Inventory Management in Crypto Custody Service – What must be Observed when Taking Custody of Crypto Assets?

According to BaFin, over fifty potential service providers already informed the supervisory authority about their intention to apply for an authorization to conduct crypto custody services until the end of November 2020. Less than ten actual applications have been submitted to BaFin until now. Even though it can be assumed that some of those that informed BaFin about their intentions will, in fact, change their mind and not apply for authorization, it is obvious that there will be numerous authorized crypto custody service providers in close future in Germany. These competitors will only be able to coexist, if their respective business models differ from each other and cater to different market niches. This leads to the question of what, if any, the supervisory options are that crypto custodians have to differentiate themselves from their competitors.

One problem that occurs when designing business models that include crypto custody services stems from the fact, that the German legislator opted to only privilege those crypto custody service providers with specific supervisory exemptions, that do not provide any financial services as defined in the German Banking Act (KWG) other than crypto custody services. Crypto custodians therefore have very little leeway when it comes the actual design of their business model. The abovementioned exemptions are real simplifications that providers should not waive without good reason. Specifically, the provisions concerning the capital requirements with regards to the EU Capital Requirements Regulation (CRR) and the German Solvency Regulations are only applicable to these service providers to a limited extent. Furthermore, in contrast to other financial service institutes pure crypto custodians are not subject to limitations when it comes to the non-commercial granting of large-scale loans and they are unaffected by the German regulation on the supervisory requirements for institutions’ remuneration systems, meaning that they can freely decide on their payment structure. There are therefore numerous good reasons for financial service providers to offer exclusively crypto custody services.

Business models that intend to offer crypto custody services and unregulated ancillary services can be implemented without the loss of the abovementioned supervisory privileges. Ancillary services in this sense are services that are not classified as banking services or financial services in the sense of the KWG. Examples for these services would for example be user-friendly and easy to use interfaces, additional features that support the user with the creation of declarations for the tax authorities or the general supply of crypto deposit statements.

The business model of crypto custodians evolves around the safeguarded crypto assets. They are being managed, stored and safeguarded for the customer. Certain business models might also intend to utilize the safeguarded customer crypto assets for their own business purposes, e.g. to supply other customers with temporary liquidity for trades on the crypto market. BaFin clarifies in its published administrative practice on the crypto custody business that the core element of crypto custodian services is that the service provider has the private keys and therefore actual access to the safeguarded crypto assets. BaFin explicitly states that the custody of crypto assets can also be provided in collective holding. The authority therefore accepts business models that mix crypto assets of different customers in centralized wallets. In these cases, the crypto custodian owes its customers the transfer of crypto assets of comparable kind and quality, if the customer demands the repayment of the stored amount and not the transfer of the originally submitted assets. An interim use of the crypto assets by the crypto custodian for its own business purposes would therefore not per se be unthinkable.

Crypto custodians always have to ensure that they are at any point in time able to transfer the owed amount of crypto assets to the customers should they demand it. Furthermore, they have to ensure that the interim usage of the safeguarded crypto assets does not constitute an additional banking or financial service for not losing the supervisory privileges for crypto custodians. Customers of crypto custodians may expect a secure custody of their crypto assets, which means that the requirements for the contractual terms of custody are appropriately high. In any case in which the business model of a crypto custodian intends the interim usage of the stored crypto assets, an early dialog with BaFin prior to the actual application is highly advisable in order to avoid problems during the authorization process.

Attorney Lutz Auffenberg, LL.M. (London)

I.  https://fin-law.de

E. info@fin-law.de

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