At the end of July, the German Federal Government approved the draft bill for the transposition of the 5th EU Anti-Money Laundering Directive (AMLD 5). Since virtual currencies, as stated by the European Banking Authority Opinion on ‘virtual currencies’ (EBA Opinion on ‘virtual currencies’, 2014), are linked to money laundering and terrorist financing risks, AMLD 5 sets a specific focus concerning this matter.

The anticipated amendments establish crypto assets (so-called “Kryptowerte”) as a financial instrument to the German Banking Act (KWG). Furthermore, crypto asset custody is being introduced as a new type of financial service and will, therefore, require the authorization of BaFin. Crypto asset custodians, which handle the private keys necessary to hold and transfer crypto assets, are therefore obliged to fulfill the regulatory requirements of institutions in the meaning of KWG. To translate this and to illustrate the impact, soon those high-level, high-standard, high-cost market infrastructures known from traditional capital markets since decades will have to also be in place for all companies handling crypto assets. Because by definition, exchanges are not just trading venues but also do custody as part of it. Thus, these companies are affected as well. Although the draft bill has yet to be approved to come into force, it can be assumed that this will not happen with significant changes.

Some Few Words in the Law with Major Implications

These new rules will have a significant impact on the blockchain ecosystem and pose immense challenges throughout the industry. The point where things not only get complicated but bear far-reaching effects on the blockchain economy manifests in a newly added constraint. Accordingly, a crypto asset custodian is restricted to provide any other regulated banking or financial service, which requires authorization. While this sentence sounds complicated, it means the following: A company seeking to do custody for crypto assets is allowed to do so (after applying for a license with BaFin) but only if this very company is not providing other banking or financial services. This means that handling crypto assets has to be separated from traditional financial services. Of course, a larger bank can found a subsidiary to do so, as it cannot handle crypto assets with its (1) existing legal entity and (2) also not with its existing licenses. In other words: a new legal entity is required and a new license is required.

With the implementation of crypto assets as a financial instrument in the meaning of KWG, the definition becomes crucial. A security token, for example, contains characteristics of a security and a crypto asset at the same time. In this case, the classification as a crypto asset is subordinated to the definition of traditional financial instruments. As a result, a security token might be classified as a security and not as a crypto asset.

Depending on how this will be outlined in the law, a crypto wallet provider might thus not be allowed to hold and store crypto currencies (e.g., Bitcoin) and security token (e.g., Bitbond Token) in the same legal entity. This reasoning is linked to the high IT risks and enormous requirements concerning IT security for crypto asset custodians. As a consequence, every bank or financial service provider in Germany is forced to establish a subsidiary to offer its customers’ custody service for crypto assets. At a later stage, in the Industry 4.0, every machine equipped with a wallet with crypto assets stored on it will force its manufacturer or owner to find a solution in order to meet the regulatory requirements. Most probably, in these industrial areas, outsourcing providers will emerge which own the required license and can be subcontracted by a machine manufacturer to deliver its services.

Economic Effects and Outlook

The path taken by the German legislator also triggers a significant cross-border effect at the EU level. Usually, “passporting” rights enable companies registered in the EU to conduct business with any other state in the EU without the need for further authorization from each country. Since custody services for crypto assets is not a financial service as defined in the European regulation, the usual “passporting” regime is not applicable within the EU. As a consequence, financial institutions located in Germany (e.g., Bitcoin.de, Bitwala) or the EU (e.g., Bitstamp, Bitpanda), which aim to provide these financial services in Germany will have to apply for authorization in order to target German investors.

If the planned law comes into place, BaFin will likely handle not only a significant amount of authorization requests but will have to do that on a case by case basis, given the legal and technical complexity. Regarding the timeframe for the transposition of this draft bill, this task seems not unfeasible but ambitious. Affected companies must notify BaFin of the intention to apply for permission until February 1, 2020, and submit a complete application by June 30, 2020.

Let’s now take a closer look at the risks and opportunities for players in the field which will now require a license (Type 1 and Type 2), or which will inevitably need one in the future (Type 3), and a new cooperation model that might evolve (Type 4).

Type 1: Startups Requiring a License

For startups, the challenges of the anticipated amendments are undoubtedly the highest. The compliance with requirements stemming from the German Banking Act, e.g. organizational structure and capital requirements, may pose obstacles that are difficult to overcome. With regard to the situation in which our digital economy driven significantly by startups, the approach of the German legislator must be viewed critically since the intended regulation goes beyond the requirements of AMLD 5. To be very clear, a significant share of startups will not be able to fulfill these requirements and, consequently, will either (1) go out of business or (2) leave the country and relocate their business to innovation-friendly hubs such as Liechtenstein, Malta, Switzerland or elsewhere. The European Central Bank emphasized that “disjointed regulatory initiatives at the national level could trigger regulatory arbitrage and, ultimately, hamper the resilience of the financial system to crypto-asset market-based shocks” (European Central Bank, Occasional Paper Series No 223, 2019). Without a level playing field on the EU level, Germany might weaken its position as a business location in the long term by forcing startups to leave the country due to the imposed authorization requirements. It needs to be acknowledged that these new hurdles will also drive bad actors and startups of poor quality in other legislations — an effect which is of course desired. But the key question is — and it cannot be answered clearly — whether the hurdles installed will be too high for high-quality startups.

Type 2: FinTechs Requiring a License

For established FinTechs in the field, the new requirements should represent feasible hurdles. Startups which can be associated with this type are for example SolarisBank, Bitcoin.de, Bitwala, or Fidor Bank.* On the one hand, they already possess the technical know-how for their core business and, on the other hand, they already have partnered with banks in order to offer their service or hold banking licenses themselves. However, even in these setups, it may be necessary to establish a subsidiary and apply for the corresponding license as crypto asset custodian. Nevertheless, FinTechs should perceive that the licensing process is an opportunity to significantly improve their market position after a “shake out”, which can be expected for late 2020 when dozens of companies (in particular, crypto exchanges) will have to stop operating in Germany as a significant share of them will not be able to fulfill the requirements. If certain startups manage to acquire the license, they will benefit from consumer confidence that comes with it. This should improve their business. Compliance with the strictest regulatory standards that currently exist should further enhance this effect.

Type 3: Traditional Banks and Financial Intermediaries Interested in Offering Crypto Asset Custody

For banks, the recent development provides opportunities and bears risks at the same time. This category applies to the big players such as Börse Stuttgart — but also to smaller companies such as VPE Bank, Futurum Wertpapierhandelsbank, etc. — if, and only if, they seek to tap into this new market segment.* If they refrain from doing so, they would — of course — not be affected.

At this stage, it is reasonable to say that most financial institutions will not have difficulties with setting up a subsidiary and applying for a license. However, some traditional banks will have significant problems with the implementation of the technology in their existing business. Often, banks still do not understand blockchain technology with its specific details when it comes to crypto custody. Also, some kind of inhouse “crypto ban”, which often is in place, led to the fact that only issues such as financing criminals and the electricity consumption are associated with Bitcoin and other crypto assets. A more neutral discussion did not take place due to the “crypto ban.”

It can be assumed that outsourcing of crypto asset custody is not a solution because the entity looking for an external partner remains the service provider for its customers and falls, therefore, under the newly added restriction. Eventually, every existing financial institution will have to found a legally independent entity, which can be fully owned by the proprietary company, in order to provide crypto asset custody for its customers. From a compliance point of view, financial institutions will benefit from decades of experience working with regulators such as BaFin. In addition to that, these institutions can leverage their established reputation, which should facilitate the licensing process. It can be challenged, however, whether they see the huge chance of this new market, whether they have the technological know-how to operate in the crypto area or whether they find ways to insource or acquire this knowledge from third parties.

Type 4: Joint Ventures Between Financial Institutions and Startups

The combination of startups and established financial institutions appears to be a very interesting construction in a legal sense. This mode could be applicable for a potential joint venture between a custody provider such as Riddle & Code, Finoa, Tangany, or Qredo on the one hand side and a larger player such as Deutsche Bank, Commerzbank, etc. on the other hand side.* While this is possible, it can threaten the startup and the larger player if exclusivity would be demanded. Either it restricts the startups from growing or the larger player has an undesired lock-in; that is, the larger player has made the decision for one specific provider but it later appears that other providers would have been the better option. An interesting construction therefore could be for financial organizations such as Deutsche Börse and others to collaborate with crypto “system providers” such as Avaloq, Blocksize Capital, Iconiq Lab or Crypto Finance because they have the technical knowledge, can connect multiple custody providers at the same time and, thus, would not require the decision for one single selected provider.*

Banks can bring their experience and reputation to the table, which should be helpful given the relatively tight timeframe for the transition phase. Furthermore, the knowledge in dealing with regulators and implementing directives at the international level would be invaluable. Startups, on the other hand, can help their counterpart with technological expertise and therefore solve banks biggest challenges. Additionally, the regulatory requirement to separate crypto asset custody from other banking business would automatically be met in a joint venture. From the consumer’s point of view, this solution also appears beneficial. A vast number of customers would thus gain access to a service that has not been available to most clients up to now. Also, the reputation of the bank in question would provide the necessary confidence in the service, which the startup alone would not be able to provide.

Conclusion

The approach of the German legislator to a comprehensive regulation for the crypto asset sector is an essential step for the evolution of the industry. And it has to be like this. So many undesired things happened during the crypto craze of 2017 from Bitcoins being stolen, thousands of customers being betrayed, market manipulation happening, money laundry going on etc. — if the crypto market should mature, then larger players need to join the market. In consequence, requirements to operate in this market must be the same standards as we know it from traditional capital markets.

Progressive regulation enables the blockchain ecosystem to offer products on a solid legal foundation. Only legally compliant products can provide the necessary consumer confidence for further adoption. Therefore, it can be viewed very valuable that Germany took the initiative and now starts regulating crypto assets on a broad scale. Shaky startups and bad actors will be driven out of the market. In turn, good ones will find solutions for growing further — alone or in a cooperative mode with others.

There is, however, a need for debate and discussion on the extent of the new regulatory framework. By going beyond the requirements of AMLD 5, the German legislator creates a situation which might have serious consequences. German startups may have to relocate to a jurisdiction that allows them to continue their business if the planned regulatory hurdles prove to be too high. In this context, a joint European effort on crypto asset regulation would be desirable. But if Europe as a whole does not move, what should BaFin and the German legislator do? Wait and see? Luckily, they acted.

It will be exciting to observe, as time passes, which strategies the market players take — be it young startups or mature banks. It will also be exciting to see which players will be successful with their tactics and which small and large players will go out of business. One thing must be clear: Those companies now being able to handle crypto assets such as Bitcoin will be the ones to handle securities (running on blockchain), the Euro (running on blockchain), etc. in the future.

Remarks

*) Company names listed in these sentences are presented as illustrations. We felt that this article can be must better understood if we present some potential examples of companies we have in mind. Company representatives who not want to be named, should simply contact us and we change the article and add other names.

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Authors

Benjamin Schaub is a project manager and research assistant at the Frankfurt School Blockchain Center (FSBC). His interests include blockchain regulation and governance as well as blockchain use case development. You can contact him via mail (benjamin.schaub@fs-blockchain.de) or on LinkedIn (www.linkedin.com/in/benjamin-schaub).

Prof. Dr. Philipp Sandner has founded the Frankfurt School Blockchain Center (FSBC). In 2018 and in 2019, he was ranked as one of the “top 30” economists by the Frankfurter Allgemeine Zeitung (FAZ), a major newspaper in Germany. Further, he belonged to the “Top 40 under 40” — a ranking by the German business magazine Capital. Since 2017, he is member of the FinTech Council of the Federal Ministry of Finance in Germany. The expertise of Prof. Sandner includes blockchain technology in general, crypto assets such as Bitcoin and Ethereum, the digital programmable Euro, tokenization of assets and rights and digital identity. You can contact him via mail (email@philipp-sandner.de) via LinkedIn or follow him on Twitter (@philippsandner).