TIME TO REGULATE.

Jannah Patchay, Markets Evolution, evaluates the need for regulation of crypto-asset trading, and why now is the right time

As we watch MiFID II gradually morph into MiFID III, spurred on by the Investment Firm Review and set against the dramatic background of a will it/won’t it happen cliff-edge Brexit, the question foremost on the minds of many is probably not “what does the future hold for global crypto-asset regulation?”. And yet this is precisely the time to be asking that very question.

There is often a tendency in the media and in the popular psyche to conflate crypto-assets with cryptocurrency in general or with Bitcoin in particular. This is an overly-simplistic characterisation and neglects the many forms that crypto-assets now take. In fact, whilst crypto-assets are typically conflated with blockchain, both the UK’s FCA and ESMA prefer to make use of a broader description that encompasses any asset based on cryptography and distributed ledger technology (DLT – of which blockchain is a subset) that can be stored, transferred or traded electronically.

The field of comparative global crypto-asset regulation does not yet seem to be a particularly wide one. The earlier fashion for often bewildering Initial Coin Offerings (ICOs), based on flamboyant “white papers”, gave rise to genuine investor protection concerns and attracted a great deal of regulatory attention. These have now given way to the more structured Security Token Offerings (STOs).

There are some easily identifiable trends emerging that are unlikely to be reversed. Firstly, regulators tend to go with what they know when assessing the applicability of their regulatory perimeter and oversight to any new product or service. In practice, this means that the earliest and most obvious forms of crypto-assets captured by regulation have been those that most closely resemble existing regulated assets. Both the FCA and ESMA have identified three broad categories into which all crypto-assets may be sorted: Exchange Tokens, used as a means of exchange, including cryptocurrencies; Security Tokens, which confer an equity stake, represent a debt or a return based on future income; and Utility Tokens, which are not necessarily transferable outside of the application or platform whose functioning they enable.

They then go on to assess crypto-assets within these three categories against the existing regulatory perimeter. Eligible ICOs and STOs would, for example, fall within the scope of the Prospectus and Transparency Directives, which currently govern the offer of securities to the public in the EU. Security tokens may fall within the definition of a financial instrument for MiFID purposes, which would not only bring them within the scope of the full MiFID II/MiFIR regime, but also potentially in scope for the Market Abuse Regulation (MAR) as well. Any party involved in buying or selling, or in facilitating the buying or selling of these eligible crypto-assets is then comprehensively captured by all the applicable rules on marketing, investor protections, governance, transparency and trade execution. Exchange and utility tokens that are pegged to the movement of an underlying currency may fall within the definition of electronic money, and therefore come into the scope of the E-Money and Payment Services Regulations. Given this approach, there has been no specific new legislation introduced for the regulation of crypto-assets in either the EU or the UK.

In the US, a similar approach has already led to both the CFTC and the SEC laying claim to those crypto-assets most closely resembling the assets currently under their respective purviews (commodities and commodity derivatives, for the CFTC, and securities, for the SEC). The complexity of untangling the various combinations of state laws and federal regulatory regimes that might be applicable to any given crypto-asset or its application is extremely onerous.

The shared goals and mandates of most regulators include prevention and detection of market abuse, protection of investors, and identification of potential systemic risks. It is therefore striking that, thus far, the vast majority of exchange tokens (and activities related to them, including the operation of exchanges) remain unregulated. The CFTC categorises cryptocurrencies as commodities – but commodity spot is not subject to the same intensive Dodd-Frank rules as commodity derivatives, in the US. The FCA also considers, in its recent proposed guidance on crypto-asset regulation¹, that exchange tokens are akin to commodity spot and FX spot, neither of which fall under the definition of transferable securities in the UK, or financial instruments more widely in the EU.

There are two salient points to raise in response to this assessment. First, the comparison to FX spot and commodity spot is arguably superficial and only valid when looking at the characteristics of these instruments, as opposed to the nature of their market structures and trading activity. The incumbent spot markets are well developed, highly liquid, with standardised contracts in place, and a high degree of price transparency. Exchange tokens are highly volatile (and correspondingly less liquid), bid/offer spreads are wide and there is a lack of market data and transparency data around the price formation process.

Second, both the UK Cryptoassets Taskforce Report, and the European Securities and Markets Stakeholder Group (SMSG) Advice to ESMA² comment on the prevailing use of exchange tokens less as a means of exchange and more as an investment. Both publications, as well as the recent FCA-commissioned research on Consumer Attitudes and Awareness of Cryptoassets³, make extensive reference to the investor protection concerns around exchange tokens. The combination of these factors, along with the concentration of exchange token holdings amongst a very small number of investors, also contributes to the risk of market abuse.

In the US, an optional regulatory structure for cryptocurrency trading venues is already being considered at the federal level. It would not be unreasonable to predict that the introduction of a UK/EU regulatory regime applicable to exchange tokens will occur at some point in the near future.

There are broadly two options for such a regime: extension of the existing regulatory perimeter, or the creation of a new regulatory regime specifically for exchange tokens. Given the already-visible gaps in the existing regime when it comes to coverage of cryptocurrencies, and the need to navigate their unique characteristics (lying somewhere between and combining aspects of securities and currency spot), the latter is more likely to be the case.

Footnotes:

1. www.fca.org.uk/publication/consultation/cp19-03.pdf
2. www.esma.europa.eu/sites/default/files/library/esma22-106-1338_smsg_advice_-_report_on_icos_and_crypto-assets.pdf
3. www.fca.org.uk/publications/research/consumer-attitudes-and-awareness-cryptoassets-research-summary

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