Decentralized Exchanges - Crypto Exchanges Without a BaFin License?

(For German version click here)

 

Decentralization was one of the main motivations of the authors of the Bitcoin whitepaper in 2008. The Bitcoin ecosystem was supposed to enable payments between the users without the necessity of intermediaries such as payment processors or banks. While the possibility of peer-to-peer payments is an inherent use case with all cryptocurrencies the trading of cryptocurrencies took a rather centralized path right from the beginning. The majority of all crypto transactions take place on crypto exchanges which act as a centralized entity for the matchmaking between the buy and sell orders of their customers. From a regulatory point of view these exchanges are, depending on the way they operate, either a multilateral crypto trading facility, a crypto exchange bureau or a crypto broker. The operating of a crypto exchange in Germany is a regulated business that requires a BaFin approval.

What is a Decentralized Exchange?

Decentralized Exchanges (Dex) differ from centralized crypto exchanges due to the fact that the cryptocurrencies of the users are not stored with the operator of the exchange to settle the trades that are made on the exchange. Instead users can settle their trades directly via a Blockchain address that they control. To do so, they have to interact with a smart contract that works as a decentralized App (dApp). This dApp automatically matches the participating parties of the trade and settles the transaction. The participating parties of the trade transfer the cryptocurrencies to be exchanged to a blockchain address associated with the smart contract instead of transferring them to a blockchain address that is controlled by the operator of the crypto exchange. As soon as the smart contract received the transactions of both parties it will automatically settle the trade.

Is a BaFin License Required to Operate a Decentralized Exchange?

The questions if and how a Decentralized Exchange has to be regulated under German law depends on how the exchange in question is designed. In a constellation in which the underlying smart contract is operated by a determinable administrator the aforementioned advantage of not having to store the traded cryptocurrencies on a wallet associated with the exchange is retained. Nevertheless, in this example the administrator might be operating a multilateral crypto trading facility, if he matches the buy and sell orders of his customers concerning cryptocurrencies (and therefore financial instruments) according to a pre-determined system via the smart contract. This kind of activity is cannot be carried out in Germany without the prior approval of BaFin. If however the Decentralized Exchange would be designed as an open source project without a determinable administrator it would lack an operator that could be addressee of an authorization obligation. This kind of exchange would also cater to the original idea of decentralization as promoted by Satoshi Nakamoto.

Does the Operation of a Decentralized Exchange Hold Regulatory Advantages for the Operator?

A decentral design of a crypto exchange does not only protect the customers of said exchange from the insolvency risk of the exchange. The provider himself might have substantial benefits from operating a decentralized exchange instead of a centralized one. First of all, the provider does not have to protect the cryptocurrencies of his customers in his own wallets with private keys against cyber-attacks because these cryptocurrencies are at no point in time in his possession. In order to be approved by BaFin centralized crypto exchanges have to design risk management concepts that explain in detail how they intend to deal with the added risk that arises from the custody of customer assets. Second of all, the starting capital requirements can be higher for centralized crypto exchanges than for their decentralized counterparts. If the operator of a multilateral crypto trading system for example stores security tokens of his customers in his own wallets he has to show a starting capital of at least 125.000 euros to BaFin instead of the 50.000 euros that would be required in case of not storing securities or funds of customers. Furthermore, a Decentralized Exchange is an interesting option with regards to the German Ministries of Finance draft legislation for the transposition of the 5. European AML Directive. The draft proposes that crypto custodian business shall be regulated as a financial service. Decentralized Exchanges would not subject to this regulation because they will never be in possession and therefore never have custody of their customer’s cryptocurrencies.

 

Attorney Lutz Auffenberg, LL.M. (London)

 

I.  https://fin-law.de

E. info@fin-law.de