How Germany’s regulators beat the SEC in the race for crypto regulation – and convinced me to set up my business there
There is prestige in building a successful business in the US, and when we set out to build a liquidity solution for security tokens, a US launch was firmly in our sights.
However, the US lacked the regulatory framework to facilitate a service model that could leverage asset digitization and the benefits of blockchain technology, let alone support its development. This was not the place to build innovative blockchain technology.
Instead, we went to Germany to set up our business – and we weren’t alone in doing so. Thanks to the attitude of financial market regulator BaFin, Germany is home to a vibrant blockchain ecosystem that is surprisingly ahead of the US
While not everything is rosy when dealing with regulators, at least the regulatory process has converged. German authorities have consistently worked towards the goal of legitimizing the digital asset landscape and integrating it into the financial markets. Today, BaFin has become a world leader in applying existing financial market legislation to crypto – and Germany has been propelled to the forefront of industrialized countries embracing crypto and decentralized finance (DeFi).
Monitored innovation
An amendment to the German Banking Act introduced in 2020 brought crypto-assets into line with traditional securities. The move gave clear direction to the market and meant that service providers had to be licensed, a requirement that elevated crypto providers and created parity with traditional financial players.
This approach by BaFin has brought significant benefits to the German financial sector. By nailing the colors to the mast and classifying crypto as a financial instrument, BaFin has offered innovators the clarity and confidence needed to build projects. That’s why Germany is leading the way in crypto and blockchain technology in terms of progressive tax laws and forward-looking fiscal policies, allowing its biggest funds and asset managers to keep digital assets on their balance sheets.
The regulator’s stated mid-term goals (which would see it through to 2025) would see regulation extended to DeFi with the aim of protecting market participants from unreasonable risks. Although it has been careful to stipulate that regulation must be tailored and appropriate to avoid stifling the development of new technologies, BaFin has been clear that DeFi will not be given regulatory carte blanche. And that is critical. This technology has the potential to overhaul our entire financial system; it needs appropriate, specific regulation if it is to compete with traditional financial markets.
The issue of securities
While BaFin has made progress towards understanding the technology and encouraging progress, the SEC has issued a series of statements that lack tangible guidance on how to view blockchain-based models. At the heart of the confusion is an inability to determine whether digital assets are a security.
In the US, the Howey test sets the bar for what does and does not constitute a financial security. A transaction which Howey considers to be “the investment of money in a joint venture with a reasonable expectation that profits will be derived from the efforts of others” is an “investment contract” and therefore qualifies as a security.
If classified as a security, digital assets would be subject to federal securities laws, would fall within the purview of the SEC and would have to be traded through a securities exchange or SEC-registered broker-dealer. It would take unregulated crypto trading platforms out of the mix and would hamper protocols with tokens that are not designed as investment instruments.
Both former and current SEC executives have tread carefully on the subject, suggesting that the regulator considers all digital assets (with the exception of Bitcoin) to be securities, but stopping short of actually confirming it.
The effect of this approach has been to chase innovators out of the US into markets with regulatory clarity, where there is less risk of projects being derailed or shut down immediately by the regulator.
But the tide is changing and the SEC is making great efforts to better understand the crypto industry. It will lead an international DeFi working group within IOSCO to “further examine the market integrity, investor protection and financial stability risks of DeFi”, based on the regulator’s DeFi report published earlier this year.
We’ve also seen the introduction of two bipartisan crypto laws this year, the Lummis-Gillibrand Responsible Financial Innovation Act and the Digital Commodities Consumer Protection Act of 2022. Digital assets are a difficult issue in an election year, and both are unlikely to pass, but they demonstrate a growing understanding among lawmakers across the aisle on the issues of crypto regulation in the United States
Both bills work to establish jurisdiction between the Commodities Future Trading Commission (CFTC) and the SEC. Unfortunately, that’s a feat that requires a clear definition of what digital assets constitute a security, and since both bills don’t use Howey, there’s no solution either.
A regulatory blueprint for DeFi
Just as the DeFi industry divides into regulated and unregulated entities, we also see a divide between national regulators. The different approaches of the SEC and BaFin are just two examples of a situation that unfolds daily around the world.
Never before has the impact of a regulator supporting development been so obvious. Innovations are coming thick and fast, and regulators who don’t make an effort to understand the technology, support its development and properly regulate it pose a serious risk to the growth of their economies.
Forward-looking regulators such as BaFin have been successful because they tried to understand the potential of the technology. By engaging with entrepreneurs and innovators of all sizes rather than just large players, BaFin has developed a broad understanding and position that will be applicable for years to come.
If the SEC wants to understand what the future of DeFi is in the US, it can take a closer look at use cases in Germany and how they work in practice. It will find a full-fledged regulatory plan to follow.
Philipp Pieper is co-founder of Swarm, a regulated DeFi platform under BaFin in Germany. He sits on the Digital Finance Forum, which advises the German finance minister on the future of financial markets.
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