EU regulators aligned on the need for regulatory action on crypto-assets
The European Banking Authority (EBA) and the European Securities and Markets Authority (ESMA) have outlined their analysis on how crypto-assets fit into the existing EU regulatory framework in two recent reports. Both supervisors stress that the existing framework does not adequately provide for crypto-assets, creating substantial risks regarding investor protection and market integrity. They also appear to be aligned on the need for further regulatory action on crypto-assets, although it remains to be seen what action will be taken.
Both the EBA Report with advice for the Commission on Crypto Assets, and the ESMA Advice on Initial Coin Offerings and Crypto Assets to the Commission, the European Parliament and the Council of the EU have been published in response to a request from the EU Commission in its 2018 FinTech action plan for the European Supervisory Authorities (ESAs) to assess the suitability of the regulatory framework with regard to crypto-assets.
Below we provide a summary of the analysis conducted and the conclusions reached in both reports, and we highlight some key points of interest for market participants from the more detailed ESMA analysis.
In its advice, ESMA outlines its position on:
- the gaps in the existing regulatory framework where crypto-assets qualify as financial instruments; and
- the risks that are left unaddressed when crypto-assets do not qualify as financial instruments.
The report follows work ESMA has carried out with national competent authorities (NCAs) analysing different crypto-asset business models and how they (and crypto-assets) fit into the existing regulatory framework.
ESMA concludes the following:
- for crypto-assets that qualify as financial instruments, ESMA believes there are gaps in the existing regulatory framework, which did not contemplate crypto-assets in its design;
- for crypto-assets that do not qualify as financial instruments, ESMA believes there are substantial risks for investors and questions regarding market integrity. The most significant risks ESMA identifies include fraud, cyberattack, money laundering and market manipulation.
- However, ESMA notes more generally that it sees the “tokenisation” of assets as a potential long-term trend that has the potential to create beneficial outcomes for both market participants and investors.
To ensure a level playing field and address investor protection concerns, ESMA believes that it is not an option simply to “Do Nothing”, and that the most appropriate course of action will be to implement a bespoke regime for specific types of crypto-assets at EU level.
Key points of interest for market participants from the ESMA advice
Legal qualification of crypto-assets
- ESMA found that where a crypto-asset has attached profit rights (even without necessarily having ownership or governance rights), this was considered sufficient for a majority of NCAs to qualify such crypto-assets as transferable securities (where such crypto-assets also met the other conditions to qualify as transferable securities). Those NCAs that disagreed with this view may (in ESMA’s view) do so on the basis of a more restrictive transposition of MiFID II.
- Utility tokens were not considered as transferable securities/financial instruments by any NCA. ESMA notes that the rights utility tokens convey seem to be too far away from the monetary and financial structure of a transferable security/financial instrument.
- The view that all crypto-assets should be subject to some form of regulation was held by the “vast majority” of NCAs.
The Markets in Financial Instruments Directive framework (MiFID)
- ESMA gives a preliminary view that crypto-asset platforms with a central order book and/or matching orders are likely to qualify as multilateral systems, and so should operate as regulated markets, multilateral trading facilities or organised trading facilities under the MiFID II framework.
- ESMA confirms that platforms that are used to advertise buying and selling interests and where there is no genuine trade execution or arranging taking place may be considered as bulletin boards and fall outside the scope of MiFID II, as per recital 8 of MiFIR.
The Settlement Finality Directive and the Central Securities Depositories Regulation (CSDR)
- ESMA has flagged difficulties in achieving settlement finality where there is no clear operator of the system, although they have not ruled it out, noting that “additional consideration” needs to be given as to whether it can be achieved for a permissionless blockchain. ESMA does note, however, that there are “specific governance issues with permissionless DLTs, which makes them less suitable to the processing of financial instruments, at least in their current form”.
- ESMA confirms that where crypto-assets are transferable securities which are traded on a trading venue or transferred following a financial collateral arrangement, they would have to be recorded with an authorised central securities depository (CSD). ESMA also raises interesting questions as to how crypto-asset “miners” would fit into the CSDR regime in terms of governance and technical requirements, given their novel and fundamental role in the settlement process.
- ESMA states that any technology, including distributed ledger technology, could be used as a method for the initial book-entry form recording required by Article 3 of CSDR, so long as the book-entry form is with an authorised CSD.
Safekeeping of ownership of securities and rights attached to securities
ESMA gives a preliminary view that controlling private keys on behalf of clients might amount to safeguarding, but notes that this will require further consideration, in particular in the context of multi-signature arrangements.
In its assessment of how existing EU law applies to crypto-assets, the EBA notes that, typically, activities/services relating to crypto-assets do not constitute regulated activities within the existing regulatory framework. The EBA report does, however, include a table that lists observed crypto-asset activity by regulated entities and notes this activity is regarded to be relatively limited, and also provides some use-cases where crypto-assets have been assessed to be e-money.
The EBA confirmed it is aligned with the Financial Stability Board in the view that crypto-assets do not currently give rise to concerns regarding financial stability.
However, the EBA is concerned that the absence of regulation gives rise to risks regarding:
- consumer protection;
- operational resilience; and
- market integrity.
Further, the EBA notes that EU member states have adopted differing approaches to tackling issues presented by crypto-assets, which is creating risks to the level playing field. It also suggests that market developments also point to the need for a further review of EU anti-money laundering legislation.
The report flags that there are issues that fall outside the EBA’s mandate, such as the accounting and tax treatment of crypto-assets.
EBA recommendations and further actions
With this analysis in mind, the EBA recommends to the Commission that:
- the Commission carries out a comprehensive cost/benefit analysis, on a holistic basis and taking into account issues beyond the financial sector, to determine the appropriate EU-level response at this stage;
- the Commission should have regard to the latest recommendations and any further standards/guidance from the Financial Action Task Force (FATF) with respect to what FATF calls “virtual assets”;
- the Commission takes steps where possible to promote consistency in the accounting treatment of crypto-assets.
The EBA also identifies a number of actions that it will take in 2019 to enhance the monitoring of financial institutions' crypto-asset activities and consumer-facing disclosure practices.
Most notably, the EBA intends to develop a common monitoring template which can choose to issue to financial institutions, payment institutions and electronic money institutions. In the EBA’s view, due to an absence of specific reporting requirements in most EU member states regarding crypto-assets, NCAs are not well-equipped to monitor risks associated with crypto-asset activities. This template is intended to help NCAs more effectively monitor crypto-asset activities.
What happens next?
In its advice, ESMA provides a clear statement that taking no action to address the concerns regarding investor protection and market integrity with respect to crypto-assets is not an option. The EBA is also clear that further action from the Commission is merited.
Following the publication of these reports, it appears that the ball is in the Commission’s court, although it remains to be seen exactly how the Commission will respond.