“MARKETS IN CRYPTO ASSETS” – FROM THE WILD WEST TO A SEAT AT THE TABLE

Since the invention of bitcoin in 2008, the market for cryptocurrencies has existed in a lawless vacuum, where the established financial sector has passively followed the market from the sidelines, and the disruptive cryptocurrency companies have self-regulated to form industry standards. However, this will soon change. As part of a a new digital package with the name “digital finance”, the EU Commission has presented a new financial regulation of cryptocurrencies, called “markets in crypto-assets”. This legislation is the first industry–specific regulation targeting professionals trading in cryptocurrency. This in an epoch creating piece of legislation, which will have definitive consequences for the industry as a whole. In this article we present an overview of the content of this regulation and its meaning.

This article is the first in a series of articles, which will explain the content of ”digital finance”. 

1. BACKGROUND

As part of the Commission’s strategy for strengthening the EU’s abilities in the areas of competition and innovation in the financial sector, the Commission has recently presented the ”digital finance” package. Digital finance will ensure a uniform regulation of digital markets across the member states of the EU, so that newly established fintech companies can grown and increase in scale, so the EU is prepared for the digital age and for applications such as blockchain and “distributed ledger technology”.

Digital finance contains the following three legal initiatives:

• Regulation on Markets in Crypto-assets (link).
• A pilot regime for market infrastructures based on distributed ledger-technology (link).
• Changes to the directive on markets for financial instruments after MiFID II (link).

It is noteworthy that all of these initiatives are in draft form, and we expect them to be changed before their final adoption.

This article will focus on the Regulation on Markets in Crypto-assets (abbreviated here as “MiCA”), whilst the pilot regime for market infrastructures based on distributed ledger technology and the changes to the directive on markets for financial instruments after MiFID II will be examined in independent articles on this site.

2. MICA – WHAT DOES THE LAW CONTAIN?

With the exception of the latest changes to the Money Laundering Act, which came into force in January 2020 and which cover certain professionals trading in cryptocurrency, cryptocurrency currently falls outside of financial regulations. As a consequence of this, cryptocurrency falls outside of the supervisory scope of the Danish Financial Supervisory (Finanstilsynet) and creates a legal status, where such businesses, in the worst case follow no regulations and in the best case, are self-regulating according to guidelines outside of the public authority’s sphere of influence.

MICA was developed due to the recognition that cryptocurrencies, including the price-stable “stablecoins”, will be “beneficial for the establishment of a sustainable Crypto-asset ecosystem in the EU”. Therefore, the purpose of MiCA is not to strangle the market for a newly created and potentially revolutionary technology, but instead to make it possible and support the potential that lies in cryptocurrencies, while simultaneously reducing the risks. MiCA concretely states that “small and medium-sized enterprises and start-ups should not be subject to excessive administrative burdens”.

In other words, it is the ambition of the Commission to be complicit in transforming the industry from a lawless legal vacuum to a regulated industry, which can ensure the proper conditions for future growth and innovative solutions.

The initiatives in MiCA are strongly inspired by Capital Markets legislation, especially MiFID II and prospectus legislation regarding white papers. However, these initiatives are specially designed in regards to the decentralized nature of cryptocurrencies and their special technological characteristics. Existing regulations on e.g. capital requirements, the deposit of assets, an obligatory complaint procedure for investors and investor’s rights regarding issuance are repeated in MiCA. Additionally, intensive regulation of crypto-assets with collateral will be implemented, typically regarding stablecoins, with more intensive requirements for e.g. capital, investor’s rights and supervision.

3. THREE CATEGORIES OF CRYPTO-ASSETS

It is commonly known that different types of cryptocurrencies exist today. Each cryptocurrency has certain special characteristics, which must be put to an independent legal analysis before a decision regarding the legal status of a cryptocurrency can be reached, including whether the cryptocurrency is covered by e.g. the extant financial regulations as e.g. a financial instrument after Appendix 5 in the Financial Business Act.

With MiCA, the Commission has recognized the diversity of cryptocurrencies and classifies them under three categories of cryptocurrencies, which are all together classified as “crypto-assets”.

The three categories of crypto-assets are as follows:

• Asset-referenced tokens.
• E-money tokens (or electronic money tokens).
• Other crypto-assets.

Every crypto-asset is subject to specialized regulation. The regulation that applies to asset-referenced tokens does not apply to e-money tokens and other cryptocurrencies and vice versa.

Here is an overview containing a description of the proposed regulation for each of the three categories of cryptocurrencies.

It is intended that the services covered by MiCA and which fulfil its regulatory obligations should be granted a license. The license will be introduced as a trans-national EU passport, which gives the service providers the opportunity to widen the scope of their activities to encompass all of the member states, thereby incurring the advantages of the inner market.

4. REGARDING STABLECOINS

Stablecoins – which, depending upon the securities behind them, can be described as either asset-referenced tokens or e-money tokens according to MiCA – have won a special place in the world of cryptocurrencies. Stablecoins have the special characteristics of utilizing the advantages of blockchain technology while at the same time avoiding the extreme volatility of cryptocurrencies. The combination of these two factors means that stablecoins have a genuine basis for justification. The Commission has identified this and states the following on page 2 of MiCA:

”A relatively new subset of crypto-assets – the so-called ‘stablecoins’ – has recently emerged and attracted the attention of both the public and regulators around the world. While the crypto-asset market remains modest in size and does not currently pose a threat to financial stability, this may change with the advent of ‘global stablecoins’, which seek wider adoption by incorporating features aimed at stabilising their value and by exploiting the network effects stemming from the firms promoting these assets.”

MiCA will introduce an especially intensive regulation of stablecoins, precisely because of threats to financial stability. Currently this includes both centralized stablecoins such as Tether’s USDT and Facebook’s Libra as well as decentralized stablecoins such as e.g. MakerDAO’s Dai.

Among other things, it is worth mentioning that issuers of asset-referenced tokens must be granted permission from the national financial supervisory bodies (Finanstilsynet in Denmark) prior to issuing stablecoins, unless the value of the issued stablecoins is under 5 million euros.

Additionally, MiCA introduces especially stringent rules for issuers of ”significant asset-referenced tokens”. These are defined as tokens, which can be used ”by a large number of holders and which could raise specific challenges in terms of financial stability, monetary policy transmission or monetary sovereignty.” It is noteworthy that these issuers will be entitled to preform their activities, although MiCA states that these issuers should be subject to more stringent requirements such as higher capital requirements and the establishment of a liquidity management policy.

The classification ”significant asset-referenced token” requires that a minimum of three out of five of the following requirements are fulfilled:

1. 2 million customers.
2. A market capitalisation of 1 billion EUR.
3. 500.000 transactions or transactions with a value of 100 million EUR per day.
4. Reserve assets of 1 billion EUR.
5. Used in at least 7 Member States.

Finally, it must be noted that only legal entities incorporated in a Member State in the EU will be granted permission as issuers of stablecoins. This will in practice mean that issuers of stablecoins incorporated in e.g. the USA or Asia will not be granted permission to issue stablecoins aimed at EU Member States.

MiCA does not address the decentralized nature of some crypto-assets, including whether or not regulation of decentralized issuers of crypto-asset services will be difficult, either generally or in relation to stablecoins in particular, and does not address how these challenges will be met if the regulation does prove difficult.

5. ISSUERS OF CRYPTO-ASSET SERVICES

MiCA has a large scope of application and is intended to cover the whole industry and not only the actors which either trade or issue cryptocurrency. In the future, it will only be possible for a company to deliver crypto-asset services if the company (i) has a registered office in the EU, and (ii) have been authorised as a crypto-asset service provider by the competent authority of the Member State where its registered office is located.

Crypto-asset services are defined as one of the following activities:

• The custody and administration of crypto-assets on behalf of third parties.
• The operation of a trading platform for crypto-assets.
• The exchange of crypto-assets for fiat currency that is legal tender.
• The exchange of crypto-assets for other crypto-assets.
• The execution of orders for crypto-assets on behalf of third parties.
  Placing of crypto-assets.
• The reception and transmission of orders for crypto-assets on behalf of third parties.
• Providing advice on crypto-assets.

As it can be seen, a broad definition is used, which is clearly inspired by the MiFIDs list of ”investment services”. This is to say, that one can differentiate between the practices of the competent authorities when interpreting what is meant by ”crypto-asset services”.

The regulations which the issuers of crypto-asset services must live up to have certain traits in common with the principles contained in the Financial Companies Act. Issuers of crypto-asset services must from here on out have solid management protocols, including a clear organisational structure with a well-defined, transparent and consistent distribution of responsibility, and effective procedures for identifying, managing, monitoring and reporting the risks, which issuers are or will be subject to. The management body and the shareholders of issuers of crypto-assets should have a good reputation and sufficient expertise, and be suitable, fit and proper with respect to the control and prevention of money laundering and the financing of terrorism.

Additionally, the issuers of crypto-assets should produce a business continuity policy and have effective internal control mechanisms and procedures for risk assessment, as well as have adequate systems and procedures to safeguard the security, integrity and confidentiality of information they receive. Finally, the issuers of crypto-asset services must have adequate systems for records to be kept of all crypto-asset services, orders and transactions undertaken by them, as well as systems, procedures and arrangements in place to monitor and detect potential market abuse committed by customers.

6. ISSUERS OF CRYPTO-ASSETS

In 2017 cryptocurrencies achieved sudden increases in market value, which did not seem to have upper limits. One of the driving forces behind this was the so-called initial coin offerings (ICO’s), which were a way in which companies could obtain external financing for the issuance of cryptocurrency. ICO’s became enormously popular in a short period of time, and number of projects achieved a higher value than many stock exchange listings from the same period.

Concurrent with the increase in the popularity of ICOs, the attention that the competent authorities paid to ICOs increased. Whilst ICOs were made illegal in several countries, the EBA (The European Banking Authority) decided to issue a warning regarding participation in ICOs.

The Commission is aware of the ICO’s inherent risks but also their potential. The Commission therefore states that ”by streamlining capital-raising processes and enhancing competition, issuances of crypto-assets can allow for a cheaper, less burdensome and more inclusive way of financing small and medium-sized enterprises (SMEs).”

Through MiCA, a set of rules will be adopted, which will create a balance between, on one side, consumer protection, and on the other side utilizing the potential for procuring external financing with the help of cryptocurrency. It is very realistic that technological companies in particular will procure external financing after the same principles we currently know from the stock market shortly after the adoption of MiCA.

These issuers will now be subject to the supervision of the competent national authorities and be subject to more obligations. Issuers of crypto-assets must, just like crypto-asset services, be legal entities and must be identifiable as such. This leaves open the question of how DeFi-solutions, which are solutions developed through the use of smart contracts without a central legal entity, will be treated under MiCA.

Additionally, it is a requirement that a white paper be developed for a crypto-asset. The requirements for the White Paper are also described, and prior to a crypto-asset being publically offered, it is a requirement that the competent authorities receive notification of the white paper. If the white paper lives up to the requirements in MiCA, the crypto-asset can be offered to the public without a pre-approval. However, the issuer and its management bear civil liability. In Denmark, the normal rules for compensation after Danish law will apply.

Like other areas included in MiCA, there are certain exceptions for the issuance of crypto-assets, after which the rules are not applicable. The rules for issuers are not applicable in the following situations, where the crypto-asset:

• are offered for free,
• are automatically created through mining,
• are unique and not fungible with other crypto-assets (NFT),
• are offered to fewer than 150 investors,
• have a total market value of under 1,000,000 EUR over a period of 12 months, or
• are solely offered to qualified investors.

If one of the above is fulfilled, the issuer will be subject to less stringent regulation, according to which the issuer must be established as a legal entity and fulfil the ”continuing obligations” in regards to the table above on ”other crypto-assets”.

7. WHEN WILL MICA BE IMPLEMENTED?

It is currently unknown exactly when MiCA will be applicable in the Member States, but it will presumably be in the course of 2024.

It noteworthy that MiCA has been developed as a EU regulation. This means, that MiCA will have a direct effect in the Member States as soon as it is adopted. The Member States do not have to adopt special regulations in their national law, which have the risk of eventual over-implementation. This means that the regulation will be fully harmonised between all of the EU Member States.

8. OUR EVALUATION

MiCA will undoubtedly usher in a new epoch for all who work professionally with cryptocurrency.

Within the industry, it has never been a question as to if regulation would be adopted, but rather a question of how the regulation would be formulated.

It is worth noting that MiCA does not prohibit activities related to cryptocurrency, but instead creates a clearer framework for these activities. This framework is developed as a cross between capital market regulation, stock-market regulation, the Financial Business Act and prospectus regulation – and therefore the regulation conforms to the market and to standards already known in the established financial industry – and to which the crypto-assets industry must match.

It must be pointed out that MiCA is a draft regulation, which has not yet been adopted in Parliament and the Council. We are participating in the legal preparation work, and therefore are aware that there are a number of elements in MiCA, which can be expected to be changed before the regulation is adopted.

Despite the fact that MiCA will be subject to certain changes, it is our clear expectation that the structure and the considerations behind it will remain. With other words, we can look forward to the industry being transformed into a regulated industry within a short number of years, and while the legal regulation itself will first come into force in 2024, it will see actors conform to the rules laid out in MiCA long before then.

Naturally, Samar Law is following this development closely, and we are available if you should have any questions.

This article was written by Attorney Payam Samarghandi and Junior Legal Advisor Tobias Hermansen.