GERMANY: An Introduction to FinTech Legal

Introduction: Fintech in Germany 

Fintech continues to be more than a trendy buzzword in Germany, despite – or because of – the pandemic-shaped developments in the market, which have only surged during the war in Ukraine. Between 2015 and 2019, the German fintech market grew by 119.2% on average per year. For the time being, it reached a peak in 2021. During 2022, the German fintech market cooled down a little following the global macroeconomic environment, and this continued in 2023. This development has also been influenced by recent phenomena such as rising interest rates, high inflation, the energy crisis and uncertainties in the German real estate market. These aspects are likely to hamper the opportunities for fintech start-ups to acquire new capital in 2024, and financing rounds continue to decrease in both numbers and volume in 2023.

However, this does not mean a loss of relevance. The German regulator has recognised the persistent importance of this market sector and increased its endeavours to question the variety of business models. In the ongoing transformation from classic banking models financing Germany’s global players to making financial services available to everyone with ease, the fintech sector is still seen as one of the key drivers of this transformation, and is expected to remain as such in the coming decade.

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 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.

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, which not only grows in quantity but also gains quality. The cleaner the data basis, the more efficient its usability can be.

The entities most commonly involved in this development are start-ups. In the German financial services market, however, “grown-ups” (ie, large and established banking institutions) are also eager to settle down in the fintech market.

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 and Frankfurter Sparkasse with 1822direkt, just to name a few.

Almost 20 years later, the fintech sector represents the second largest start-up sector, forming a highly innovative segment of financial services on the market. Total fintech investment in the EMEA region (Europe, Middle East and Africa) rose to a record USD77 billion in 2021, with Nordic countries at the top (USD18.5 billion in total), followed by Germany (USD5.4 billion), mainly driven by growing venture capital investments. Despite (or because of) the current challenging environment, many fintechs have managed to increase their capital since commencement in the past few years. However, the fintech market cooled down considerably in 2023. With the crazy financing rounds of the past few years coming to an end, it seems that many fintechs are entering into a consolidation phase towards profitability which, in turn, regularly comes with severe job cuts.

In September 2023, approximately 650 fintech companies were deemed active in the German market. Nine of them are considered unicorns valued at over EUR1 billion: Trade Republic, N26, Raisin DS, Mambu, wefox, Solarisbank, Scalable Capital, Enpal and Tools for Humanity (Worldcoin).

Established banks in Germany do engage in the fintech area by way of co-operation, with such co-operation being concluded in order to move towards more digital and thus more promising business models. For example, DKB commenced co-operation 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) has faced the dominance of the established US payment solutions, such as PayPal, Apple Pay, Google Pay and 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 came into effect in July 2023. However, recent news reported that existing Maestro cards could remain in service until 2027, rather than the service just being shut down.

Looking at the German market, the biggest challenge when structuring financial services business models (eg, in co-operation with an established bank) is meeting the regulatory requirements while also boosting efficiency and maximising the customer experience. This is challenged further by the fact that regulatory standards across Europe still vary, although the European legislator and the European Banking Authority are putting remarkable effort into establishing a level playing field.

Hot Topics 

The following topics might be worth considering in the years to come.

Regulator's focus  

For quite some time, the German regulatory authorities have been becoming more active, particularly the Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht – BaFin). These activities, described in more detail below, may materially impact fintechs' underlying business model, or already do so.

BaFin is increasingly interested in fronting bank business models, putting a strong focus on lending models and seeming to be particularly curious about Know Your Customer processes and the identity of investors further down the refinancing chain. This strategy perfectly meets BaFin president Mark Branson's agenda: to give institutions the chance to test and learn, but also to follow a more active approach when it comes to supervision.

In performing this active approach, BaFin has proven that it does not hesitate to make use of its regulatory powers. A prominent example is the new customer limitation of 50,000 customers per month for N26, introduced in July 2023. Given that the business models of most fintechs, and presumably also N26, are based on the assumption of growth, such BaFin action significantly affects the business plan – and also potential refinancing options.

But it is not only BaFin that is active and affecting business models: EU member states have agreed on a prohibition of the so-called Payment for Order Flow (PFOF) model. As a form of compensation that a brokerage firm receives for directing orders for trade execution to a particular market maker or exchange, usually in terms of fractions of one or more euro per share, the PFOF is the main source of income for neobrokers like Trade Repulic, Scalable Capital or Flatexdegiro. According to the EU, this compensation model shall be prohibited as of 2026. Such prohibition would materially affect the income streams of these neobrokers, which are then forced to amend their current business model.

Artificial intelligence  

Although artificial intelligence is one of the most prominent buzzwords nowadays, it seems that it will still be some time before it is seen in daily use. Before talking about artificial intelligence seriously, it is questionable as to what this term actually refers to – and what artificial intelligence actually means. Although inventions such as ChatGPT are pretty impressive and allow a brief estimate of the potential of artificial intelligence, any final and irrevocable shifts of decisions to machines are still a way off.

The limiting factor, apart from computing resources, seems to be regulatory hurdles. Experts unilaterally note that true artificial intelligence, in parts, without any human interaction brings uncertain consequences and can be very dangerous. Just recently, one of the pioneers of artificial intelligence research at Google, Geoffrey Hinton, quit his job due to major concerns over and potential threats resulting from the technology of artificial intelligence. There is no doubt about the supporting role of artificial intelligence in data analytics and decision preparation. However, and despite all the uncertainty, it will still take some time for financial regulation to accept autonomous decisions by machines without human interaction.

Established and upcoming fintech business models

In addition to typical loan fronting models, the so-called buy now pay later (BNPL) service is an already well-established fintech business model. BNPL services allow customers to pay for their online shopping items, car repairs or solar panels, for example, in instalments over time. Legally speaking, BNPL services qualify as traditional instalment payment options, and are by no means a new phenomenon on the market. What is new in 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, such premium does not apply to BNPL services. Merchants and service suppliers benefit from receiving the total invoicing amount immediately thanks to co-operation with a BNPL fintech.

From an economic perspective, this forms a new refinancing model for businesses, which 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, 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. With the surge in interest rates in Germany, Europe and the USA, BNPL fintechs will have to raise their interest rates as well. These will be a major cut in the financial situation of many consumers. With the consumers mainly or at least often being relatively young, this can lead to a debt spiral.

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 have lacked confidence in digitalisation 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, 27% of all payments are still 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.

There is another triggering aspect for established fintechs to rethink their existing business models: the continuous interest rate increase. Neobrokers start to offer their customers considerable interest rates on their deposits transferred to their settlement accounts. Although these accounts shall serve as payment accounts to settle broking activities, neobrokers now encourage their customers to use these accounts as deposit accounts. With this alternative business model, neobrokers are starting to compete with true deposit fintechs such as Weltsparen. Thanks to the increase of deposit interest rates, Weltsparen has reached a new peak of received deposits: EUR50 billion.

Crypto-assets and cryptocurrencies 

Drawing attention to crypto-assets and particularly cryptocurrencies, two main trends will lead the way: the licence requirement for cryptocustody business established in 2020 on the one hand, and continued thoughts and discussions on digitising our good old currency, the euro, on the other.

Unfortunately, the crypto world already had its own Wirecard moment with the FTX scandal emerging at the end of 2022. This particular case shows a major weakness of the crypto world: the identification and traceability of the parties – and more importantly the funds – involved.

Under the cover of anti-money laundering regulation (ie, the German implementation of Directive (EU) 2018/843 – AMLD5), crypto-assets have found their way into German law. Since 1 January 2020, offering cryptocurrency services in Germany such as cryptocustody services qualifies as financial services regulated by 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 cryptocurrencies as an accounting unit (ie, for payments), however, does not require a regulatory licence. In June 2021, Coinbase obtained the first cryptocustody licence granted by the German regulator, followed by Kapilendo, Tangany, Upvest, Bitpanda, blocknox, Finoa and Hauck Aufhäuser Digital Custody.

The regulation obliges crypto-assets to meet the same regulatory standards as have already applied to traditional capital markets for years. For the industry, this could initiate competition for the most efficient, customer-friendly cryptoservices 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 leads market participants to 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-asset 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 that German crypto-asset fintechs will be in a favourable position in the European crypto-assets market.

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

Putting all the enthusiasm aside, there are some issues that must be considered before inventing a digital, blockchain-based crypto-euro to replace central bank money. Euro member states mutually agree that data protection and cybersecurity aspects in particular need 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. In addition to the practical obstacles, there is much conservatism towards digital payment structures, especially in Germany, although the younger generations tend to be more open to the payment digitisation. Therefore, officials in Germany are deemed to have issues convincing the public of a convincing use case.

Electronic securities  

Following the implementation of AMLD5 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 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 cryptosecurities registry management (Kryptowertpapierregisterführung). Service providers intending to manage a cryptosecurities register thus require a licence.

With the implementation of the Future Financing Act (Zukunftsfinanzierungsgesetz), the eWpG covers not only bearer bonds (Inhaberschuldverschreibungen) but also company shares (Aktien). The introduction of the eWpG can be seen as a first step towards changing the securities market in general.

To further promote Germany as a funding location, the Regulation on Crypto Fund Units (Verordnung über Kryptofondsanteile – KryptoFAV) extends the eWpG and opens up the possibility to issue cryptofund units to providers of investment funds.

Regtech  

Regtech is a combination of the words “regulatory” and “technology”. It can be seen as a sub-category of the fintech industry and describes innovative technologies for the observance of regulatory compliance of companies (ie, financial institutions).

One of the major use cases of regtech is the complex world of compliance and anti-money laundering. For example, regtechs such as Regpit offer all-in-one compliance tools for financial institutions in the form of Software as a Service.

To keep up with data masses, future regtech solutions are expected to make use of partial artificial intelligence, which enables huge amounts of data to be reviewed within seconds. The extent of artificial intelligence use will be determined by the regulator. This field has been shaped by such uncertainty to date that it is hard, if not impossible, to predict the path that will be taken over the next few years.

Legal Challenges 

As can be expected from these topics and the uncertainty associated with these trends, a major challenge for the legislator and the 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 or the other, 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 to identify the associated risks and the regular adaption of legal and supervisory requirements.

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

Outlook 

The German fintech market is quite established. However, since many business models are 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 other players in the next couple of years. This consolidation trend has obviously already started, and will be fuelled by increasing interest rates and the focus set by the regulator.

Being the largest economy in Europe, the German market provides 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 making the German fintech market 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 the entry market for business development efforts in the EU. By complying with German regulatory and legal requirements, fintechs could certainly be trusted 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 high legal certainty. Therefore, companies that master the German regulatory framework are deemed to be well positioned for EU-wide scaling, making the German market an attractive entry market for new players.