Honesty is the best policy, but to make it work one needs the regulation. MiCA is going to do that in crypto assets’ market. MiCA’s development is coming to an end with so-called Level 2 products forming the full crypto regime. I’d like to share some thoughts on few topics, in particular, the distinction between crypto asset and financial instrument, what a stablecoin is, and the rules for traditional intermediaries.
Crypto asset vs financial instrument
A share of AAPL issued on DLT would still be a common share and not a crypto asset, and vice versa, holding a crypto asset will not confer the same rights as holding a share. So it is up to investors to consider whether they want to buy a share of, let’s say, a start-up and wait while it’s value will become sky high and share the profits together, or whether to fund a project or expect returns from the speculation. The regulatory distinction between what is a financial instrument on DLT and what is a crypto asset is already solved in 2023 when the definition of financial instruments was amended in all EU MS’s national laws because of the DLT Pilot Regulation (Article 18(1)). It was necessary to enable the functioning of DLT trading platforms - trading venues for DLT instruments (shares, bonds, funds) enabling the trading of tokenized instruments and direct retail participation. So it’s official, tokenized common share, debt instrument is a traditional instrument with the same rights and obligations for holders of them. No doubt that the tokenization of those instrument will be beneficial for all, including investors who will get access to a wider range of investment products thanks to reduced minimum amount for the investments (e.g. example real fractionalization) and investment horizons, as well as reduced implicit costs (the ones that exist but you will not get a receipt for them). A bit outdated but comprehensive report by the FED outlines some use cases.
MiCA does not regulate tokenized assets where traditional instruments are issued on DLT. It looks straightforward, but ESMA received a lot of feedback in its public consultation on the draft guidelines on the classification of crypto and financial instruments. The problem is that assigning an instrument to the right category can be a complex task. This is because some crypto assets, at least for the moment, promise to give holders rights that are essentially the same as those granted by financial instruments. There is a fine line. So the market participants are asking for the standardized classification test or more concrete guidance, as ESMA's guidelines are a good example of how to say nothing of value by writing 39 pages. And I am fully on ESMA's side in this regard, this is related to how the EU regulatory process is structured with the mandates (powers), another topic maybe for next posts. On the other hand, if a persons would classify an instrument wrongly, then they are subject to heavy fines, because it means that those persons provided services without necessary authorization (without Prospectus regulation’s obligations if it would be a financial instrument).
To apply The Howey test in the EU would require a cosmograph, as such a test would basically cover at least 27 cases in each instrument from all EU Member States (MS). The universe of financial instruments in the EU is fragmented. National company laws or civil codes usually define what is a common share or debt instrument. Derivatives have been regulated later and are understood in a fairly similar way in all countries. So we have a problem with two main types of instruments - ordinary shares and debt instruments. These instruments can be classified according to the type of claim the holder has on the issuer. For example, in Lithuania, the definition of ordinary (common) shares includes all three elements: the right to participate in the management of the shares (i.e. in the general meeting), the right to receive part of the company's profit (i.e. to receive a dividend), and the right to receive a liquidation proceeds.
So issuers of crypto assets should look carefully whether they are not promising in a white paper to grant the same rights, which would basically be equivalent to the rights of financial instruments.
NFTs are not out of scope of MiCA by default. Quite a large part of crypto assets are game tokens, in the form of NFTs, where a user pays to "catch a fish, grow a carrot or buy a new outfit". The general rule is that if it is not transferable and negotiable on the markets, then MiCA, MIFID do not apply. So if you can only sell directly to the issuer, to the gaming platform or to another user, then it should not be covered by MiCA. But if there is a market where you buy a claim, then it is a negotiable instrument and then MiCA applies.
Just one remark regarding derivatives. If a derivative is settled in cash it is a financial instrument as referred to in point 4 of Annex I Section C of MIFID. If a derivative is settled in crypto assets then the regulation is not clear and the MiFID definition needs to be amended.
All this leads to the understanding that MiCA's passporting regime can be arbitrary if an issuer chooses a more favorable MS. Because once approved (for ART) or notified (for other crypto assets and EMT), the white paper will be valid in all MS. But the same regime applies in traditional markets and that is how harmonization works. MSs that are not happy with another MS's approved instrument being distributed to their citizens do not have so much practical power in this regard, although a regulatory process exist.
A rather interesting point raised by a few respondents relates to staking in the context of classification, as they see staking as being classified as a collective investment undertaking. In general, staking is not a regulated crypto-asset service, so an entity does not need a licence to provide this service (unless this service is provided in combination with other services for which a licence is required, as explained by ESMA's QnA). Services that are not mentioned in Article 3(1)(16) of MiCA are not regulated services - no authorization is required, no rules exists unless each MS introduces national ones. Other example of non-regulated services is lending, research and analysis. As well as dealing on own account - it is not a crypto service, otherwise every private person should be subject to MiCA who buys-sells for the intention to gain profits. Just MiCA and MiFID are structured differently in this respect, while MiFID explicitly exempting such persons in Article 2(1)(d), MICA does not even include them in its scope. I think a rationale is that retail clients are direct members of trading platforms, exchanges, which is not the case for financial instruments.
Collective investment undertakings basically “pools together capital raised from its investors for the purpose of investment with a view to generating a pooled return for those investors”, so staking does not qualify to fit in such a definition.
The classification of ARTs is a more complex topic since ART should not be confused with tokenized assets or traditional instruments, such as derivatives, collective investment undertakings. It is new type of (investment or payment) instrument. It is quite clear what EMTs are (i.e., e-money on DLT, MiCA applies for them for investor disclosure requirements mainly). The situation for ARTs is not so straightforward as there is no practical example in the market yet. I think the closest connection could be taken from asset-backed securities. An asset-backed security is a representation of an interest in assets and is secured by assets (i.e. backed by assets). Since ART is secured by certain assets, the key aspects is that the issuer would have corresponding amount of such assets to liabilities (to an equivalent amount of tokens issued), otherwise it is only the illusion of backing and where liabilities and assets do not match the issuer may lose the ability to redeem (holders always have the redemption right). Supervisors are already preparing to supervise that, there is a pilot project Pyxtail developed by BIS and BoE which has created a prototype that allows supervisors to conduct real-time supervision of assets by collecting, storing and analysing on-chain and off-chain data and enabling the monitoring of digital asset balance sheets.
For classification purposes, the list of traditional EU instruments is available in other formats that could be helpful. For example, the ECB has a regulation listing all the instruments that can be used for statistical purposes. And the Guidelines. Just to note that this could be taken as an inspiration, for an official reference the process is basically to dig into the national laws and applicable regulations. So it should be feasible to get the information. With the more complex cases entities can ask NCA’s interpretation.
Trust vs Intermediation
Even if trust without intermediary (CeFI) is the spirit of the whole blockchain thing, the reason for holders to buy or get services from regulated entities are obvious. After MiCA people will be able to buy crypto assets on decentralized exchanges or other intermediaries that don't see the need to be licensed or follow MiCA rules. Users may get cheaper services and an access to crypto assets that are prohibited in the EU, but in this case they are exposed to all other types of additional risks (and I am not talking about market risk which every buyer of crypto that is enormously exposed to).
Supervisors have the ability to prohibit a few of the biggest ones from doing so, but they will not be able to stand by every single one. Especially, in case of crypto assets’ market which is resource intensive with its more than 20 000 crypto assets, and still evolving new business models. Quite an issue will be no reporting requirements. MSs usually perform supervision based on the reports (capital, market conduct) and clients’ complaints data reports. Although now saw that some national MSs are introducing reporting requirement that is better for them and market participants. Better to provide a report when you know instead of ad hoc report with short notice.
The Bank of Lithuania, for example, has a procedure that basically takes a few days to block websites with a court order, but this is one of few good practice that other MS do not have.
Besides additional risks (fraud, counterparty default of unregulated intermediary) regulated trading platforms, exchanges do due diligence of crypto asset they offer (note that trading platforms under MiCA are analogous to stock exchanges, exchanges provide exchange of funds to crypto/other crypto service). MiCA does not address the sustainability of other crypto assets. New token listings generate the increased returns mostly in the beginning of trading, then some of these projects literally disappear. MiCA does not introduce own funds requirements for issuers of other crypto assets. In other words, the risk appetite of such issuers is not limited at all. One issuer can issue hundreds of crypto assets, the capital requirement (if you look at the level of risk taking) can be 2 500 euros in some countries (and it is only the initial capital that differs from the capital requirement). Technically, it could take only 3 hours or so to write a white paper. Basically, no more MiCA obligations for them. Meanwhile, ordinary shares (and other securities) are issued by well-established companies. Trading venues (e.g. Euronext, Nasdaq) have to carry out internal due diligence to determine which securities they will allow to trade. For example, criteria could be that the company must have been active for the last 3 years, the market capitalization must be at least 5 million, and the company must have audited financial statements. MiCA has no such requirements. Trading platforms, exchanges will have to define all the rules themselves. This requirement will indirectly get rid of useless crypto assets - not all will be able to comply with trading platforms due diligence requirements or submit MiCA complaint white paper which trading venue accepts. Those “unadmitted” may go to not authorized intermediaries, DEX. And users who buy from MiCA authorized exchanges, trading platforms will be in a better position than those who buy from unregulated entities.
Another issue is that some intermediaries want to avoid authorization and are trying to find ways of doing so by setting up complex structures with hundreds of global entities and saying that in the EU they will provide only lightly regulated service (such as reception and transmission of orders) and route those orders to non-EU regulated trading venues. MiCA trading platforms cannot trade on their own account. Their business model should be to generate fees and commissions, otherwise they may have an information advantage over their members. I assume this is the main reason why the intension is not to establish trading venue in the EU.
So far, this section has mostly referred to other crypto assets. The situation is different for issuers of stablecoins (EMTs or ARTs), as they are subject to capital requirements that will limit their risk appetite. For EMT issuers, the initial capital is 350k euro, and once in operation, issuers must calculate their own funds according to specific methods (based on the volume of activity) and use this amount if it is higher than initial capital. For issuers of ART initial capital is 350k euro or up to 3% of the value of the reserve. 3% of the reserve value is a high amount, especially considering that these are only CET1 instruments. In comparison with traditional finance, let's take asset managers, their capital requirement is only 125k euro (subject to an increase if AUM exceeds 250 mln euro) and they manage billions of assets. Both ART issuers and asset managers are subject to the requirement to secure the assets in custody, so the capital requirement for ART issuers is extremely high and double (i.e. you must have own funds and to safeguard those reserves at credit or other regulated institutions which already have own funds requirement for that asset). Capital requirement for CASPs is much higher than for other traditional intermediaries as well. CASPs are subject to a fixed overhead requirement, which, in simple terms, is ¼ of company’s annual expenses, which is high for start-ups due to their investments in technology or human resources when they start business. Furthermore, they can only have only CET1 instruments which I never understood why is that. Insurance which is allowed not as option since it decreased capital even more. This is the opposite of the EU's aim to foster a number of innovation – with frozen capital, start-ups won't have much left for the investment into the technology and innovation.
Role of traditional intermediaries
If a firm manages assets for others (fund managers, pension funds) or gives advice, custody assets and there is at least one financial instrument, the firm must comply with MiFID rules and obtain a license accordingly. Under MiCA, if a firm provides a service with at least one crypto asset, the firm must comply with MiCA either by obtaining a license or by applying for an extension of the license (for already regulated firms that already provide analogous traditional services, Article 59). As clients may in the future ask for portfolio diversification, especially in relation to stablecoins, more traditional asset managers, banks and other regulated entities should also be concerned about the development of MiCA. Because if they include in clients portfolio at least one crypto asset, they will need MiCA rules. At the moment the regulatory approaches goes to diverge direction. Let's take as an obvious example the suitability regime (i.e. tests to check the client's objectives, risk level, financial capabilities). MiCA and MiFID requirements for very similar in its nature and the objective suitability test differ. So it will be more complicated for clients to fill in two questionnaires that are not aligned. The same applies to periodic statements. Stablecoins, in particular EMTs (they are traditional asset and stablecoin, service with which is subject to MiCA requirements), will become more popular because of tokenization, this may be an issue in the future. Asset managers engage a bit even now as of Q1 2024, there were 77 investment funds with crypto exposure, with a net asset value (NAV) of between 2-4 bn euro. These are mainly alternative investment funds (EU version of hedge funds) as maximum investment limit for retail UCITS funds is 10% of NAV. In addition, UCITS funds may hold stablecoins as a liquid asset with a 20% limit. But there are different interpretations in Member States on this, so ESMA is conducting a consultation on eligible assets for UCITS funds, which includes a question on crypto asset exposure, and will clarify this later.
As crypto assets are complex products, the regulation of them is also complex but when interpreted correctly one will see that for honest activity it does not put too much prohibitions. I hope that this post will give a bit of some clarification on the above aspects.
Last modified 22/09/2024
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