On 19 October 2018, the Securities and Markets Stakeholder Group (SMSG) published its Own Initiative Report advising the European Securities and Markets Authority (ESMA) on Initial Coin Offerings (ICOs) and crypto-assets (Report). In its Report the SMSG examines whether and, if so, how crypto-assets should be regulated and advises ESMA on the next steps it should take to mitigate the relevant risks, focusing particularly on investor protection issues.
The report classifies crypto-assets on the basis of their economic function as:
- payment tokens, which are used as a means of payment for acquiring goods or services;
- utility tokens, which are intended to provide access to a specific application or service but are not accepted as a means of payment for other applications; and
- asset tokens, which represent assets such as a debt or equity claim on the issuer.
According to the Report, crypto-assets could potentially increase competition and efficiency in the payments markets, facilitate financial inclusion and provide an alternative source of financing. They may, however, also raise a number of risks, including money laundering, market abuse, speculation and high price volatility.
The Report provides an overview of the most recent market developments with regards to ICOs and maps out the position of securities authorities across Europe. According to the findings, there are divergent regulatory approaches within the European market which result in an uneven playing field and undermine the internal market. At the same time, warnings published by competent authorities do not provide sufficient protection for investors. The SMSG therefore, concludes that a robust and effective regulatory framework is necessary and urges ESMA to clarify the application of existing regulation to crypto-assets.
The application of existing EU regulation to crypto-assets
The Report examines whether and to what extent the current financial services regulatory framework applies to crypto-assets and, in particular, the second Markets in Financial Instruments Directive (MiFID II), the Prospectus Regulation and the rules relating to market abuse. The SMSG notes the following:
- MiFID II should be amended to cover certain crypto-assets that do not fall within its current scope but are nevertheless perceived by investors as investment products. More specifically, transferable payment tokens, such as Bitcoin and transferable utility tokens are increasingly considered as investment products. Additionally, even though the SMSG does not consider them to be financial instruments, some investors may perceive asset tokens that share characteristics with derivatives, although the underlying asset is not a commodity, as investment products. Due to the transferability and fungibility of these crypto-assets, concerns arise in terms of investor protection and market abuse. Therefore, the SMSG advises ESMA to consult with the European Banking Authority (EBA) and ask the European Commission to amend the Level 1 text of MiFID II so that these crypto-assets are included in the MiFID II list of financial instruments.
- Certain transferable asset tokens share common features with transferable securities and may consequently be subject to the existing MiFID II regulation. In particular, transferable asset tokens which give right to a financial entitlement are functionally similar to either bonds (when the entitlement is a predetermined cash flow) or shares (when the entitlement is a share of profit). Moreover, transferable asset tokens which give a right to an entitlement in kind and give the holder decision power over the project, have common features with shares. Some asset tokens which give a right to an entitlement in kind, without giving the holder decision power and that share characteristics with asset-linked notes, could also be considered as transferable securities. ESMA should clarify, by way of Level 3 Guidelines, the definition of ‘transferable securities’ under MiFID II, to determine whether these asset tokens are subject to MiFID II and the Prospectus Regulation.
- Other transferable asset tokens are more akin to derivatives. In particular, asset tokens which give right to an entitlement in kind, without giving the holder decision power where the underlying object is a commodity, share important characteristics with derivative contracts relating to commodities. If these are settled in cash, then they may be considered as ‘financial instruments’ under MiFID II. If they are physically settled and are tradable on a regulated market, a Multilateral Trading Facility (MTF) or an Organised Trading Facility (OTF), then they would constitute ‘derivative products’ under MiFID II. ESMA should therefore, produce Level 3 Guidelines to clarify the definition of ‘commodity’ under MiFID II and determine whether the above asset tokens are to be considered MiFID II financial instruments.
- Where crypto-assets qualify as MiFID II financial instruments, an organisation of a secondary market in those crypto-assets would be classified as an MTF or an OTF under MiFID II. The Market Abuse Regulation would also apply to these MTFs and OTFs. Additionally, a person giving investment advice on or executing orders in crypto-assets considered to be financial instruments would be an investment firm, which, unless exempt, should be licensed accordingly. ESMA should also clarify these aspects by way of Level 3 Guidelines with regards to the transferable asset tokens discussed above.
Lastly, ESMA should consider coordinating national regulatory sandboxes and innovation hubs by providing guidelines with minimum criteria for national regulatory authorities. These should explain the information requirements on the exact scope, operating conditions and investor protection measures of the particular sandbox or hub as well as the reporting requirements regarding the experiences and the FinTech initiatives tested.