ANALYSIS — Two leading financial regulatory authorities are preparing to release pivotal reports on cryptoasset regulation throughout the European Union with recommendations that set the stage to create a separate “bespoke” regime for cryptoassets that are not currently subject to regulation in the bloc.
The reports by the European Securities Markets Authority (ESMA) and the European Banking Authority (EBA), scheduled for publication this week, will get close scrutiny from U.S. regulators and market participants watching whether the EU approach will conflict with work underway at the Securities and Exchange Commission, Commodity Futures Trading Commission, Treasury Department and Congress.
First indications are that the two financial blocs — the EU and U.S. — may not be on the same page. The EU reports make scant mention of purported benefits of cryptoassets and blockchain technology, seeing mostly risks —for regulators, investors and markets. U.S. regulators, by comparison, have been more open to the blockchain technology on which cryptoassets rely.
With cryptocurrencies like bitcoin globally traded, the reports could have global reverberations.
European Commission Vice President Valdis Dombrovskis requested the assessments of applicability and suitability of current EU law to cryptoassets. But the reports go considerably farther than the request. They not only outline the bloc’s regulatory challenges but also suggest that steps be taken to prevent risks to investor protection, market integrity and market operations.
Heads up, U.S.
The outcome will matter to U.S. regulators, lawmakers, market participants and developers because the EU has the potential to steer the development of this fledgling technology. Companies and individuals may prefer the certainty of even poorly written EU rules with regional uniformity over U.S. rules scattered over a fragmented array of federal and state authorities. That, in turn, could determine whether investment in cryptoassets or commercial relationships in a supply chain follows a European model.
The ESMA report included a survey sent to the bloc’s national regulators concerning how they treated six sample cryptoassets. The assets were not randomly selected, but were real, “hard to classify” cryptoassets that reflected differing characteristics that ran the gamut of products seen in the market, including cryptoassets that had heavy investment features, some that were designed to access online services (or “utility”), hybrid instruments and some that were used for payments.
ESMA provided national regulators with unofficial disclosures of the cryptoassets that their issuers provided investors, called white papers. The agency then asked regulators whether or not they treated any of the sample cryptoassets as “transferable securities” under MiFid, one of Europe’s major legislative frameworks.
Though the framework is a regional enactment, member states define what a “security” (and by extension transferable security) is in practice, since some countries have very unusual financial instruments due to local corporate and property law traditions. But where national authorities do call an asset a security, issuers and firms trading such securities in their jurisdiction should be subject to not only to applicable national rules, but also a panoply of EU financial rules, including on prospectuses, transparency, market abuse, short selling, settlement, securities depositories and MiFID II, the updated regulatory regime.
Gap in the EU rules
ESMA found that some member states narrowly define transferable securities, but others had broader interpretations that captured a greater range of cryptoassets. Moreover, regulators differ substantially over how to regulate the novel financial products: some national regulators are contemplating bespoke rules for a subset of cryptoassets; others were not. But the noteworthy finding is that the vast majority of jurisdictions don’t believe the rules in place would cover all the varieties of cryptoassets ESMA classified. ESMA estimated that at least 10 percent to 30 percent of the cryptoassets are unregulated.
ESMA’s conclusion? An EU-wide approach is necessary, though one with rules tailored to the particular risks of the financial instrument in question — with anti money laundering rules a common minimum baseline to be implemented across all cryptoassets and jurisdictions. The report also implied that a raft of other rules could come into force in the sector, including harmonized transparency requirements, impacting, among other things, white paper disclosures.
The EBA’s report goes beyond banking, and assesses not only cryptoassets’ deployment as “money” but also cryptoasset infrastructures. Dispensing with a survey, the report observes that most cryptoassets don’t meet the definition of “electronic money,” and services relating to custody and trading platforms aren’t regulated activities under EU financial services law.
For the EBA, that’s a problem. It sees a high risk for money laundering and to consumers who aren’t aware the asset isn’t regulated. Furthermore, the report says national regulators were taking, or were poised to take, very different responses to cryptoassets, from prohibitions of certain cryptoassets to continued non-regulation. Finally, the EBA notes the absence of common EU-wide accounting standards for cryptoassets.
The ESMA and EBA aren’t the final word. But the EBA is advising the European Commission to conduct a comprehensive cost-benefit analysis to determine if any action is required at the EU level. Notably, the EBA believes that any analysis should include a close look at the energy costs associated with blockchain technologies, as well as the costs and benefits of the activities themselves where cryptoassets are being used.
On both points, the analysis poses risks. Blockchain makes big demands on energy supply that are considered by many, especially in environmentally conscious Europe, to be wasteful. And examining the merits of any use of a cryptoasset use at this early stage poses considerable challenges for entrepreneurs seeking to develop a technology before its potential is realized.
The EBA also suggests that authorities should pay close attention to how interconnected crypto-based financing is to the traditional economy. The report is explicit about authorities and institutions adopting a conservative prudential approach to the treatment of exposures to cryptoassets, supplemented by the development of a common template to monitor the level and type of cryptoasset activity underway in a jurisdiction.
Breaking with U.S., UK, Asia trends
The EU reports are the latest example of regulators globally trying to come to terms with the unique features of cryptoassets and their place in regulatory systems built for centralized financial products like traditional stocks and bonds. The reports also make repeated overtures to international coordination in the sector, especially to stop money laundering.
But the clear departures from some international trends deserve attention. Many jurisdictions explicitly seek to balance the benefits of innovation with the risks of untested technologies. Both EBA and ESMA approaches barely refer to the presumed benefits of innovation, and at least one raises a question as to the value of crypto-use cases. The cost-benefit analysis recommended likewise is not framed as one that should weigh efficiency, convenience or increased access to financial services against consumer in devising regulatory policy in the sector.
Neither approach refers to regulatory sandboxes, either, or more general experimental approaches to administrative oversight, which have gained currency especially in Britain, Singapore, Hong Kong and, incrementally, the United States.
Europe also appears far more willing than the U.S. to consider a full-scale, distinct regulatory framework for cryptoassets. Although a series of bills have been introduced to streamline or clarify rules in the sector, U.S. regulators have for the most part felt that the existing regulatory regime is sufficient, and robust enough to adapt to the challenges posed by cryptoassets. Only CFTC Chairman Christopher Giancarlo has viewed the agency's authority insufficient in the space — and even he has indicated a preference for increasing the scope of existing rules, not creating a new framework.
The level playing field
The two reports are silent on the issue of enforcement, but the issue looms large. This is in part because EU member states are largely responsible for enforcing EU financial services law and interpret cryptoassets differently, but it also reflects members’ diverging preferences as to the stringency of supervision that should be applied.
On one end of the spectrum are authorities like Germany’s BaFin, which have attempted — at times to be struck down by courts — to cast a wide net over cryptocurrency transactions. At the other end are jurisdictions like Malta, which in July ushered into law what some describe as the first blockchain/cryptocurrency regulatory framework, and designed specifically to attract cryptocurrency transactions to the island.
Should Americans be worried?
The reports are still subject to European Commission approval and implementation. But Dombrovskis has vocally articulated interest in a joint European approach to cryptoassets, especially in the fight against money laundering. With these reports the Commission will be poised to set in motion a process that would create new pressures to not only conform industry practices to an increasingly harmonized regional regime, but also provide a platform for deeper member state enforcement. If properly and swiftly implemented, Europe could find itself both better regulated, as well as more competitive.
Editor’s Note: Chris Brummer is a professor at Georgetown Law. He is partnering with CQ, Roll Call and FiscalNote to launch coverage of fintech and its implications for businesses, consumers, regulators and lawmakers.