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New European legislation for crypto-assets

On 24 September 2020, the European Commission officially published their proposal for the Regulation of Markets in crypto-assets (MiCA) and a pilot regime for market infrastructure based on distributed ledger technology (DLT pilot regime) which are part of a larger package of published EU strategies related to Digital Finance.

Due to the constant development of virtual currencies on the crypto market, in addition to the term “cryptocurrency” a new broader term, “crypto-asset” has been created. As a result, the proposed MiCA regulation offers several definitions of terms related to crypto-assets, since previously a generally accepted definition did not exist. The term crypto-asset itself is defined as “digital representations of values or rights, which may be transferred and stored electronically, using distributed ledger technology DLT (henceforth only as DLT) or similar technology”. Furthermore, MiCA defines DLT technology as “a type of technology that supports the distributed recording of encrypted data”. Blockchains are probably the most known type of DLT; however, it is important to note that these terms are not synonyms.  A blockchain is a type of DLT with a very specific technological base, but not all DLTs are blockchains.

Today there are more than 5,100 crypto-assets on the market with a total market capitalisation exceeding 250 billion dollars. Crypto-assets have many different forms and properties although they can generally be divided into two categories, with cryptocurrencies on one side and tokens on the other.

Cryptocurrencies (such as Bitcoin, Litecoin, Ethereum, Monero) are designed to perform the role of a currency, meaning that they should function as a general-purpose medium of exchange and that they should also be a viable alternative to the legal tender issued by governments. However, they do not have any underlying asset, claim or liability, which makes them susceptible to high price volatility and hinders their ability to effectively perform the role of a currency. They are therefore commonly referred to as traditional “non-backed” cryptocurrencies. Furthermore, the basic idea behind cryptocurrencies is that each of these assets has its own blockchain.

Tokens, on the other hand, are crypto-assets that represent digital representations of interests or rights to (access) certain assets, products or services. Cryptocurrencies are usually used for only one thing (payments) whilst tokens have a wide range of uses, such as payments or access to products or services (for example, the Siacoin utility token is used to access a decentralised Sia cloud storage, the use of which is paid for in Siacoins). Just as cryptocurrencies have their own blockchain, a token, on the other hand, is issued on an existing platform or another blockchain (for example, an ERC20 token is any token that uses the Ethereum blockchain).

The crypto market also gave birth to “stablecoins”, which like Tether (USDT), Multi-collateral DAI (DAI) and Gemini Dollar (GUSD) are variants or rather subcategories of cryptocurrencies that are usually linked to the price of another asset or group of assets and are designed to maintain a stable value. Like the traditional “non-backed” cryptocurrencies, stablecoins are designed to perform the role of a currency, but they also share a number of properties with tokens.  For example, both are usually issued on an existing blockchain, which means they can be identified as tokens from time to time. However, whilst a token is issued with a very specific function or for a very specific purpose, a stablecoin lacks these elements. It is also important to mention stablecoins such as Facebook’s project Libra and the Central bank’s digital currencies (CBDC).

With the development of technology, digital financial services are being used for a growing number of purposes. The current status of European regulation, (many areas are not regulated at all) causes market fragmentation in financial services in the form of crypto-assets. This results in the use of crypto-assets for illegal activities. Some member states (e.g. Malta) have already introduced regulations in the area of crypto-assets whilst others are trying to implement them. Various providers of services connected to crypto-assets have started operating on the Slovak financial market, which has only recently introduced specific requirements for these types of services by transposing the V. AML directive into Slovak law.

The European Union is trying to resolve the aforementioned lack of regulation by introducing MiCA and the DLT Pilot regime, which are meant to develop a solution for addressing the risks associated with the digital transformation, in particular by introducing data protection and adequate supervision.  Furthermore, the new regulation is aimed at creating a more digital financial sector and to provide an EU regulatory framework to facilitate digital innovation in the interest of consumers and market efficiency. These regulations are also a way for the EU to promote an economic recovery strategy for the social and economic damage caused by the coronavirus pandemic. At the same time, a common approach to the digital single financial market would be less of a barrier for European consumers in cross-border operations.

MiCA is aimed specifically at crypto-assets which are currently not regulated by any existing regulation on financial services. They include crypto-assets, utility tokens (crypto-assets used as access keys for services) and stablecoins divided into asset-referenced tokens (referencing multiple currencies commodities, other crypto-assets or a combination thereof) and the newly defined e-money token (referencing a single currency).

The crypto-assets that already fall under existing EU legislation on financial services will continue to be regulated by this legislation. They include crypto-assets that can be classified as financial instruments (defined in Article 4 (1) point 15 of Directive 2014/65/EU of the European Parliament and of the Council), and are therefore subject to EU securities markets legislation (e.g. MiFID).

To ensure consumer protection, MiCA covers all issuers of crypto-assets as well as all companies providing services related to crypto-assets. Providers of services related to crypto-assets (in particular trading platforms, exchange offices and wallet service providers) must have a physical presence in the EU and be subject to prior approval by the competent national authorities before commencing their activities. They will be subject to capital requirements as well as various IT requirements to prevent against cyber theft and hackers. As far as entities issuing crypto-assets are concerned, their obligation is to publish a white paper containing all relevant information on the specific crypto-asset, in particular, a detailed description of the entity issuing the crypto-assets, the project and the intended use of the funds, the conditions, rights, obligations and risks.

As the aforementioned definition has already stated, crypto-assets are one of the main users of DLT in the field of finance. This is because crypto-assets can enable a cheaper, less burdensome way of financing small and medium-sized enterprises (SMEs) through the simplification of processes. Because of this and in connection with the EU’s goal to promote cryptocurrencies and the wider use of DLT, but in a regulated environment, the EU has proposed the creation of a secure framework to support innovation and competition, i.e. the DLT Pilot regime.

The DLT Pilot regime is a Commission proposal which sets out clear and uniform requirements for the operation of the DLT market infrastructure (e.g. the conditions for obtaining authorization to operate the DLT market infrastructure). The authorization to carry out the activity will be regularly checked by the supervisory authorities. The main objective is to remove regulatory barriers to issuance, the trading of financial instruments in the form of crypto-assets and to enable regulators to gain experience in the use of DLT technology in market infrastructures. At the same time, it contains deviations from the existing rules, which serve as an experiment in a safe environment to test solutions using DLT and to provide the basis for possible further changes.

The competent national authorities of the Member States will monitor compliance with all of these requirements and designate a competent authority to be the single point of contact. In the case of asset-referenced tokens, supervision will be performed by the European Banking Authority (EBA). E-money tokens will be subject to double supervision by the competent national authorities and the EBA.

In the Slovak Republic, since crypto-assets are not recognised as an official domestic or foreign currency, they do not represent electronic money within the meaning of the Payment Services Act and have no physical consideration in the form of legal tender, the question remains whether they should be treated as financial instruments. According to MiCA, it is important to distinguish between crypto-assets that qualify as financial instruments and represent the risks of a financial instrument and crypto-assets that have different functions and therefore do not present the same risks (for example, utility tokens). The EU considers their regulation as financial instruments to be disproportionate, as it would hamper innovation. As the new framework aims to provide legal certainty for all crypto-assets, the Commission proposes to clarify whether the current definition of financial instruments (under MiFID II) also covers DLT-based financial instruments.

Since the V. AML directive came into force (10 January 2020) many providers of services related to crypto-assets have been regulated by anti-money laundering institutions and many wallet service providers hold financial licenses (for part of their activities), MiCA will also apply to providers of services related to crypto-assets that have not been regulated under the financial services framework.

The V. AML Directive was transposed into Slovak law and became effective on the 1 November 2020 via an amendment to the Act on Protection against Money Laundering Terrorist Financing. With this amendment, subjects providing services related to crypto-assets were included among obliged entities and are subject to the same obligations as banks and financial institutions. Their duty is to perform due care by verifying the identity of clients before concluding a business relationship with them, reporting unusual business operations to the financial intelligence unit and developing their own activity program that takes into account risk factors and determines the scope of care to be taken to prevent money laundering.

MiCA and the DLT pilot regime are currently only proposals for regulation and must still go through the EU legislative process which can take from 18 to 24 months.  Given the constant development in the area of crypto-assets, this can mean that the proposals may still change significantly. The European Commission also announced its intention to create additional legislative proposals to create an EU framework that would allow crypto-asset markets, as well as the tokenization of traditional financial assets and the wider use of DLT in financial services.