The European Securities and Markets Authority (hereinafter, "ESMA") has published on January 9, 2019 an Advice on ICOs and crypto-assets in order to clarify the existing legal regime applicable to crypto-assets that qualify as financial instruments.
After analyzing the different business models of crypto-assets, the risks, potential benefits and how they fit within the existing regulatory framework, ESMA has detected various problems related to the applicable regulatory framework. In this respect, ESMA differentiates between crypto-assets that qualify as financial instruments in accordance with the Directive 2014/65/EU of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments (hereinafter, "MIFID II") and crypto-assets that do not qualify as financial instruments.
Regarding the first category, ESMA highlights the existence of diverse regulatory requirements which should be reconsidered in order to allow an effective application of the existing legal regime. Regarding the second one, ESMA warns against the absence of an applicable legal regime and the potential risks that they imply for investors. In particular, ESMA notes that, at least, the requirements related to the prevention of money laundering should be applicable to all crypto-assets – whether or not they are qualified as financial instruments - and all activities in which they are involved.
ESMA's Advice includes the following interesting points:
Regulatory implications related to the crypto-assets that qualify as financial instruments
ESMA analyses the legal provisions that can be potentially applied to crypto-assets that qualify as financial instruments. In particular:
- Directive (EU) 2018/843 of the European Parliament and of the Council of 30 May 2018 on the prevention of the use of the financial system for the purposes of money laundering or terrorist financing.
- MiFID II Directive.
- Directive 2013/50/EU of the European Parliament and of the Council of 22 October 2013 on the harmonisation of transparency requirements in relation to information about issuers whose securities are admitted to trading on a regulated market.
- Directive 2011/61/EU of the European Parliament and of the Council of 8 June 2011 on Alternative Investment Fund Managers.
- Directive 2009/44/EC of the European Parliament and of the Council of 6 May 2009 amending Directive 98/26/EC on settlement finality in payment and securities settlement systems and Directive 2002/47/EC on financial collateral arrangements with regards to linked systems and credit claims.
- Directive 97/9/EC of the European Parliament and of the Council of 3 March 1997 on investor-compensation schemes.
- Regulation (EU) 2017/1129 of the European Parliament and of the Council of 14 June 2017 on the prospectus to be published when securities are offered to the public or admitted to trading on a regulated market, and repealing Directive 2003/71/ECText with EEA relevance.
- Regulation (EU) No 596/2014 of the European Parliament and of the Council of 16 April 2014 on market abuse.
- Regulation (EU) No 600/2014 of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments.
- Regulation (EU) No 909/2014 of the European Parliament and of the Council of 23 July 2014 on improving securities settlement in the European Union and on central securities depositories.
Potential issues related to the crypto-assets that qualify as financial instruments
As the EU's existing regulatory framework was not created with crypto-assets in mind, the national authorities with competencies in securities markets are now facing a new challenge: interpreting the existing requirements, which may not apply consistently across Member States, and trying to avoid regulatory arbitrage.
First, ESMA considers greater clarity about the types of services and activities that may be defined as "custody/safekeeping services" under the EU financial regulation. In ESMA's opinion, having control of private keys on behalf of the clients could be considered equivalent to custody/safekeeping activities and, therefore, the existing requirements should apply to those who provide these services. In the meanwhile, some technical changes on requirements are needed in order to provide clarity on their interpretation.
Second, ESMA considers need for greater clarity concerning the concepts of "settlement" and "settlement finality" when applied to crypto-assets. In particular, ESMA considers that there should be a distinction between those DLT considered "permissioned" and those considered "permissionless". This said ESMA has identified some governance issues within permissionless DLTs, making them less suitable to the processing of financial instruments. Another related issue ESMA has identified is the role of the "miners" as, given their novel and fundamental role in the settlement process, it is still unknown how they will be treated under the existing legislation.
Third, the ESMA has identified specific risks in the underlying technology, which may need an update in the requirements. ESMA believes that protocol and intelligent contracts that support encryption activities should be guaranteed somehow, in order to comply with the minimum reliability and security requirements. In addition, we must take into account new cybersecurity responses, including hacking risks, in order to assess if they are appropriately addressed by the existing set of rules.
This said, many of these issues would require Level 1 measures, which would be complemented by Level 2 technical standards and Level 3 measures adopted by ESMA.
Other issues that ESMA is concerned about are:
- The existing lack of clarity when applying the existing rules to the decentralized and hybrid models that use smart contracts to match orders and to conclude transactions;
- The necessity of carrying out some amendments to the pre- and to the post-trade transparency requirements that apply to venues trading crypto-assets, as the current requirements were established taking into account traditional financial instruments;
- The possibility that affected market participants will not be able to comply with all the necessary data requirements before the respective Regulatory Technical Standards (e.g. transaction reporting, instrument reference data...);
- The fact that the current reporting regimes rely on common identifiers such as ISO 6166 ISIN code, which have not been adapted to the new developments in the crypto-asset domain; and
- The necessity of further analysis on the interaction between crypto-assets that are qualified as financial instruments and other financial instruments in order to determine if there are some gaps with respect to MAR (Market Abuse Regulation) and SSR (Short Selling Regulation).
Potential issues related to the cryto-assets that do not qualify as financial instruments
ESMA warns that a very small volume of currently issued crypto-assets are likely to qualify as financial instruments under the MiFID II Directive. In relation to this type of crypto-assets, ESMA is aware that some Member States are considering the implementation of legal regimes which could be applicable. Nevertheless, ESMA is concerned about the inexistence of a harmonized legal regime.
In view of this situation, ESMA proposes two options:
- Option A: Implementing an "ad hoc" legal regime for the crypto-assets that do not qualify as financial instruments. This legal regime would adapt the risks and specific problems of this type of crypto-assets. In particular, ESMA notes that the proposed legal regime should be flexible enough in order to cover the wide variety of features and risk factors of these crypto-assets.
- Option B: Do nothing. ESMA believes that this option does not resolve the problems resulting of the protection of the investor and market integrity. In opinion of ESMA, Option A is the most appropriate.
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