In its report from 19 October 2018, the Securities and Markets Stakeholder Group (SMSG) advises the European Securities and Markets Authority (ESMA) to contain the risks of ICOs and crypto assets. The report not only gives an overview of the current state of regulation in 36 different jurisdictions, but also recommends a new systematical approach to the categorization and, thus, regulation of different types of tokens.
What this briefing is about
This SMP Transactions Briefing highlights the key points of the SMSG report. Although the report is not binding for ESMA or market participants, it provides important perspectives in the crypto context on a European level.
The SMSG advises ESMA on all regulatory and supervision matters. It was established to facilitate consultation with stakeholders and comprises – as ESMA itself puts it – "a broad range of financial market stakeholders" to enable "the broadest possible stakeholder representation". At least five of its members are, at any time, independent top-ranking academics. The SMSG assessment does, therefore, carry some weight and may very well have an effect on ESMA's future orientation with regards to a potential pan-European crypto regulation.
The report provides a taxonomy of crypto tokens, namely:
SMSG evaluates the benefits and the risks associated with different types of crypto tokens, to then determine whether each type of token already falls within existing regulation, and, if so, which aspects need to be clarified or whether there is a need for new crypto-specific regulation.
With regard to payment tokens, SMSG recognizes that the increased competition in payment markets as well as the open-source network approach, which empowers individuals with open access to businesses and services without institutional barriers, can be beneficial, especially as it may facilitate financial inclusion for people lacking access to these institutions (e.g. migrants). Moreover, permissionless DLT networks have the potential to empower its users to have sovereign control of their own private data and digital identification.
SMSG, however, also argues that payment tokens may give rise to new types of fraud, may be used for money laundering and may only be used as mere speculative investment objects. The assumed high volatility is likely to raise to additional investor protection issues tracing back to the market's sole dependency on offer and demand by the network users. There is no additional intermediary (i.e. a central issuer such as a central bank) being able to intervene to smoothen price fluctuations.
From a regulatory perspective, SMSG concludes that payment tokens are currently not considered to be financial instruments pursuant to MiFID II. Given the risk associated with its increased usage as investment objects, SMSG, however, proposes to consider to include payment tokens under the financial instrument catalogue of MiFID II, similar to how it is currently done in Germany. In Germany, the financial supervisory authority (BaFin) classifies payment tokens such as Bitcoin as units of account and thus as financial instruments, based on a broader definition of financial instruments in the German Banking Act (Kreditwesengesetz). However, it is noteworthy that the Berlin Court of Appeal (Kammergericht Berlin) recently objected to the classification of payment tokens as units of account (cf. our SMP Transactions Briefing: Bitcoin – not a financial instrument after all?).
From a commercial perspective, SMSG perceives utility tokens as an alternative for early stage funding of innovative projects to traditional venture capital funding. However, utility tokens also may entail investor protection issues, in particular counterparty and performance risks. The issuer may not deliver the service as expected or go out of business, making the token useless and, therefore, worthless. If traded on secondary markets, such tokens may be subject to speculative investments, leading to investor protection and market abuse concerns.
If tokens are classified as utility tokens by the national supervisory authorities, they are currently not covered by any financial regulation. For regulatory purposes, SMSG distinguishes between transferable and non-transferable utility tokens.
For non-transferable utility tokens, SMSG does not see a need to bring them into the scope of MiFID II, the Prospectus Regulation or the Market Abuse Regulation. Regarding transferable utility tokens, on the contrary, SMSG proposes to consider also including such tokens in the catalogue of financial instruments under MiFID II, as they have the potential to become investment-like objects, possibly leading to risk very similar to risks known on capital markets. If utility tokens were classified as financial instruments, this would also allow to consider relevant secondary markets as Multilateral Trading Facilities (MTF) or Organized Trading Facilities (OTF).
SMSG distinguishes two different categories of asset tokens: (i) asset tokens representing a physical good and (ii) asset tokens representing a monetary claim on the issuer.
Whether asset tokens representing a physical good are covered by MiFID II, the Prospectus Regulation, and the Market Abuse Regulation, depends on whether such tokens qualify as financial instruments (for MiFID II and MAR) and transferable securities (for Prospectus Regulation). If a specific asset token provides the investor with project-related governance rights such as voting rights, the asset token has the essential characteristics of a share. If it is also transferable, it might be considered a transferable security subject to MiFID II and the Prospectus Regulation.
Concerning asset tokens representing a monetary claim, SMSG clearly sees similar characteristics to securities or derivates. If an asset token gives right to a financial entitlement, SMSG is of the opinion that it represents the features of either bonds or shares. If such an asset token is also transferable, it shares important characteristics with transferable securities under MiFID II, and may, therefore, be subject to MiFID II and the Prospectus Regulation.
SMSG urges ESMA to clarify, in particular, the MiFID II definition of "transferable security" in Level 3 Guidelines, as well as the definitions of MTF and OTF and to also clarify whether the organization of a secondary market for such asset tokens can be considered an MTF or an OTF. SMSG additionally urges to add new definitions in order to cover a range of asset tokens as financial instruments.
What are the consequences of the SMSG Report?It remains to be seen, if and to what extent ESMA will adopt the SMSG positions and recommendations and, in cooperation with the European Banking Authority, actively approach the European Commission in order to seek changes to the current regulatory framework.
Irrespective of ESMA's adoption, however, the key take away is that the SMSG clearly tends to adopt a rather strict regulatory approach with regards to different tokens on a European level in order to mitigate potential speculative and market abuse risks.
The SMP #TeamCrypto will report on further developments and is, of course, available for questions and discussion.