The ESMA report is long awaited and covers an “Advice: Initial Coin Offerings and Crypto Assets” (Advice) plus an “Annex 1: Legal qualification of crypto assets - survey to NCAs” (Annex).
The Advice begins with a reflection on the current European Crypto Assets market by defining the Crypto Assets actors and business models. In addressing the European regulators and the National Competent Authorities (NCAs), ESMA outlines the risks and issues for consideration. Whilst ESMA acknowledges the different types of Crypto Assets (more than 2,000), it points out that based on this, there are risks to both investor protection and market integrity. Interestingly, ESMA (as well as the EBA) points out that the Crypto Assets do not represent a threat to financial stability because of their modest size in the global financial market (the 2018 Crypto Assets market cap. of USD 130 billion vs. USD 22 trillion S&P 500 market cap). However, the report highlights the economic and technical benefits of ICOs and Crypto Assets, provided relevant safeguards are in place.
With respect to the possible regulation and supervision of Crypto Assets, the Advice states that it is important first to legally define Crypto Assets. While there is no legal definition of Crypto Assets under EU law, ESMA points out that for the purposes of the regulation and supervision of Crypto Assets, it is necessary to test whether the issued or traded Crypto Assets qualify as financial instruments (unlike the EBA, ESMA is not looking at means of payments in this report). Only if this test is positive will the legal framework for the regulation and supervision of financial instruments apply to Crypto Assets. In fact, these EU financial rules (the Prospectus Directive, the Transparency Directive, MiFID II, the Market Abuse Directive, the Short Selling Regulation, the Central Securities Depositories Regulation and the Settlement Finality Directive) are likely to apply to the issuers/traders/advisors of Crypto Assets. If the test shows that the Crypto Assets do not fall under the financial instruments’ definition, no financial regulation or supervisory rules will apply. ESMA highlights the risks of such unregulated environment for consumers and is in favour of the application of Anti-Money-Laundering (AML) provisions to all Crypto Assets and related activities.
The Advice shows that even where the financial instrument test is positive (and the broad set of EU financial rules therefore apply), there are still gaps and issues for consideration by EU policymakers because of the unique characteristics of the Crypto Assets sector (eg the decentralized nature of underlying technology, risk of forks, and the custody of the underlying assets).
The report ends with a list of European jurisdictions (so far France, Liechtenstein, and Malta) which have introduced light regulation for “non-financial instruments Crypto Assets” which may apply (as some rules are structured on an opt-in regime) to their issuers and traders. Even though ESMA recognises such proactive and supportive approaches, it strongly prefers an EU-wide approach considering the cross-border nature of Crypto Assets.
ESMA’s Annex sets out the EU-wide results of the legal qualification of Crypto Assets, which is based on surveys of NCAs. By looking at six ICOs from 2018, the results show that NCAs categorise Crypto Assets as “Utility Tokens”, “Security/Investment Tokens”, and “Hybrid Tokens” (a mix of Utility, Investment/Security and Payment Token). Unlike the EBA, ESMA is not considering pure Payment Tokens, because it does not believe that such Tokens qualify as financial instruments (it is important to note that whilst the majority of NCAs might agree with this understanding, the German NCA, BaFin, considers Payment Tokens to be Units of Accounts and therefore financial instruments (see our recent elexica publication BitCoin-Trading: German Court Ruling vs. BaFin’s Understanding for a discussion of the issues arising from this).
Whilst all NCAs agreed that pure Utility Tokens do not qualify as financial instruments and are therefore not regulated, the European regulators believe that Security/Investment Tokens generally qualify as financial instruments (but not necessarily as Securities under MiFID II). For the majority of NCAS, Investment/Security Tokens would qualify as financial instruments once they represent profit rights, without having necessarily ownership or governance rights attached.
Most of the NCAs consider that there is no need to qualify all Crypto Assets as financial instruments. They agree that a case-by-case evaluation of the Crypto Assets business is needed to determine whether financial rules should apply. Nevertheless, they believe that all Crypto Assets business should be subject to some form of (light) regulation.
Whilst ESMA limits its report generally to the primary Crypto Assets market (eg ICOs), the EBA report (entitled Report with advice for the European Commission) provides an overall approach also focusing on the secondary market (eg crypto exchanges). The results of the EBA and ESMA reports do not diverge. In fact, the results of the application of the current EU financial services law to Crypto Assets are the same. However, the ESMA report also considers pure Payment Tokens and the application of the EU payment services legal framework.
Overall, the EBA report shows that Crypto Assets fall outside the scope of EU financial services regulation. The EBA has identified only a few cases in which Crypto Assets may qualify as electronic money. These results give rise to potential issues, including regarding consumer protection, operational resilience and market integrity. The report sets out actions which the EBA will take to enhance monitoring in relation to financial institutions’ crypto-asset activities, including with regard to consumer-facing disclosure practices.
With respect to AML and Combating-the-Finance-of-Terrorism (CFT) in the Crypto Assets market, the EBA supports the latest FATF recommendations (which are in line with the G20 commitments) and acknowledges the upcoming AML Directive 5 rules (introducing AML/CFT obligations for Virtual Currency traders). However, the EBA believes that there is a need for greater AML and CFT coverage for (i) providers of exchange services between crypto-assets and crypto-assets; and (ii) providers of financial services for ICOs.
Both reports provide guidance to the market and advice to relevant policymakers. ESMA and the EBA recommend further analysis to determine what is needed at the EU level to address the identified Crypto Asset issues, specifically with regard to the opportunities and risks presented by Crypto Assets activities and new technologies that may involve the use of Crypto Assets. By limiting its report to ICOs solely, ESMA declined to set out its views on the secondary Crypto Assets market. The upcoming EU Blockchain studies might bring more regulatory guidance on the secondary Crypto Assets market.
It will be interesting to see how the Crypto Assets market actors and the NCAs react to these reports. We have already seen Crypto Asset market players using the different jurisdictional application of EU financial rules on ICOs as a playing field for regulatory arbitrage. As we witness a new era of STOs, Crypto Funds and Blockchain-technology-based financial services (eg custodian services), it will be important to anticipate how policymakers and NCAs may react.
This document (and any information accessed through links in this document) is provided for information purposes only and does not constitute legal advice. Professional legal advice should be obtained before taking or refraining from any action as a result of the contents of this document.