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Expert opinion

Crypto-assets under legal microscope: a summary of ESMA Advice on ICOs and crypto-assets

Friday 8 March 2019 | 07:34 AM CET

Crypto-assets have drawn significant attention globally, amid rising concerns over the risks surrounding transactions with these assets.

Setting the context

In November 2017 and February 2018, the European Securities and Markets Authority (ESMA), a European Union financial regulatory agency, issued two statements on Initial Coin Offerings (ICOs) and a warning on Virtual Currencies (VCs), to show its concern regarding these instruments, and to remind companies involved in ICO activities of their obligations under the EU regulatory framework. Moreover, ESMA advises the European Commission, Council, and Parliament to focus on providing buyers with information about the risks associated with crypto assets that may not be considered financial instruments, rather than offering buyers a more ‘elaborate regime’ that focuses on crypto assets that are financial instruments.

Crypto-assets depend on cryptography and Distributed Ledger Technology (DLT), and range from cryptocurrencies – or virtual currencies – to digital tokens issued through ICOs. As tokens can take different forms (payment token, utility token, securities token), it is difficult to classify and regulate them.

Advice synopsis/outline

ESMA maintains its neutrality, believing that there is no ‘one size fits all’ solution when it comes to legal qualification, as crypto-assets are diverse, and some have hybrid features. For this reason, it released this Advice, which outlines the actors and the business models involved in the crypto space, the risks and issues to be taken into consideration, and legal (regulatory) involvement in crypto-assets (AMLD5 and terrorist financing).

Who are the actors involved?

A crypto-asset is not issued or guaranteed by a central bank. As they have several features and may serve different functions, one may differentiate between: investment-type crypto-assets, utility-type, payment-type, or the ones that have hybrid features and may evolve over time.

Actors involved in crypto-assets are:

DLT – crypto-assets are dependent on DLT, a means of saving information through a distributed ledger, which is built upon a cryptography system. This system uses pairs of public keys essential for identification, and private keys used for authentication and encryption.

Digital wallets – that store the public and private keys, and interact with DLTs in order to enable users to transact crypto-assets and surveil their balances. One can distinguish between software/hardware, cold/hot wallets, and wallet providers (or custodial wallet providers), which hold the crypto-assets (e.g. private keys) on their behalf.

Miners – a network of computers, which are meant to include the transactions in the blockchain. DLT networks can be permission-less (e.g. most crypto-assets issued recently through ICOs), or permission-based (e.g. tokenized forms of traditional financial assets). For the first case, virtually anyone can become a miner, for the second one, only the parties that meet certain requirements are allowed to continue in the validation and consensus processes. In case of hybrid models, a combination between the two DLT networks may be used.

ICOs – permit businesses to raise capital for their projects, by issuing digital tokens in exchange for other crypto-assets or fiat currencies. Trades are made on specialised platforms that are either ‘centralised’ (hold crypto-assets on behalf of their clients; the trade occurs on the books of the platform/off-chain), or ‘decentralised’ (the trade settlement occurs on DLT/on-chain).

Risks and issues to be taken into consideration

ESMA advises cautions in regards to the fact that not all crypto-assets share the same characteristics. While some may fall within the scope of EU financial regulation, others may not, even though some retail investors perceive the latter as security-like investments. This might pose another issue: whether investors are aware of the risks prior to investments. 

ESMA also suggests that many platforms trading crypto-assets are similar to the existing ones. The questions that arise are whether these platforms are adequate enough to ensure orderly trading, and to prevent potential conflicts of interest. It also inquires if centralised platforms, which are in control of clients’ assets and of fiat money, have the necessary measures to guard these assets. Decentralised platforms, which allow investors to remain in control, have the same vulnerabilities as DLTs: delays in processes, governance issues, conversion between fiat and crypto is not permitted, and investors may not have the expertise to keep their private key safely.

Miners might face risks such as not receiving the proper incentive to mine transactions. This might lead to the suspension of their activities, and transactions would be left pending.

Legal (regulatory) involvement in crypto-assets

ESMA stresses upon the fact that currently there is no definition of the term in the EU financial securities laws. In what the legal qualification of crypto-assets is concerned, the question that rises is if these assets qualify as MiFID II (the Market in Financial Instruments Directive framework) financial instruments.

As such, in 2018, ESMA undertook a survey of National Competent Authorities (NCAs) of Member States to gather feedback on the possibility of legally qualify crypto-assets as financial instruments. Most NCAs assessed that investment-type along with hybrids of investment, utility, and payment types could be deemed as transferable securities and financial instruments defined under MiFID II, which means that they should comply with the existing EU financial regulation. However, the results of the survey suggest that no NCA labelled utility-type assets as transferable security.

At the same time, NCAs believe that there is a need to distinguish between the types of assets, as the existing regulation was not drafted considering these instruments. Moreover, changes in the legislation or additional provisions may be in order to align and respond to the unique characteristics implied. NCAs also advise that all crypto-assets activities should be subject to AML laws.

Views on AMLD5 and terrorist financing

In 2014, The European Banking Authority (EBA) highlighted that virtual crypto-to-fiat exchanges and providers of crypto custodial wallet services should be brought into the AMLD scope in order to control the risks of money laundering and terrorist financing. Although amendments were agreed to in the context of the AMLD5 negotiations, this will be implemented into law by 10 January 2020.

Concluding, Daniel Chatelain, CEO, PayKademy, said: ‘Regulation of ICOs is still a work in progress and may vary widely from one country to the next’, as Europe is not the only region that considers jurisdictions. For instance, while countries such as China, Macau, and Pakistan ban ICOs, US’s approach on ICO rules varies from state to state. However, although EU states (France, Liechtenstein, Malta, Lithuania) may have already created their own bespoke legislation in order to attract investors, we will have to wait and see the extent of EU’s intervention on local state regulation following the report.

As mentioned in the beginning of this analysis, crypto-assets are not issued or guaranteed by a central bank, but they can take different forms and have different features, which makes them difficult to be classified and regulated. To find out more about this topic, check out our interviews with Annie Leblanc, financial investigator, Autorité des Marchés Financiers, and Daniel Chatelain, as well as FBI’s opinion on ICOs and cryptocurrencies.

About Simona Negru

A graduate of English/Spanish Language and Literature studies, with an MA in American studies, Simona is always on the lookout for the best and new stories to capture. A passionate content editor, Simona is keen on discovering and sharing all the relevant news and topics on both distributed ledgers and cryptocurrencies, as well as online security and digital identity, all while finding the hottest trends in the industry for The Paypers’ readers.
 

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