Crypto-Assets: Challenging the Harmonisation Principle

National vs Supranational Regulatory Action

With the exponential use of crypto-assets across Europe, a number of EU and EEA Member States have proposed or adopted domestic regulatory solutions to deal with these new products. This includes: 

• Switzerland’s FINMA Initial Coin Offerings (ICOs) Guidelines (February 2018); 
• Gibraltar’s proposal for a Token Regulation (March 2018);
• the Bank of Lithuania’s position on virtual assets and ICOs (February 2019);
• the French AMF’s ICO authorisation framework, also known as the PACTE law (May 2019);
• Liechtenstein’s Token and TT Service Provider Act; (May 2019); 
• the UK FCA’s recently published Guidance on Crypto-Assets (July 2019); 

The EU itself, meanwhile, has been slow in taking action in this space. As it stands, there is no crypto-asset specific legislation at this level. Virtual currencies may be under EU law as far as the Fifth Anti-Money Laundering Directive (5AMLD) and the Directive on combatting fraud and counterfeiting of non-cash means of payment are concerned, but their scope is limited to very specific applications. 

In fact, the main approach of EU institutions thus far has been to monitor developments in the markets. Based on its FinTech Action Plan, the Commission tasked the European Supervisory Agencies (EBA, ESMA and EIOPA) to consider, within their own remit, the crypto-asset space and share their conclusions and advice. On 9 January 2019, both the EBA and ESMA published their advice to the Commission (1) (2). They both concluded that EU law does not effectively cover crypto-assets. The EBA advised the Commission to carry out a cost/benefit analysis to assess, on a holistic basis, whether EU-level action is appropriate and feasible at this stage to address the issues identified. ESMA expressed support for this view, adding in its own report that greater clarity should be provided for crypto-assets that constitute 'financial instruments' and a bespoke regime should be implemented for those that do not. It is based on these findings that the Commission is currently assessing whether legislative action is needed. 

A New Asset Class?

There has been great debate as to where crypto-assets lie in the financial ecosystem. How does one define a crypto-asset? Should we look at how it is used? Its purpose? What about those with hybrid properties? Are they a new asset class altogether? 

Such debate, while still complex, can be solved when you’re dealing with a harmonised regulatory framework. For example, in the U.S., many crypto-assets are considered securities (investment contracts). Thanks to the Supreme Court judgement in SEC v. Howey (1946), U.S. regulators can apply the relatively simple and flexible "Howey Test” to any new financial product. Under this test, a transaction constitutes a security if:

• It is an investment of money
• There is an expectation of profits from the investment
• The investment of money is in a common enterprise
• Any profit comes from the efforts of a promoter or third party

The test has proved very useful in ensuring relative legal certainty for American crypto-asset issuers and service providers, unlike for their European counterparts.

This is where the complexities of European law become clear. By contrast with across the Atlantic, the flagship piece of EU law for 'financial instruments' is the Markets in Financial Instruments Directive (MiFID II). The Directive imposes investor protection rules across the whole EEA, and extends the range of investment services for which a firm can obtain an EU ‘passport’ (i.e. obtaining authorisation in one EU state, the home state, enables a firm to provide investment services in another EU member state, the host state, without requiring any further local authorisations).

However, due to Member States’ sophisticated but differing financial regulations, MiFID II does not define what constitutes a security. This is because there is no consensus among the national authorities. As a result, while an individual Member State can agree to a taxonomy within its own jurisdiction, there is no basis under MiFID II to make a distinction between the different crypto-assets at the EU level. Is a particular crypto-asset a security? This is left for national regulators to decide.

As if this wasn’t complicated enough, EU institutions themselves may have different views on this. The European Central Bank’s Crypto-Asset Task Force recently published an Occasional Paper on Crypto-Assets: Implications for financial stability, monetary policy, and payments and market infrastructures. They define crypto-assets as ‘any asset recorded in digital form that is not and does not represent either a financial claim on, or a financial liability of, any natural or legal person, and which does not embody a proprietary right against an entity.’ In other words, the focus on their analysis are crypto-assets that lack a claim or liability. 

While the Task Force stresses that this Occasional Paper is for the purpose of analysing possible implications for monetary policy in the Euro, financial stability and the smooth operations of payment systems and financial infrastructure, one can wonder the effects their definition of crypto-assets may have on the wider EU regulation debate. How does the ECB’s view fit with the advice made by the ESAs, and the work currently undertaken within the Commission? 

Competition or Fragmentation?

The lengthy process by which EU-level legislation becomes law is particularly problematic for the crypto-asset space as it may further undermine the integrity of the Single Market. Due to the only recently elected European Parliament, and the new College of Commissioners that will not take office until 1 November 2019, a crypto-specific proposal is unlikely to be put forward until the end of 2019 or even 2020.

Meanwhile, a number of national regulators have already begun taking action in their respective jurisdictions (see above) and this may already be causing friction. For example, while the EBA currently separates crypto-assets between exchange, security and utility tokens, the UK’s FCA has taken a different approach, now characterising them as either security, e-money or unregulated. 

Moreover, while in some Member States a crypto-asset service provider may only require to be registered, other jurisdictions may demand a licence and clear authorisation.

There’s nothing inherently wrong with Member States going ahead with domestic regulation. However, these developments could mitigate the level-playing field, lead to higher risk for consumers due to confusing overlapping rules, and even threaten future financial stability as crypto-asset use scales up.

The confusion around how to deal with crypto-assets at the EU level has unearthed a deeper problem. That is, as far as financial services are concerned, this is hardly a Single Market. More harmonisation in other areas of the industry would have enabled the Commission to assess crypto-assets much more efficiently. This is why we are seeing domestic regulatory solutions appear while the EU’s response remains unclear. 

Policy Recommendations

A harmonised European regulatory framework for crypto-assets would be better suited to ensure a level playing field across the EU, and protect the rights of consumers and investors alike. It would also promote industry growth. The lack of regulatory certainty is harmful to market players as they lack the passporting rights other financial services providers enjoy for cross-border business. This is especially detrimental to crypto-asset service providers as the underlying technology, distributed ledgers, are cross-border by nature. Europe was left behind during the internet revolution as other major economies gave rise to digital giants, such as Google and Alibaba. Sound regulation for the next wave of innovations (Blockchain, AI, Cloud Computing, Quantum Computers etc) could make the EU the most prosperous and advanced digital economy.

For this to occur, the regulatory gaps identified by the ESAs in their January 2019 report must be plugged. The Commission should assess regulatory suitability in this space. In particular, it should focus on the definition of financial instruments within the scope of MiFID II. Beyond crypto-assets, the fact that the term 'financial instrument' is not constantly interpreted across Member States is a major issue. Clarity in this area would enable a logical basic taxonomy that can be applied across the Union. 

The next step would be to discuss a clear regulatory scheme for the “gatekeepers” i.e. crypto-asset service providers at the intersection with the regulated financial system, such as custodian wallet providers and exchanges. However, this may be challenging when looking at the increasingly popular decentralised business models. While for centralised service providers, this set-up is no different from the traditional financial intermediation business, hence a similar framework could be used to regulate and authorise the activities, decentralised entities do not foresee the involvement of an identifiable intermediary. In such cases, a principles-based approach, complemented by a formal mechanism to validate the observance of such principles, could be considered. Such principles could include technological integrity; algorithms/protocol service performance and transparency; stress-tested operational security and cyber-resilience; and regulatory compliance. 

Finally, it is key for the authorities to have a continuous dialogue with the private sector, such as through designated forums or partnerships. As the crypto industry is very young, understanding its benefits and risks is a learning process both for the companies involved and the regulators.