Patrick Hansen is the Head of Blockchain at Bitkom, and a RegTrax Contributor for the European Union
On September 24th, 2020, the EU Commission published a proposal for the regulation of crypto assets: the “Markets in Crypto-Assets Regulation” (MiCA). The proposal is part of a comprehensive “Digital Finance Package,” which also includes other documents such as a “Digital Finance Strategy,” a “Retail Payment Strategy,” and legislative proposals for a “DLT Pilot Regime” and for more “digital resilience” in the financial sector. Once adopted and in force, the MiCA will be directly applicable law in all EU member states and regulate all issuers and service providers dealing with crypto-assets.
The MiCA has the potential and the outspoken ambition to set global standards for the oversight and regulation of digital, blockchain-based assets. By implementing clear-cut rules and long-term legal certainty, the EU could attract crypto talent, companies and investments from all over the world. On the other hand, critical voices fear that parts of the regulation might overshoot the mark, impose insurmountable constraints on businesses and put an end at various innovative crypto use cases in the EU. In this piece, I will briefly outline the MiCA’s genesis, present its key regulatory aspects, and evaluate its possible positive as well as negative implications for the crypto-sector.
From Zero to MiCA in just Two Years
For some, the crypto market in Europe is still nothing more than an often-talked about, but financially insignificant, nerdy niche. So how did this legally binding and directly applicable regulation emerge in the EU? In my view, MiCA is the result of three key developments of the last two years, each of them reinforcing the others.
- At the end of 2017 and the beginning of 2018, within the framework of the EU FinTech Action Plan, the EU Commission instructed the European financial supervisory authorities (EBA, EIOPA, ESMA) to examine the applicability of EU financial law to these new types of crypto-assets (e.g., Bitcoin). This was no sooner said than done—the European Banking Authority (EBA) published its Report with Advice for the European Commission in early 2019. According to this report, crypto-assets do not fall under EU law to a large extent, while at the same time posing non-negligible consumer protection and money laundering risks. The mandate was clear: the EU must take action.
- And the EU has taken action, at least in part. Under the 5th Anti-Money Laundering Directive, the EU Commission obliges its member states to take action by early 2020 at the latest. However, this results in a veritable patchwork of national initiatives. Countries such as Germany, France, Lithuania, and Malta have adopted very different rules, while other states have done nothing at all. Ostensibly, the still-young crypto sector has gotten more and more fragmented—a clear locational disadvantage for the EU.
- Diem (formerly Libra), the global stablecoin project initiated by Facebook in June 2019, was a real wake-up call for regulators worldwide. One interpretation of Diem’s emergence is that the blockchain space has clearly grown out of its infancy, with global corporations now working on crypto-initiatives. The realization amongst EU regulators was clear: a fully harmonized, comprehensive, and binding legal framework was needed in order to prevent regulatory loopholes and a fragmented market.
Conclusion: A combination of a lack of applicable EU law, increasing regulatory fragmentation within the EU, and a maturing crypto sector with the lighthouse project Diem (considered by many regulators and politicians to be a threat to financial stability and national sovereignty) forced the EU to act.
Which rules apply to crypto-assets under MiCA?
The MiCA includes all types of crypto-assets that are not yet covered by EU financial law (especially MiFID II). This also means, however, that “security tokens” (tokens that function like existing securities, such as company stocks or bonds) that are already regulated as shares, bonds, or investment funds do not fall under the MiCA. For all other forms of crypto-assets, various regulation categories are created:
- Crypto-assets generally, as a “catch-all” category (e.g., bitcoins, ether, litecoins, etc.)
- Utility Token (e.g., Filecoin token, Basic Attention Token, etc.)
- ART – Asset-Referenced Token (e.g., Libra Basket Coin, etc.)
- EMT – E-Money Token (e.g., USDC, Libra Euro, etc.).
ART and EMT allude to what we commonly refer to as stablecoins, depending on whether they are pegged by a single fiat currency (e.g., Euro, U.S. dollar, etc.) (EMT), or are linked to several fiat currencies, commodities such as gold, or the value of other crypto-assets (ART). For these two “stablecoin” categories (i.e., ART and EMT), there are also additional requirements if the token is considered “significant”— for example, if a broad usage and a large emission volume are expected. This addition was obviously made with the Diem project in mind.
Rules for issuers:
Issuers of these crypto-asset categories in the EU must, in the future, publish a white paper (if no exception applies) and send it in advance (20 days prior to the emission) for notification to their respective national financial supervisory authority, such as the BaFin in Germany. The supervisory authority can then prohibit the issuance of those tokens. Further, for ART, the issuer requires an authorization to offer ART and the explicit prior approval of the white paper by the national financial supervisory authority. Additionally, for “significant” ART & EMT crypto-assets, the European Banking Authority (EBA) is responsible for supervision and approval, with the help of to-be-formed colleges of national supervisors. Depending on the crypto-asset category, different regulatory duties and requirements will therefore apply for issuers. If all obligations are fulfilled, the crypto-asset can be issued and offered directly throughout the entire EU market.
Rules for service providers:
Except for existing credit institutions and MiFID II (EU Markets in Financial Instruments Directive) investment firms, services based on crypto-assets—for instance, engaging in activities such as custody, brokerage, trading, or investment advice—will require prior approval from national supervisory authorities to offer crypto asset services under MiCA. These regulatory requirements concern, among other things, the initial capital reserves, the security of the IT infrastructure, the corporate governance structure, and the suitability of the management board. For countries like Germany, where licenses already exist for certain crypto-related financial services, there will be “simplified authorization procedures” to upgrade those licenses. This could turn out to be a major competitive advantage for EU nations that are already pioneers in the crypto space (such as Germany), since those service providers will supposedly be able to acquire the new licenses more quickly. Again, once approved, the service can be offered throughout the EU via the European financial “passporting.”
In addition to those rules for crypto-asset issuers and crypto-asset service providers, MiCA also introduces rules against market manipulation and insider trading on crypto asset trading platforms. For example, leveraging large amounts of crypto-assets (so-called crypto whales) on regulated crypto-exchanges in order to drive prices and thereby profit would no longer be allowed. Just like in the traditional capital market, those activities will be illegal in the EU once MiCA comes into force.
A Political Milestone for Crypto Adoption—If Key Criticisms are Addressed
Let us start with a positive outlook. The MiCA will create a fully harmonized European crypto-asset market. It aims at establishing legal certainty throughout the EU via clear classification of assets and transparent guidelines for service providers and issuers. Thanks to this new legal framework, more institutional investors and resources will enter and grow the market. Plus, due to the size and relevance of the EU internal market with its nearly 450 million customers, the MiCA can potentially set global standards and shape regulation internationally, similar to what the General Data Protection Regulation (GDPR) has achieved in the data protection sector.
From a global perspective, the EU is undeniably taking a leading role with the introduction of this proposal, particularly in light of the inconsistent regulatory environment in the USA (which varies largely among states and offers the potential for state and federal laws to conflict) or the restrictive attitude towards cryptocurrencies of many Asian countries like China, India, or Indonesia. In June 2020, Valdis Dombrovskis (the former EU-Commission Vice President for Financial Services), openly stated the EU’s ambition to lead the way in global crypto-regulation. The MiCA could prove to be a critical piece towards that goal and attract crypto talent, companies, and investments from around the world. With technologies such as Cloud Computing or Artificial Intelligence being by now out of the EU’s reach in the global competition, could the EU become a globally leading vanguard in the blockchain space?
MiCA’s success largely depends on many open questions and some key criticisms of the proposal that still need to be addressed or rather changed in the legislative procedure. From my point of view, apart from numerous minor technical and judicial criticisms on single articles and wordings, the major concerns come down to three key areas.
- The regulation of utility tokens and the question of technology neutrality. Utility Tokens are defined in MiCA (art. 3 (5)) as a “type of crypto-asset which is intended to provide digital access to a good or service, available on DLT, and is only accepted by the issuer of that token”. The scope of this definition clearly includes non-financial types of assets, for example DLT-based mobility vouchers. Currently, voucher-like assets such as frequent flyer miles or Ebay vouchers do not fall under EU financial regulation (see EU directive 2016/1065). Hence, in order to ensure a technology-neutral policy approach, they shouldn’t be included in the scope of MiCA either, only because they are based on DLT. The commission should reconsider the scope of the regulation here, otherwise that could prevent a lot of interesting non-financial blockchain use cases in the real economy due to regulatory hurdles (whitepaper, etc.), compliance costs, and tax reasons.
- The regulation of Decentralized Finance (DeFi) and decentralized token issuances. The issuance of a crypto-asset in the EU requires, amongst others, the publication of a white paper and notification to a supervisory authority and the establishment of a legal entity in the EU. DeFi token projects such as Uniswap, Compound, or Maker could clearly never comply with these standards. While they might benefit from the grandfathering clause (crypto-assets issued before the entry into force of MiCA will not need to comply, with the exception of ART, and EMT), future DeFi tokens will not. And as a result of their incapacity to comply due to their decentralized nature, crypto trading platforms under MiCA won’t be allowed to list them any longer. Obviously, this would also be true for all well-known crypto-currencies such as Bitcoin, Ether, Litecoin, etc., if—hypothetically—they were to be issued after MiCA’s entry into force.
The DeFi ecosystem is a – if not the – crucial driver of innovation in the crypto space. If the EU wants to enable a thriving EU crypto market and EU crypto-asset service providers to be competitive, it clearly shouldn’t put an end to the legality of future DeFi tokens and projects. Nevertheless, this whole concern depends on the definition and interpretation of an “issuer of crypto-assets” who according to MiCA (art. 3 (6)) is “a legal person who offers to the public any type of crypto-asset […].” The EU Commission or the EU financial supervisory authorities should clarify that decentralized projects don’t fall under the definition of a “legal person” and should thus be exempted from the aforementioned regulatory obligations.
Obviously, the difficulty will be the definition and operationalization of “decentralization” criteria. Once established, on the other hand, it would not only provide clarity with regards to decentralized token issuances, but also to decentralized financial services such as decentralized exchange, borrowing, lending etc. and their applicability within MiCA. Otherwise, projects like Uniswap, Compound, Aave and others are doomed to a long-term regulatory gray area.
- The regulation and effective banning of stablecoins in the EU. The MiCA proposes almost insurmountable challenges for stablecoins. As one example, issuers of e-money-tokens (EMT) must be authorized as a credit institution or an e-money institution and comply with e-money-institutional requirements, separate from the newly introduced EMT-specific requirements regarding a necessary white paper authorization, redemption rights, operational obligations etc.
Plus, under MiCA’s thresholds, most of the relevant stablecoins on the market (Tether, USDC, Dai, etc.) would currently count as “significant”, since they easily exceed one billion market capitalization and/or 100 million daily trading volume. That means that they would need to meet additional obligations, e.g., own capital funds of at least 3% of the average amount of the reserve assets (art. 41 (4)). Tether, for example, with currently approximately 25 billion US Dollars backing its stablecoins, would have to hold at least 750 million(!) of own funds.
The issuance of stablecoins is, in most cases, not a very profitable undertaking. But even without this knowledge, it seems quite clear that no issuer of the most used stablecoins on the market will be able and willing to comply with all those obligations and apply for EU licences. That means, however, that they can’t be listed on EU trading platforms, a heavy locational disadvantage for EU trading platforms. Of the 30 trading pairs with the highest trading volumes of the biggest crypto trading platform Binance, 26 include a stablecoin. Over half of all Bitcoin trades are effectuated with Tether alone. This effective banning of basically all relevant stablecoins for EU crypto asset service providers would hence not only radically limit the competitiveness of EU-regulated companies, but presumably drive many EU consumers towards non-EU regulated foreign exchanges, thereby largely thwarting the EU’s goal of better consumer protection.
My understanding of the harsh stablecoins regulations, which cover a big part of the MiCA proposal, is that the EU stakeholders’ fear of the economic and monetary implications of the Diem project made them abandon their otherwise reasonable and proportional approach towards crypto and set a sign of political strength. This becomes even clearer when considering that the EU openly accepts to create an overlapping regulatory framework for e-money-tokens, where both the E-Money-Directive and the MiCA apply. For all other crypto-assets including security tokens, where only MiFID II applies, a clear and unique regulatory handling was the explicit goal. Without further changes—namely lower and more proportionate requirements and, for example, changes to the definition of “algorithmic” stablecoins so that it could at least apply to the DAI-stablecoin (“algorithmic” stablecoins do not fall under the definitions of EMT & ART and would therefore benefit from the grandfathering clause and lower requirements)—the MiCA will basically suppress stablecoins and damage EU companies as well as customers.
More generally speaking, the MiCA will only prove a success if the requirements for startups are not set too high. The EU commission’s impact assessment of the proposal currently estimates 35000-75000 EUR one-off costs for the whitepaper, 2.8-16.5 EUR million one-off compliance costs for unregulated entities, plus 2.2-24 million recurrent compliance costs (capital reserves, reporting, IT-security, governance, etc.). These financial and administrative burdens could prove insurmountable for some of the younger market participants.
There is a fine line between global locational advantage through clear regulatory rules and the outward migration of innovative companies due to too high requirements. During the ongoing feedback process, the EU Commission should be particularly attentive towards the needs of younger market participants in order to ensure the viability of the startup ecosystem that propelled this whole crypto industry in the first place.
It is hard to guess the date when the MiCA will be adopted and come into force, especially considering the upcoming legislative process in the EU Parliament and the Council of the EU, as well as the foreseen transition period of 18 months. Based on estimations from EU regulators and comparisons with other EU-regulations in the financial sector, we will probably have to wait between two to four years from now until the rules apply.
The discussion on crypto-asset regulation has transformed from a nerdy, niche discussion to a priority agenda item in the highest political institutions and levels in Europe. As one example, I recently had the honor of moderating a fireside chat on crypto regulation between German State Secretary Dr. Jörg Kukies and EU Commission Director Marcel Haag (an archived version of the event is available here). Also, the crypto-industry is now much better organized politically in trade associations and industry representations (INATBA, Bitkom, etc.) and has learned how to engage with political stakeholders and express its interests.
This maturing political ecosystem around crypto assets is what makes me the most confident that suitable solutions for the major concerns raised here will be found and that the great potential of the comprehensive MiCA proposal will be realized. Put into crypto-terminology: I am bullish about the European crypto industry and, more generally, a growing European mainstream adoption of crypto thanks to MiCA.
Patrick Hansen is the Head of Blockchain at Bitkom, and a RegTrax Contributor for the European Union