How Germany’s regulators beat the SEC in the race for crypto regulation–and convinced me to establish my business there
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Philipp Pieper
6 min read
There is prestige to be had building a successful business in the U.S. and, when we set out to build a liquidity solution for security tokens, it was a U.S. launch we had firmly in our sights.
However, the U.S. lacked the regulatory framework to facilitate a service model that could leverage asset digitalization 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 found our business–and we weren’t alone in doing so. Thanks to the attitude of the financial market regulator BaFin, Germany is home to a vibrant blockchain ecosystem that’s surprisingly ahead of the U.S.
While not everything is rosy when working with regulators, at least the regulatory process has been converging. The German authorities have been consistently working 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 law to crypto–and Germany has been propelled to the forefront of industrial nations embracing crypto and decentralized finance (DeFi).
Supervised innovation
An amendment to the German Banking Act introduced in 2020 brought crypto assets in line with traditional securities. The move provided clear direction to the market and meant that service providers needed to be licensed, a requirement that elevated crypto providers and created parity with traditional financial players.
This approach by BaFin has delivered meaningful benefits to the German financial sector. By nailing its colors to the mast and classifying crypto as a financial instrument, BaFin has offered innovators the clarity and confidence needed to build projects. It’s the reason Germany is leading the way in crypto and blockchain technology in terms of progressive tax laws and forward-leaning fiscal policy, allowing its largest funds and assets managers to hold digital assets on their balance sheets.
The regulator’s stated mid-term goals (which will carry it through to 2025) will see it extend regulation to DeFi with the aim of protecting market participants from unreasonable risks. Although it’s been careful to stipulate that regulation must be tailored and appropriate to prevent stifling the development of new technologies, BaFin has been clear that DeFi won’t get regulatory carte blanche. And that’s critical. This technology has the potential to overhaul our entire financial system; it needs suitable, specific regulation if it is to compete with traditional financial markets.
The question of securities
While BaFin has made strides toward understanding the technology and encouraging progress, the SEC has issued a litany 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 U.S., the Howey Test sets the bar for what does and doesn’t constitute a financial security. A transaction deemed by Howey to be “investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others” is an “investment contract” and so qualifies as a security.
If classed as a security, digital assets would be subject to federal securities law, they would fall within the ambit of the SEC and would need to be traded via a securities exchange or SEC-registered broker-dealer. That would take unregulated crypto trading platforms out of the mix and would severely hamper protocols with tokens that aren’t designed as investment instruments.
Both the past and present SEC chairs have stepped gingerly around the subject, hinting that the regulator considers all digital assets (with the exception of Bitcoin) to be securities but stopping short of actually confirming it.
The impact of this approach has been to chase innovators out of the U.S. to markets with regulatory clarity, where there is less risk of projects being derailed or shut down instantly by the regulator.
But the tide is changing and the SEC is making great efforts to better understand the crypto industry. It will head up an international DeFi working group within IOSCO to “further explore the market integrity, investor protection and financial stability risks of DeFi”, building on the regulator's DeFi report published earlier this year.
Both bills work to establish jurisdiction between the Commodities Future Trading Commission (CFTC) and SEC. Unfortunately, it's a feat that requires a clear definition of which digital assets constitute a security and, since both bills default to applying Howey, it’s not a solution either provides.
A regulatory blueprint for DeFi
Just as the DeFi industry is bifurcating into regulated and unregulated entities, so too are we seeing a divide open up between national regulators. The different approaches of the SEC and BaFin are just two examples of a situation that is playing out daily around the world.
Never before has the impact of a regulator supportive of development been so obvious. Innovations are coming thick and fast, and regulators that don’t make efforts to understand the technology, support its development, and regulate it appropriately pose a serious risk to the growth of their economies.
Forward-looking regulators such as BaFin have been successful because they sought to understand the potential of the technology. By engaging with entrepreneurs and innovators of all sizes rather than just big 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 U.S., it can look into use cases in Germany and how they operate in practice. It will find a fully-fledged regulatory blueprint 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.
The opinions expressed in Fortune.com commentary pieces are solely the views of their authors and do not reflect the opinions and beliefs of Fortune.
