GERMANY: An Introduction to FinTech Legal

An Introduction to FinTech in Germany 

Schalast & Partner Rechtsanwälte mbB  

Prof. Dr. Andreas Walter, LL.M.  

Alexander Gebhard, LL.M.  

Simon Waldbröl  

Datum:  

Frankfurt am Main, 19 December 2022 

1. Introduction: FinTech in Germany

FinTech remains by far more than a trendy buzzword in Germany, despite – or because of – the pandemic-shaped developments on the markets. Between 2015 and 2019, the German FinTech market grew by 119.2% on average per year. For the time being, it has reached a peak in 2021. During 2022, the German FinTech market has cooled down a little following the global macroeconomic environment. This development has also been influenced by the recent rise in loan interests as well as the high inflation, which hampers the opportunities for FinTech start-ups to acquire new capital. This does not mean, however, a loss of relevance. The German regulator has recognised the persistent importance of this market sector and acts accordingly. In the ongoing transformation from classic banking models financing Germany’s global players to making financial services available to everyone at ease, the FinTech sector is seen as one of the key drivers of this transformation and expected to be in the upcoming decade.

1.1 FinTech Definition

It should not be surprising that there is no legal definition of the term FinTech except for the well-known fictional neologism combining the terms financial services and technology. As perhaps in every other market, in Germany a FinTech is commonly understood as a company providing financial services and adding modern technologies to these services.

We recently see 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 data basis. This basis not only grows by quantity but moreover it gains quality. The cleaner the data basis, 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, ie, 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-dot-com age. The trend was driven by established banks transforming from counter banking to direct banking business. All well-known German banks got involved in this transformation, eg, 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 on the market. Although new FinTech foundations slightly decrease by 1% per quarter, the number of financing rounds increases by 6% per quarter. Total FinTech investment in the EMEA region (Europe, Middle East, Africa) rose to a record USD77bon in 2021, with Nordic countries at the top (total of USD18.5bn) followed by Germany (USD5.4bn) in 2021, mainly driven by growing venture capital investments. Despite (or because of) the current challenging environment, many FinTechs increased their capital since commencement of the crisis. Particularly notable in the second half of 2021 was a capital raising of USD900m by the German Neobank N26. This trend confirms the increasing market consolidation and speaks for the durability of German FinTechs. In October 2021, approximately 650 FinTech companies were deemed active in the German market. Seven of them are considered unicorns valued over EUR 1bn: Trade Republic, N26, Raisin DS, Mambu, wefox, Solarisbank and Scalable Capital.

Even though this forms a picture of a largely mature environment, there still great market potential. Approximately 75% of banking customers used online banking services in 2021. Compared to recent years, the number of online banking usage increased steeply and has been on a high level since the beginning of the pandemic (2020: 79%; 2017: 58%). Currently dominating is a trend from direct banking to digital banking. Other than counter-banking, direct and digital banking services are being provided through the internet. Digital banking services use far more sophisticated technologies than direct banking services.

Established banks in Germany do engage in the FinTech area by way of cooperation. Such cooperation is being concluded in order to move towards more digital and thus more promising business models. For example, DKB commenced to cooperate with two FinTechs to enter the robo-adviser market. Another example is the disruptive market of payment platforms. For the past few years, the European Payments Initiative (EPI) faces the dominance of the established US payment solutions such as Pay-Pal, Apple Pay, Google Pay or VPay. German players such as paydirekt or Giropay try to oppose the established US competitors. Just how disruptive the market can be became evident with the discontinuation of Maestro, the payment solution of Mastercard, which was intended to come into effect in July 2023. However, recent news reported that existing Maestro cards could remain in service until 2027, rather than just shutting down the service.

As we look at the German market, the biggest concern when structuring financial services business models - eg, in a cooperation with an established bank - is meeting the regulatory requirements while at the same time boosting efficiency and maximising customer experience. This gets more challenging due to the fact that regulatory standards across Europe still vary, although the European legislator and the European Banking Authority put remarkable effort in establishing a level playing field.

2. Hot Topics

In the following, 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 private clients' market, one of the key drivers is the idea of banking the unbanked, or rather the unbankables. Whereas the unbanked define clients not using financial services yet (except for, say, a simple deposit account), the unbankables are the potential client group that would probably get 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 are therefore in the capacity of offering more flexible and tailored solutions.

A service not only requested by 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 that are by far not a new phenomenon on the market. What is indeed new in BNPL structures is the motivation on both sides: whereas traditional instalment payment agreements with the merchant, service supplier or credit card providers require the customer to pay a premium, such premium does not apply to BNPL services. Merchants and service suppliers benefit from receiving the total invoicing amount immediately thanks to the cooperation 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. Although the BNPL market for consumers seems rather saturated (and in no way we agree on this), the area of non-consumer (ie, B2B) BNPL products could develop to an entirely new trend. This is no surprise, since the key argument here is the same as already mentioned: SME financing. In the B2B BNPL area, it is not only merchants looking for a refinancing alternative to bank loans but also B2B buyers using the product in the checkout process.

The other key driver in the FinTech sector is the extension and inclusion 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 lack 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 cash payments fell from 74% in 2017 to 58% in 2021. In e-commerce business, still 27% of all payments are invoicing-based. However, the usage of e-payment methods like PayPal grew rapidly by 11% compared to 2020 to 49 % in 2021, followed by 18% of credit card payments and only 4% of debit card payments.

2.2 Crypto Assets and Crypto Currencies

Drawing the attention to crypto assets and particularly crypto currencies, two main trends will lead the way: the licence requirement for crypto custody business established in 2020 on the one hand and continued 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 (ie, the German implementation of Directive (EU) 2018/843, "AMLD5"), crypto assets found their way into German law. Since 1 January 2020, offering crypto currency services in Germany such as crypto custody services qualify as financial services regulated by Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht, "BaFin"). Providing distribution, custody and trade services such as broking, trading for the account of others or exchanging activities might, as the case may be, trigger a licence requirement. Using crypto currencies as an accounting unit, ie. for payments, however, does not require a regulatory licence. In June 2021, Coinbase obtained the first crypto custody licence granted by the German regulator, followed by Kapilendo, Tangany and Upvest – and very recently Bitpanda.

The new regulation obliges crypto assets to meet the same regulatory standards as already 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 regulatory requirements (a so-called race to the bottom). FinTechs need to consider that it is not (yet) possible to passport a crypto assets licence. As a consequence, crypto assets service providers need to obtain the German crypto assets licence in order to approach the German market.

Since the German legislator 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 Crypto Currencies

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 has initiated a two-year test period focusing on the needs of users and on allocation mechanisms. This test period ends in October 2023. Up and until then, no further efforts towards a digital Euro are to be expected. Furthermore, the European Central Bank has announced in September 2022 to collaborate with five companies – one of them being Amazon – to develop potential user interfaces for the digital Euro.

One of the main benefits desired by introducing digital currencies is the efficiency increase of payment transactions. To this day, bank-to-bank payment transfers often take a few days. With a Euro 2.0 based on blockchain technology, payment transfers could be executed within, if at all, seconds. In this context, transaction costs charged by the respective service provider might decrease significantly. Furthermore, a cross-border payment transfers boost would open the opportunity for German industry to approach foreign markets and increase their international competitiveness. Germany’s nature as export nation highlights just how important such a development would be for our markets.

Putting all the enthusiasm aside, 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 particularly data protection and cyber security aspects need to be taken into proper consideration. Digitising a currency issued by state authorities requires significantly more effort than issuing crypto currencies by private providers which possibly becomes an innovation revolutionising the FinTech market.

2.3 Electronic Securities

Following the AMLD5 implementation, in June 2021 the Electronic Securities Act (Gesetz über elektronische Wertpapiere, "eWpG") entered into force. 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 (ie, paper-based) securities certificate by recording the issuance in an electronic securities register. Such an 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 these 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.

In order to further promote Germany as a funding location, the Regulation on Crypto Fund Units (Verordnung über Kryptofondsanteile – "KryptoFAV") will extend the eWpG and open up the possibility for issuing crypto fund units to providers of investment funds. It is currently being drafted.

2.4 Establishing new platforms for discussion

In March 2022, Federal Minister of Finance Christian Lindner founded the Digital Finance Forum ("DFF") together with experts from Germany's digital finance industry with the aim of "Shaping the Future of Finance". The forum deepens the exchange between politics and practice in order to reinforce Germany as a digital finance location and prepare accordingly for the future. DFF regularly gathers at roundtables to discuss current topics such as payments, retail banking or investment and blockchain. For example, DFF roundtable regarding the topic of payments discussed the implementation of a digital Euro.

Only two months later, in May 2022, BaFin hosted an industry meeting called "BaF-inTech" for the first time. The participants discussed the opportunities and risks of the digitalisation of banking transactions as well as digital central bank money.

Thus, German authorities continue to deepen the communication with the FinTech industry. This indicates that the German regulator has recognised the increased importance of this market sector.

2.5 Regulatory Sandbox?

German regulatory market is known as strongly regulated and 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 grown-up competitors.

For the German market, a regulatory sandbox could on the one hand boost the motivation of FinTech start-ups to make effort 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 legislator currently deny 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.

2.6 Crowdfunding Regulation

Being approximately one year in service, it is time to evaluate the Regulation on European crowdfunding service providers for business (Regulation (EU) 2020/1503, "Crowd-funding Regulation"). The Crowdfunding Regulation is to our impression lacking behind the initial expectations.

This might be caused by the non-binding character of the regulation: as we read the Crowdfunding Regulation, crowdfunding 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 therefore any added value of the Crowdfunding Regulation is questionable.

2.7 FinTechs vs Neobanks vs Established Banks – what are the chances?

With all the focus on FinTechs, there is another species on the market: Neobanks. Neobanks are digital banks that often started as FinTechs and emerged to 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 Neo-bank in Germany is N26 with its European competitors such as 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 come to the force of BaFin more and more. This recently led to a number of BaFin orders. Particularly N26 has been criticised for its anti-money laundering measures. In November 2022, Coinbase has been criticised as well for organisational deficiencies. This blends in with an increasingly strict monitoring practice on the part of BaFin regarding the renowned players. When Marc Branson became the new BaFin President in August 2021, the number of BaFin notices for regulatory offences increased strongly. Compared to established banks, Neobanks are significantly less engaged in lending business. Alongside deposit business, the contrasting business line that could compensate lacking 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 rapidly adapt to changing customer needs. But when it comes to the actual product of financial services, established banks can certainly keep up. Could these different strengths together be a new way to success? Cooperations between banks and FinTechs typically address regulatory concerns – ie, the FinTech is not planning to obtain a licence for the services it intends to offer and the cooperation bank enters into the business model as a licensed participant. One possible cooperation gateway could be the financing business. Whereas many SMEs are facing serious liquidity threads, finance (eg, 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 not least survive the competition.

3. Legal Challenges

As can be expected, a major challenge for the legislator as well as for supervisory authorities will be to further reduce 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 of both, the applicable regulatory requirements are not clearly determined beforehand. Triggered by the invention of new products in the FinTech market, German authorities face a constant race for identifying associated risks and regular adaption of legal and supervisory requirements.

One of the major concerns for FinTechs probably is data security. The number of cyber-crimes in Germany rises 8 to 15% each year whereas the aggregated damage is estimated to exceed EUR100 billion. The more cyberattacks are publicly disclosed, the more likely customers lose trust in the affected sector. The prevention of cyberattacks is therefore essential to scale digital banking products.

4. Outlook

The German FinTech market can be considered as quite established. However, since many business models are similar to the ones 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 other players 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 legislator is eager to improve innovation and it seems as if it is 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 legislator 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 trust to comply with the regulatory standards in foreign jurisdictions as well.

German legal and judicial environment is said to be reliable and credible – market participants can expect a high legal certainty. Therefore, companies that master the German regulatory framework are deemed well positioned for EU-wide scaling.