not sufficient. Furthermore, the place of jurisdiction at the branches’ facilities for lawsuits by customers and business partners against the branch office cannot be excluded contractually, so that plaintiffs always have the opportunity to sue the branch office at its location.

            Attorney Lutz Auffenberg, LL.M. (London)

            I.  https://fin-law.de

            E. info@fin-law.de

            Read More:

            Let´s Build a Crypto Custody (Part I) – What Qualification is Required by the Management?

            Let’s Build a Crypto Custodian (Part II) – How Much Regulatory Starting Capital Does a Crypto Custodian Require?

            Let’s Build a Crypto Custodian (Part III) – What Requirements Will BaFin Place on Risk Managing Strategies?

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              Jan 06, 2020

              Between the Poles – Is Blockchain-based E-Money not a Crypto Asset?

              Nowadays, there are many different ways in which money is digitally usable. Scriptural money can only be created virtually by credit institutions and is used among the involved payment institutions in electronical form whenever a payer initiates a transaction. Also on the side of the payment initiating payer digital tools such as banking apps are used. In addition to scriptural money there is another legal form of digital money in the European Union. Since the first e-money directive 2000/46/EC came into effect, which in the meantime has been repealed by the second e-money directive 2009/110/EC, e-Money is defined as every electronically, including magnetically stored monetary value as represented by a claim against the issuer which is issued on receipt of funds for the purpose of making payment transactions, and which is accepted by a natural or legal person other than the electronic money issuer. Since the creation of Bitcoin in 2009, there are blockchain based payment units, that can also be considered as a digital form of money. With scriptural money, e-money and cryptocurrencies there are at least three different forms of digital money.

              E-MONEY CAN BE ISSUED ON A BLOCKCHAIN BASIS

              Interestingly, the definition of e-money according to the e-money directive does not preclude the issuing of e-money on a blockchain basis. It is legally and technically possible for a central administrating issuer to create a smart contract on a blockchain and issue standardized and tokenized payment tokens. If the issuer would guarantee the possibility to exchange these tokens back at any time into legal tender, they would qualify as e-money according to the definition. The decentralized allocation and storage of the tokens would not lead to a different result, since the definition only requires the storage of the units. Therefore, the tokens would not necessarily have to be stored with the emitter. But would these e-money tokens also fall under the definition of the new financial instrument of crypto assets and would they therefore be both, e-money and a financial instrument according to the German Banking Act (KWG)?

              BLOCKCHAIN-BASED E-MONEY WOULD NOT BE A CRYPTO ASSET

              According to the newly introduced definition in the KWG, crypto assets are digital representations of value that is not issued or guaranteed by a central bank or any other public authority and does not possess the legal status of currency or money, but is accepted by natural or legal persons as a means of exchange or payment on basis of an agreement or actual practice or which serves investment purposes and which can be stored, traded and transferred electronically. According to this definition, e-money tokens can be crypto assets. The scope of the definition is restricted in the second sentence of the definition itself which states that e-money units are not crypto assets. A qualification of e-money tokens as crypto assets is therefore impossible according to the legal wording. If a service provider would offers to customers the storage of their e-money tokens, a BaFin authorization for crypto custody services would not be required.

              SO E-MONEY TOKENS WOULD NOT QUALIFY AS FINANCIAL INSTRUMENTS ACCORDING TO THE GERMAN BANKING ACT?

              E-money tokens as a form of e-money would also be subject to the German Payment Services Act (ZAG), in which the German legislator integrated the provisions from the second e-money directive. As shown above, the tokens could not be defined as crypto assets. That however does not automatically mean that e-money tokens cannot qualify as financial instruments according to the KWG at the same time. Under its administrative practice, BaFin qualifies e-money units as units of account and therefore as financial instruments in the sense of the KWG. Providers that e.g. offer brokerage services in regard to e-money tokens or the option to buy and sell e-money tokens on a regular basis and commercial scale can therefore be subject to BaFin authorization according to the KWG. The mere custody of e-money tokens for customers on the other hand would not be subject to authorization, because the KWG requires an authorization only for custody services regarding fiat money, securities or crypto assets.

              Attorney Lutz Auffenberg, LL.M. (London)

              I.  https://fin-law.de

              E. info@fin-law.de

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                Dec 30, 2019

                Crypto Assets and AML – When are Crypto Businesses Subject to the German Money Laundering Act?

                As of 2020 the German legislator is going to introduce crypto assets into the German Banking Act (KWG) as a new form of financial instruments and crypto custody services as a new form of financial service which is subject to authorization. Basis for these legal innovations is the amending directive to the fourth European Anti-Money Laundering Directive commonly known as the fifth AML Directive. While transposing the directive into national law, the German legislator exceeded the directive’s requirements. According to the wording, the directive requires the member states to introduce a definition for virtual currencies rather than for crypto assets and the introduction of a financial service such as the crypto custody service, which is subject to authorization, is also not explicitly required by the directive. With regards to virtual currencies, the focus of the EU directive was to subject service providers that are either engaged in exchange services between virtual currencies and fiat currencies or that provide custodian wallets for virtual currencies to the AML regulations of the member states. The EU legislator wanted the aforementioned service providers especially to be obliged to verify their customers identity via the so called Know-Your-Customer (KYC) procedure. Further on, the directive should ensure that the service providers implement sufficient risk management and adequate documentation procedures. But which businesses are now subject to the German Money Laundering Act (GWG) since the German legislator did not transpose the provisions of the fifth AML Directive literally?

                CRYPTO EXCHANGES WERE SUBJECT TO THE GERMAN AML ACT EVEN BEFORE THE TRANSPOSITION OF THE FIFTH AML DIRECTIVE

                In contrast to the other EU member states, Germany officially defined most cryptocurrencies already since 2013 as financial instruments as defined in the KWG, because BaFin stated early that they qualify Bitcoins and comparable cryptocurrencies as units of account and therefore as financial instruments according to the KWG. The regulation of units of account, such as special drawing rights of the International Monetary Fund or the predecessor of the euro, the “European Currency Unit” (ECU), are specific features of the German banking regulatory law and are not intended by the European directives. The qualification of cryptocurrencies as units of account results in the fact that the commercial exchange of cryptocurrencies, under certain circumstances, is qualified as a financial service, so that the service providers qualify as financial service institutions and therefore are subject to BaFin authorization long before the transposition of the provisions of the fifth European AML Directive into German law. According to the GWG, all financial service institutions are obligated to identify and verify customers via KYC procedure, implement a risk management for prevention of money laundering, notify the competent authorities when suspicion of money laundering arises and fully and adequately document these procedures. Crypto exchanges in Germany therefore had to fulfill the GWG requirements long before the transposition of the fifth European AML Directive came into effect. In addition to that, they are obligated to obtain BaFin authorization if they intend to offer their services in Germany on a commercial scale.

                CRYPTO CUSTODY SERVICES WILL BE SUBJECTED TO THE GERMAN AML ACT IN 2020

                Crypto custody services were not subject to authorization prior to the transposition of the fifth European AML Directive in Germany. The KWG did not qualify the custody of units of account as a service that is subjected to authorization. Providers of custody services for cryptocurrencies or other virtual currencies therefore could offer their services without prior BaFin approval. They were considered as unregulated service providers and not as financial service providers and consequently were also not subjected to the regulations of the GWG. This changes with the introduction of the crypto custody service as a financial service. As of 2020, service providers that safeguard crypto assets for customers on a commercial scale will be qualified as financial service institutions and will therefore have to comply with the provisions of the GWG as well.

                WHAT ABOUT OTHER BUSINESSES WITH CRYPTO RELATED BUSINESS MODELS?

                Not only crypto exchanges and crypto custody service providers are already or will be obligated to fulfill the GWG requirements as of the year 2020. Since units of account and the soon to be introduced crypto assets are financial instruments according to the KWG, businesses that intend to offer either purchase and selling services, commission services or advisory services regarding these financial instruments on a commercial scale will in many cases be regulated as financial service institutions or even as banks and will therefore be obligated to fulfill the AML requirements of the GWG.

                Attorney Lutz Auffenberg, LL.M. (London)

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                  Dec 23, 2019

                  Let’s Build a Crypto Custodian (Part III) – What Requirements Will BaFin Place on Risk Managing Strategies?

                  r authorization for the new financial service of crypto custody services. Several national and international market participants already display a keen interest in obtaining the authorization for said financial service. Even though it remains to be seen which companies actually apply for authorization and which of those applicants will be approved by BaFin, it nonetheless seems likely that in the course of 2020 several companies will be authorized for crypto custody services, so that crypto custody from then on will take place under BaFin supervision in Germany. Since the legislator took his time with the final version of the amendments to the German Banking Act (KWG), the authority did not have a lot of time to develop an administrative practice for the authorization and supervisory process. Since the crypto custody service is hardly comparable to any other regulated financial or banking service, BaFin has to apply due diligence when developing the requirements to be demanded under the ongoing supervision of crypto custody services in the future. One of the main aspects will be the risk managing strategy of crypto custody service providers since these businesses are subject to very specific risks compared to other institutions.

                  WHAT ARE THE GENERAL FACTORS THAT MUST BE MET BY FINANCIAL SERVICE PROVIDERS REGARDING THEIR RISK MANAGING STRATEGY?

                  The establishment, implementation and constant development of an adequate risk managing strategy is a key aspect of financial services supervision. The KWG requires financial institutions to develop and implement a procedure to determine and ensure its risk-bearing capacity. A careful and restrictive determination of the risks and the necessary risk coverage potential has to be the basis for the aforementioned procedures. In principle, the institutions are obliged to autonomously decide on how they implement the legislative requirements. BaFin as the supervisory authority is merely tasked to reprehend grievances and intervene if it comes to the conclusion that an institution does not fulfill the aforementioned legislative requirements. In order to facilitate the fulfilment of these obligations, BaFin substantiated its administrative practice and published the minimum supervisory requirements to risk management (MaRisk). Therefore, supervised institutions know what the competent authority requires of them and can navigate along the requirements of the MaRisk when developing their risk managing strategy. In addition to the specifications regarding the general risk managing strategy and risk-bearing capacity, the MaRisk also includes the minimum requirements for the design of internal monitoring systems and stress tests as well as design and process requirements for the technical and staff capacities and IT-emergency plans.

                  WHAT ARE THE ADDITIONAL RISKS THAT CRYPTO CUSTODY SERVICE PROVIDERS WILL FACE?

                  Crypto custody service providers in comparison to other financial service providers will face additional, crypto-specific risks. One of those crypto-specific risks is the risk of losing the private keys to customer’s crypto assets, especially since these keys cannot be replicated and losing the private key equates to losing the crypto asset itself. The risk managing strategy of crypto custody service providers will therefore have to address this issue extensively. Another aspect that has to be addressed in the risk managing strategy of crypto custody service providers will be the adequate protection against unauthorized third party access of customer private keys, since the knowledge of the private key equates to the possibility of disposition regarding the associated crypto asset. If a third party obtains knowledge of the private key, they will have the option to transfer the associated crypto asset to another wallet and therefore finally deprive it from the crypto custody service provider’s area of disposition. It must be taken into consideration that attacks on custody wallets are not necessarily unrelated third party attacks from outside but potentially can also be executed internally by employees. Crypto custody service provider will have to protect themselves from these risks through the usage of multisig-wallets and careful selection of employees with access rights. Another question that will arise with regards to the IT-equipment is to what extend the systems can be connected to the internet or to cloud solutions to minimize the danger of external hacker attacks.

                  BAFIN DEVELOPS ADMINISTRATIVE PRACTICE REGARDING CRYPTO CUSTODY SERVICES

                  BaFin already announced that it is developing an administrative practice concerning crypto custody services. Companies that already expressed interest in applying for authorization to conduct crypto custody services will be individually informed by BaFin as soon as the authority substantiated its administrative practice in order to allow the future applicants a thorough and comprehensive application preparation. This will certainly take a while. Nonetheless, future crypto custody service providers should start to grapple with the requirements now in order to keep the application preparation time as short as possible.

                  Attorney Lutz Auffenberg, LL.M. (London)

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                    Dec 16, 2019

                    Payment Services with Cryptocurrencies – Can an Authorization for Payment Services be Required?

                    According to the basic idea of Satoshi Nakamoto, Bitcoin was meant to be an electronic peer-to-peer payment system that would function directly between the users without the necessity of payment processors such as banks. The massive increase in value since the mining of the first Bitcoin – to almost 20.000 euros per Bitcoin temporarily – as well as similar increases of the value of comparable cryptocurrencies led to the perception that Bitcoin and other cryptocurrencies are first and foremost a new type of asset for speculative investments. Nevertheless, there are now numerous service providers that offer their customers the opportunity to pay invoices with cryptocurrencies even though they are denominated in euros, USD or other legal currencies. These service providers require their customers to transfer the equivalent of the invoice amount to them in cryptocurrencies, then the service provider exchanges the transferred cryptocurrencies into the needed fiat currency and transfers the amount to the banking account of the invoicing party. If this business model would only use foreign exchange and legal tender, it would be subject to authorization according to the German Payment Services Act (ZAG). The acceptance of customer money and the transfer to the invoicing party would constitute a money remittance as defined in the ZAG which is a payment service and therefore subject to authorization from BaFin. But why is this service not regulated as a money remittance service if the invoice recipient pays with cryptocurrencies?

                    PAYMENT SERVICES ONLY RELATE TO LEGAL TENDER AND E-MONEY

                    The ZAG regulates the offering of payment services such as e.g. the money deposit and withdrawal at ATMs, the execution of transfer orders with and without credit granting, the issuing of payment cards and other payment instruments and of course money remittance services. These services all relate to payment processes that occur on basis of money in the sense of legal tender or e-money. Even though this restriction is not explicitly made in the ZAG, it can be derived from the fact that the ZAG is based on the second Payment Service Directive (PSD2). Article 4 nr. 25 of the PSD2 states that “funds” means banknotes and coins, scriptural money or electronic money as defined in the second European e-money directive. Cryptocurrencies such as Bitcoin, Litecoin, IOTA or Monero therefore do not constitute “funds” in the sense of the directive and can therefore not be the subject of payment services in the sense of the PSD2. The case would be different if at some point in the future e.g. blockchain-based central bank money as it is currently being considered by the Chinese and Russian central banks came into existence. E-money on a blockchain-bases could also qualify as “funds” in the sense of Article 4 nr.25 PSD2. These cryptocurrencies could then potentially be subject to payment services in the sense of the ZAG.

                    IS THE SERVICE OF FORWARDING CRYPTOCURRENCIES WITHOUT CONVERSION SUBJECT TO AUTHORIZATION?

                    The forwarding of cryptocurrencies from an invoice recipient to the invoicing party without the conversion to fiat currency, other crypto assets or other means of payment will only seldomly require the services of a money remittance service provider. The use of these services only makes economic sense, if the service provider would act as a fiduciary regarding the usage of the transferred cryptocurrencies. In these cases, the primary function of the money remittance service provider would not be the transmission of funds but rather the monitoring of the agreed upon payment conditions of the involved parties. If money transmission is just a by-product to the main service, BaFin in certain cases does not consider the forwarding to be subject to authorization.

                    SO MONEY REMITTANCE SERVICES INCLUDING CONVERSION OF CRYPTOCURRENCIES TO FIAT ARE NOT SUBJECT TO AUTHORIZATION?

                    Even though the receipt of customer cryptocurrencies in order to convert them to fiat currency and subsequently forward them via bank transfer to a payee does, as shown above, not constitute a money remittance service as defined in the ZAG, the exchange from cryptocurrency to fiat currency can constitute trading in financial instruments, if the cryptocurrency in question is to qualify as either a unit of account, a crypto asset or any other financial instrument in the sense of the German Banking Act (KWG) and therefore might be subject to authorization. Depending on the specific case and the way the cryptocurrencies are handled, the exchange might be considered either a financial commission business, investment brokerage or proprietary trading which are all subject to authorization.

                    Attorney Lutz Auffenberg, LL.M. (London)

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                      Dec 08, 2019

                      Crypto Custody Business and Grandfathering – Who Can actually Profit from the Transitional Rule?

                      With the year 2020, the new financial service of crypto custody business will be introduced in Germany. Custodians of crypto assets from then on can offer their services only if they acquired a BaFin authorization beforehand. Since the German legislator took his time with the new law and the exact requirements for a successful authorization application have only recently become clear, a transitional arrangement for operators of crypto custody service providers will be in effect. This means that crypto custody service providers can continue offering their services without BaFin authorization if they comply with certain requirements and time limits. But what exactly are the requirements to trigger this so-called grandfathering rule?

                      IMPORTANT: GRANDFATHERING REQUIRES EXISTING BUSINESS OPERATIONS

                      The wording of the transitional regulation which will be incorporated on the 1st of January 2020 into the German Banking Act (KWG) states that businesses that will be subject to authorization because of the newly introduced financial service of crypto custody service business can continue their operations without BaFin authorization if they notify BaFin about their intention to apply for authorization in writing until the 31st of March 2020 and subsequently apply for authorization until the 30th of November 2020. Then, the authorization to conduct crypto custodian business is considered to be provisionally granted. Therefore, businesses intending to offer crypto custody services for the first time on or after the 1st of January 2020 cannot profit from this grandfathering regulation according to the wording of the law. These businesses will not become subject to authorization because of the introduction of the crypto custody service as a new financial service into the German Banking Act (KWG) but rather because of the start of their business. Businesses planning to profit from the grandfathering rule should therefore fulfil the requirements as a crypto custody service provider before the end of the year. This means that these businesses should try to offer the custody of crypto assets such as e.g. Bitcoin, Litecoin or ERC-20 tokens that do not classify as securities to the German market and (in a best-case scenario) start operations prior to the new year. Additionally, the scope of the offered service has to be conducted commercially or at least in a commercial extent. It would therefore not be sufficient to simply store some crypto assets of friends or family on a free-of-charge basis.

                      BAFIN ASKS FOR INTENTION NOTIFICATION – NO EFFECT FOR GRANDFATHERING

                      On the 4th of December 2019, BaFin publicly asked businesses intending to apply for authorization for the new crypto custody services to non-bindingly and informally report their intentions and a short summary of their business model to the authority. BaFin thereby intends to get a proper overview of the market and to gather information required in order to develop their supervisory standards for the application process and the ongoing supervision of crypto custodians. At the same time, BaFin states that this non-binding report of intention does not have any effect with regards to the above-mentioned grandfathering rule, since the legal basis for the acceptance of that rule will only become effective next year and any intention notification that is made prior therefore cannot have any effect. In its public statement BaFin ensures that the non-binding report of intention that it asked for is completely voluntary and will have no effect on a later application process. Businesses that comply with the BaFin request will however receive further information regarding the application process as soon as the authority substantiates its administrative practice regarding the crypto custody business. Such information certainly will not have a negative effect on the applications procedures of the companies.

                      Attorney Lutz Auffenberg, LL.M. (London)

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                        Dec 02, 2019

                        Let’s Build a Crypto Custodian (Part II) – How Much Regulatory Starting Capital Does a Crypto Custodian Require?

                        As of the first of January 2020, crypto custodian services will be regulated as a new financial service in Germany. The safekeeping of cryptocurrencies and crypto tokens for customers on a commercial extent will at that point in time require a prior authorization by BaFin. The new financial service touches on a core issue of crypto-related business models which is the reason why numerous market participants already expressed interest in acquiring a BaFin license for the crypto custodian service business. The first mandatory step for a successful BaFin application for a crypto custody service provider license has to be a meticulous planning of the application and related to that a thorough examination of the regulatory requirements to fulfil. The first part of our multipart blog “Let’s Build a Crypto Custodian” covered the requirements that BaFin places on the managing directors of a crypto custody service provider. The second part addresses the question of how much starting capital must be shown to BaFin in order to successfully obtain a license to provide crypto custody services.

                        MINIMUM STARTING CAPITAL DEPENDS ON THE PLANNED ACTIVITIES

                        The German Banking Act (KWG) stipulates that German banks and financial service providers must have a certain minimal capital at their disposal at any point in time. If the starting capital drops below the statutory minimum, BaFin has to be notified immediately and, as a worst-case-scenario, might revoke the authorization of the company. The legal term “starting capital” is therefore somewhat misleading. The legal minimum amounts depend on the specific activity that the applying company plans to offer. Crypto custody service providers which solely offer custody services for crypto assets and no further banking or financial services and that do not plan to trade financial instruments for their own account require a starting capital of at least 125.000 euros according to the regulations. In the case that further banking services next to the crypto custody service like deposit or lending services are offered, the minimum starting capital increases to 5.000.000 euros. If the intention is to deal in financial instruments on own account beside the crypto custodian services the amount increases to a minimum of 730.000 euros. This might be the case if e.g. a crypto trading platform offers their customers by way of proprietary trading or financial brokerage the option to sell or acquire cryptocurrencies as well as the custody service.

                        STARTING CAPITAL FOR THE CUSTODY OF SECURITY TOKENS IS PROBLEMATIC

                        A special case must be made for companies intending to offer their clients custody services for security tokens that qualify as securities. As of the first of January 2020, security token will constitute crypto assets and so be suitable objects for crypto custodian services as the definition in the German Banking Act will state that crypto assets are digital representations of values that can be transferred, saved and traded and that are designed for investment purposes. If the tokens are designed as a security, the custody of these tokens would most probably also constitute a security depository business which would require a substantially higher starting capital. Insofar, the legal wording does not suggest a subsidiarity of the crypto custody service to the security depository service. Even though the explanatory memorandum to the governmental draft indicated the legislative will of such a subsidiarity, the actual wording of the finalized law does not contain it.

                        HOW MUCH STARTING CAPITAL IS REQUIRED FOR THE OPERATION OF A DEPOSITORY BUSINESS?

                        Interestingly, the German Banking Act (KWG) does not stipulate a minimum starting capital for providers of security depository services. The starting capital of 5.000.000 euros according to sec. 33 subsection 1d of the German Banking Act only applies to CRR regulated institutions and therefore only to banks that provide deposit and lending business in relation to money in the form of legal tender. Even though there is no legal regulation, there are many good arguments that the regulatory starting capital of 5.000.000 euros should also apply to security depository banks. From a regulatory point of view and in consideration of the risks associated, it does almost make no difference if the service provider safeguards values of their customers in the form of money or securities.

                        Attorney Lutz Auffenberg, LL.M. (London)

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