New guidance from the European Securities and Markets Authority (ESMA) and the European Banking Authority (EBA), which advises the European Commission, has put forward clear and unambiguous rules for the treatment of crypto-assets.
Both agencies dropped hefty policy papers on the topic on Wednesday 9 January 2019.
While in the past, European regulators have gone little further than warning the public about investing in ICOs, these joint reports dictate specific terms on how the financial system should deal with cryptocurrencies, utility tokens and other new asset classes.
Crypto-assets are evolving rapidly, and expanding far beyond mere financial products.
This serious interest from these powerful regulators implies that a) in future, populations will have much wider access to all kinds of crypto-assets; and b) that new regulations will be broadly in line with how traditional financial institutions are currently treated.
This is a 30-page document classifying terms and clarifying how crypto-assets fall under existing laws.
The EBA echoes the viewpoint of the head of the Bank of England Mark Carney, saying that it does not believe crypto-assets “give rise to implications for financial stability”.
Carney had said cryptocurrencies posed little threat to global stability in a letter to G20 finance bosses, in his role as head of the global Financial Stability Board. He has since gone much further in detail into his position, which Copper has covered in depth here.
Interestingly enough, the focus of the EBA seems to be shifting away from risks and towards opportunities.
That regulations on crypto-assets are so “divergent” country to country, say the EBA, is a major problem for regulators. The EBA says its intention is better consumer protection, market integrity, and maintaining a “level playing field”.
As such it sets out “advice to the European Commission regarding the need for a comprehensive cost/benefit analysis to determine what, if any, action is required at the EU level at this stage to address these issues.” This analysis will “take account of the potential application of DLT and crypto-assets beyond the financial sector, and should extend to aspects relating to the environmental impact of some crypto-asset activity”.
The EBA also “calls on the Commission to take steps where possible to promote consistency in the accounting treatment of crypto-assets.”
There will be more and closer monitoring of banks and financial institutions interactions with crypto-assets, whether that is exposure from a financial standpoint or offering services to customers.
The report suggests there are implications for exchanges, and firms offering cold storage, custody or execution services to institutional clients.
The EBA assess that crypto-assets “fall outside the scope of EU financial services regulation” and “specific services relating to crypto-asset custodian wallet provision and crypto-asset trading platforms do not constitute regulated activities under EU financial services law”.
‘Crypto-assets’, rather than ‘cryptocurrencies’, will be the term the European authorities will use in future. Use of crypto-assets is evolving rapidly, the EBA recognises.
There is no common taxonomy or naming system in use by international standard-setting bodies for the various types of uses for tokens - security tokens, utility tokens etc, it notes.
However, it does recognise three main types of token:
Payment tokens (cryptocurrencies), which are used as a means of exchange. Stablecoins fall under this definition.
Investment tokens, which grant ownership rights or entitlements similar to dividends.
Utility tokens, which are not used as payment but instead grant access to blockchain-based services, like cloud storage.
This next section clarifies how crypto-assets are viewed under current EU financial law.
In essence, “the current perimeter of regulation is such that crypto-assets may, depending on their characteristics, qualify as financial instruments, electronic money or none of the foregoing.”
There will be no overarching rules on what does and does not fit the definition of a crypto-asset.
Instead, under the 2009 second Electronic Money Directive (EMD2), which classifies various financial terms, and under the 2015 second Payment Services Directive (PSD2) “it is essential for an assessment to be carried out on a case-by-case basis, bearing in mind that different crypto-assets have different characteristics, which in some cases may change during the lifecycle of the asset”.
“Crypto-assets are not recognised in any of the Member States or by the European Central Bank” as legal tender but the EBA has carried out an assessment of whether crypto-assets may qualify as ‘electronic money’ within the EMD2 or as ‘funds’ under the PSD2. This is intended to complement ESMA’s analysis of whether crypto-assets may qualify as ‘financial instruments’ within the scope of EU law.
Crypto-assets are not legal tender anywhere in the EU. They can, however, be defined as “electronic money” under EMD2, the EBA recognises.
The disruptive nature of the technology, in terms of cross-border payments, is an issue for the bloc, says the EBA, because “many competent authorities do not hold, and do not have the power to acquire, information about the activities of firms beyond their respective regulatory perimeters.” This point implies there will be a requirement for closer co-operation between banking authorities across Europe when considering the impact of crypto-assets.
While blockchain was the buzzword of 2018, Distributed Ledger Technology is now the acceptable name for the same thing. Trade finance, securities markets and managing KYC/customer due diligence are all being improved with DLT, write the EBA.
Along with calling for much more analysis, more co-operation between countries to draft legal frameworks for dealing with cryptocurrencies and other digital assets, the EBA highlights that “the interest of regulated financial institutions in crypto-asset activities is likely to grow, particularly in the context of the increasing use of DLT-based solutions which may entail the use of some sort of crypto-asset for access purposes (i.e. ‘utility’ type tokens).”
“It appears that there is a need to clarify the appropriate accounting treatment of crypto-assets, which in most cases would provide a link to the existing prudential treatment.”
The EBA notes the absence of clarity at the level of international and national accounting standard setting bodies about whether, for example, a holding of a crypto-asset should be treated as an intangible asset.
“The EBA also observes that the absence of clarity regarding the accounting treatment may give rise to queries about the consequential prudential treatment under current EU law (the CRD/CRR). The EBA observes that, without the necessary clarifications, divergent approaches could emerge undermining the level playing field.”
The EBA recommends that the European Commission take steps where possible to promote consistency in the accounting treatment of crypto-assets.
Payment and money institutions must have arrangements in place to mitigate the risks involved with crypto-assets, and that involves cybersecurity and the reputational damage that such a hack can cost.
Exchange hacks have cost investors billions of dollars over the past five years. As Forbes writes, hacks in 2018 alone cost $856m, more than double that of 2017.
If authorities find issues with institutions who deal with crypto-assets, they can impose additional liquidity requirements on the business as well as restricting or limiting business operations.
Through the rest of 2019 the EBA has pledged to develop a “common monitoring template” for authorities to track the level and type of crypto-asset activity, to report to the European Commission on bank holdings and exposure, and to continue warning the public on the risks of liquidity and lack of legal framework for consumer protection.
The European securities regulator published a 50-page report detailing exactly how and where crypto-assets should be regulated by member states.
And strong regulation is the key. “Where regulation does not apply to crypto-assets and related activities, regulators need to consider whether it should, and if so how,” says the report.
The ESMA also follows the EBA in declaring that the market for crypto-assets is relatively modest and poses no threat to financial stability. It adds that some heavily-criticised elements of the process, like ICOs, could in actuality be beneficial to the system as a new way of raising capital, if only they were properly regulated.
The concerns over ICOs continue: “Most businesses raising capital through ICOs are at the initial stages of development, often not even operating businesses but just ideas, even if we are starting to see some larger companies issuing crypto-assets as well. The likelihood that they fail is therefore high and investors have a significant risk to lose their capital. One report of a sample of ICOs from 2017 suggests that a significant minority (30%) have lost all of their value, and a vast majority are valued at below their ICO price. Some projects did, however, have working products or prototypes. There have also been widespread reports and concerns around fraudulent ICOs, whereby crypto-assets either do not exist or issuer/developers disappear after the ICO. These could represent up to 80% of ICOs according to some sources.”
The most significant risks are fraud, cybersecurity failings, money-laundering and market manipulation, it says.
And “Because the range of crypto-assets are diverse and many have hybrid features, ESMA believes that there is not a ‘one size fits all’ solution when it comes to legal qualification.”
The most telling move by the ESMA is to bring crypto-asset companies in line with other financial firms under MiFID II, or the Markets in Financial Instruments Directive. This is the EU legislation which regulates how and where financial instruments (shares, bonds, derivatives) can be traded. It’s is the backbone of all financial rulings across the EU.
When crypto-assets don’t qualify as financial instruments under MiFID, where they are utility tokens or similar non financial products, the ESMA says there are two main options for EU policymakers and regulators.
Option A - set up a specific regime for that class of products.
Option B - they could decide that crypto-assets fall outside their purview and just do nothing. The ESMA says this is not viable and won’t protect the public, so only “Option A is the most appropriate course of action.”
Where crypto-assets do fall under the definition of financial instruments under MiFID, issuers must produce a prospectus, under the Prospectus Directive, to give investors the necessary information to make an informed choice. “The information shall be written and presented in an easily analysable and comprehensible form,” says the law.
Another transparency requirement called the Prospectus Regulation will apply from 21 July 2019. The only time these prospectus rules do not apply are when the crypto-assets do not qualify as transferable securities. Also exempt are offers where the total amount of fundraising does not reach €1m, the offer is addressed to fewer than 150 people, or the fundraising is only aimed at private clients rather than the general public. Where the fundraising limits are between €1m and €8m, this decision whether to apply transparency regulations will be down to member states themselves.
Further transparency requirements will bring ICOs under the same laws as any other capital-raising offers. Under the 2013 Transparency Directive, issuers of securities must: “[disclose] periodic and ongoing information...e.g., annual financial reports, half-yearly reports, interim management statements, acquisition or disposal of major holdings and any changes in the rights of holders.”
The report notes France, Liechtenstein and Malta are the three European countries to have set out their own comprehensive legal frameworks for the treatment of ICOs and cryptocurrencies.
There will be new requirements for firms involved in the production or management of crypto-assets: they must have enough capital. Again, this will bring crypto firms in line with other financial institutions and covers four stages: €25,000, €50,000, €125,000 and €730,000 for those companies dealing with the most complex financial instruments.
Elsewhere in the EU leadership there is high stakes political drama afoot. Brexit is all-consuming and The Guardian, quoting senior sources, reported how Brexit could be delayed beyond the hard exit limit of 29 March 2019 until at least July.
There are potentially trickier times ahead for regulators, and for Europe as a whole.
As of January 2019, the presidency of the Council of the EU is with Romania - its first time holding this position. This leading role decides on policy direction for the bloc, is done on a rotating basis every six months.
What this really means is that Bucharest now holds the keys to the kingdom in terms of political and monetary priorities. There are potentially dangerous waters to navigate, given the infighting and internecine strife in Romanian political circles. The leader of Romania’s largest party, Liviu Dragnea of the Social Democrats, is alleged to have siphoned off €21m of EU funds in a corruption scheme, for example.
However, Romania wants to accelerate EU fiscal growth. Along with expanded social programs, stronger cybersecurity and a plan to continue the push for digitalisation, Romania’s leadership make it clear that growth and investment is key to 2019.
Their main priority reads: “Advancing the EU agenda in the economic and financial fields, in order to stimulate growth and investment, to deepen the Economic and Monetary Union as well as to support structural reforms.”
These “structural reforms” are in evidence in the ESMA and EBA papers and bode well for an exciting 2019 for the cryptocurrency industry in Europe.
In essence, these policy papers represent the clearest indication that the EU as a collective is ready to properly legitimise cryptocurrency holdings and trading at an institutional level.
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