Since the invention of bitcoin in 2008, the cryptocurrency market has been in a lawless vacuum, with the established financial sector passively watching from the sidelines and the disruptive cryptocurrency companies self-regulating by industry standards. But that's about to change. As part of a new digital package called "digital finance", the European Commission has unveiled a new financial regulation of cryptocurrencies, called "crypto-asset markets". The legislation is the first industry-specific regulation targeting cryptocurrency traders. It is a positively epoch-making move that will have a significant impact on the industry as a whole. In this article, we provide an overview of the content and significance of the regulation.
This article is the first in a series of three articles that will explain the content of "digital finance".
As part of the Commission's strategy to strengthen EU competitiveness and innovation in the financial sector, the Commission has recently presented the Digital Finance package. Digital finance will ensure uniform regulation of digital markets across EU member states so that fintech start-ups can scale up and grow, and the EU is equipped for the digital age and applications such as blockchain and distributed ledger technology.
Digital Finance specifically includes the following three legislative initiatives:
For the record, we note that all initiatives are drafts that we expect to change before final adoption.
This article will focus on the regulation on markets in crypto-assets (abbreviated here as "MiCA"), while the initiatives pilot scheme on market infrastructure based on distributed ledger technology and amendment of the Markets in Financial Instruments Directive following MiFID II will be covered in separate articles later on this page.
In addition to the recent amendment to the Money Laundering Act in January 2020, which covers certain cryptocurrency traders, cryptocurrencies currently fall outside the scope of financial regulation. This has the consequence that cryptocurrencies fall outside the supervisory area of, for example, the Danish FSA and creates a legal situation where traders at worst do not follow any regulation and at best are self-regulating according to guidelines that are beyond the influence of the authorities.
MiCA has been drafted in recognition that cryptocurrencies, and in particular the price-stable stablecoins, will be "beneficial for the establishment of a sustainable crypto-asset ecosystem in the Union." The purpose of MiCA is therefore not to stifle the market for a newfound and potentially revolutionary technology before it has gained ground in the established financial market, but instead to enable and support the potential of cryptocurrencies while reducing the risks. Specifically, MiCA states that "small and medium-sized enterprises and start-ups should not be subject to disproportionate administrative burdens."
In other words, the Commission wants to help transform the industry from a lawless legal vacuum to a regulated industry to ensure the right conditions for future growth and innovative solutions.
The measures in MiCA are strongly inspired by capital market law, especially MiFID II and prospectus law regarding whitepapers, however, these are designed specifically for the decentralized nature and technological peculiarities of cryptocurrencies. Existing regulation on, for example, capital requirements, deposit of assets, a mandatory complaints procedure available to investors, and investor rights in relation to the issuer are thus repeated in MiCA. In addition, intensive regulation of collateralized crypto-assets, typically stablecoins, will be introduced, with stricter requirements on capital, investor rights and supervision.
It is common knowledge that there are different types of cryptocurrencies today. Each cryptocurrency thus has unique characteristics that must undergo an independent legal analysis before the legal status of the cryptocurrency can be concluded, including whether the cryptocurrency is covered by the existing financial regulation as, for example, a financial instrument under Appendix 5 of the Danish Financial Business Act.
With MiCA, the Commission has recognized the diversity of cryptocurrencies and introduces three different types of cryptocurrencies, all included under the collective term "crypto-assets".
These are the following three crypto-assets:
Each crypto-asset is subject to its own independent regulation. The regulation that applies to asset-based tokens does not apply to e-money tokens and other crypto-assets and vice versa.
Below is an overview describing the intended regulation for each of the three forms of cryptocurrency.
ASSET-BASED TOKENS
E-MONEY TOKENS
OTHER CRYPTO ASSETS
Stablecoins - which, depending on the underlying collateral, are either referred to as asset-based tokens or e-money tokens in MiCA - have gained particular traction in the crypto world. Stablecoins are particularly characterized by leveraging the benefits of blockchain technology while avoiding the extreme volatility of cryptocurrencies. The combination of the two means that stablecoins have a real public good justification. The Commission has identified this and states, among other things, the following on page 2 of the MiCA:
"A relatively new subset of crypto-assets has recently emerged - the so-called "stablecoins", and they have attracted the attention of both the public and regulators around the world. Although the crypto asset market remains modest in size and does not currently pose a threat to financial stability, this could change with the new "global stablecoins" seeking to gain wider acceptance by incorporating elements aimed at stabilizing their value and by leveraging the network effects stemming from the companies that promote these assets."
Precisely because of the threat to financial stability, MiCA will introduce particularly intensive regulation of stablecoins. These include both centralized stablecoins such as Tether's USDT and Facebook's libra as well as decentralized stablecoins such as MakerDAO's Dai.
Among other things, it can be stated that issuers of asset-based tokens must obtain authorization from the national financial supervisory authority (Finanstilsynet in Denmark) before they can issue stablecoins, unless the outstanding amount in stablecoins is less than 5 million euros.
In addition, MiCA introduces particularly strict rules for issuers of "significant asset-based tokens". These are characterized by the fact that they can be used "by a large number of holders and [may] give rise to particular challenges with regard to financial stability, monetary policy transmission or monetary sovereignty." It is noteworthy that these issuers will be eligible to carry out their activities, however, MiCA notes that they should be subject to stricter requirements such as higher capital requirements and interoperability requirements and that they adopt a liquidity management policy.
It is a "significant asset-based token" if it meets at least three of these five requirements:
Finally, it should be noted that only legal entities based in the EU seeking authorization as issuers of stablecoins will be granted authorization. In practice, this means that issuers of stablecoins based in, for example, the US or Asia will not be authorized to issue stablecoins targeted at EU member states.
MiCA does not address the decentralized nature of some cryptoassets, including whether the regulation will face challenges in regulating decentralized cryptoasset service providers in general and stablecoins specifically, and if so, how these challenges will be addressed.
The scope of MiCA is broad and aims to cover the entire industry and not just those who either trade or provide cryptocurrency. Going forward, crypto-asset services can only be provided by companies that (i) are based in the EU and (ii) are authorized as a crypto-asset service provider by the relevant supervisory authority.
Crypto-asset services are defined as one of the following activities:
As can be seen, this is a very broad scope that is clearly inspired by the MiFID list of "investment services". This also means that the authorities' practice regarding this can probably be referred to when interpreting "crypto-asset services".
The regulation that providers of crypto-asset services must comply with has some common features with the principles of the Financial Business Act. Thus, crypto-asset service providers must now have robust governance arrangements, including a clear organizational structure with a well-defined, transparent and consistent division of responsibilities and effective procedures to identify, manage, monitor and report the risks to which they are or will be exposed. The management body and capital owners of crypto-asset service providers should be of good repute and sufficient expertise and be 'fit and proper' with regard to anti-money laundering and combating terrorist financing.
In addition, crypto-asset service providers must establish a business continuity plan and have well-functioning internal control and risk assessment mechanisms and adequate systems and procedures to ensure the integrity and confidentiality of the information they receive. Finally, crypto-asset service providers must have adequate arrangements for recording all transactions, orders and services related to crypto-assets that they provide and have systems in place to detect potential market abuse by customers.
In 2017 in particular, cryptocurrencies experienced sudden price increases that seemed to have no upper limit. One of the drivers behind this was the so-called initial coin offerings (ICOs), a way for companies to obtain external funding in exchange for issuing a cryptocurrency. ICOs became hugely popular in a short time and a number of projects achieved a higher value than several IPOs made during the same period.
As the popularity of ICOs grew, so did the authorities' attention to them, and while ICOs were made illegal in several countries, the EBA (European Banking Authority) decided to issue a warning about participation in ICOs.
The Commission is aware of the inherent risk but also the potential of ICOs. Thus, the Commission states that "streamlining the supply of capital and enhancing competition for crypto-asset issuance could open up opportunities for a cheaper, less burdensome and more inclusive way of financing small and medium-sized enterprises ("SMEs")."
MiCA thus adopts a set of rules that balances between consumer protection on the one hand and, on the other hand, the exploitation of the potential of raising debt capital using cryptocurrency. It is highly realistic that, shortly after the adoption of MiCA, technology companies in particular will raise external capital through regulated issuance of cryptocurrency according to the same principles as we know from stock exchange law today.
These issuances will now be supervised by relevant national competent authorities and be subject to several obligations. Crypto-asset issuers, like crypto-asset services, must be legal entities and thus must be identifiable. This leaves open the question of how DeFi solutions, which are solutions developed through smart contracts without a central legal entity, will be handled under MiCA.
In addition, it is a requirement that a white paper is prepared for the crypto-asset. The requirements for the white paper are also listed, and before a crypto-asset can be offered to the public, it is a condition that the relevant authorities are notified of the white paper. If the white paper meets the requirements of MiCA, the crypto-asset can be offered to the public without prior approval, but civil liability for the issuer and its management applies. In Denmark, the general rules of Danish law on damages will apply.
As in other areas of MiCA, there are also certain exceptions for the issuance of crypto-assets where the rules will not apply. It follows that the rules for issuances do not apply in cases where the crypto-assets:
If one of the above is met, the issuer will fall under a more relaxed regulation, whereby the issuer must be established as a legal entity and fulfill the "ongoing obligations" according to the above table on "other crypto-assets".
It is not yet known when exactly MiCA will take effect in the Member States, but it will probably be during 2024.
It should be noted that MiCA is drafted as a regulation. This means that MiCA takes direct effect in the Member States as soon as it is adopted. This means that each Member State does not have to independently adopt the legislation into national law with the risk of possible over-implementation. This means that the regulation is fully harmonized across all EU Member States.
MiCA will undoubtedly be a game-changer for anyone dealing professionally with cryptocurrency.
For the industry, it has never been a question of whether a regulation would be passed in this area. Rather, the question has been how the regulation would be implemented.
It is noteworthy that MiCA does not prohibit activities related to cryptocurrencies, but rather creates a clear framework for the activities. The framework is developed at the intersection of capital market law, stock exchange law, the Financial Business Act and prospectus law, and is thus a market-compliant regulation that is already known to the established financial industry and which the crypto-asset industry must now align with.
It must be emphasized that this is still a draft that has yet to be adopted by the Parliament and the Council. We are participating in the preparatory work, through which we are already aware that there are several elements of MiCA that are likely to be amended.
While the content of MiCA will undergo some changes, it is our clear expectation that the structure and considerations behind it will remain. In other words, within a short number of years we can look forward to the industry being transformed into a regulated industry, and while the legislation itself will probably not come into effect until 2024, we will probably see players adapt to the rules of MiCA long before then.
Samar Law is of course following the development closely, and we are of course available if you have any questions.
.svg){kind=icon}
