The European Banking Authority (EBA) and more recently its sister European Supervisory Authorities (ESAs), the European Securities and Markets Authority (ESMA), as well as the European Insurance and Occupational Pensions Authority (EIOPA) have used 2018 to accelerate their further policymaking or delivery of actions that flow from various “FinTech Action Plans1 as well as their multi-annual supervisory priorities.2 Establishing a comprehensive regulatory framework for initial coin offerings (ICOs), Token Generating Events (TGEs) and, more widely, activity relating to crypto-assets in general has been central to the activity of the European Commission and each of the three European Supervisory Authorities (ESAs).
On January 9, 2019 the EBA published its “Report with advice for the European Commission on crypto-assets” (the EBA’s 2019 Report),.3 considering the applicability of the second E-Money Directive, the second Payment Services Directive to crypto-assets, crypto-asset custodian wallet provision and, to a lesser degree, crypto-asset trading. On the same date ESMA published its formal advice on ICOs and crypto-assets4 (ESMA’s 2019 Advice),5 which broadly covers the “rest” of the financial markets space —excluding pensions and insurance—which are in EIOPA’s sphere. At the time of writing, EIOPA has yet to publish its own response to the European Commission’s request to the ESAs pursuant to its FinTech Action Plan. In general, the EBA’s response is less proactive than ESMA in the need to redress the current gaps across the EU’s financial services regulatory regime and more generally the absence or fragmented nature of the treatment of crypto-assets that are not within the EU’s financial services “regulatory perimeter.” Importantly, both the EBA and ESMA agree on differentiating treatment of crypto-assets depending on whether it qualifies (or ought to be deemed to qualify) as a “financial instrument” and be in the EU’s existing regulatory perimeter or, if not, then be outside the perimeter. That outside perimeter itself may get its own EU-wide regime.
This Client Alert assesses the key policy recommendations that the EBA and ESMA have now presented back to the European Commission urging them to implement a comprehensive regulatory framework. This Client Alert should also be read in conjunction with our standalone coverage on the ESA’s Joint Report on Regulatory Sandboxes and Innovation Hubs6 as well as coverage on new powers for the ESAs in respect of anti-money laundering given the extension of much of the existing framework to crypto-assets and digital wallet providers7.
Supervisory outcomes of the ESA’s review
Both ESMA and the EBA’s supervisory focus is on the investor protection and market integrity issues relating to ICOs and crypto-assets rather than, as a result of the market’s modest size, the financial stability implications. Both ESAs argue that if appropriate safeguards are put in place, then the ICO as a fundraising process or the increased mobilization of traditional assets through the tokenization process could be advantageous. Some of those safeguards build off ESMA’s review of how National Competent Authorities (NCAs) of EU Member States (except Poland) and including Liechtenstein as well as Norway categorize a sample set of six ICO crypto-assets8. Part of that survey is to assess whether and how crypto-assets can be treated as “transferrable securities” or other forms of “financial instruments” for the purposes of MiFID II. The EBA’s 2019 Report also confirms it has been actively monitoring developments without pointing to specific published results for 2018 but does communicate that in 2019 it will step up its monitoring of actors in the sector and their compliance with existing EU rules, possibly including those firms that are outside the scope of EU rules and well outside its current institutional mandate.
ESMA’s survey also determined that there are supervisory convergence measures that will need to be taken—remedy situations where some Member States have defined the term “financial instrument” differently. Similar measures invariably will be required to ensure that going forward NCAs do not define the same crypto-asset in a different manner. The results of the survey are in their own right insightful on how NCAs vary in their approach; over time we expect these differences to subside for a number of reasons, including those explored below.
ESMA and the EBA consider that for those crypto-assets that can qualify or are deemed to qualify as a “financial instrument” within the meaning of the existing “traditional” EU financial regulatory regime, then that regime should apply to those instruments. For any crypto-assets that fall outside the existing financial regime and for which there is a wide and varying degree of rather fragmented legal standards at the national and EU level, ESMA and the EBA consider two options: either Option B – to do no nothing and keep the status quo or Option A – to implement an ad-hoc legal for crypto-assets that do not qualify as financial instruments in the form of a standalone EU-wide “crypto-asset specific” (CAS) regulatory regime. Appendix 5 to ESMA’s 2019 Advice looks at efforts in France, Liechtenstein and Malta in terms of creating specific regimes for crypto-assets that the existing EU framework does not cover. This legal regime would aim to be flexible and adapt the risks and specific problems present in this type of crypto-asset. The EBA also notes that there is a need to clarify the appropriate accounting treatment of crypto-assets – and not just for prudential regulatory treatment purposes.
In short, change is coming to crypto-assets not only for those that can be captured by the existing EU concept of a financial instrument and brought into the regulatory perimeter, but for the wide variety of instruments that are outside the financial sector scope and might be subject to this new CAS regime. What a future EU-wide CAS regime might look like and how it would interoperate with national laws, or whether a financial instrument could fall into CAS or be upgraded etc., as well as, perhaps more generally whether it might be preferential for issuance instead to be in the financial sector regime remains to be seen, as these pertinent questions are not addressed by the EBA nor ESMA. However, what is certain is that the ESAs may continue to step up supervisory scrutiny regarding how crypto-assets are offered to EU domiciled investors regardless of into what regime a crypto-asset may ultimately fall. This means that issuers from outside of the EU will need to take note of these new developments if there is a nexus to the EU plus EEA Member States.
EBA’s and ESMA’s policy advice… if it looks like a financial instrument…
ESMA’s survey of NCAs confirmed general support for a CAS regime (subject to cost reservations) and that for those that are capable of being treated as financial instruments, they should be in scope and required to comply with existing EU financial services regulatory requirements.
ESMA’s 2019 Advice also spends some time differentiating between types of crypto-assets—often departing from classifications used by the Financial Stability Board’s own policy efforts9 such as eschewing the international usage of “security token” and referring to it as an “investment-type crypto-asset.” “Utility-type crypto-assets” equate to “utility tokens” and correspondingly “payment-type crypto assets broadly correspond to “payment tokens.” While the Glossary in Appendix 1 of ESMA’s 2019 Report may be welcome, the divergence from terminology used by international standard setters may be less so. What is more frustrating is that the EBA’s 2019 Report does not use the same taxonomy as that of ESMA and does not update its own “Glossary for Financial Innovation.”10 What the EBA’s contribution does do quite well is focus on consumer protection elements that ESMA does not pick up on, including the fact that crypto-asset trading platforms (what most will call “exchanges”) and custodian wallet providers (what most will call “digital wallets”) are currently not, partly due but also irrespective of crypto-assets’ qualification (or lack thereof) as financial instruments, beyond the regulatory perimeter, and thus they are not subject to conduct of business and disclosure obligations, do not conduct suitability assessments, do not segregate asset holdings, nor are users able to benefit from compensation schemes or clear rules on liability. Other areas such as crypto-to-crypto or crypto-to-fiat lending11 or peer-to-peer exchange of cryptocurrenices (also known as “atomic swaps”) are not even addressed by ESMA or the EBA—nor are the risks and opportunities of cross-chain interoperability of distributed ledger systems. The same is true in the lack of consideration given to coin ranking sites—which perform conceptually similar services to say a credit rating agency.
While it is certainly welcome that ESMA proposes to tackle the wide nature of types of crypto-assets and their risk profiles by establishing a common standard of definitions and concepts, the Commission will probably need to step in or task one of the ESAs or a third-party to draw up that definitive list in a manner that is “institutional, jurisdiction, sector and technology agnostic.” Even if a list is put in place, ESMA’s statements are noteworthy in that each individual issuance’s attributes will need to be reviewed on its merits as to whether it falls within the existing regulatory regime across the EU. As ESMA’s 2019 Advice does not commit to establishing what that harmonized process could like it remains to be seen whether, ESMA, working with the ESAs, would establish a set of principles on how to determine when an issuance is a “utility-type crypto-asset” that thus s outside the financial services regulatory perimeter.
ESMA warns that with continued evolution of markets, as well as the blurring of boundaries, notably in situations where traditional financial instruments being traded and/or settled on digital ledger technology, prove tricky. So too does the need to ensure that investors are sufficiently warned and cognizant of the risks involved in investing into an ICO or otherwise using crypto-assets, especially since most investments come from retail clients’ savings and/or to a lesser degree from lending channels.
As in previous warnings from ESMA or the EBA, most recently in February 2018, ESMA’s 2019 Advice reconfirms that if a crypto-asset qualifies as a financial instrument for the purposes of MiFID II, then the crypto-asset and various events triggering regulatory compliance obligations would need to be observed as with “traditional” financial instruments. Where for example existing rules contain obligations with which crypto-assets are required to comply, such as an ICO taking place where the transaction and instruments are considered equivalent to equity securities, and the initial public offering process the requirement to publish a Prospectus would apply as if the ICO issuer were an issuer of equity securities. Where these rules require information that is conceptually irreconcilable with crypto-asset, ESMA’s 2019 Advice introduces a concept of NCAs seeking “adapted information” thus providing a reasonable scope for flexibility. From a practical perspective, we imagine this would mean that those compiling such information would need to explain the degree of and grounds for such adaption.
ESMA’s 2019 Advice also focuses on how crypto-asset trading platforms might be treated within the EU’s existing MiFID II/MiFIR framework if they operate in a manner that would quality them either as a Multilateral Trading Facility (MTF) or Organized Trading Facility (OTF). ESMA sets out that where crypto-assets qualify as a financial instrument and a platform operates a central order book and/or matching orders then they are likely to qualify as a Regulated Market, MTF or OTF under MiFID II. Where operators deal on own account and executed client orders against proprietary capital, they instead ought to be treated as MiFID investment firms i.e. broker/dealers. In keeping with the current EU regulatory concepts, platforms that merely advertise buying and selling interests and where there is no trade execution or arranging taking place are considered to be “bulletin boards” and thus, on those grounds, outside the scope of MiFID II/MiFIR. While ESMA’s 2019 Advice may restate existing EU regulatory concepts—the fact that it considers how it would apply these in its approach to platform operators contributes to greater certainty.
Upgrading to the current framework?
ESMA’s advice concludes on most of the existing EU regulatory framework having been designed and delivered prior to the emergence of crypto-assets. ESMA recommends that certain pre-digital financial services concepts are revisited and perhaps “adapted with updates.” This includes assessing the current concepts around “settlement,” “settlement-finality,” the types of services and activities that may qualify as “custody/safekeeping service,” in particular having control over private key of clients as that could fall within the regulatory perimeter and trigger obligations12. ESMA also states that it considers the need for further clarity on the role of miners in the settlement process, as well as differentiating between digital ledger systems and whether they are permissioned or permissionless. It also extends to how the concept of reconciliation in the EU’s Central Securities Depositor Regulation may be extended and adapted to crypto-assets.
Both ESMA and EBA recognize that there are a number of gaps in conceptual translation and equivalence that would need to be plugged with legislative policymaking or clarification instruments, and this might require revisiting existing concepts or technical formats. Some of that exercise may have positive spillover effects, and in other areas the approach may be better served by using Q&A and other similar tools to adapt the existing traditional regime in a particular manner. By contrast, establishing the CAS regime, where both ESMA and the EBA imagine the far greater share of crypto-assets are likely to qualify, is likely to occur but may take time to deliver against what is a very busy legislative schedule at the EU and national level.
For market participants, regardless of whether they are issuer, investor or potential user of digital ledger technology, the European Commission’s commitment to advancing a CAS regime may mean that it looks to take the best of existing national regimes, not only in the interests of speed, but the fact that this is easier to implement as an EU-wide “jurisdiction and technology-agnostic” tool to harmonize law in this rapidly evolving area. Moreover, this might allow a greater degree of certainty in respect of new and existing issuance – NB none of the proposals made by ESMA or the EBA propose a phased application or grandfathering regime for existing issuances in circulation.
Outlook and next steps
Regardless of whether a crypto-asset is likely to qualify under the EU’s existing or adapted financial services regime or under its proposed CAS framework, those involved—whether as issuers, intermediaries or investors—may want to take preparatory action. This is recommended even where ESMA and EBA have presented calls (ESMA more fervently than EBA) for regulatory reform to the European Commission that could have benefitted from greater coordination and cross-institutional consistency between the two ESAs but also from the work of international standard setters, especially given the EBA’s efforts in its FinTech Knowledge Hub13.
With the identified shortcomings, the European Commission is now under pressure to act. It cannot afford inaction or just further consultation. This is driven not only by a need to improve standards in what has been termed a “wild market” but also to ensure that certain NCAs do not underpin the Commission’s overall aims to create a level playing field, which in turn is part of the continued efforts to finalize a more “single” Single Market for financial services built upon a Single Rulebook, with possible crypto-asset specific adaptations along with a new CAS regime. Moreover, the Commission needs to act confidently as competition is heating up amongst EU Member States vying to attract crypto-asset activity and revenue. With various EU NCAs, including the UK’s own efforts pushing ahead quite substantive proposals for rules that will have transformative effects on the crypto landscape and the token economy, the race to see who can forward-proof faster is certainly on at the national level but also at the EU level that will sit above national efforts.
For market participants, part of that preparatory action might include working together with counsel and structuring stakeholders to map not only how an existing or planned issuance may be treated but also how to forward-plan structuring components for this new regime when it comes. Moreover, we anticipate that the Commission could also decide to task non-financial supervisory bodies (which might have a comparably more manageable workload and resourcing), such as the Blockchain Observatory, to coordinate more fully, especially when it comes to proposing a CAS framework.