European Supervisory Authorities recommend a pan-EU approach to crypto regulation

Since the crypto bubble of 2017 many national regulators around Europe and beyond have been moving to implement regulatory regimes within their jurisdictions so as to place themselves as “market leaders” in crypto and FinTech regulation. However, within the EU it is fair to say that the industry, and public sector, have been waiting with anticipation to see where the EU moves to next on this topic – and in particular whether we will have a harmonised regime for crypto regulation in Europe.

While the ESMA and EBA reports described below keep the powder on this topic dry to an extent, telltale signs suggest that pan-EU regulation in crypto, beyond merely anti-money laundering issues, may be on its way.

The European Securities and Markets Authority (ESMA) and the European Banking Authority (EBA) published reports, on 9 January 2019, to the European Commission on the suitability of current European Union (EU) legislation to crypto-assets and Initial Coin Offerings (ICOs).

Even though reports confirmed that the current levels of crypto-assets-related activity in the EU neither impedes nor negatively impacts financial stability in the EU, both authorities highlight the fact that some crypto-asset activities are not caught by the current EU financial services framework and as a result several ambiguities in the applicability of the current regulatory regime arise causing important operational risks both to investor protection and market integrity which need to be carefully addressed.

The EBA report

The EBA’s report highlights several concerns regarding crypto-regulation, of these the key points in our view are as follows.

• The EBA acknowledges money laundering and consumer risks posed by crypto-assets because crypto-related ‘financial’ services are not generally perceived as being subject to regulation under the banking, payment services and electronic money framework set out in the Capital Requirements Regulation (EU) No. 575/2013 (CRR); the Second Payment Services Directive 2015/2366/EU (PSD2) or the Electronic Money Directive 2009/110/EC (EMD).
• There is a pervasive lack of clarity on the treatment of crypto-assets under current EU regimes which has led at times to a degree of misalignment between them: for example, crypto-assets are not recognised as money under the CRR, but may be recognised as “electronic money” under EMD and as “funds” under PSD2 in certain circumstances.
• The EBA outlines in detail the applicability of current accounting and prudential regulatory frameworks as they relate to crypto-assets. The main issue, and what is being seen on a global basis, is that the current regimes, designed pre-2017, simply do not contemplate crypto-asset technology. Allied to this, the EBA notes that the Basel Committee for Banking Supervision (BCBS) is actively engaged with the EBA with respect to the prudential regulatory treatment of crypto-assets.[1]
• The EBA report notes the lack of clarity at international accounting standard level as to whether crypto-assets would be recognised as an intangible asset. It is worth noting that, at the time of writing, various analyses have been completed by specialist International Financial Reporting Standards (IFRS) advisors that deal with challenges facing crypto-asset accounting. These focus on the constantly evolving nature of crypto-assets together with the lack of relevant formal accounting pronouncements. The prevailing view is that crypto-assets would generally meet the definition of intangible assets under IFRS. This analysis naturally has an impact on the prudential regulatory treatment of crypto-assets.[2]
• As regards valuations of crypto-assets, the EBA report suggests that a “conservative approach” should be taken for exposures, pending further regulatory developments and the outcome of the BCBS analysis. It remains to be seen how this may impact, for example, the treatment of crypto-asset derivatives under the mark-to-market method. The conservative approach may mean that crypto-assets will be treated under CRR in a similar way to exotic commodities (ie those which are not precious metals).
• Finally, and perhaps most importantly, the EBA has urged the Commission to address the possibility of an EU-wide regulatory approach on crypto-assets. More specifically EBA notes that the Commission should carry a cost/benefit analysis, considering issues inside and outside the financial sector so as to assess if any regulatory action is required to achieve a common EU approach to crypto-assets. The report also advised the Commission to consider the Financial Action Task Force’s (FATF) recommendations of October 2018 and to take steps to promote consistency in the accounting treatment of crypto-assets.

A copy of the EBA report is here.

The ESMA report

ESMA’s report follows a request by the Commission in its 2018 FinTech Action plan calling European Supervisory Authorities such as ESMA to assess the suitability of the current EU regulatory framework on ICOs and crypto-assets.

ESMA’s report acknowledged that the gaps in the current regulatory regime on crypto-assets arise mainly as a result of their ambiguous legal status and, in particular, whether they are recognised as “financial instruments”.

As with the EBA report ESMA acknowledges that under certain circumstances some crypto-assets may qualify as “transferable securities” or other types of financial instruments within the meaning of the Markets in Financial Instruments Directive 2014/65/EU (MiFID II). To reach this conclusion ESMA has been cooperating with national competent authorities (NCAs) and has noted that while transposing MiFID II into national law, the interpretation of the term “financial instruments” differs from one NCA to the other resulting in regulatory and supervisory issues.

The report also outlines that many financial rules under secondary legislation including 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 will apply to those crypto-assets which qualify as financial instruments and transferable securities under MiFID II.

Nonetheless, the report highlights the existence of gaps and ambiguities in the current regulatory regime of crypto-assets which should be addressed by the Commission. In particular, the report calls for greater clarity and certainty in respect of the types of services that may qualify as custody / safekeeping activities under the EU financial services framework as well as the concepts of settlement and settlement finality which apply to crypto-assets. Importantly, ESMA acknowledges that there is currently no legal definition of “crypto-assets” in the EU financial securities laws, although Fifth Anti-Money Laundering Directive (EU) 2018/843 (5AMLD) does introduce a definition of “virtual currencies” for the first time into European jurisprudence. Under 5AMLD “virtual currencies” means a digital representation of value that is not issued or guaranteed by a central bank or a public authority, is not necessarily attached to a legally established currency and does not possess a legal status of currency or money, but is accepted by natural or legal persons as a means of exchange and which can be transferred, stored and traded electronically.

ESMA recognises and expects that the market for crypto-assets is evolving and follow-up work will be needed with these developments. ESMA states that they will be engaging with global regulators on an ongoing basis as market developments occur. Given the prevalence of international standards increasingly being used in new offshore laws and regulations, this will likely have an impact in shaping regulation of crypto-assets going forward.

Despite the above, the report confirmed the risk which exists in case the wider regulation of crypto-assets may result in a more reckless adoption and use of same. As a result ESMA recommends warning buyers about the risks of those crypto- assets, which do not qualify as financial instruments.

Lastly, similar to the EBA report, ESMA also highlighted the importance of updated risk disclosure and anti-money laundering requirements in relation to providers of crypto-to-crypto exchange services providers as well as providers of financial services for ICOs.

A copy of the ESMA report is here.

Food for thought

NCAs across the EU and beyond should take particular heed of the EBA and ESMA reports: while they rush to regulate in the current absence of EU regulation it may soon be the case that they will have to make significant alterations to their regimes so that they comply with eventual pan-EU regulation. These reports suggest such regulation is on its way.

If you have any questions, please contact Aki Corsoni-Husain, Katerina Katsiami or your usual Harneys contact.

[1] The resulting guidance from the BCBS will extend globally and have an impact on the regulatory treatments of crypto-assets, and as such will be of relevance to Harneys non-EU jurisdictions such as the Cayman Islands and British Virgin Islands.

[2] Intangible assets are deducted from Common Equity Tier 1 items under Art 36(1)(b) of the CRR.