What has happened?
The European Securities and Markets Authority (ESMA) has published a report on cryptoassets and initial coin offerings (ICOs), clarifying existing rules for cryptoassets that qualify as financial instruments and setting any regulatory gaps and issues that EU policymakers should consider.
What does this mean?
In its Advice to the European (EU) Institutions, ESMA noted that the legal status of cryptoassets is a key consideration for regulators, as this determines whether financial services rules apply and, if so, the level of protection for investors.
ESMA's report follows a request by the European Commission in its 2018 FinTech Action plan for all European Supervisory Authorities, of which ESMA is one, to assess the suitability of the EU regulatory framework in respect of ICOs and cryptoassets.
Another of the European Supervisory Authorities, the European Banking Authority (EBA), recently published the results of its own assessment of the applicability and suitability of EU law to cryptoassets.
To better understand when cryptoassets qualify as financial instruments, ESMA has been working with national competent authorities (NCAs) on analysing the different business models of cryptoassets (such as investment-, utility-, hybrid- or payment-type cryptoassets) as well as the risks and potential benefits they may introduce and how they fit within the existing regulatory framework.
This exercise showed that most NCAs consider that certain cryptoassets can qualify as transferable securities or other types of MiFID II financial instruments.
However, while transposing MiFID II into national laws, many NCAs defined the term "financial instruments" differently, some using a restrictive list of examples and others broader interpretations.
"This creates challenges to both the regulation and to the supervision of cryptoassets," ESMA said.
In its report, the regulator identified a number of concerns in the current financial regulatory framework, which broadly fall into two categories.
Cryptoassets that qualify as MiFID financial instruments
For cryptoassets that qualify as transferable securities and MiFID financial instruments, many EU financial rules already apply, such as the Prospectus Directive, MiFID II, the Market Abuse Directive or the Transparency Directive.
However, ESMA said there are a number of "gaps and issues" in the existing regulatory framework when applied to cryptoassets "that leave certain risks unaddressed or that may not be adapted to [distributed ledger technology]".
ESMA believes these issues should be considered and potentially addressed by the European Commission, including:
- Greater clarity is needed around the types of services/activities that may qualify as custody/safekeeping services/activities under EU financial services rules in a DLT framework.
- Greater certainty is needed around the concepts of settlement and settlement finality applied to cryptoassets.
- Some risks specific to the underlying technology may need new/enhanced requirements.
Cryptoassets that do not qualify as MiFID financial instruments
Even though, according to ESMA, the size of the crypto market is still small and it does not currently raise financial stability issues, it still had concerns about the risks posed to investor protection and market integrity.
The report said:
"Where cryptoassets do not qualify as MiFID financial instruments and unless they qualify as electronic money, they are likely to fall outside of the existing EU financial services rules, in which case investors will not benefit from the safeguards that these rules provide."
Further, investors will not find it easy to distinguish between those cryptoassets that are within the scope of EU financial rules and those that are not, especially if they are offered on the same platforms.
Against this background, the regulator foresees two options: implementing a bespoke regime for specific types of cryptoassets or doing nothing, with ESMA recommending the first option is followed.
The report said:
"EU policymakers could consider the opportunity to set up a bespoke regime for those cryptoassets that do not qualify as financial instruments. Such a bespoke regime… would allow tailoring the rules to the specific risks and issues posed by those cryptoassets."
ESMA also believes that anti-money laundering (AML) rules should apply to all activities involving cryptoassets, in line with the recommendations in the EBA report on cryptoassets that came out on the same day as ESMA's report.
The regulator therefore called on EU policymakers to review AML requirements, including with regard to providers of crypto-to-crypto exchange services providers and providers of financial services for ICOs.
In addition, they should also consider the need for appropriate risk disclosure requirements to be in place.
Finally, the report noted that wider regulation may have slightly unintended consequences, such as "risking legitimising cryptoassets and encouraging wider adoption".
"Therefore, at this stage, ESMA advises to focus the regime for cryptoassets that are not financial instruments on warning buyers about the risks of those cryptoassets, instead of a more elaborate regime that could legitimise cryptoassets and bring them into a similar regulatory remit as the one for cryptoassets that are financial instruments," the report said.
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