Draft regulation on markets in crypto-assets: end of the crypto-asset "pump and dump" and Ponzi-schemes?
The EU Commission has recently published a proposal for a new regulation proposing a "MiFID light"-style regime regulating both issuers and service providers of crypto-assets. If adopted in its present form, the regulation will usher in radical changes in the legal framework surrounding the EU crypto market.
On 24 September 2020 the European Commission published a new draft regulation aimed in part as a response to the growing regulatory uncertainty regarding crypto-assets and the rise in crypto-asset "pump and dump" and Ponzi-schemes which have been a recurring feature of the crypto-asset news cycle in the last couple of years.
The Commission's proposal is part of the EU Digital Finance Package and consists of a draft regulation of markets in crypto-assets (the "Regulation"), including regulation specifically aimed at utility-tokens, stablecoins and e-money tokens.
The proposal represents a significant shift in the existing legislative framework for crypto-assets which have so far only been subject to limited regulation in many member states, including under the EU Fifth Anti-Money Laundering Directive.
Therefore, we will focus on the newly proposed rules in this Plesner Insight.
Background of the Proposed Regulation
The current EU and national legal framework for crypto-assets is very heavily fragmented, but a fundamental distinction is drawn under EU law as well as the national laws of most member states between on the one hand crypto-assets with "securities features" (which are typically subject to the full force of existing EU and national securities laws on financial instruments), and on the other hand cryptocurrencies, utility tokens and other crypto-assets without "securities features" (which in many member states are not regulated at all or only subject to limited AML regulations). The aim of the Regulation is to address this difference in regulatory pressure by introducing a new and extensive framework applicable to crypto-assets which are not financial instruments. Crypto-assets with "securities features" are therefore expressly excluded from the scope of the Regulation and will instead continue to be subject to existing regulation for financial instruments.
Scope of the Regulation
Issuers and crypto-asset service providers
If passed in its current form, the Regulation will apply to persons engaged in the issuance of crypto-assets or who provide services related to crypto-assets within the EU. However, and in line with the existing regulation regarding the offering to the public of financial instruments, the proposed rules will generally not apply to the extent that the crypto-assets are offered solely to, and can only be held by, qualified investors or if the offer does not exceed certain de minimis thresholds over a 12-month period.
Types of crypto-assets
The Regulation defines crypto-assets as "a digital representation of value or rights which may be transferred and stored electronically, using distributed ledger technology or similar technology", which is a broad definition intended to capture a wide variety of crypto-assets (but expressly excluding any crypto-asset which are financial instruments).
Under the new general definition of "crypto-assets", the Regulation introduces three types of crypto-assets: (i) utility tokens (crypto-assets intended to provide digital access to a good or service, available on DLT, and is only accepted by the issuer of that token), (ii) asset-referenced tokens (crypto-assets purporting to maintain a stable value by referring to the value of several fiat currencies, one or several commodities or one or several crypto-assets, or a combination of such assets, i.e. effectively stablecoins) and (iii) e-money tokens (crypto-assets the main purpose of which is to be used as a means of exchange and that purport to maintain a stable value by referring to the value of a fiat currency).
We note several uncertainties in the proposal already in these definitions which are central in determining the obligations on issuers and service providers of a given crypto-asset under the Regulation, e.g.:
- what if other parties than the issuer accept a would-be utility token?
- what if a would-be asset-referenced token only references a single fiat currency and is not intended to be used as a means of exchange (but e.g. as a unit of account or store of value)?
Issuers of crypto-assets
General requirements for issuers of crypto-assets
The Regulation sets out rules applicable to any issuer of crypto-assets, defined as a "legal person who offers to the public any type of crypto-assets or seeks the admission of such crypto-assets to a trading platform for crypto-assets".
The Regulation prohibits issuance of crypto-assets by anyone other than legal entities thus aiming at existing crypto-assets many of which purport to be issued by a "community", "organisation", "initiative" or other similarly nebulous constructs - or have no identifiable issuer at all.
Furthermore, the Regulation will require the issuer to publish a white paper which must comply with the requirements set out in the Regulation. Specifically, the white paper must include a detailed description of the issuer and the issuer's project as well as the type, terms and characteristics of the crypto-asset being offered to the public. Generally, the requirements for the white paper appear aimed at creating a "light" version of the requirements for a prospectus pursuant to the EU Prospectus Regulation.
The white paper will not be subject to prior approval by any national authority; however the issuer must notify the white paper as well as all marketing material regarding the crypto-asset to the relevant national authority and explain why the crypto-assets are not to be considered a financial instrument pursuant to MiFID II. The national regulator will also have the authority to demand that the issuer amends the white paper "where necessary for consumer protection or financial stability".
Furthermore, the Regulation sets out ongoing obligations of the issuers of crypto-assets, including the obligation to act honestly, fairly and professionally and to maintain all of their systems and security access protocols to appropriate EU standards. The latter may be seen as rule to mitigate risks related to the DLT often used in connection with crypto-assets issuances.
Lex Libra? - additional requirements for issuers of asset-referenced tokens and e-money tokens
For issuers of asset-referenced tokens (stablecoins), the Regulation sets out a number of additional requirements. Most notably, issuers of asset-referenced tokens must be authorised by the competent national authority in order to issue such tokens, save in respect of certain de minimis issuances. The Regulation specifically requires any issuer seeking authorisation for the issuance of asset-referenced tokens to be established in the EU thus closing the EU market to stablecoins issued by US, Asian or other non-EU issuers.
Such issuers will also be obligated to inter alia have robust governance arrangements in place, establish and maintain a complaints handling procedure and ensure that members of the management body are 'fit & proper'.
In addition to the above, issuers of asset-referenced tokens will be subject to own funds requirements of the higher of EUR 350,000 and 2% of the average value of the asset reserve and must maintain a reserve of assets, which must be kept segregated from the issuer's own assets and such reserve assets may only be invested in highly liquid financial instruments with minimal market and credit risks. The Regulation generally establishes detailed rules on the custody and management of the asset reserve and possible claims of the holders against the asset reserve.
Pursuant to the Regulation, the issuance of e-money tokens, will, subject to certain de minimis thresholds, only be allowed for credit institutions or electronic money institutions pursuant to the EU Second E-money Directive.
Holders of e-money tokens must have a claim on the issuer and the token must be redeemable at par value. Furthermore, the Regulation requires issuers investing funds received in exchange of e-money tokens to be invested in assets denominated in the same currency as the one referenced by the e-money token.
"Significant" asset-referenced tokens and e-money tokens
The Regulation also introduces the concept of "significant" asset-referenced and e-money tokens, which covers tokens which may be or become systemic within the EU. No doubt these requirements have been largely influenced by the political and central bank controversy in many countries in the wake of the announcement of the Facebook-sponsored Libra project.
It will be the EBA who will be tasked with determining whether an asset-referenced or e-money token is "significant" based on certain criteria set out in the Regulation including the size and customer base and value or market capitalisation of the tokens, the number or value of the transactions carried out and the interconnectedness with the financial system. Such tokens will also be subject to direct EBA supervision.
Issuers of "significant" asset-referenced or e-money token deemed will be subject to material additional obligations, including the requirement to (i) adopt, implement and maintain a remuneration policy that promotes sound and effective risk management, (ii) asses and monitor the liquidity needs to meet redemption requests and (iii) increased own funds requirement.
Crypto-asset service providers
General requirements for crypto-asset service providers
Under the Regulation, any person offering crypto-asset services must be authorised to do so. In order to obtain such authorisation, the service provider must be incorporated in a legal entity within an EU member state.
As is the case for issuers of crypto-assets, a crypto-asset service provider must also adhere to certain own funds requirements, governance requirements (including 'fit & proper' requirements for the management body) and certain requirements related to outsourcing of operational functions.
Notably, the proposed definition of a "crypto-asset service" is broad (clearly modelled over the MiFID list of "investment services") and includes any of the following services or activities related to any type of crypto-asset:
- custody and administration on behalf of third parties;
- operation of a trading platform;
- exchange of crypto-assets for fiat currency or other crypto-assets;
- execution of orders on behalf of third parties;
- placing of crypto-assets;
- reception and transmission of orders on behalf of third parties; and
- providing advice on crypto-assets.
Thus, it must be expected that almost all market participants currently providing advice or services related to crypto-assets will be required to obtain an authorisation under the Regulation.
Requirements for the provision of specific crypto-asset services
In addition to the general requirements for crypto-asset service providers, the Regulation sets out additional requirements service providers authorised for, among other, (i) custody and administration on behalf of third parties, (ii) operating a trading platform, (iii) exchange of crypto-assets against fiat currency or other crypto-assets, (iv) execution of orders, and (iv) advice on crypto-assets.
Prevention of market abuse
In addition to setting out rules for crypto-asset issuers and service providers, the Regulation introduces prohibitions and requirements for crypto-assets admitted to trading on a crypto-assets trading platform. The proposed rules, which are in line with the rules set out in the EU Market Abuse Regulation, includes prohibition of insider dealing and market manipulation as well as requirements related to the disclosure of inside information.
Aside from maintaining basic standards of market integrity, these rules have likely been prompted by numerous examples across the world of so-called "pump and dump" schemes and other gross market irregularity related to certain crypto-assets.
The Regulation also introduces a new sanctions regime for infringement of the rules set out in the Regulation.
Following the general structure of the Regulation, the proposed sanctions regime distinguishes between sanctions for violations of the rules applicable to (i) issuers of crypto-assets (other than asset-referenced tokens or e-money tokens), (ii) issuers or asset-referenced tokens or e-money tokens, (iii) crypto-asset service providers, (iv) the rules on prevention on market abuse involving crypto-assets, and finally (v) "significant" asset-referenced tokens and e-money tokens.
The competent authority for infringement of any rule (other than the rules specifically related to "significant" asset-referenced tokens) will be the national authority in the relevant member state. The Regulation sets out a requirement for the Member States to grant the relevant the national supervisory authority the power impose, inter alia, fines on legal or natural persons for infringement of these rules. The size of the proposed fines varies depending on the type of infringement and whether the offender is a legal or natural person but can - depending on the circumstances - be in the amount of EUR 15,000,000 or - if the offender is a legal person - between 3 % or 15 % of the total annual turnover of the offender .
For infringements of the rules regulation "significant" asset-referenced tokens and e-money tokens, the EBA will be the competent authority and will have the powers to impose fines of up to 15 % of the annual turnover towards issuers of "significant" asset-referenced tokens and up to 5 % of the annual turnover towards issuers of "significant" e-money tokens.
Thus, with the proposed sanctions regime, the Commission proposes to effectively introduce a regime not unlike the existing sanctions regime under the EU General Data Protection Regulation (GDPR).
The proposed rules constitute a significant shift in the existing regulation of crypto-assets. As the proposals have not yet been subject to review by the European Parliament or the Council, it remains to be seen if and in what form the proposed rules will be adopted. However, market participants should stay alert of the development going forward as the proposed Regulation will impose new and substantive obligations on any issuer or service-provider of crypto-assets