BaFin Updates Its Warnings On Investments In Crypto-Assets – Fin Tech – European Union

QuickTake

In keeping with activity of both the EU-level financial
regulatory and supervisory authorities as well as activity advanced
at the national level by respective competent authorities, the
German regulator has published a renewed and perhaps most
comprehensive warning on investments in cryptocurrencies and
crypto-assets. This warning contains a number of details ranging
from definitions of core concepts (which go beyond definitions in
law) as well as relevant risk factors. Financial services firms but
also crypto-asset service providers will want to take note of the
German regulator’s focus and tone in this warning and update
their client-facing documentation and general disclosures
accordingly.

In light of both growing supervisory scrutiny in Germany but
equally across the EU-27 on compliance with investor protection
requirements such as investment advice as well as suitability and
appropriateness requirements firms will want to ensure their
marketing materials and client-facing documentation can pass
muster. This is certainly the case given that both compliance
obligations and supervisory scrutiny in this area will likely only
increase in the transition to the EU’s pan-European regime for
the regulation of crypto-assets. Despite this renewed warning and
equally irrespective of Germany’s regulator and legislator
advocating for comprehensive regulation of cryptocurrencies and
crypto-assets, Germany remains one of the most supportive EU Member
States for facilitating a safe, efficient and sustainable market
for investors in cryptoassets as well as traditional products
facilitating access to or tracking of cryptocurrencies and/or
cryptoassets.

This Client Alert discusses the details of this new regulatory
warning, the requirements that firms will want to consider and the
outlook ahead given future rulemaking. This Client Alert should be
read in conjunction with other standalone coverage from PwC
Legal’s RegCORE as it applies to developments relating to
cryptoassets in German but also EU-wide regulation.

Overview

“Modern, digital and lucrative: this is the image that
cryptocurrencies have among some private investors. Enthusiastic
reports and investment tips on Bitcoin, Ether and Co. are
circulating in the social media. In particular, apps for mobile
trading make it easy to buy coins and tokens. However, investments
in crypto assets are highly speculative – and just as risky.”
This is how the German Federal Financial Supervisory Authority
(BaFin) on 4 February 2022 introduced the themes set out in its new
and revised consumer protection warning for investors in
crypto-assets. The rationale for such warning, which in its
drafting can be interpreted as being token and technology agnostic
and thus all-encompassing for fungible and non-fungible tokens and
cryptocurrencies, reiterates the high speculative nature of the
investments and the associated high risk.¹

Importantly, due to BaFin’s own legislative rulemaking, very
much ahead of the finalisation of the EU’s proposal for a
Regulation on Markets in Crypto-Assets (MiCA), German law treats
crypto-assets as “financial instruments” in the context
of the German Banking Act (KWG). Thus, activity in relation to
crypto-assets will, unless structural and/or statutory exemptions
apply, require a KWG authorisation from the BaFin. This requirement
has extraterritorial effect and thus BaFin’s most recent update
to its consumer protection warning should, even if at the time of
writing it being only available in German, be of interest to all
parties wishing to conduct activity with a nexus to Germany as well
as investment recommendations published via social media –
which the BaFin has also warned on.²

BaFin’s focus in its most recent consumer protection warning
provides a comprehensive consolidation (and revision) of its
previous warnings. It also includes key concepts and approaches
that have been previously covered at the EU-level notably by
authorities such as the European Securities and Markets Authority.
The overarching message is clear and simple, namely that when it
comes to investments crypto-assets or traditional financial
products with a crypto-asset exposure: the prospect of high returns
always comes with high risks.

Accordingly, BaFin appeals to investors to exercise caution and
conduct careful due diligence given that an investment in coins or
tokens at the same time carries a high risk and possibly the entire
invested sums being at risk of loss. BaFin’s warning also sets
out certain “risk factors” (discussed below) as well as
definitions, both of which financial services providers but in
particular crypto-asset investment service providers may wish to
consider but also to include these in their client-facing materials
or cross-reference to BaFin’s warnings. BaFin also published in
this consumer protection warning, details of its register of firms
that it is or has been investigating for conducting unregulated
activity. ³

There are also however some items that the BaFin warning is
silent on and this is perhaps equally noteworthy in that the
BaFin’s warning does not extend to (at present) risks arising
in the context of:

• margin lending or otherwise borrowing of fiat currencies
  including to increase exposure in cryptoassets;
• “atomic swaps” or lending crypto-assets against other
  crypto-assets;
• cross-chain settlement of transactions in crypto-assets;
• staking i.e., collecting rewards for holding particular
  crypto-assts
• digital and operational risk to which crypto-asset trading
  venues as well as wallet providers (including those that are
  registered for crypto-custody services in Germany) might be exposed
  to, notably as a result of energy supply resilience challenges
  and/or cyber-crime (including fraud) causing trading outages or
  financial crime in fake platforms, fake coins, tokens, assets
  including non-fungible tokens (NFTs – NB the present warning
  does not single out any point on NFTs but might do so in a further
  revised form);
• absence of depositor or investor compensation scheme protection
  outside of Germany (while it does warn on the absence of such
  protection in Germany); and
• differing treatment on a cross-border basis in relation to
  regulation (including market abuse), tax and differing investor
  protection and disclosure obligations.

Important definitions of BaFin concerning crypto-assets

In the context of BaFin’s risk analysis and contents of its
warning, it also sets out a “glossary of terms”. These
include definitions (in German but translated in English below) for
the following concepts that go beyond what is set out at law (in
Germany or at the EU-level).

Blockchain:

Blockchains are tamper-proof, distributed data structures in
which transactions are logged in chronological order, traceable,
immutable and without a central authority. Blockchain technology
enables ownership relationships to be secured and regulated more
directly and efficiently than before, as a complete and unalterable
data record provides the basis for this. Crypto-assets are just one
application, although the best known, of this. Blockchain
technology itself is innovative and novel but not problematic from
a supervisory perspective.

Contracts for Difference (“CFD”):

CFD are a category of so-called derivatives, i.e., financial
instruments whose price depends on how the price of an underlying
asset develops. With CFDs, two parties bet by contract on how the
price of a certain underlying asset will develop. Due to
significant investor protection concerns, BaFin issued a product
intervention measure in its general ruling of July 23, 2019,
restricting the marketing, distribution, and sale of CFD to retail
investors in Germany. Due to the high volatility of crypto-assets,
a stricter leverage limit applies to these CFD. Retail investors in
Germany are now only allowed to trade CFD with such underlying with
a leverage of up to two (initial margin
protection).⁴

Distributed Ledger Technology
(“DLT”):

DLT refers to the technological framework around the use of
distributed ledgers. Blockchains are based on this technology – so
they are a possible application of DLT, and Bitcoin is the most
well-known use case for the use of blockchains. However,
blockchains or distributed ledgers can be used for many other
applications and records besides Bitcoin, such as digital identity
management. It is not uncommon to find synonymous use of the terms
blockchain technology and distributed ledger technology in academia
and practice.

E-money:

E-money is any monetary value. However, this monetary value must
represent a claim on the provider, be created in exchange for
payment of a monetary amount and be stored electronically. For
example, customers can purchase E-money in the form of payment or
voucher cards at retail outlets or on the Internet and then use it
to pay at various online retailers.⁵

Volatility

Volatility refers to the range of fluctuation in exchange rates
or prices. It is a measure of the intensity of fluctuations in the
value or price of a value. Thus, volatility is also a measure of
the uncertainty of an investment and its price risk. The higher the
volatility, the more the price fluctuates and the higher the risk
of an investment.

Certificates:

Certificates are securities that can generally be traded.
Legally, they are debt securities. The holder has a claim to
payment or repayment of a cash amount or delivery of an underlying
against the issuer of the certificate under the conditions
specified in the certificate.

BaFin’s risk factors specific to crypto-assets

BaFin has put forward a collection of risk factors (in German
– summarised and translated below for convenience)…