BaFin

Topic Fintechs Virtual Currency (VC)

Innovative means of payment have different names on a national and international level. They may be called virtual, digital, alternative or crypto currencies, money or coins, among other things. Examples include Bitcoin, Litecoin and Ripple.

In its Opinion, the European Banking Authority (EBA) defines virtual currencies as a digital representation of value that is neither issued by a central bank or public authority, nor necessarily attached to a legal tender. VCs are accepted by natural or legal persons as a means of payment and can be transferred, stored or traded.

How it works

All VCs are based on the idea of a substitute currency, not issued by the state and limited in supply. Unlike money that can be printed in unlimited amounts by central banks, and unlike deposit money created by commercial banks, the creation of VC units takes place in strict accordance with a fixed mathematical protocol within a computer network. This process is also known as "mining".

Anyone interested can download a program to participate in the network and mine VCs, as long as their computer is powerful enough. The network operates on a peer-to-peer basis, meaning that all of its participants are generally treated as equals. There is no central entity to monitor or manage transactions or balances.

VCs are assigned to traceable places in the network ("addresses"), which as a rule consist of randomly generated series of digits or numbers. The owners manage their VCs with pairs of a private and public key, which are used to authenticate transactions. All users can transfer their VCs among each other within the network, but they have to regularly exchange corresponding target addresses outside the network.

The VCs stored in specific places as well as all transactions made to date are publicly visible in a central file, or blockchain. Based on the places in the network, though, it is not visible which person is the actual owner of the VCs. Once carried out, transactions are generally irreversible. Apart from transferring VCs within the network, it is also possible to transfer places and keys among individuals physically on data carriers, for example.

Queries for BaFin

In accordance with BaFin's legally binding decision on units of account within the meaning of section 1 (11) sentence 1 of the KWG, Bitcoins are financial instruments. Units of account are comparable to foreign exchange with the difference that they do not refer to a legal tender. Included are also value units which function as private means of payment in barter transactions and any other substitute currency that is used as means of payment in multilateral accounting on the basis of contracts under private law.

This legal classification applies in general to all VCs. What software they are based on or which encryption technologies they apply is immaterial in this respect.

By contrast, VCs are not legal tender and so are neither currencies nor foreign notes or coins. They are not e-money either within the meaning of the German Payment Services Supervision Act (Zahlungsdiensteaufsichtsgesetz – ZAG); they do not represent any claims on an issuer, as in their case there is no issuer.

The situation is different for digital means of payment which are backed by a central entity that issues and manages the units. Such companies usually carry out e-money business pursuant to section 1a of the ZAG (e-money).

Authorisation requirement

Just using VCs as a substitute for cash or deposit money to participate in exchange transactions as part of the economic cycle does not require authorisation. A service provider or supplier may receive payment for his or her services in VCs without carrying out banking business or financial services. The same applies to the customer. Equally, mining VCs in and of itself does not trigger an authorisation requirement as the "miner" does not issue or place the VCs. The sale of VCs, either self-mined or purchased, or their acquisition are generally not subject to authorisation.
However, under additional circumstances, a commercial handling of the VCs may trigger the authorisation requirement under the KWG (general Guidance Notice on authorisation). Failure to obtain authorisation generally constitutes a criminal offence under section 54 of the KWG. Typical business constellations are summarised below.

Authorisation requirements for platforms and exchanges

Commercial trading in VCs is mostly done via platforms, often called exchanges. These encompass a large number of different business models. In order to answer the question of whether or not authorisation is required, a distinction must be made between the transactions' technical execution and their individual configuration.

Those buying and selling VCs commercially in their own name for the account of others carry out principal broking services which are subject to authorisation. The purchase and sale of VCs is made for the account of others when the economic advantages and disadvantages of that business affect the principal. In addition, the activity must be similar enough to the broking services within the meaning of the German Commercial Code (Handelsgesetzbuch), although individual rights and obligations may deviate from those typical for broking services. In the case of VC platforms, the principal broking services that require authorisation exist when:

  • the individual participants are authorised to give instructions to the platforms until the realisation of the orders by setting the number and price of the transactions,
  • the individual participants are unaware of their transaction partners and the platform does not act as representative of the participants but rather in its own name,
  • the economic advantages and disadvantages of the transactions affect the participants that transfer money to the platform's accounts or transfer VCs to their addresses, and
  • the platform is obliged to account to the participants for the execution of transactions and to transfer acquired VCs.

If no principal broking services are carried out by platforms, they may instead be operating a multilateral trading facility. This brings together, in the system and in accordance with pre-determined provisions, multiple third-party buying and selling interests in financial instruments in a way that results in a contract for the acquisition of these financial instruments. This implies that there is a framework regulating the membership, trading in VCs among participants, and notifications regarding finalised transactions. There is no need for a trading platform in a technical sense. Multilateral means that the operator only brings together the parties of a potential transaction in VCs. Interest in purchase and sale may take the form of expressions of interest, orders and quotes. The existence of multiple parties means first and foremost that no brokering instruction is needed in individual cases. Under the framework, the interests must be brought together leading to the signing of the contract via software or protocols without the parties being able to decide in individual cases whether they want to enter into a VC transaction with a particular contracting party. It is irrelevant whether the contract is then executed within the system or not.

The existence of multilateral trading facilities is likely in particular in the case of platforms where sellers place VCs and set a price threshold above which a trade should be executed, or where sellers secure their transactions by a deposit in the form of VCs that are transferred to the platform but only released after the seller has confirmed the payment.

Where platforms offer region-specific paid directories of persons or undertakings offering VCs for sale or purchase, this usually constitutes a case of investment and contract broking.

Authorisation requirements for mining, purchase and sale

Providers that act as "currency exchanges" offering to exchange legal tenders against VCs or VCs against legal tenders carry out trading for own account. This is the case when VCs are not only mined, purchased or sold in order to participate in an existing market, but when a special contribution is made to create or maintain that market. Due to the additional service element, this then constitutes trading for own account that requires authorisation. This may be the case, for instance, when a person publicly advertises regular purchases and sales of VCs.

Although mining VCs in itself does not trigger an authorisation requirement, if mining pools offer shares in proceeds from mined and sold VCs on a commercial basis, for instance in exchange for computing power of the user, they generally are subject to authorisation.

Practical information

In practice, VC undertakings often did not offer detailed explanations as to how they work at all, or did so in a vague manner. In many cases, no general terms and conditions were provided, either. Authorisation requirement is a complex legal issue, in particular due to the technical specificities. Therefore, potential providers should early on obtain an assessment of their planned business activities in order to clarify whether they are subject to supervision by BaFin.

Providers that increase the level of risk the users of VCs are already exposed to are subject to financial supervision by law, as are traders in other financial instruments such as shares, derivatives and foreign exchange. BaFin's task is to ensure that the financial and organisational standards are met in business with customers and financial instruments, that unreliable providers are kept off the market and – in the interest of the customers and the German financial market – that appropriate measures to prevent money laundering are taken. Banks or financial services providers that already have authorisation pursuant to section 32 of the KWG may therefore also carry out transactions in VCs which they are already allowed to in, for instance, shares.

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