It is increasingly becoming a certainty that crypto-assets are here to stay. Also regulators are now more convinced that these will be here for the long run. Long time taken a wait-and-see attitude, there is growing consensus at European regulators to come up  with EU-wide regulation. While on the one hand EU regulation could give the crypto market legitimation and encourage the adoption of crypto-assets. Doing nothing could endanger both investors and financial markets.

Question is however: how should this regulation be shaped taken account the various specifics of crypto-assets and its users.  And to what extent may the EU intervene on existing local member state regulation. Early this month, both the ESMA and EBA published their advice to the relevant EU institutions.

So let’s have a deeper dive.

What are crypto-assets (not)?

What makes shaping regulation for crypto-assets so difficult is that these are a unique phenomenon when compared to conventional financial instruments. According to Oliver Wyman  they are governed by “a fundamentally different set of constraints, and as a consequence regulators have to take into account these specifics”.

First of all crypto-assets are not tied to national governments and central banks. No government regulation or guidance currently exists around managing crypto-assets. Most crypto-assets are not based within any one specific jurisdiction.

Second, the crypto-asset environment is not bound to one country. There is no single sovereign state that is responsible for regulatory oversight at all times. This will make it difficult to apply traditional regulation to control these crypto-assets.   

A third complicating factor for shaping regulation is that cryptocurrencies as they are generally known today in fact do not perform all the functions that are generally understood to define the term currency. They are not acting as a medium of exchange; they are not particularly good as a store of value, given their volatility; and they are not being used as a unit of account. That is why for reasons of regulation it is better to use the term ‘crypto-assets’ instead of the more commonly ‘cryptocurrencies’

Why regulation for crypto-assets?

Regulatory certainty is a critical prerequisite and catalyst for technology adoption in financial services in general, also for crypto assets. It is becoming more evident that regulatory certainty can support safe innovation in the crypto-asset sector.

There are a number of issues that ask for specific attention by regulators.

First (and foremost) from a risk point of view. There are the inherent risks to investments due to volatile crypto-asset markets, when compared to conventional fiat currencies. Related to this is the vulnerability of crypto-assets to market manipulation given that the exchanges currently “sit outside of market abuse regulations”.

There is also increased scope for hacking, leading to the theft of the crypto-assets. Crypto-asset platforms are widely considered to provide opportunities for money laundering and other criminal activities because exchanges allow anonymous access and are not governed by any (AML) regulation.

Each of the above concerns underpin the need of a secure regulatory environment that offers investors and consumers sufficient safeguards. There are however many ways to create a workable, balanced regulatory framework. One that addresses consumer and market risks while supporting innovation, efficiency and competition. But finding this is a real challenge.

What regulations for crypto-assets?

So what regulation. In other words how best to regulate these crypto-assets taking account of the various specifics compared to traditional assets.

Crypto-asset regulation should be focused on the following issues: AML and KYC; investor and customer protection; stability of individual financial institutions  and of the financial system as a whole; and taxation.

A first point of discussion is: should one make up rules specifically for crypto-assets as a category. Or should one regulate crypto-asset activities in the same way as (fundamentally) similar financial activities that already exist especially when there is a great similarity with the existing financial economy.

And there are other factors regulators should be aware of such as the decentralisation issue which means that there are a multitude of stakeholders which bear (co-)responsibility for decisions. But also the different governance models as well as the dynamics of the various crypto-asset networks. These issues further complicate making regulation special focused on crypto-assets.

European approach

ESMA advice

The European Securities and Markets Authority (ESMA) published its advice on cryptocurrency assets early this month to the different institutions of the European Union (EU). While acknowledging that some of the emerging crypto-assets do not fall under any regulatory jurisdiction, the ESMA claims that to do nothing endangers investors and markets alike.

Though EU wide regulation would encourage adoption and legitimized cryptocurrencies in the eyes of the ESMA, at the same time they voiced concern about perceived risks posed to investor protection and market integrity. The ESMA itself thereby identified “the most significant risks as fraud, cyber-attacks, money laundering, and market manipulation.”

ESMA has identified a number of gaps in the existing financial regulatory framework regarding crypto-assets, that fall into two categories:

· For crypto-assets that qualify as financial instruments under MiFID, there are areas that require potential interpretation or re-consideration of specific requirements to allow for an effective application of existing regulations. The ESMA therefore recommends EU policymakers implement a “bespoke regime for these specific types of crypto-assets”.

· Where these assets do not qualify as financial instruments (and that is the majority) the absence of applicable financial rules leaves investors exposed to substantial risks. At a minimum, ESMA believes that AML requirements should apply to all crypto-assets and activities involving crypto-assets.

The report thereby cited a recent survey of national crime agencies showing a broad consensus advising that all crypto-assets should fall under anti-money laundering (AML) legislation, this in order to prevent excess regulation.

“In order to have a level playing field and to ensure adequate investor protection across the EU, we consider that the gaps and issues identified would best be addressed at the European level." Steven Maijoor, chair ESMA.

The report mentions that some smaller member states have or are creating their own bespoke legislation to attract investors and companies, forming multiple blockchain hubs, including the Netherlands, Luxembourg and Liechtenstein, and plainly recommends EU intervention.

European Banking Authority assessment

The European Banking Authority (EBA) is also calling on the EU to look into whether there should be a block-wide regulatory approach to crypto-assets. EBA's assessment came on the same day that the European Securities and Markets Authority (ESMA) made its call for a common EU-wide approach to crypto-assets to ensure investor protection.

In its assessment of the applicability and suitability of EU law to crypto-assets, the EBA notes that these fall outside the present scope of EU banking, payments and electronic money regulation.

"The EBA's warnings to consumers and institutions on virtual currencies remain valid. The EBA calls on the European Commission to assess whether regulatory action is needed to achieve a common EU approach to crypto-assets." Adam Farkas, EBA executive director

Bruegel report: The Economic Potential and Risks of Crypto-Assets: is a Regulatory Framework needed

In  the so-called Bruegel Report the authors analysed and assessed  the economic potential and risk of crypto-assets and discussed key regulatory questions that EU policymakers need to confront.

This report that was written at the request of the Austrian Presidency of the Council of the European Union for the informal ECOFIN meeting of EU finance ministers and central bank governors (September 2018) showed that different regulators in Europe classify and treat cryptocurrencies differently.

In order to come to a European approach, European policymakers must first decide whether crypto assets should be isolated, regulated or integrated. According to the report, at this point regulation is the right approach.

Second, global cooperation in managing risks of the new technology should be ensured while reaping the opportunities it ‘undoubtedly’ provides. The G20 and the Financial Stability Board should set regulatory norms that address the various policy questions.

Third, EU policymakers need to agree on the right moment to move supervision of crypto assets from the national level to the EU level. In a single market for capital, “diverging supervisory practices can come with significant downsides and this is particularly true for highly mobile crypto-assets”. However, different supervisory practices can allow experimentation with different approaches to a fast-changing technology, according to the report.

UK Treasury Select Committee

In September last year, the Treasury Select Committee of the UK House of Commons issued a report on its inquiry into the regulation of crypto-assets. They examined, amongst other subjects, the role of digital currencies (read: crypto-assets) in the UK and how these should be regulated.

Though overall market capitalisation remains small, the Committee has clearly recognised the need to regulate crypto-assets. Currently, crypto assets themselves are not within the scope of FCA regulation. This is because crypto assets “generally do not meet the criteria to be considered a specified investment under the Regulated Activities Order, nor would they typically qualify as ‘funds’ or ‘e-money’ in the Payments Services Directive 2 and E-Money Regulation 2009.”

The Committee sees a role for crypto-assets, particularly in financial innovation such as international remittances. However, they identified a number of significant potential risk issues. The first is the risk of loss to investors (price volatility, theft and loss). Second is the potential damage to market integrity (price manipulation). Third is the risk of financial crime (money laundering, financing of terrorism). The Committee concludes that crypto-assets need to be (better) regulated to prevent investor losses and financial crime.

The Committee concluded that crypto-assets present new challenges to existing regulation. The report therefore recommends improvements to consumer and anti-money laundering protections (AML) when dealing in crypto-assets. The improvement should be achieved in part by extending the Financial Services and Markets (FSMA) RAO Act to crypto-assets and associated activities. This is considered to be the quickest method to achieve this, which would enable the FCA to protect consumers in respect of their dealings in crypto-assets.

However, with Brexit negotiations having the highest priority, there is no clear timeline as to when it will consider the Committee’s proposal to implement new legislation specifically regulating crypto-assets. The UK government’s consultation period is expected to run to the end of 2019, thereby delaying any concrete progress.

Although international regulation on crypto assets is still in its infancy, the Committee encouraged UK regulators to engage with international bodies to share best practice. The EU directive to bring crypto assets under AML regulation should be seen as a step forward in combating this problem. If the UK leaves the EU without a transition period next March, the Committee wants to see the EU directive replicated in UK law.

The need for Global standards

Though the EU is moving in the right direction, given the global character of crypto-assets, there is a clear need for standards on crypto-assets that would apply across the globe or at least in the major economies. The Group of 20 (G20) as well as other global bodies such as the Financial Stability Board and the International Organization of Securities Commissions are all pleading for greater regulation of crypto-assets in a more global context.

“We will regulate crypto-assets for anti-money laundering and countering the financing of terrorism in line with FATF standards and we will consider other responses as needed.”  Group of 20 Document.

The G20 is also reviewing a document on AML standards for the crypto market, but it is still unclear how far they advanced.

Will be continued …….