September 2020 developments
In September 2020 the European Commission (the Commission) adopted a legislative proposal for Regulations for markets in cryptoassets and on a pilot regime for market infrastructures based on distributed ledger technology (the Regulations). The proposed Regulations are part of a broader digital finance package introduced by the Commission to enable and support the potential of digital finance to boost innovation and competition, while at the same time mitigating risks stemming from it.
As part of the Commission’s March 2018 FinTech Action plan, the European Supervisory Authorities were mandated to produce advice on the applicability and suitability of the existing EU financial services regulatory framework on cryptoassets.
This proposal takes into consideration advice received from the European Banking Authority (EBA) and the European Securities and Markets Authority (ESMA).
For both cryptoassets and distributed ledger technology (DLT) market infrastructures the Regulation has four overarching objectives:
- To create legal certainty - a robust legal framework that clearly defines the regulatory treatment of all cryptoassets not covered by current legislation is required.
- To support innovation - a safe and proportionate framework that supports innovation and fair competition is needed to promote the development of cryptoassets and use of DLT.
- To ensure appropriate levels of consumer and investor protection and market integrity - as most cryptoassets are unregulated, this is of particular importance.
- To ensure financial stability - some cryptoassets bear the potential to become widely accepted and embedded in the financial system. Consequently, safeguards are required to address risks to financial stability and policy that could arise from these cryptoassets.
Next steps and timing
The proposed Regulations will be considered by the Council of the EU and the European Parliament.
Feedback on the proposed markets in cryptoassets Regulation can be submitted until 2 December 2020. Once adopted, it is proposed that the Regulation would apply in EU member states 18 months after entry into force, apart from provisions in respect of asset-referenced tokens and e-money tokens, which would apply from the date the regulation enters into force.
It is proposed that the Regulation on a pilot regime for market infrastructures based on DLT would enter into force 20 days after publication in the OJEU and apply 12 months after that.
Cryptoassets: What is the commission proposing and why?
Some cryptoassets already fall under existing EU financial services regulations and will remain subject to the relevant legislation. For example, some qualify as financial instruments and are subject to EU securities markets legislation such as MiFiD.
But where existing rules are not suitable for cryptoassets and distributed ledger technology, , the Commission is proposing a pilot regime for markets that trade and settle in financial instruments in cryptoasset form.
This pilot regime allows for exemptions from existing rules, and allows regulators to gain experience on the use of DLT in markets and for companies to test out DLT-based solutions. The intention is to allow companies to learn more about how the current rules operate in practice, and see whether changes are needed to allow innovation.
For cryptoassets that aren’t covered by any existing legislation, the Commission is proposing a framework designed to protect consumers and the integrity of previously unregulated cryptoasset markets.
The proposed regulation will cover entities issuing cryptoassets, firms providing services around cryptoassets, entities that allow customers to buy or sell cryptoassets for fiat currency or other cryptoassets, cryptoasset trading platforms, and many others.
It also contains requirements for stablecoins, cryptoassets designed to minimize the volatility of their price by tying their value to a stable fiat currency or other stable asset. Stablecoins are further divided into e-money tokens and asset-referenced tokens. Stablecoins that are more systemic, or “significant”, will be subject to enhanced rules.
Cryptoassets: which assets and services will be regulated under the new regime?
The Regulation will cover all cryptoassets not currently caught under existing financial services regulations.
The Regulation lists them as follows:
- Utility Tokens - a type of cryptoasset that is intended to provide digital access to a good or service, available on DLT, and is only accepted by the issuer of that token.
- Asset-Referenced Tokens - a type of cryptoasset that purports to maintain a stable value by referring to the value of several fiat currencies that are legal tender, one or several commodities or one or several cryptoassets, or a combination of such assets.
- E-Money Tokens - a type of cryptoasset the main purpose of which is to be used as a means of exchange and that purports to maintain a stable value by referring to the value of a fiat currency that is legal tender. They will be treated and regulated as e-money under the Electronic Money Directive 2009.
Cryptoassets: key elements of the proposal
In-scope crypto-assets can be admitted to trading on specialist platforms or offered to the public. On the whole, issuers will have to be authorised, unless the market (including eligible investor class, as qualified investors only) is limited.
To be authorised, there will be a requirement for cryptoasset service providers to have a physical presence in the EU and they will be subject to prior authorisation from a national competent authority before commencing their activities. The compliance standards they will need to meet are capital requirements, governance standards, an obligation to segregate their clients’ assets from their own assets, and cyber security requirements
There will be a prohibition on market abuse in the secondary markets for previously unregulated cryptoassets. Measures will be implemented to prevent insider dealing and market manipulation. For example, cryptoasset service providers would be required to have surveillance and enforcement mechanisms to deter potential market abuse.
Cryptoasset issuers will be required to publish a white paper including all the relevant information on the specific cryptoasset. The information would include a detailed description of the issuer, the project and planned use of funds, conditions, rights, obligations and risks. In addition, members of the issuers’ management body will have to meet probity standards, and there is a proposed prohibition on misleading market communications by issuers.
Issuers of asset-referenced tokens will be have to be authorised, meet governance requirements, comply with conflict of interests rules, possess disclosure stabilisation mechanisms, comply with investment rules and meet additional white paper requirements
Issuers of e-money tokens will need to be authorised and comply with regulatory requirements of the Electronic Money Directive and the Regulation on Markets in Cryptoassets.
Cryptoasset service providers will need to comply with prudential requirements, rules on safekeeping clients’ funds, governance requirements , complaint handling procedures, and management of conflicts of interest. There are additional type specific requirements dependent on the type of cryptoasset service provider.
For effective supervision, Member States have to choose a competent authority as a single point of contact. The EBA is the supervisor of issuers of significant asset-referenced tokens. Significant e-money token issuers are dual supervised by the EBA and national competent authorities.
Cryptoassets: scope of the new regime
There are transitional provisions in the Regulation that include a grandfather clause for cryptoassets issued before the entry into force of the Regulation, with the exception of asset-referenced and e-money tokens.
For example, several wallet providers already possess financial licences (such as licences as electronic money providers) and several cryptoasset service providers are already regulated institutions for anti-money laundering purposes.
But, as has been mentioned already, previously unregulated cryptoasset service providers and issuers, will be caught by this Regulation.
Asset-referenced tokens and e-money tokens are the new terms used for stablecoins
For both categories, minimum rights for investors are proposed. An example being the claim that a token holder would have against the issuer of a stablecoin.
E-money tokens will have to comply with rules set out in this new regime as well as those in the Electronic Money Directive. Issuers of e-money tokens would have to offer a 1:1 redemption right for their tokens.
Minimum requirements for asset-referenced tokens include: holders having the right to withdraw directly from the issuer in case of significant variation in value, liquidity arrangements between the issuer and asset-service providers buying and selling these tokens, and a wind-down plan that contains contractual arrangements ensuring token holders are paid any potential proceeds.
DLT market infrastructures: main features of the pilot regime
The Regulation aims to allow the operation of a DLT market infrastructure by establishing clear and uniform requirements. The overarching aim is to remove regulatory hurdles to issuance, trading and post-trading of financial instruments in cryptoasset form, and to allow business to test and regulators to gain experience on the use of DLT market infrastructures
The regime sets out the requirements for getting permission to operate a DLT market infrastructure, details the limitations on the transferable securities that can be admitted to trading, and outlines how the DLT market infrastructure, competent authorities and ESMA all work together.
In parallel, as part of this legislative package, it is proposed to amend MiFID 2 to make clear that financial instruments can be issued on a DLT and to exempt DLT market infrastructures temporarily from requirements to allow solutions for the trading and settlement of transactions of cryptoassets to be developed.
It should be noted that permissions to operate are never permanent, but are temporary and will be regularly reviewed by supervisors. Market operators who then fail to meet the relevant criteria can no longer run the pilot.
ESMA will carry out a review of the pilot regime five years after it comes into force.
Impact of Brexit: UK regime
It is important to note that the Regulations will not come into force until after the UK’s scheduled departure from the European Union. The UK will not have to comply with any of the proposed legislation. However, even with that being the case, a couple things bear mentioning.
There already exists some regulation of cryptoassets in the UK. Regulated tokens are, security tokens (defined as tokens amounting to a ‘Specified Investment’ under the Regulated Activities Order, excluding e-money) and e-money tokens (defined as tokens that meet the definition of e-money under the Electronic Money Regulations). The creation of the UK Cryptoasset Taskforce in 2018, as well as the cryptoasset consultation paper and policy statement the FCA issued in 2019 and HM Treasury 2020 consultation on cryptoasset promotions indicate UK regulatory appetite to introduce measures to ensure consumers are protected, market integrity is upheld and that competition works in the interest of consumers. The recent FCA ban on the sale of derivatives and exchange traded notes referencing certain types of cryptoassets to retail consumers is framed from the perspective of preventing consumer risk. Further regulatory consultation is also anticipated.
The rapid growth of the digital token market, and access to international markets will be relevant factors for the UK and UK based business. The EU proposals do have some parallels and equivalents in the UK financial services regulatory framework. The FCA compliance requirements for governance (SYSC), client money (CASS rules), complaints handling (DISP handbook), and capital adequacy (General Prudential handbook) are part of the compliance landscape for some of the products that firms in this space.
Whilst the UK is clearly focused on having a robust regulatory environment for Cryptoassets, there is some perceived rigidity in the EU proposals. In particular there is non-dynamic categorisation of digital assets and strong alignment with existing definitions. For example, the division of Stablecoin into separate regulatory brackets, one under the highly European e-money categorisation, is not necessarily resonant with a fully global approach. Through consultation and reflection, from a UK perspective, on its comparative existing regulatory platform and strong global interactivity, we would be pleased to see a more dynamic regulatory environment being maintained.