End of the line for financial market regulation?

DeFi on the rise – End of the line for financial market regulation?

With his law firm Fin Law, specialist lawyer Lutz Auffenberg has specialised in the field of fintech and innovative technologies. In particular, blockchain technology and its regulation is the focus of his work. In his guest article, he looks at the upward trend of DeFi and financial market regulation.

For some months now, projects that focus on the provision of applications in the decentralised financial market have been gaining in importance. Decentralised finance, or „DeFi“ for short, refers to decentrally functioning smart contract applications (dApps) that enable users to conduct transactions in the financial market without having to involve a central service provider. The most prominent example is Bitcoin Profit decentralised exchange platforms (DEX), which offer users the opportunity to exchange crypto assets for other crypto assets without a central platform operator, solely via an automated smart contract on a blockchain infrastructure. The operation of an exchange platform for crypto-securities is, at least according to German banking supervision law, usually an activity requiring a licence, so that the platform operator may not provide the platform without a licence from the competent supervisory authority BaFin and subsequent supervision by BaFin and Deutsche Bundesbank. However, if an exchange platform lacks an operator, the question arises as to the starting point for financial market regulation.

DEX as a multilateral trading system without an operator

According to German banking supervision law, the operation of exchange platforms for crypto-securities may involve the performance of several banking transactions or financial services, which may result in a licensing requirement. The operation of an exchange platform is conceivable, for example, by way of investment brokerage, proprietary trading, financial commission business or in the form of a multilateral trading system. However, in order to trigger a licensing obligation with subsequent institutional supervision under the German Banking Act (KWG), the activity must necessarily be carried out by an operator who can be the addressee of the supervisory obligations, especially since a licensing obligation is only provided for by the KWG if „someone“ (legal wording: „who“) conducts banking business or provides financial services on a commercial scale in Germany. It is therefore conceivable that a decentralised exchange service that automatically executes exchange orders from users for crypto assets via a smart contract qualifies as a multilateral trading system within the meaning of the KWG, but a licensing requirement fails because there is no operator.

Concrete contribution of the initiators decides on the duty to obtain a licence

However, the lack of a classic operator in DeFi projects is not a matter of course that can be assumed as a fact without further examination of the project realisation. Rather, in individual cases it is also conceivable that the concrete contribution of an initiator or project participant in the realisation of a DeFi project can be classified as an operation within the meaning of the licensing requirement of the KWG. This could be the case, for example, with projects that do not function in a completely decentralised manner, but in which a central entity ultimately stands in the background that reserves administrator rights with regard to the underlying smart contract in order to be able to influence the transaction processing. In individual cases, it will depend on the concrete scope of such administrator rights in order to be able to make a supervisory decision on the operator status of a project participant. Furthermore, a licensing requirement under the KWG would only come into consideration if the operator in question were also acting commercially or on a commercial scale and had a concrete connection to the Federal Republic of Germany.