The decision of the German government to regulate digital asset custodians as ‘financial services institutions’ by 2020 has caught many wallet providers and exchanges by surprise and drawn widespread criticism for its potential impact on the prospects of Germany as a European FinTech hub. The draft act is set to take another step towards adoption later this month when the second German legislative chamber (Bundesrat) is expected to vote on the Government’s proposal.

Impact far beyond Germany

The regulation will not only affect German based custodians and trading platforms, but every entity providing custodial services (regarding digital assets and private keys) for third parties if they address the German market or German customers. Hence, companies located in other countries have to assess whether they will be regarded as cross-border service providers by the German regulator, BaFin, and thus need to obtain a license if they want to continue to offer their services.

According to BaFin’s supervisory practice, the repeated targeting of the German market on a commercial basis qualifies as cross-border provision of financial services, even if the company does not maintain a registered office in Germany. Most companies will offer their services “commercially” as this merely requires their operations to be set up for the long term and with the intention of making a profit. More interesting, however, is the question whether the service provider is “targeting” the German market. In order to avoid regulation, some companies might consider to not actively market to and address the German market and basically hope that German customers will contact them on their own initiative. This so called “reverse solicitation” does not require licensing in the customer’s country of residence because there was no active marketing on behalf of the service provider. Obviously, there are a number of risks and disadvantages involved when taking on customers (especially retail customers/consumers) from other countries without being properly licensed. First of all, the extent of permitted marketing activities into the German market is very limited. Depending on the specific content, this relates to every activity like roadshows, online advertising and the content of the company’s homepage. BaFin will take all those activities and circumstances into account when assessing whether it can be assumed that German customers approach foreign service providers on their own initiative or rather as a consequence of targeted marketing.

Dr. Carola Rathke, Partner at Eversheds Sutherland cryptopractice says:

“For anyone trying to build a strong market presence in the German crypto assets market or a significant customer base, betting on reverse solicitation will most likely not be a sustainable business model. And with Brexit looming, BaFin will pay close attention to unregulated crypto custodians signing up German customers.”

Investor trust through regulation

Germany is one of the first countries to specifically regulate and supervise crypto custodians, hence, for the time being, there is no possibility of passporting existing licenses. It still has to be seen if other European countries will follow the example – Germany’s government seems to be certain of this being the case. And although it is not clear by now to which extent, the Dutch National Bank is the next regulator that has announced it will subject crypto service providers to its licensing regime in some way. Key markets in continental Europe appear to be headed towards some degree of financial supervision of custodians which could open up passporting for custodians already holing a BaFin license, if the countries would make a bilateral agreement. With the prospect of digital securities and funds, institutional investors will look for well-regulated and supervised custody solutions. Many custodians will find that the process and the requirements of obtaining a German crypto custody license is challenging but manageable. And it might be exactly what it takes to get ahead of competitors – especially when targeting institutional investors.

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