MiFID II, Crypto Assets and the Cryptocurrency Market
In December of 2017, Bitcoin made international headlines after its value skyrocketed to just under 15,000 GBP per bitcoin. The rate of growth which Bitcoin exhibited throughout 2017, as well as in the years prior, was unprecedented; it demonstrated the volatility of cryptocurrencies, while simultaneously cementing the fact that they could not be ignored by regulatory bodies.
Coincidentally, this surge in Bitcoin’s value coincided with another important change in the world of finance: namely, the implementation of MiFID II in January of 2018. ESMA’s regulatory framework – the Markets in Financial Instruments Directive – was intended to promote market transparency while protecting investors and market participants. It is likely the most important piece of financial legislation of the 21st Century.
Despite the close temporal proximity that the Bitcoin surge and MiFID II shared, many argue that the initial Directive provided insufficient legislative information on cryptocurrencies and crypto assets.
What Are Crypto Assets?
While most laypeople will likely be aware of the term ‘cryptocurrency’, the term ‘crypto asset’ is perhaps somewhat less familiar. A crypto asset might be understood as any private, digital asset whose value depends on cryptography and some form of distributed ledger technology (DLT). It is, as such, an umbrella term: a cryptocurrency is simply one category of crypto asset. All cryptocurrencies are crypto assets, but not all crypto assets are cryptocurrencies.
Crypto assets can be categorised according to three distinct ‘tokens’. These are:
– Security Tokens: These are digital instruments which indicate rights to ownership or profit. For instance, they may indicate an ownership position in an entity, or a creditor relationship with an entity.
– Payment/Exchange Tokens: Cryptocurrencies fall under this header. Payment tokens are instruments designed to be used as a medium of exchange, often on a peer-to-peer (P2P) network not backed by any central authority. In the case of cryptocurrencies, blockchains – comprehensive records of all cryptocurrency transactions – are used in place of a central authoritative body.
– Utility Tokens: These instruments are, as the name suggests, utilitarian. They provide holders access to current or prospective products or services.
Now that we’ve explained what a crypto asset is, it’s time to examine the extent to which they are covered by MiFID II regulations.
Are Crypto Assets Covered by MiFID II?
This is a difficult question whose answer is entirely dependent on one uncertainty: which crypto assets, if any, can also be defined as ‘financial instruments’? The language of MiFID II is such that only entities who deal in financial instruments are required to adhere to the legislative framework it puts forward. If crypto assets are not considered financial instruments, but rather defined as a different entity altogether, then, in theory at least, they would not fall under the remit of MiFID II.
This, obviously, is a worrying thought, and an entirely unregulated crypto asset market would be vulnerable to all forms of market abuse. However, in an attempt to help elucidate upon this issue, ESMA published the results of a survey conducted in conjunction with the National Competent Authorities of all EU member states in January 2019. The report was entitled ‘Advice on Initial Coin Offerings and Crypto Assets’, and is commonly referred to as ‘The ESMA Advice’.
The survey and the corresponding report aimed to better define which crypto assets should be regarded as financial instruments, and which would therefore be covered by MiFID II. This report detailed the criteria which must be met if a crypto asset is to be regarded as a financial instrument respectively, be it a transferable security, a share in a collective investment undertaking, or a derivative contract.
Despite this attempted clarification, there is still a fair amount of ambiguity surrounding crypto assets and financial instruments, particularly in relation to transferable securities. According to the ESMA Advice, for a crypto asset to be a transferable security, it must be the following three criteria
– The crypto asset must belong to a class of securities
– The crypto asset must not be a payment instrument
– The class of securities must be capable of being negotiated on the capital markets
This last point is where the uncertainty arises. The issue is that this criterion does not specify that the class of securities to which a crypto asset belongs must actually be traded, merely that it is capable of being negotiated. This wording is somewhat ambiguous and leaves a fair amount of wiggle room. Moreover, the phrase ‘capital markets’ seems overly broad; it is not necessarily a trading venue, but could be understood as, in the words of representatives from McCann FitzGerald, ‘any place where buying and selling interests meet’.
Crypto Assets as MiFID Financial Instruments
While this ambiguity persists, there is certainty as to the protocol once a crypto asset has been defined as a MiFID Financial Instrument. Once it is established that a crypto asset qualifies as a Financial Instrument, any entity who deals with said instrument must be authorised as an investment firm. These authorised firms must comply with the entirety of MiFID’s relevant legislation.
Despite this, the process must be clarified further if adequate regulation is to be established. Some NCAs are beginning to offer guidance (see Kingsley Napley’s report on the FCA’s crypto asset guidance), and, in New York, the first guilty conviction of crypto money laundering took place in April 2019 (see RiskTech Forum’s report). While these actions indicate a step in the right direction, a more unified approach must be taken if crypto assets are to be efficiently regulated.