Crypto View - July 2024

Since the last Crypto View we have had some political developments in both the UK and US. While President Biden and former President Trump's views on crypto are well known, the decision by Biden to stand aside for the November election has introduced an element of uncertainty to the future of cryptoasset regulation in the US. The same is true in the UK, where we are still waiting to see how a new Labour government might impact crypto regulation here.

This month has been marked by significant regulatory developments in the crypto sector, with the approval of Ether ETFs standing out as a major milestone. We also delve into the latest in DeFi, DAOs, and the UK's updated draft bill on digital assets as personal property. 

Turning our focus to MiCA, in big news ESMA has released a legal opinion on the broker model used by many crypto firms to route EU trades to exchanges outside the EU, indicating that the MiCA authorisation application for these firms should be carefully scrutinised to avoid regulatory arbitrage- we've shared our thoughts on this below. We also observe a concerted effort toward harmonising the regulatory environment for cryptoassets across the EU. These updates include the introduction of guidelines and consultation papers aimed at clarifying the classification of cryptoassets, enhancing the supervision of cryptoasset service providers, and establishing a standardised approach for reporting and compliance under MiCA.

TradFi gains approvals...and restrictions

SEC approves Ether ETFs

The Securities Exchange Committee (SEC) has approved filings for the long-awaited spot exchange-traded fund (ETF) for ETH, Ethereum's native cryptocurrency. Nine ETH ETFs received approval from the SEC on 22 July 2024. This follows the approval of BTC spot ETF back in January, which marked the most rapid influx of funds into exchange-traded products ever recorded, propelling the price of the leading cryptocurrency to unprecedented highs. Despite ETH ETFs achieving trading volumes exceeding $1 billion on their first trading day, with a net flow of $106.78 million, their fund inflows have yet to reach the heights observed in BTC-focussed ETFs. For perspective, BTC ETFs boasted a first-day trading volume of $4.5 billion and a net flow of $600 million. Nonetheless, it is predicted that the new ETH ETF could see as much as $20 billion of investment in its first year.

European Lawmakers introduce updated rules on banks' cryptoasset activities and exposures

On 19 June, the European Parliament and Council introduced the Capital Requirements Regulation 3 (CRR3) and Capital Requirements Directive 6 (CRD6), a comprehensive legislative package that includes new guidelines for banks engaging in cryptocurrency operations. The CRR3 and CRD6 regulations, which took effect on 9 July, introduce a transitional crypto regime. This regime categorises cryptoasset exposures for banks by assigning specific risk weights and limits their direct exposure to the most speculative cryptoassets.

We then saw the Basel Committee on Banking Supervision publish its final disclosure framework encompassing banks' cryptoasset exposures. The Committee also maderevisions to its cryptoasset standard. Set for implementation on 1 January 2026, the amendments include clarifications on stablecoins' reserve assets and a due diligence requirement for banks to guarantee a thorough understanding of the stablecoin's stabilisation mechanism.

ECB publishes report on stablecoins' impact on banks' balance sheets and prudential ratios

The ECB has published commentary about the theoretical dynamics between stablecoin issuers and credit institutions. The analysis reveals that collecting deposits from stablecoin issuers transform retail deposits that can serve as a stable source of funding for banks into volatile deposits that cannot, serving as a less efficient source of funding and weakening a bank's liquidity coverage ratio. This is because banks need to reinvest deposits from stablecoin issuers in low-risk assets to maintain their liquidity targets, as these deposits face significant short-term outflow risk (unless the stablecoin holders can be identified). Exempting central bank exposures from the leverage ratio may mitigate or exclude the prudential impact on capital and incentivise stablecoin issuers to contract with central banks.

FCA and Law Commission updates for the UK

The Law Commission publishes a scoping paper on DAOs

The Law Commission has published a scoping paper on Decentralised Autonomous Organisations (DAOs), establishing a definition, categorising them legally, and exploring potential legal reforms to support their development (without yet making formal law reform recommendations).

Released on 11 July 2024, key findings include:

• No immediate requirement for a DAO-specific legal entity to be created but a review of the Companies Act 2006 and other business organisation laws is recommended to better integrate technology into governance.

• A proposal to explore the creation of a not-for-profit association with flexible governance for non-profit DAOs and a suggestion that the planned upcoming review of trust law could include considerations for more adaptable trust structures.

• A reassessment of anti-money laundering regulations to ensure they align with technological advancements, such as distributed ledger technology (DLT).

The paper also highlights important considerations in financial services and securities regulations for DAO participants. The paper states that "it is possible that the governance tokens issued by some DAOs could constitute security tokens" and that this will need to be determined on a case-by-case basis using FCA guidance. It also considers the regulatory implications of DAO activities, such as treasury and security dealings, which may require FCA authorisation and/or compliance with regulatory obligations such as the Prospectus Directive. Additionally, it confirms that "it is possible for a DAO to be a CIS" but again this should be assessed on a case-by-case basis. 

If you would like to discuss this further, please contact me, George Morris, or Oli Ward.

The Law Commission publishes draft Bill and supplemental report on ownership of digital assets

Following the Law Commission's final report, "Digital assets as personal property," in June, the Law Commission has published a supplemental report and draft Bill that would validate a third category of personal property. This report aims to clarify that digital assets, including cryptocurrencies, can indeed be considered personal property, addressing prior legal uncertainty. The proposed legislation would play a crucial role in how digital assets are treated, especially in scenarios such as theft, bankruptcies or succession planning, potentially benefiting the projected 4.7 million Britons holding crypto. The Government is currently reviewing this proposed legislation and other recommendations from the June 2023 report.

FCA provides further guidance on best practice for cryptoasset promotions

Just as we were about to publish Crypto View on 7 August, the FCA published findings from its review of crypto firms' compliance with PS23/6- Financial promotion rules for cryptoassets. The 'back end' rules contained in this Policy Statement cover topics like the 24 hour cooling off period, personalised risk warnings, client categorisation and appropriateness assessments.

Readers won't be surprised to hear that the FCA had some serious concerns with the industry's application of its rules, and while some firms demonstrated good practice, the FCA found multiple instances where firms did not meet the required standards. Additionally, the FCA confirms that firms should not be relying on industry comparisons to benchmark what is acceptable, due to the levels of poor practice in the market- instead firms should engage with the FCA directly.

Please do reach out to me directly if you have questions on the UK's financial promotion regime.

Travel Rule Guidelines

The EBA has issued new guidelines on the "travel rule" to combat money laundering and terrorist financing in cryptoasset transactions. These guidelines expand on the types of information that must accompany fund transfers and certain cryptoasset transactions. They also outline the necessary details and conditions that must be incorporated into the policies and procedures of Payment Service Providers (PSPs), Intermediary PSPs (IPSPs), Crypto Asset Service Providers (CASPs), and Intermediary CASPs (ICASPs).

Crypto Regulations around the world

South Korea: First crypto regulation comes into effect

Passed on 18 July  2023, South Korea's Virtual Asset User Protection Act has now come into effect, following a one year grace period. The framework enforces stricter requirements for digital asset exchanges, with an aim to enhance investor protection. Obligations on service providers include to safe keep at least 80% of user crypto deposits in cold storage separate from their own funds and to maintain cryptocurrency reserves equal in amount and type to customer deposits.

Switzerland: Stablecoin Guidance

The Swiss Financial Market Supervisory Authority (FINMA) has published its guidance on stablecoins, highlighting risks related to bank guarantees that might bypass licensing requirements, and emphasising concerns over money laundering and reputational damage to the Swiss financial sector. FINMA also details regulatory expectations for stablecoins and mandates minimum requirements for default guarantees to safeguard depositors, aiming to address and mitigate associated risks.

Hong Kong: Distributed Ledger Technology (DLT) Guideline

On 17 July 2024, the Hong Kong Monetary Authority (HKMA) and the Financial Services and the Treasury Bureau (FSTB) released conclusions to their December 2023 consultation on regulating stablecoin issuers in Hong Kong. The paper covers definitions, licensing, and supervisory aspects of the topic. The HKMA is currently preparing a bill to implement the regulatory proposal and will soon publish guidelines to clarify licensing and supervision processes for compliance.

Qatar: Distributed Ledger Technology (DLT) Guideline

The Qatar Central Bank has issued the "Distributed Ledger Technology (DLT) Guideline" to regulate DLT use in the financial sector, supporting the country's FinTech Strategy and Third Financial Sector Strategy. This regulatory framework aims to encourage financial institutions to innovate using DLT, which promises enhanced efficiency, lower costs, and improved security.

This month in MiCA

This month has seen a number of jurisdictions begin to publish information on their approach to the MiCA authorisations.

Spain

The Spanish National Securities Market Commission (CNMV) has released two documents (the Authorization Manual for Crypto Asset Service Providers (PSC) and the Notification Model for financial entities) to facilitate the application and notification process for cryptoasset service providers. These are designed to clearly guide and ensure compliance with MiCA and are mandatory for any firm seeking to engage in the provision of cryptoasset services to ensure a standardised approach to authorisation and notification.

To discuss Spanish MiCA authorisations, please reach out to my colleagues Maria Tomillo and Gema Fernandez.

Luxembourg

To gauge the level of interest and planning among cryptoasset firms with existing authorisations, the Luxembourg Commission de Surveillance du Secteur Financier (CSSF) issued a questionnaire in June. This questionnaire is mandatory for firms holding the necessary authorisation and intending to offer crypto-related services as per Article 60 MiCA, with responses due by 26 July 2024.

To discuss authorisation in Luxembourg, please reach out to my colleague Cathrine Foldberg-Moller.

Cyprus

Similar to Luxembourg, the Cyprus Securities and Exchange Commission (CySEC) issued Circular 648 informing regulated entities about the notification procedure under Article 60 of MiCA. Again, existing regulated firms are required to complete the questionnaire, with a deadline of 26 July 2024.

If you are considering applying for authorisation in Cyprus, we would be more than happy to discuss this further with you, along with our colleague Grigoris Sarlidis at Erotocritou.

Italy

The Bank of Italy has issued a Communication to clarify the distinctions among cryptoasset categories, their risk profiles, and their appropriateness for payment functions, emphasising the regulation's role in reducing regulatory uncertainty and organising the cryptoasset market.

To discuss authorisation in Italy, please get in touch with my colleagues Romeo Battigaglia and Mirella Di Carlo.

As well as the above, the European Securities and Markets Authority (ESMA) and EBA have released several publications related to MiCA in the last month.

ESMA

On 31 July, ESMA published an opinion addressed to national competent authorities (NCAs) to address perceived regulatory and supervisory arbitrage risks stemming from business setups that involve a multifunction cryptoasset intermediary (MCI) only seeking authorisation under MiCA for brokerage services, rather than as a trading platform. In these setups, which are currently prevalent across the EU, an international exchange operated outside the EU has a group company located within the EU authorised as a broker to gain access to EU clients. The opinion shares criteria for NCAs to consider when assessing a CASP's MiCA authorisation application to avoid this regulatory arbitrage.

To be clear, the Level 1 text of MiCA, does not expressly prohibit EEA-based MiCAR brokers from broking onto non-EEA exchanges - indeed the inclusion of the activity of reception and transmission of orders as an activity suggests the drafters contemplated this. However, as outlined by ESMA, the concern is that this "brokerage model" could be used to circumvent MiCAR requirements on trading venues, as customers would be able to access a non-EEA venue via an EEA broker. ESMA suggests that in such circumstances, and particularly where the non-EEA venue is part of the same group as the EEA broker, the non-EEA venue is in fact soliciting clients in the EEA in breach of MiCA. 

The focus of the Opinion is very much on intra-group arrangements, rather than between different firms, and it does make it look as though MiCA was drafted without an understanding of how the crypto market in Europe operates. ESMA outlines four factors that regulators should consider as very likely indications of unlawful solicitation of EEA clients: 

• the EEA broker systematically routes orders received to the group's execution venue located outside of the EEA; 

• the EEA broker has not analysed the availability of other suitable unaffiliated execution venues; 

• when promoting or advertising its services, the EEA broker relies on the reputation and brand of the non-EEA exchange to attract business from EEA clients, making it, for instance, difficult to distinguish its services from those of the group's execution venue; and

• the EEA broker has no or very limited sources of revenue (e.g. fees or commissions, spreads) for its brokerage activities with EEA clients or has revenue flows that significantly diverge from what would be expected where an independent broker and independent execution venue interact. 

Despite the Opinion, it does continue to be the case that the routing of orders by EEA-authorised brokers to non-EEA exchanges is not expressly prohibited, it will likely just prove to be far harder than firms anticipated. ESMA outlines a very narrow path forward for brokers who wish to continue operating in this way. This involves firms having sufficient substance in the EEA (EEA brokers cannot just be a letterbox), firms having suitable oversight of outsourced functions, ensuring that conflicts of interest are appropriately managed, and being able to demonstrate that they are achieving best execution for their clients. 

Further, in specifying the four factors listed above, we can see that ESMA is explicitly targeting large exchanges which hold their liquidity outside the EEA and which they consider are utilising a "brokerage model" to gain access to EU clients, without moving their activities to the EU. It sees these firms as engaging in regulatory arbitrage by only seeking authorisation under MiCA for brokerage services (e.g. reception and transmission of orders, execution of orders for crypto assets on behalf of clients and/or exchange of crypto assets for funds or for other crypto assets) while leaving a large part of the group activities (and in particular the operation of a trading platform for cryptoassets) outside of the EU, and so not subject to MiCA. 

Classifying Cryptoassets

MiCA has published a consultation paper on guidelines for explanations and opinions to be submitted when classifying cryptoassets. Firms will be required to submit an explanation or legal opinion to justify their classification of cryptoassets under certain circumstances. The consultation seeks feedback on the draft guidelines that set out a uniform test in the form of a flow chart for crypto-asset classification to ensure consistent application of MiCA. Feedback is also requested on the standardised templates that firms would use to justify the classification of a cryptoasset in the following cases:

• When submitting a white paper for asset-referenced tokens (ARTs), which requires accompanying legal opinion that explains the classification of the cryptoasset.

• When submitting a white paper for cryptoassets that are not ARTs or e-money tokens (EMTs), which requires an accompanying explanation of the classification of the cryptoasset.