GERMANY: An Introduction to FinTech Legal
FinTech in Germany: An Introduction
1. Introduction: FinTech in Germany
FinTech remains far more than a trendy buzzword in Germany, despite – or because of – the pandemic-shaped developments in the markets. Between 2015 and 2019, the German FinTech market grew by 119.2% on average per year. This growth steadily continues in the financial centres of Frankfurt, Berlin, Hamburg and Munich. The FinTech sector is seen as one of the key drivers of the ongoing transformation from classic banking models financing Germany’s global players to making financial services available to everyone with ease, and this is expected to continue in the upcoming decade. However, a bubble is far from being in sight.
1.1 FinTech Definition
It should not be surprising that there is no legal definition of the term FinTech except as a neologism combining the terms financial services and technology. As in probably every other market, in Germany a FinTech is commonly understood as a company providing financial services and adding modern technologies to these services.
We have recently seen most FinTechs combine emerging internet-based platforms resulting in a wider range of (cross-border) participants with decentralisation and privatisation of data and its documentation. Decisions are transferred from a few thought leaders to algorithms and artificial intelligence based on blockchain and distributed ledger technologies. These organisms are supplied by an ever-growing database. This database not only grows by quantity but moreover it gains quality. The cleaner the database, the more efficient its usability can be.
Mostly involved in this development are start-ups. In the German financial services market, however, we also see grown-ups, i.e. large and established banking institutions being eager to settle down in the FinTech market.
1.2 Market Overview
FinTech in Germany emerged in the millennial and post-dotcom age. The trend was driven by established banks transforming from counter banking to direct banking business. All the well-known German banks got involved in this transformation, e.g. Deutsche Bank with Deutsche Bank 24, Commerzbank with comdirect, Frankfurter Sparkasse with 1822direkt just to name a few.
Almost twenty years later, 10% of all start-ups in Germany are FinTechs. The FinTech sector represents the second-largest start-up sector, forming a highly innovative segment of financial services in the market. Although new FinTech foundations slightly decreased by 1% per quarter, the number of financing rounds increases by 6% per quarter. In the first half of 2021 alone, FinTech investments rose to a total of EUR 2.5 billion, which is more than the aggregated investments of the past three years. Despite (or because of) the current challenging environment, many FinTechs have increased their capital since the start of the crisis (e.g. Trade Republic USD 900 million and wefox USD 650 million). This trend confirms the increasing market consolidation and speaks for the durability of German FinTechs. In October 2021, approximately 650 FinTech companies were deemed to be active in the German market. Seven of them are considered unicorns, being valued at over EUR 1 billion: Trade Republic, N26, Raisin DS, Mambu, wefox, Solarisbank and Scalable Capital.
Although this forms a picture of a largely mature environment, there is still plenty of market potential. Approximately two thirds of banking customers used online banking services in 2020. Compared to recent years, online banking usage increased steeply (2019: 50%; 2018: 50%; 2017: 45%), but there still seems to be a long way to go. Currently dominating is a move from direct banking to digital banking. Other than counter banking, direct and digital banking services are being provided over the internet. Digital banking services use far more sophisticated technologies than direct banking services.
Established banks in Germany engage in FinTech by way of co-operation, in order to move towards more digital and thus more promising business models. Just recently, DKB began co-operating with two FinTechs to enter the robo-advisor market. Another example is the disruptive market of payment platforms. For the past few years, the European Payments Initiative (EPI) faced the dominance of the established US payment solutions such as PayPal, Apple Pay, Google Pay or VPay. German players such as paydirekt or Giropay are trying to oppose these established US competitors. Just how disruptive the market can be became evident with the discontinuation of Maestro, the payment solution of Mastercard.
As we look at the German market, the biggest concern when structuring financial services business models, e.g. in a co-operation with an established bank, is meeting the regulatory requirements while, at the same time, boosting efficiency and maximising customer experience. This becomes more challenging due to the fact that regulatory standards across Europe still vary, although the European legislature and the European Banking Authority put remarkable effort into establishing a level playing field.
2. Hot Topics
In the following sections, we briefly summarise the topics that, in our view, might be worth considering in the years to come.
2.1 Banking the Unbankables, BNPL and Payment Behaviour
In the German market, one of the key drivers is the idea of banking the unbanked, or rather the unbankables. Whereas the unbanked can be defined as clients not using financial services yet except for, say, a simple deposit account, the unbankables are the group of potential clients who would probably be rejected by established banks. Since a large part of the German population is already banked at least in some way, the target group to focus on is more the unbankables rather than the unbanked. This target group is expected to be addressed by FinTechs rather than established banks. FinTechs prove to be more customer-centric and focused on the customer experience. They therefore have the capacity to offer more flexible and tailored solutions.
A service with broader appeal than just the unbankables is the so-called Buy Now, Pay Later (BNPL) service. BNPL services allow customers to pay for their online shopping items, car repairs or solar panels in instalments over time. Legally speaking, BNPL services qualify as traditional instalment payment options, which are certainly not a new phenomenon in the market. What is new with BNPL structures is the motivation on both sides: whereas traditional instalment payment agreements with the merchant, service supplier or credit card provider require the customer to pay a premium, this premium does not apply to BNPL services. Merchants and service suppliers benefit from receiving the total invoicing amount immediately thanks to the co-operation with a BNPL FinTech. From an economic perspective, this forms a new refinancing model for businesses that is more attractive than common SME refinancing. Therefore, businesses are willing to receive a discounted invoicing amount whereas the discount remains with the FinTech structure and can be considered as refinancing costs.
The other key driver in the FinTech sector is the extension of financial services into everyday life, be it payment services, account information services or new ways to both invest and borrow money. For the longest time, German market participants lacked confidence in digitisation and are still comparatively sceptical about modern banking solutions. In a challenging post-pandemic environment, there is at least hope for the FinTech sector to benefit from this change in banking behaviour. The discussion on the abolition of cash money finally found its way into German payment behaviour: in retail business, the proportion of payments made in cash fell from 74% in 2017 to 60% in 2020. In ecommerce, 30% of all payments are still invoicing-based, another 25% is processed by PayPal and 18% by direct debit.
2.2 Crypto Assets and Cryptocurrencies
With respect to crypto assets, and particularly cryptocurrencies, two main trends will lead the way: the recently established licence requirement for crypto custody business on the one hand and initial thoughts and discussions on digitising our good old currency, the euro, on the other.
2.2.1 Licence Requirement
Under the cover of anti-money laundering regulation, i.e. the German implementation of Directive (EU) 2018/843 (AMLD5), crypto assets found their way into German law. As of 1 January 2020, offering cryptocurrency services in Germany, such as crypto custody services, qualify as financial services regulated by the Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht, or "BaFin"). Providing distribution, custody and trade services such as broking, trading on account or exchanging activities might, as the case may be, trigger a licence requirement. Using cryptocurrencies as an accounting unit, i.e. for payments, however, does not require a regulatory licence. In June 2021, Coinbase obtained the first crypto custody licence granted by the German regulator.
The new regulation obliges crypto assets to meet the same regulatory standards as have already been applicable to traditional capital markets for years. For the industry, this could initiate a competition for the most efficient, customer-friendly crypto services promising protection, legitimacy and security to market participants; a so-called race to the top. The flipside could possibly be a regulation arbitration between European legislators that makes market participants search for the jurisdiction providing the least-burdensome regulatory requirements; a so-called race to the bottom. FinTechs need to consider that it is not (yet) possible to passport a crypto asset licence. As a consequence, crypto assets service providers need to obtain the German crypto assets licence in order to access the German market.
Since the German legislature was the first to implement the EU crypto assets requirements into national law, chances are good to put German crypto assets FinTechs in a favourable position in the European crypto assets market.
2.2.2 Euro 2.0 and Cryptocurrencies
Initiated by FinTechRat, an advising committee to the Federal Ministry of Finance (Bundesfinanzministerium), discussions on future digital concepts for currencies are expected to intensify in the next couple of years. Also, the European Central Bank recently initiated a two-year test period focusing on the needs of users and on allocation mechanisms.
One of the main benefits desired of the introduction of digital currencies is to increase the efficiency of payment transactions. Even now, bank-to-bank payment transfers often take a few days; whereas, with a Euro 2.0 based on blockchain technology, payment transfers could be executed within seconds or fractions of a second. In this context, transaction costs charged by the respective service provider might decrease significantly. Furthermore, a cross-border payment transfers boost would create opportunity for German industry to access foreign markets and increase their international competitiveness. Germany’s nature as an export nation highlights just how important such a development would be for our markets.
However, there are some issues remaining to be considered before inventing a digital, blockchain-based crypto-euro replacing central bank money. Euro member states mutually agree that data protection and cyber security needs to be taken into proper consideration. Digitising a currency issued by state authorities requires significantly more effort than issuing cryptocurrencies by private providers, which possibly becomes an innovation revolutionising the FinTech market.
2.3 Electronic Securities
Following the AMLD5 implementation, the German legislature recently passed the Electronic Securities Act (Gesetz über elektronische Wertpapiere, "eWpG"). The eWpG allows the issuance and trading of securities without a physical securities certificate. In simple terms, the eWpG replaces the issuance of a physical (paper-based) securities certificate by recording the issuance in an electronic securities register. This electronic securities register can be based on the blockchain technology. In order to do so, the eWpG introduces a new financial service in addition to those already established in the German Banking Act: the crypto securities registry management (Kryptowertpapierregisterführung). Service providers intending to manage a crypto securities register thus require a licence.
Although the eWpG only covers bearer bonds (Inhaberschuldverschreibungen) and not (yet) company or fund shares, the introduction of the eWpG can be seen as a first step towards changing the securities market in general.
2.4 Regulatory Sandbox?
The German regulatory sector is known for being strongly regulated and for setting high requirements for participants. This could, however, be detrimental for start-ups as they are not (yet) able to meet these high standards. Other jurisdictions provide for a so-called regulatory sandbox for start-up FinTechs. Such sandboxes provide a playing field where FinTechs are given the opportunity to test their business models in the market without the obligation to meet all regulatory requirements like their established competitors.
For the German market, a regulatory sandbox could on the one hand boost the motivation of FinTech start-ups to focus on the German market, which could consequently have a positive impact on its attractiveness in the regulatory competition between EU member states. On the other hand, regulatory requirements and the importance of a service being tested in the market would become subject to discussions with the regulator. Furthermore, a level playing field for all participants, whether start-ups or grown-ups, avoids competitive disadvantages and is crucial for constructive competition.
BaFin and the legislature currently prevent the introduction of such a regulatory sandbox in Germany. Although denying such a sandbox, BaFin is well aware that young players need to breathe under the regulatory requirements and tends to adjust the intensity of the supervision depending on the risk associated with a given business model, taking into account the principle of proportionality: BaFin practice is not only determined by regulatory requirements set out by law but also by assessing the risk profiles of FinTechs. This assessment by the regulator considers both the scope of service as well as the business model and its risk complexity. While for identical risks and business models, identical regulatory standards should apply, BaFin at the same time tends to give new players the room to grow into their regulatory status.
2.5 New Refinancing Models
As of today, most FinTechs in the refinancing sector mediate loans from co-operation banks to their customers and sell these loans to investors. These loans are not sold entirely to one investor but sliced and sold to several investors. As a consequence, each investor is obliged to comply with regulatory provisions, particularly KYC and anti-money laundering provisions.
Investors typically seek for attractive refinancing models without time and cost consuming administration. As FinTechs and their refinancing engagements are growing, new refinancing models meeting the expectations of investors, co-operation banks as well as FinTechs are expected to evolve. In the German market, emerging securitisation models typically provide for eligibility criteria meeting the investment and regulatory standards of investors, e.g. banks, pension funds or life insurance. A refinancing model can alternately be set up through a fund structure. In such a structure, customers participate from a fund that is financed by a major loan from a co-operation partner.
Another popular (re-)financing model in the German market is crowdfunding. The funding amounts of crowdfunding platforms inviting investors to participate in typical loan products such as real estate loans increased by approximately 65% on average per annum, resulting in a total amount of almost EUR 3 billion in 2019. It should be noted that this trend is developing independently of the recently introduced Regulation on European crowdfunding service providers for business, Regulation (EU) 2020/1503, (the Crowdfunding Regulation). As we read the Crowdfunding Regulation, crowd-funding providers may opt for submission to the regulation; in contrast to other regulatory provisions, the Crowdfunding Regulation is not mandatorily applicable. Crowdfunding businesses are already covered by existing German regulatory law and so it is questionable whether the Crowdfunding Regulation provides any added value.
2.6 FinTechs vs Neobanks vs Established Banks – What are the chances?
With all the focus on FinTechs, there is another species in the market: Neobanks. Neobanks are digital banks that often start as FinTechs and emerge as fully-fledged, and therefore licensed, banking institutions. Defined as such, there is no clear distinction between FinTechs and Neobanks. The most prominent example of a Neobank in Germany is N26, with its European competitors including Revolut or Monzo.
German Neobanks have recently been shaken by negative publicity. Some critics see excessively poor cost management and strict internal regulations lead to increasing losses. Neobanks are being scrutinised by BaFin more and more, and this recently led to a number of BaFin orders. N26 in particular has been criticised for its anti-money laundering measures. Compared to established banks, Neobanks are significantly less engaged in the lending business. Alongside deposit business, the contrasting business line that could compensate for a lack of commissioned income is more and more neglected. The downturn possibly gets accelerated by a declining innovative power.
Putting all the challenges and differences between established banks and FinTechs aside, what are the chances for both systems? Well, it is not only in dealing with the current crisis that FinTechs are ahead of established banks. They also offer many other advantages. FinTechs particularly benefit from their ability to adapt rapidly to changing customer needs. But when it comes to the actual financial service products, established banks can certainly keep up. Could combining these different strengths together be a new way to success? Co-operations between banks and FinTechs typically address regulatory concerns; for instance, where the FinTech is not planning to obtain a licence for the services it intends to offer and the co-operation bank enters into the business model as a licensed participant. One possible co-operation gateway could be the financing business. Whereas many SMEs are facing serious liquidity threats, finance (e.g. factoring) FinTechs could at least present a swift and flexible alternative to conventional bank loans.
It will become more and more crucial for established banks to see FinTechs not only as competitors but also as necessary partners in order to meet the increasing expectations of their customers and survive the competition.
3. Legal Challenges
As can be seen from the discussion above, a major challenge for the legislator as well as for supervisory authorities will be the reduction of regulatory blind spots. The German Banking Act (Kreditwesengesetz) makes a distinction between financial services providers on the one hand and banks on the other. Since FinTechs cannot always be undoubtedly qualified as one or the other, the applicable regulatory requirements are not clearly determined at the outset. Triggered by the invention of new products in the FinTech market, German authorities face a constant race to identify associated risks and regular adaptation of legal and supervisory requirements.
One of the major concerns for FinTechs is data security. The number of cyber-crimes in Germany rises between 8% and 15% each year, and the aggregated damage is estimated to exceed EUR 100 billion. The more cyberattacks are publicly disclosed, the more likely customers are to lose trust in the affected sector. The prevention of cyberattacks is therefore essential to scale digital banking products.
The German FinTech market is quite established. However, since many business models are quite similar to those of competitors and the vast majority of FinTechs are not yet profitable, several players are expected to vanish from the market or to merge with others in the next couple of years.
Being the largest economy in Europe, the German market provides for lots of business opportunities. Germany has managed to become an important technology centre that offers excellent research and development conditions. The German legislature is eager to improve innovation and it seems to be understood nowadays that by being quick, there is a chance to lead the way.
Although German laws and the regulator are known to be rather strict, particularly with respect to consumer protection and risk mitigation requirements, this could have a positive effect on the German FinTech as an attractive entry market. Many regulatory requirements derive from EU law or are influenced by EU-wide developments. A rather strict implementation of EU requirements into national laws and guidance by the German legislature could push the German market as entry market for business development efforts in the EU. By complying with German regulatory and legal requirements, FinTechs could certainly expect to comply with the regulatory standards in foreign jurisdictions as well.
The German legal and judicial environment is said to be reliable and credible – market participants can expect a high degree of legal certainty. Therefore, companies that master the German regulatory framework are thereby deemed well positioned for EU-wide scaling.