Shearman & Sterling LLP | FinTech Insights | European Securities and Markets Authority Publishes Recommendations on Crypto-Assets and Initial Coin Offerings
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  • European Securities and Markets Authority Publishes Recommendations on Crypto-Assets and Initial Coin Offerings
    01/18/2019
    The European Securities and Markets Authority has published a report on the application and suitability of the EU securities regulatory framework to crypto-assets, including Initial Coin Offerings. The report is in response to the European Commission's request in its FinTech Action Plan 2018. Like the European Banking Authority, which published a report on the same day in relation to banking sector issues, ESMA found that EU activities related to crypto-assets are fairly low and do not present any financial stability risks.

    ESMA's report focuses on the legal qualification of crypto-assets under EU financial securities laws and highlights that this may differ across EU member states because it will be subject to the national laws implementing EU legislation. ESMA notes that there is currently no legal definition of crypto-assets and that a key consideration is whether a crypto-asset qualifies as a financial instrument under the revised Markets in Financial Instruments package. Where a crypto-asset qualifies as a MiFID financial instrument, the full requirements under various securities legislation may apply, subject to any applicable exemptions.  According to ESMA, the rules in the Prospectus Directive would apply to an issue of crypto-assets offered to the public, including through an ICO, where the instruments are transferable securities. The prospectus for the issue would likely include detailed information on the issuer's venture, the features and rights attached to the crypto-assets, the terms and conditions and expected timetable of the offer, the use of proceeds and risks related to the underlying technology. National regulators could use the existing schedules, adapting the information to the specific characteristics of the issuer and the crypto-assets. ESMA states that the issuer of crypto-assets that are transferable securities admitted on a regulated market located or operating in a member state would be subject to the disclosure requirements of the Transparency Directive.

    ESMA confirms that where crypto-assets qualify as financial instruments under MiFID II a number of investment services and activities are likely to apply, such as placing, dealing on own account, operating an MTF or OTF and providing investment advice. ESMA focuses on platforms trading crypto-assets and the investment services and activities that these platforms may provide. ESMA's preliminary view is that platforms trading crypto-assets with a central order book and/or matching orders under other trading models are likely to qualify as multilateral systems and would need to comply with the requirements applicable to regulated markets, MTFs or OTFs. Different requirements will apply where the operator of a platform is dealing on own account and executing client orders against proprietary capital because the operator will be acting as a broker or dealer. ESMA notes the following challenges arising from the application of MiFID II to platforms and the related crypto-assets:

    1.      Platforms with disintermediated access may experience difficulties in complying with the rules to conduct checks on members and participants because of the number of individual investors and the potential that those investors may not satisfy the requirements;

    2.      Even though certain crypto-assets may be assessed as transferable securities, not all member states consider them to equity or non-equity instruments and as a result the application of pre- and post-trade transparency provisions is not consistent across member states;

    3.      The data reporting and regulatory reporting requirements are not designed to capture crypto-assets; and

    4.      Trading platforms with decentralised business models present issues on the identification of the operator. However, these models might mitigate some risks of traditional trading venues, such as counterparty risk.

    ESMA confirms that the Market Abuse Regulation would apply to crypto-assets that qualify as financial instruments and that are traded or admitted to trading on a trading venue. The Authority notes that new abusive behaviors could emerge which would not be captured by MAR or current market monitoring arrangements. The difficulty in identifying the operator of a trading platform also arises. ESMA also confirms that crypto-assets that are financial instruments may be subject to the Short Selling Regulation but notes that the determination of net short positions is dependent on a list of financial instruments that may not include crypto-assets.

    In relation to the Settlement Finality Directive, ESMA states that if a crypto-asset trading platform or DLT network was a securities settlement system then the system may need to be operated by a system operator. For decentralised trading platforms, the identification of the market operator is an issue again. If the platform was not assessed to be a securities settlement system then it might qualify as a settlement internaliser under the Central Securities Depositories Regulation, which would leave investors without the SFD protections. Furthermore, the SFD requires the participants to be banks, investment firms, settlement agents, CCPs or system operators. For crypto-asset trading platforms and DLT networks, in the absence of any expansion to the scope of this rule by a member state exercising its discretion under the SFD, the range of activities that they provide to individual participants would require reconsideration to comply with this condition. ESMA confirms that if crypto-assets are transferable securities which are traded on a trading venue or transferred following a financial collateral arrangement, as referred to in CSDR, then those crypto-assets should be recorded with an authorized CSD. The operator of the trading platform or DLT network would need to become authorized as a CSD or work with an authorized CSD. Analysis would be required as to whether permissionless DLTs could meet the CSDR requirements, including in relation to the miners in the network that have a significant role in the settlement process. More generally, ESMA highlights that other requirements in SFD and CSDR on both system operators and participants may not easily be translated across to crypto-asset trading platforms and DLT networks.

    ESMA also points out that several national regulators hold the view that some crypto-assets may qualify as units in collective investment undertakings, such as Alternative Investment Funds under the Alternative Investment Fund Managers Directive.

    ESMA notes that there is no EU-level harmonized definition of safekeeping  and record-keeping of ownership of securities and that which rules apply depend on whether record-keeping is at issuer level, in which case national corporate law applies or  at investor level, in which case the EU rules across certain sectorial legislation, such as MiFID II and AIFMD, will apply. ESMA's preliminary view is that control of private keys  on behalf of clients could be safekeeping services, which would bring the requirements on safekeeping and segregation of client assets into play.  

    ESMA also sets out the potential gaps and issues in the existing EU financial services rules when crypto-assets qualify as MiFID financial instruments and when they do not. The report sets out ESMA's views on steps that are needed to address the gaps and issues. For crypto-assets that qualify as MiFID financial instruments, ESMA's view is that primary EU legislation is required to provide:

    1.   Clarification on the types of services and activities that may qualify as custody and safekeeping services or activities under EU financial services rules. ESMA's preliminary opinion is that holding private keys on behalf of clients could qualify as custody/safekeeping services and that the existing rules should apply to firms providing these services. However, ESMA notes that some changes may be required to clarify how the rules should be interpreted to ensure consistent application across the EU.

    2.   Clarification on settlement and settlement finality as applied to crypto-assets and that a distinction between permissioned and permissionless distributed ledger technologies should be made. ESMA considers that permissionless DLTs have governance issues that may make them less suitable to processing financial instruments. In addition, the role of 'miners' would need to be assessed.

    3.   That reliability and safety requirements apply to the protocol and smart contracts underpinning crypto-assets and crypto-asset activities. In general, the cyber security risks presented by DLT should be analyzed to ensure that the existing requirements address those risks.

    Other issues and gaps for consideration include whether MiFID II and its underlying technical standards and guidance need to be amended to: (i) clarify how the existing rules apply to decentralized and hybrid models used by platforms trading crypto-assets; (ii) apply the pre- and post-trade transparency rules to venues offering trading of crypto-assets; and (iii) revise the various reporting requirements to apply them to crypto-assets since these are currently only designed for traditional financial instruments. In addition, ESMA recommends that further analysis should be conducted on how crypto-assets can be brought within the scope of MAR and the SSR.

    For crypto-assets that do not qualify as MiFID financial instruments, ESMA recommends that: (i) a bespoke regime is required, which would allow the rules to be tailored to the specific risks and issues that these types of crypto-assets raise; (ii) the scope of the existing AML requirements be amended; and (iii) the focus should be on establishing an appropriate risk disclosure regime as opposed to a regime that would bring these crypto-assets within the full regulatory regime. Such a disclosure regime would cover the issuer, the project, the rights attached to the crypto-asset, the underlying technology used and any potential conflicts of interest. ESMA's view is that doing nothing would fail to address investor protection and market integrity concerns.

    View ESMA's report.

    View details of the EBA's report.