Crypto Custody Service - New Financial Service Providers as the Future Centers of Power of the Crypto Market?

(For German version click here)

 

On 29th of July the German federal government resolved its draft proposal for the transposition of the provisions of the 5. European AML Directive into national law. It can be expected that this draft in its current form will be passed into law by the end of 2019. As of 1st of January 2020, crypto assets will be included in the catalogue of financial instruments in the German Banking Act (KWG) and crypto custody services will be considered as a financial service that is subject to authorization from BaFin. While the inclusion of crypto assets in the catalogue of financial instruments in the German Banking Act will not significantly affect the current regulation of blockchain units in Germany, the proposed regulation and creation of crypto custody services will lead to a situation in which the German crypto market cannot function without BaFin supervised services of this kind.

Crypto Assets Expand the Catalogue of Financial Instruments in the German Banking Act (KWG)

The criticized administrative practice of BaFin according to which Bitcoin and comparable cryptocurrencies are units of account and therefore financial instruments according to the German Banking Act (KWG) will be accompanied by the explicit qualification of crypto assets as financial instruments within the German Banking Act (KWG) itself. The German legislator does not want to leave any doubt that the German crypto market is regulated and that crypto service providers need a BaFin approval prior to the start of their business operations. After this law will be passed it will be irrelevant for the qualification as a financial instrument if a blockchain unit is meant to be an alternative means of payment such as Bitcoin or if it is meant to be an investment vehicle. The decisive factor will be if the coin in question will fit the definition. More precisely if it is the digital representation of a value that is not issued by a public institution and that is useable as a means of exchange because of a private agreement or actual practice and that can be transferred, stored, and traded electronically.

Crypto Custody Services as the New Center of Power

As of the 1st of January 2020, the storage, management and safeguarding of customer crypto assets or private cryptographic keys that are meant to store or transfer crypto assets will be a financial service that requires prior BaFin authorization. The decisive difference between the draft proposal of the German Ministry of Finance from May 2019 and this (now resolved) draft by the German federal government is the newly introduced section 32 subsection 1 g into the German Banking Act (KWG). According to this new provision, BaFin can only license companies as crypto custody services if these companies do not offer any other banking or financial services that would also require BaFin authorization. That means that companies that currently offer their customers the permanent or temporal storage of crypto assets in addition to their BaFin licensed other business model will not be able to continue doing so without outsourcing the crypto custody service to a licensed crypto custody service provider. An application from these companies for obtaining a BaFin license as a crypto custody service cannot be successful. This will especially affect centralized crypto exchanges but also financial portfolio managers and crypto payment services that have a credit balance function for their customers. Especially centralized crypto exchanges depend on the temporal storage of client crypto assets to settle the customer transactions. The German crypto market will then be regulated in a similar manner as currently the securities market, where customer securities must be stored by central securities depositories such as Clearstream AG.

What is the Reason for the Exclusive Licensing of Crypto Custody Services?

By the decision to design crypto custody services as an exclusive financial service (meaning that a company can only offer crypto custody services and no other financial or banking service that requires a BaFin license), the German legislator wants to centralize the crypto market. The exchange of cryptocurrencies or other crypto assets via service providers shall in the future require the commission of a BaFin licensed crypto custody service. The legislative decision to centralize the German crypto market is most probably influenced by the latest FATF recommendations. The FATF recommended to the global legislators to regulate crypto service providers in general in order to combat money laundering and terror financing. To achieve this, the FATF suggested that every crypto service provider that is involved in a crypto transaction should be obliged to collect information about the recipient and the sender of that transaction and provide this information to the counterpart of the transaction, specifically the other crypto service provider, as well as to the competent supervision authority. These obligations and corresponding systems can be implemented much easier in a centralized system than in a decentralized one. The basic idea of decentralization as the fundamental technical innovation of blockchain technology will however be put in tight shackles with the centralization of the crypto market.

 

Attorney Lutz Auffenberg, LL.M. (London)

 

I.  https://fin-law.de

E. info@fin-law.de