In their recently published Crypto Advice, the independent EU Authority ESMA concludes with the most important advice. They clearly articulate that European regulators should stay away from Option B: Do Nothing.
“financial regulators may consider that certain crypto-assets fall outside of their remit, and in turn should take no further action”
This option will as highlighted by ESMA fail to address the known investor protection and market integrity concerns. As detailed throughout their paper, ESMA finds many reasons why regulators should get further involved and why we should expect to see a lot more activity and updates to regulation. This is also highlighted with the complete disagreement from national authorities when asked to categorize 6 crypto-assets, as shown in the above graph.
ESMA’s founding regulation requires them to present advice to the European Parliament, the Council and the Commission. The view of ESMA will clearly have a major impact on future regulation and we should pay close attention to what they publish.
This article takes you through my Top 3 takeaways from ESMA’s advice on crypto-assets:
- Tokens Benefit End-Consumers
- Investor Protection
1. Tokens Benefit End-Consumers
ESMA finds great potential in “tokenisation of assets”. We can see a very positive attitude towards recent innovation. Efficiencies and benefits to end-consumers are highlighted. Some of the benefits highlighted in the report, and that I find very encouraging, are:
- “‘tokenisation’ has the potential to create beneficial outcomes for both market participants and investors”
- “examples of live cases where a firm has issued a traditional investment in a tokenised form, which was achieved faster and at lower cost than a traditional issuance process”
- “Tokenisation has the potential to enhance the liquidity of certain financial assets”
- “It may also reduce the need for intermediaries”
- “DLT also facilitates the use of smart contracts, which automate the execution of contract obligations, thereby potentially reducing risks and costs. This could in turn provide positive outcomes for both market participants and end-consumers.”
ESMA also takes a strong position in their advice to regulators, when they add a warning for restricting innovation:
“We anticipate potential opportunity costs if these developments were unduly restricted”
2. Investor protection
The report highlights the issues around investor protection. We shouldn’t be surprised to see this, since ESMA’s mission is defined as:
“to enhance investor protection and promote stable and orderly financial market”
Still, I am very pleased to note how these issues get emphasized. Investor protection is in my opinion the single most important priority for the crypto industry. We need to build trust and create fair and orderly markets, in order to truly establish and benefit from the token based economy. At Tritum Digital Assets we are focused on creating the leading integrated financial ecosystem to bridge traditional and digital asset markets. To succeed we need a foundation of trust and we are therefore happy to see this focus from European regulators.
“An issue that arises is whether investors understand the risks that they may be exposed to prior to investment and whether they are making investments that are appropriate to their needs”
ESMA is concerned whether investors understand the risks involved. With unregulated crypto-assets there are no prospectus where investors can find necessary information. Many crypto-assets could have low liquidity, limiting the possibility to exit a position. Another focus area is price discovery, where unregulated markets have limited pre- and post-trade information.
We should see all of the above as comforting in that ESMA clarify existing risks to the European Parliament and with this there will be increased focus on improving regulation. ESMA also raise concern that the existing requirements leaves too much open for interpretation by National authorities and thereby creating regulatory arbitrage. It is noted that current “uncertainty creates risks to investor protection and does not allow for the development of a sustainable ecosystem.”
Settlement is always in focus with crypto-assets due to the nature of Distributed Ledger Technology(DLT). With all nodes of the network holding the same truth of the ledger, and tracking ownership in real time, how will this change our view on CSDs? In EU the settlement of securities are covered under the regulation CSDR. CSDR was designed to be technology-neutral, but was also created at a time when DLT was far from common knowledge and most likely never discussed by the regulators.
CSDR specifies that a CSD has to be operated by a system operator. This would in fact disqualify all decentralized networks as being CSDs, unless they can identify a legal entity appointed as system operator. ESMA highlights that this needs further consideration.
It is however encouraging to note that ESMA is considering the possibility of the DLT network taking on the role as CSD.
“The operator of the trading platform or the DLT network would therefore need to seek authorisation as a CSD”
“Whether permissionless DLTs, due to the specific governance issues that they raise, might fulfill these requirements is an issue that requires additional consideration.”
Imagine a future where securities are, fully regulated, traded and settled on permissionless DLTs. The investor benefits in terms of cost and time reductions are endless. And I believe ESMA is getting it.
“CSDR does not prescribe any particular method for the initial book-entry form recording, meaning that any technology, including DLT, could virtually be used, provided that the book-entry form is with an authorised CSD”
The crypto-advice from ESMA makes some great points about those crypto-assets that qualify as financial instruments. They understand the risks, but more importantly they show that they understand the opportunities introduced by the new technology.
ESMA also makes interesting comments on crypto-assets that do not qualify as financial instruments. They say that policymakers could consider the opportunity to set up a bespoke regime for such crypto-assets. They also acknowledge the need for different requirements depending on the features of these crypto-assets, as some may be further away from traditional financial instruments.
What ESMA is not focusing on in this report is also important. While they present a survey among national authorities designed to understand how crypto-assets are categorized, they do not advice on the need for updated regulation in order to clarify which tokens should fall under the financial instrument definition. They conclude that categorization differs among member states, many crypto-assets do qualify as financial instruments and those that do should be regulated as such.
The almost impossible task of applying the existing definition to the new reality is illustrated by the diagram at the top of this article. ESMA asked the national authorities to categorize six existing crypto-assets (CASE1-CASE6). They do not agree on any of them and five out of six assets show total disagreement.
In my view ESMA needs to look closer at the interpretation of which existing and future tokens and trading platforms are obliged to comply with EU securities laws. We need to acknowledge the new instrument types introduced by blockchain innovation and the definition of financial instruments need to be clarified accordingly.
The author is a co-founder of Tritum Digital Assets and a former Vice President of Nasdaq and Head of Economic Research, responsible for reporting all volumes of Nasdaq’s Nordic Exchanges. He is also a former Finance Director of the US Consolidated Plan, the UTP Plan. The plan governs transaction information from all US securities exchanges, is approved by the SEC and provides millions of investors with reliable data.