And what’s the current stage of crypto regulation considering the explosive growth in popularity?
The development of cryptocurrency regulation in Europe has been ongoing on a yearly basis since the inception of digital currencies as an asset class and the launch of their trading on a broader global level.
Numerous European agencies and regulatory authorities have since issued their own documents and regulatory policy recommendations for EU states to follow in the course of cryptocurrency adoption and regulatory framework development.
This article is written based on the research by Agata Ferreira from Warsaw University of Technology, Philipp G. Sandner from Frankfurt School of Finance & Management and Thomas Dünser.
First Attempts At Regulation
The first official statements and analysis focused on virtual currencies were formed by The European Banking Authority (EBA), which issued a public warning against risky and unregulated virtual currencies all the way back in 2013.
The role of the EBA is to monitor new and existing financial activities and adopt guidelines and recommendations to promote the safety and soundness of markets and convergence of regulatory practice.
The EBA followed with an opinion on virtual currencies in 2014, identifying more than 70 risks arising from virtual currencies for:
- non-user market participants;
- financial integrity;
- existing payment systems;
- regulatory authorities;
- money laundering and other financial crime.
In 2014, the EBA did not recommend a comprehensive regulatory approach addressing all identified risks, but did suggest immediate fragmented measures including governance requirements, capital requirements, and the segregation of client accounts. It also discouraged credit institutions, payment institutions, and e-money institutions from buying, holding, or selling virtual currency to shield regulated financial services from virtual currency schemes.
The 2016 Awakening
In 2016, the ECB issued an analysis of virtual currency schemes, reiterating and confirming its earlier considerations regarding the risks from virtual currency schemes.
Despite the overall negative assessment of cryptocurrencies, the ECB acknowledged the potential advantages of virtual currencies for users, including challenging existing payment solutions regarding costs, global reach, payer anonymity, and speed of settlement.
A paper issued in 2016 analyzed the application of DLTs in securities post-trading and estimated that cryptocurrencies will soon enter the broader market as tradable assets, urging EU member states to start preparing regulations to monitor such market activities.
The ESMA move
Soon after, in early 2017, the European Securities and Markets Authority (ESMA) issued a report on the DLT applied to securities markets.
ESMA is an independent EU authority that contributes to safeguarding the stability of the EU’s financial system by enhancing the protection of investors and promoting stable and orderly financial markets.
It has full accountability towards the European Parliament, the Council of the European Union, and the European Commission. In its report, the ESMA identified several challenges of DLT to be addressed before its benefits, noting interoperability issues, lack of common standards, and potential privacy and scalability problems.
While the ESMA emphasized that the existing regulatory framework could apply to blockchain, it also acknowledged that some regulatory requirements could become less relevant and additional regulations might be needed to mitigate emerging risks.
The ESMA found no impediments in the EU regulatory framework to prevent blockchain technology from developing and fully emerging, but did stress the need for the development of a unified regulatory framework for cryptocurrencies and decentralized markets.
The ICO Boom And Legal Response
2017 was also the year of the ICO boom and the year when the US Securities and Exchange Commission (SEC) warned investors about the threats posed by crypto ICOs.
At the same time, China and South Korea banned ICOs, while in Europe, the ESMA issued two statements on ICOs, one on risks for investors and another on the rules applicable to firms involved in these offerings. The European Commission acknowledged that crypto assets had become a worldwide phenomenon and a promising new type of financial asset, but their high volatility, fraud, operational weaknesses and vulnerabilities posed many risks.
The European Commission then mandated the EBA and ESMA to assess the applicability and suitability of the existing EU financial services regulatory framework to crypto assets.
Early in 2018, the European Parliament commissioned two reports. One was on virtual currencies and central banks’ monetary policy, acknowledging that financial regulators may dislike virtual currencies because of their anonymity or cross-border circulation, money laundering risks, financing of illegal activities, tax avoidance, circumvention of capital controls, and fraudulent financial practices. The report recommended that regulators treat virtual currencies as any other financial transaction or instrument proportionally to their market importance, suggesting the cross-border harmonization of regulations.
The second report focused on the use of cryptocurrencies in financial crime, money laundering, and tax evasion, recommending that the fight against these activities should focus on cases of the illicit use of cryptocurrencies, while leaving blockchain untouched from the perspective of money laundering, terrorist financing, and tax evasion.
This report resulted in the EU amending its Fourth Anti-Money Laundering Directive to include virtual currency trading platforms and hosting wallets as entities subject to AML and combating the financing of terrorism requirements.
Risk for the Global Stability
In late 2018, the Financial Stability Board (FSB) issued a report on the crypto assets market and potential channels for future financial stability implications.
The FSB is an international authority established to coordinate the work of national financial authorities and international standard-setting bodies to develop and promote the implementation of effective regulatory, supervisory, and other financial sector policies.
The report of the FSB concluded that although crypto assets did not pose a material risk to global financial stability, they raised several broader policy issues, recommending active monitoring of the regulatory implications of crypto assets, increasing their oversight and supervision, and issuing guidance, warnings, and clarifications on the applicability of the legal framework.
The Libra Effect
A breakthrough case emerged with the announcement of Facebook’s Libra project, provoking immediate and firm official reactions worldwide. Several major authorities, including the FSB, Bundesbank, the Bank of England, and the US FRS issued statements addressing Libra.
- Many representatives of central banks and authorities requested that Libra meets the ‘highest standards of prudential regulation and consumer protection’.
- The U.S. House of Representatives’ Committee on Financial Services went as far as to request that Facebook and its partners immediately cease implementation plans ‘until regulators and Congress have an opportunity to examine these issues and take action’ and requested a moratorium on any movement forward on Libra.
The G7 meeting of July 2019 was dominated by speeches regarding the serious risks posed by global stablecoin projects. The concerns largely included anti-money laundering/combatting the financing of terrorism (AML/CFT), consumer and data protection, cyber resilience, fair competition, tax compliance, issues related to monetary policy transmission, financial stability, and the smooth functioning of and public trust in the global payment systems.
The impact of the Libra project’s proposition reverberated throughout the ensuing regulatory proposals, which illustrated a firm and skeptical approach to global stablecoin projects.
The calls included the need to ensure public trust by meeting the highest regulatory standards, prudent supervision and oversight, and globally consistent regulatory approaches has been emphasized. A unified statement on the matter of stablecoin projects at the meeting concluded that they all meet the highest standards of financial regulation, especially with regards to AML/CFT, to guarantee the stability of the global financial system.
The broader issue relating to stablecoins as a phenomenon was addressed by FINMA, the Swiss financial authority with which the Libra project has been submitted for an assessment of its project under Swiss law, published a supplement to its ICO guidelines outlining the treatment of stablecoins.
FINMA adopted a technology neutral approach and ‘same risks, same rules’ principle focusing on ‘substance over form’ and looking at tokens’ economic function and purpose. FINMA emphasized legal uncertainties regarding transferability and enforceability under civil law of claims linked to tokens. The same cautious and moot approach was adopted by the G7 and ECB, highlighting the lack of a unified framework and understanding of the potential and impact stablecoins may have if released on the open trading market.
However, the FSB had a more formulated approach, which recognized that global stablecoins could disrupt banks’ funding and have implications for financial stability, market integrity, competition, and data protection. The FSB saw the need for international cooperation in order to regulate stablecoins, but the lack of clear mechanisms led to a lack of consensus on the issue among EU member states and authorities.
The IMF Interferes
In late 2019, the International Monetary Fund (IMF) identified selected elements of regulation and supervision to assist policymakers in framing the discussion on the regulation of crypto assets.
The International Monetary Fund is an organization of 190 countries, working to foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce poverty around the world.
The IMF provided several high-level recommendations for regulators regarding crypto assets, including a sequential, risk-based, and proportional approach to developing regulatory frameworks based on priorities and resources.
It also recommended a continuous comprehensive assessment of the risks and strategies, emphasizing cross-sector and international cooperation and coordination as key elements in enhancing investor protection and minimizing the potential for regulatory arbitrage while maintaining regulatory flexibility to adapt to technological progress.
The IMF also focused on the main aspects of crypto assets, such as trading, while highlighting relatively low societal financial and technology literacy and the need to ensure that participants, investors, and customers are adequately informed about the particularities and risks of crypto assets.
Regarding the trading of crypto assets, the IMF follows IOSCO’s report, recommending robust governance requirements for platform operators, on-boarding compliance requirements for access to the platform, and resilient and safe operating systems and controls.
The IMF highlighted its concern over the lack of a global standard for the prudential treatment of exposure to crypto assets for banks or other regulated entities. The IMF also acknowledged that formulating an adequate regulatory framework for crypto assets involves intense monitoring, a flexible approach, and international cooperation.
By 2020, the ECB issued a more comprehensive official report in which it characterized stablecoin arrangements, emphasizing the role of technology-neutral regulation in preventing arbitrage, and the importance of comprehensive Eurosystem oversight, irrespective of stablecoins’ regulatory status.
The same principle for stablecoin regulation has been recognized by the FSB, which identified regulatory gaps that include incomplete or non-existent implementation of the revised FATF standards, lack of capacity to provide regulatory supervision of global stablecoin arrangements, lack of adequate competition policies, and inadequate consumer protection measures.
The latest measure of regulation was embodied by Markets in Crypto-Assets (MiCA). The given initiative launched by the European Commission proposed a pilot regime for market infrastructures that wish to try to trade and settle transactions in financial instruments in crypto-asset form to enable market participants and regulators to gain experience with the use of DLT exchanges that would trade or record shares or bonds on the digital ledger.
MiCA forms a part of a digital finance package adopted by the European Commission on 24 September 2020, which also includes a digital finance strategy. The requirements include capital requirements, custody of assets, a mandatory complaint holder procedure available to investors, and rights of the investor against the issuer. In addition, issuers of significant asset-backed crypto assets will be subject to more stringent capital requirements, liquidity management and interoperability requirements.
There is still no unified regulatory framework regarding cryptocurrencies in the European Union, a fact that highlights the fragmented nature of decision making on the continent. But given the numerous initiatives being proposed by various authorities within the EU and other countries (US and China) and the visible consensus on key issues, it is highly likely that a single approach to cryptocurrency and decentralized market regulation will be developed in the near future and a comprehensive framework will be applied.