Of Tethers & Pegs — European Financial Services Crypto-Assets Review: Part 4
Regulated ‘financial instruments’ are specifically defined under the MiFID regime. The MiFID regime covers a wide range of instruments 1
In our view, it is clear that Fiat Stablecoins and Crypto Stablecoins (like Dai) are not: money market instruments, credit risk transfer instruments, CFD’s or derivatives. MKR is also not within these categories.
The UK regulator — the Financial Conduct Authority (FCA) — have issued guidance on the meaning of some of the above terms that are helpful for this analysis:
“Transferable securities refer to classes of securities negotiable on the capital markets but excluding instruments of payment. We consider that instruments are negotiable on the capital markets when they are capable of being traded on the capital markets.
Transferable securities include (to the extent they meet this test):
– shares in companies (whether listed or unlisted, admitted to trading or otherwise), comparable interests in partnerships and other entities and equivalent securities;
– bonds and other forms of securitised debt;
– depositary receipts in respect of the instruments above;
– securities giving the right to acquire or sell transferable securities (for example, warrants, options, futures and convertible bonds); and
– securitised cash-settled derivatives, including certain futures, options, swaps and other contracts for differences relating to transferable securities, currencies, interest rates or yields, commodities or other indices or measures.”
Whilst the definition of derivatives under the MiFID regime are very wide (and tortuous to make sense of, particularly when applied to cryptocurrencies that were not envisaged by the legislators), derivatives are effectively used as market instruments intending to provide participants with some hedge or some gain (or protection from loss) based on movements in an underlying asset or index. It is a common feature of derivatives that they allow a large return or loss using a small amount of capital (i.e. they provide leveraged exposure to underlying assets) and that such capital is usually at risk. This use of leverage and the risk of total loss of capital is primarily why such contracts tend to be regulated 2 in addition to their potential impact on the market in the underlying asset they relate to.
Derivatives are not generally accepted as referring to instruments that give merely 1:1 exposure to an underlying asset without any leverage — i.e. if a Stablecoins return could largely be substituted by simply buying one US dollar then it is very difficult to see why a synthetic position in that US dollar as represented by the Stablecoin should be considered a regulated derivative contract for MiFID purposes. For a European law consideration of some aspects of Crypto-assets and EU derivatives law see here.
Given the very widely and poorly drafted EU derivatives definitions, the market function and market use of derivatives (including the ability to permit leveraged positions) are intrinsic to any regulatory analysis of which instruments should potentially be within scope for MiFID purposes on public policy grounds when the technical answer to that question is not clear. However, national competent authorities are the first stage arbiter of instruments that constitute financial instruments within the EEA 3 — subject to the ability for any person to challenge the national regulator in court on a point of European law including the meaning of ‘financial instrument’ and ‘derivative’ under EU law:
“The survey highlighted that most NCAs assessed that crypto-asset case 1, 2, 4 and 6
could be deemed as transferable securities and/or other types of financial instruments
as defined under MiFID II, although there were some variations across NCAs on the
number of cases that would qualify” ….4
“The fact that no NCA labelled case 5 as a transferable security and/or financial instrument suggests that pure utility-type crypto-assets may fall outside of the existing financial regulation across Member States. The rights that they convey seem to be too far away from the financial and monetary structure of a transferable security and/or a financial instrument.” 5
The references above are to tokens that have some investment basis within their architecture (1,2,4 & 6) versus tokens that are purely used as a utility. However, the ESMA review — based on surveys of EU national regulators — was not conclusive in respect of the exact features that would uniformly make a token a financial instrument in the opinion of European national regulators. There appears to be significant differences of opinion other than in respect of those tokens that distribute profits to tokenholders (being tokens that nearly all regulatory experts agree are likely to be deemed some form of ‘transferable security’ and therefore a ‘financial instrument’).
We also note that some Member States may also decide to implement their own additional and unique regulated instruments within their national regimes (such as the German ‘unit of account’) insofar as such implementation is not contrary to EU law including the MiFID regime.
In our opinion, FS and Dai do not represent a financial instrument. It is only with reference to ‘bonds and other forms of securitised debt’ that they could even conceivably be within the potential scope of MiFID but it is obvious why a self-issued loan using a smart contract can not meet even those definitions.
Most importantly, in respect of both Dai and FS they are clearly not negotiable securitised money market instruments. In respect of Dai the debt created within a CDP is also not currently transferable (it must be repaid by the CDP creator whose collateral backs it).
In respect of MKR, the MiFID definition that causes most concern relates to “units in collective investment undertakings” in respect of the sale and purchase of MKR other as a form of payment for services only (i.e. it’s pure utility function).
In Gibraltar and the UK, the definition of a Collective Investment Scheme is the most relevant for this Memorandum, the term is drafted purposely very wide and is at least as wide as the MiFID definition of a ‘unit in a collective investment undertaking’:
“any arrangement with respect to property, the purpose or effect of which is to enable persons taking part in the arrangement, whether by becoming owners of the property or any part of it or otherwise, to participate in or receive profits or income arising from the acquisition, holding, management or disposal of the property or sums paid out of such profits or income…An arrangement..must be such that the participants do not have day to day control over the management of the property subject to the arrangement.. and must have at least one of the following characteristics:
(i) the contributions of the participants and the profits or income out of which payments are to be made to them are pooled,
(ii) the property is managed as a whole by or on behalf of the operator of the scheme”
The use of the term ‘property’ means that arrangements involving nearly any crypto-asset could be within scope. However, given that MKR has a decentralised governance structure it would appear to us that it could not meet the central management and control test of a CIS, which in our opinion would be difficult to do given the smart contract based decentralised nature of the system and the decentralised voting mechanisms.
In addition, even if it was successfully argued that in effect MKR was not fully decentralised from a day to day perspective, any claim that it is a CIS would likely fail since there is no pooling of assets of MKR holders to buy property and no distribution of profits or income arising therefrom to MKR holders.
Each MKR holder who buys an MKR token to hold for the longer-term may have an expectation of profit from holding the same but it can not be not based either pooling of tokenholder assets (as there is no pooling) or on sole reliance on the activities of a few persons directing the management of the MKR token and Dai system (for the reasons stated above).
MKR longer-term holders are subject to the risk of gain or loss on their tokens based on a very wide range of factors and these factors will normally apply to other tokens that are considered to be utility tokens. MKR shorter-term holders are merely using the token to repay CDP obligations and so there can be no sense in which a CIS analysis could attempt to be applied.
We also note that one might also seek to contend that MKR distributes profit arising from the network to MKR holders by way of burning MKR under certain circumstances (thus decreasing MKR supply and potentially helping to maintain or increase the price of MKR on the market) — however the mechanism that provides for such burning does not give rise to a distribution of value to MKR holders and there are alternative scenarios whereby MKR holders face a risk of price loss as a result of more MKR being issued (or of network/protocol failures). In addition, the same second level analysis could be applied to many utility tokens that are not currently considered to be financial instruments.
In our view MKR holders that buy and hold MKR for the longer term are obviously investing in MKR, but that does not itself make MKR a financial instrument (including a ‘transferable security’) for MiFID purposes and the decentralised nature of the protocol does not lend itself easily to such application. In order for it to be a transferable security it would need to operate like a share in an organisation or a unit in a fund and it does not do either to a sufficient degree of correlation.
Whether decentralised DAO tokens such as MKR should be regulated to protect investors is beyond the scope of this review however one would expect a whole new form of regulated financial instrument would need to be created to achieve good regulation for such use cases.
We would expect that MKR could easily be determined to fall within the US definition of a security given the inherent vagueness and plasticity of the Howey test and any offer of MKR to US residents requires very careful consideration.
