CeFi regulation for DeFi market in Germany – still up to date?

Decentralised finance (DeFi) systems are becoming increasingly popular. They are considered more transparent, cheaper and faster than centralised finance (CeFi) systems. The number of providers and offers is growing steadily. But there are also risks to the DeFi ecosystem. The voices in the industry for specific DeFi regulation are getting louder and louder. BaFin, the German Federal Financial Supervisory Authority, also made its first prominent statement on the “hot topic” of DeFi at BaFinTech in mid-May 2022.

How DeFi works

DeFi works (more or less) without central intermediaries such as banks or other financial service providers. In this way, a wide variety of users can, among other things, digitally lend or sell crypto assets among themselves.

This is done with the help of smart contracts via so-called decentralised applications (DApps), programmes that process and monitor automated contracts. By combining these DApps, an entire DeFi market is formed.

In DeFi, control over the market is not to be borne by individuals, but by the entire community. In addition to technical risks, such as hacker attacks, this also poses problems in terms of financial supervision. This decentralised organisation means that there can be hardly any supervision, or none at all, because the current national financial supervision system is directed at a specific, central addressee, which (supposedly) does (or should) not exist in DeFi.

Regulatory developments

Since our overview of the DeFi market last year (we reported here), not much has changed in regulatory terms. Legislative measures targeting DeFi have not been taken or are in their infancy, both from a European and a national perspective.

Attempts by the industry and the literature to classify the DeFi market in regulatory terms under the existing regulations are proving difficult.

Position in Germany

Whether German supervisory law is applicable to DeFi offers at all, and if so, to which DeFi participant, is one of the central questions.

If the DeFi offer is also targeted at the German market, German supervisory law is generally applicable. But who is the addressee of the applicable supervisory law? In order to answer this question, it must be possible to find an addressee who performs an activity that is relevant under supervisory law. This may be difficult in the case of decentralised offers, behind which there is (often) no concrete company.

However, at second glance, offers often appear more decentralised than they are. For example, there are often semi-decentralised crypto trading platforms that are ultimately backed by real companies – which are of course potential addressees of regulation.

But even in the case of fully decentralised offerings, there are players that a supervisory authority such as BaFin could consider as addressees:

• Governance Token Holder – often DApps are governed by a group of developers, early adopters and initiators by assigning them governance tokens. With their help, votes are taken on significant decisions for the DApps – similar to shareholders at shareholder meetings.

• Developers – BaFin could also focus on developers of DApps, as they play a significant role in bringing DApps to the market and enabling customers in Germany to use them.

• Any person who receives fees – fees (mostly in the form of cryptocurrencies) are also collected in the DeFi world. Such persons could also be the target of regulation by BaFin, as the person collecting fees also has a significant interest in the DeFi offer.

• Initiators/supporters – here, too, BaFin could see a significant contribution to a DeFi offering in Germany and consider them as addressees of German regulation.

There may therefore indeed be enough players around (semi as well as full) DeFi offers that may be the target of regulation by regulators. It may therefore be likely that regulators will simply look through the DeFi offering and take their regulatory action against one of the main players behind it.

But financial supervision also faces new challenges in terms of content.

Cryptolending

A common activity on the DeFi market is so-called cryptolending. Here, users can agree on loans among themselves (peer-to-peer) without a central authority. Instead of fiat currencies, cryptocurrencies are usually granted as loans. This activity could in principle be relevant for supervisory purposes as a credit and thus banking business within the meaning of section 1 para. 1 no. 2 of the German Banking Act (Kreditwesengesetz, KWG).

However, so far only the granting of money loans and acceptance credits is explicitly regulated as a banking business by the supervisory authority. Money, in this respect, is only fiat currencies (such as EUR), but not crypto assets. Therefore, according to the current view, no money loan would be granted – and thus no credit business would be provided.

DeFi players are moving along paths that have not yet been trodden under supervisory law.

In addition, DeFi offers are provided on the internet and thus potentially worldwide – a risk that cannot be overlooked if this could lead to the parallel applicability of a multitude of jurisdictions around the world.

For the supervisory authority, on the other hand, finding a contact person who is usually also based abroad is likely to make it more difficult to ensure that the supervisory requirements are met.

BaFin addresses DeFi regulation

BaFin is now also considering these issues. At this year’s BaFinTech 2022, Birgit Rodolphe, Executive Director in the area of settlement and money laundering prevention at BaFin, spoke for the first time on behalf of BaFin on the hot topic of DeFi.

In her speech, she stated that although the DeFi market is not yet as established as the traditional financial market, this could change quickly. However, the same regulatory requirements apply as for the CeFi market. BaFin have clearly rejected possible facilitations for the DeFi market – certainly understandable in view of the economic and legal risks.

But there is one thing everyone agrees on:

“CeFi regulation” of the DeFi market can only be the first step towards an adapted “DeFi regulation”.

We are eagerly monitoring the regulatory developments and will keep you posted.