Regulatory classification of transactions with Bitcoins

BaFin has published its first assessment of transactions with Bitcoins

Bitcoins are growing in popularity and, as a non-governmental substitute currency with a limited money supply, promise to offer an alternative to the currencies issued by central banks. If transactions with bitcoins have so far been characterized by considerable legal uncertainty and have been hardly regulated, the financial supervisory authorities worldwide are now about to bring this area into the regulatory framework. In Germany, BaFin has recently published a paper summarizing the applicable principles for transactions with Bitcoins in Germany.

Bitcoins are a virtual currency. Transactions with bitcoins and bitcoin credits are managed in a decentralized network. In principle, every network user can participate in creating currency through cryptographic calculations. Bitcoins are produced by the users themselves on powerful computers in a process called “mining”. Therefore, there is no central bank – which performs this function for real currencies. The users have digital wallets in which to store their bitcoins. Bitcoins can be electronically transferred between participants as they wish. Their allocation is proven by an authorization in the form of a cryptographic key. For this purpose, every transaction is provided with a digital signature, assigned to a certain address, and recorded in a database operated by the entire network. The maximum number of bitcoins is limited to 21 million to protect against inflation.

The users themselves can remain completely anonymous, which is why regulatory authorities worldwide have been increasingly critical of bitcoins. However, no uniform regulatory practice for evaluating transactions with bitcoins has yet been established. This also applies at the European level. While in some countries, such as Great Britain, commercial activities with bitcoins still do not require a license, other countries even prohibit such transactions. Against this background, BaFin has recently published its opinion on the legal situation in a technical paper and thus created some degree of legal certainty for Germany.

Regulatory classification of Bitcoins

From a regulatory perspective, bitcoins are nothing more than so-called “arithmetic units”, which are classified as financial instruments under Section 1 (11) Sentence 1 No. 7 of the German Banking Act (KWG). Arithmetic units are units of account comparable to foreign exchange, but – in contrast to foreign exchange – bitcoins are not legal tender, but constitute digital money. Therefore, bitcoins are not a recognized currency, but are rather a substitute currency, which is used as a means of payment in multilateral settlement collectives based on private agreements. Contrary to what might be presumed given the technical background of bitcoins, they are not “e-money” within the meaning of Section 1a (3) of the Payment Services Supervision Act [Zahlungsdiensteaufsichtsgesetz ZAG], since there is no issuer that issues bitcoins by establishing a claim against itself.

Duty to obtain a license

Since bitcoins are classified as financial instruments, any commercial activity with bitcoins must be licensed. However, the mere use of bitcoins – whether it be to make payment as a customer or to receive payment as a dealer – does not constitute an activity requiring a license. The creation of bitcoins, i. e. mining, does not require a license. The decisive factor in whether a license is required is whether a person merely participates in the bitcoin market or actively promotes it. The type of licence needed to operate the business depends on the particular configuration of the relationship with the customer and the technical processes. The type of licence needed determines, in particular, the amount of initial capital necessary.

Financial commission business

The prerequisites needed for licensing as a financial commission business under Section 1 (1) Sentence 2 No. 4 KWG are met if, in buying or selling bitcoins, the platform operator:

- acts in its own name towards the trading partner,
- but actually acts on account of a customer, i. e. the economic benefits and detriments accrue to the customer, and
- the activity is similar to a traditional commission business.

Multilateral trading system

It is however also possible that the operation of a platform meets the prerequisites for the operation of a multilateral trading system under Section 1 (1) (a) Sentence 2 No. 1b KWG. This is the case if:

- a system is operated that brings together numerous persons interested in buying and selling bitcoins,
- there is a uniform set of rules governing membership and
bitcoin trading, and
- the contracting parties cannot decide with whom they wish to enter into a contract in an individual case, but rather persons are brought together by software or protocols for the purpose of entering into contracts with each other.

The most important distinguishing criterion from the financial commission business is the fact that the participants themselves become contracting parties.

Proprietary trading

In addition, providers can also directly convert real currencies into bitcoins for their customers. This generally meets the prerequisites for proprietary trading under Section 1 (1) (a) Sentence 2 No. 4 KWG.

Tax aspects

For tax purposes, bitcoins are assets that can be the subject of private sales transactions. Through the conversion of euros into bitcoins, bitcoins are acquired as assets. The reconversion of bitcoins into euros is generally subject to income tax, since the exchange is considered to be income from private sales transactions under Section 22 No. 2 of the Income Tax Act (EStG). In addition, trading in bitcoins is subject to value-added tax. The trade in bitcoins may precisely not benefit from the VAT exemption under Section 4 No. 8b of the VAT Tax Act (UStG), which provides that the sale of legal tender is tax-free, since bitcoins are not legal tender in the opinion of the tax administration.

Conclusion

While the regulatory assessment of bitcoins is still unclear in many European countries, most questions appear to have been clarified in Germany. In Germany, bitcoins are embedded in the existing regulatory regime due to their classification as financial instruments. Therefore, a license from BaFin is required for all commercial activity in connection with bitcoins. Since most operations in this area are start-ups, this constitutes a high hurdle.