It’s been a *big* week for crypto regulation…
It’s been a *big* week for crypto regulation:
The SEC provided additional guidance on how its proposed changes to the definition of an “Exchange” will apply to crypto and DeFi;
The House Committee on Financial Services published draft legislation for payment stablecoin issuers, building on legislative proposals which have circulated over the past year; and
The EU’s Markets in Crypto-Assets (MiCA) regulation reaches the final stage of the legislative journey and will be approved by the Parliament this coming week.
This blog provides a summary of each of these initiatives and concludes with Braithwate’s perspective on what this means for the future of digital assets and crypto businesses.
SEC definition of “Exchange”
As we commented last year when the Biden Executive Order on crypto assets was published, “the US regulatory framework will be built upon existing securities laws, banking regulation and BSA/AML rules. There will be no bespoke framework or new regulatory agency for digital assets”.
Friday’s update from the SEC makes it clear that US regulators are continuing with this approach, and the extensive legal analysis in the SEC’s updated proposal suggests that the agency is gearing up for further enforcement action.
SEC Chair Gary Gensler: “Make no mistake: many crypto trading platforms already come under the current definition of an exchange and thus have an existing duty to comply with the securities laws.”
The newly released addendum sets out detail on how the SEC sees various crypto and DeFi business models fitting into the definition of an “Exchange”. It also sets out the SEC’s response to the claim that decentralised finance (e.g. smart contracts and automated market makers) cannot comply with the registration and ongoing compliance requirements of US securities laws.
This comes hot on the heels of the Treasury’s 2023 DeFi Illicit Finance Risk Assessment, which analyses deficiencies in existing AML controls in the DeFi ecosystem and sets out plans to strengthen US regulatory supervision of AML/CFT risks in DeFi.
“The primary vulnerability that illicit actors exploit stems from non-compliance by DeFi services with AML/CFT and sanctions obligations. DeFi services engaged in covered activity under the Bank Secrecy Act have AML/CFT obligations regardless of whether the services claim that they currently are or plan to be decentralized.”
We expect the SEC to move forward with final rules this summer, with a likely compliance deadline of 12 months. Given the recent trends, we expect this will be followed by widespread enforcement action, with protracted legal battles to ensue.
House proposed legislation for Payment Stablecoin Issuers
This proposal provides a framework for the authorisation of narrowly scoped, fully reserved, stablecoin issuers, similar to the Electronic Money Institution regime in place in the UK and EU. Existing banks and FinTechs would be eligible to apply.
Such stablecoin issuers would be restricted to investing its reserves in bank deposits, Federal Reserve schemes and short-term Treasuries and would be subject to prudential rules on capital and liquidity risk management. These rules impose new costs and significantly reduce the revenue opportunities for stablecoin issuers.
In addition, the bill sets out governance and audit requirements for stablecoin issuers, which may be difficult for some of the current players to meet.
EU Markets in Crypto-Assets regulation
The EU has taken a different approach to digital assets and crypto than the US, with markedly less enforcement action and a dedicated new regulatory regime – the Markets in Crypto-Assets (MiCA) regulation – which looks set to be approved by the European Parliament this week.
MiCA provides a framework – not dissimilar to the MiFID/MIFIR framework for traditional financial instruments – for intermediaries (advisers, brokers, venues, custodians) in crypto-assets. It also sets out requirements for crypto-asset issuers to provide a prospectus-like “whitepaper” when issuing tokens.
Under the new rules, crypto-assets are assigned to one of three categories:
‘e-money tokens’, which aim to stabilise their value by referencing only one official currency (i.e. standard stablecoins; very similar to the function of electronic money as defined in Directive 2009/110/EC);
‘asset-referenced tokens’, which aim to stabilise their value by referencing another value or right, or combination thereof, including one or several official currencies. That second type covers all other crypto-assets, other than e-money tokens, whose value is backed by assets, so as to avoid circumvention and to make the MiCA Regulation future-proof; and
All other tokens, which covers a wide variety of crypto-assets, including ‘utility tokens’ and potentially Bitcoin and Ether.
Security tokens are explicitly deemed to be covered as part of the existing market regulation – MiFID II, MAR, Prospectus Directive etc.
MiCA also sets out stricter rules for stablecoins issuers who, by virtue of their scale, pose a risk to the stability of payment systems and/or broader financial stability.
Unique Non-Fungible Tokens (NFTs) are currently outside of the scope of MiCA, although fractionalised NFTs, and NFTs which are issued as part of a large, relatively homogenous, series, are considered crypto-assets and thus in-scope; in essence, the EU is saying “if an NFT or group of NFTs is promoted or traded as a speculative instrument, we will deem it to be a crypto-asset and subject it to MiCA”. The EU will review the treatment of NFTs over the next 18 months.
Many commentators have suggested that DeFi is also out of scope of MiCA. However, as the Crypto Advisory team at BCAS notes, this hinges on the interpretation of MiCA recital 12a.
MiCA recital 12a: “Where crypto-asset services as defined in this Regulation are provided in a fully decentralised manner without any intermediary they do not fall within the scope of this Regulation.” (emphasis added)
If the EU decides to take a strict interpretation of “fully decentralised and without any intermediary” then it is likely that many DeFi projects will be brought within the scope of MiCA.
Finally, in-line with the EU-wide push on ESG, MiCA requires blockchain developers to consider the adverse impacts on the climate and other environment-related adverse impacts arising from the use of computationally expensive consensus mechanisms (in particular Proof-of-Work).
MiCA urges that “such consensus mechanisms should therefore deploy more environmentally-friendly solutions and ensure that … adverse impacts are adequately identified and disclosed by issuers of crypto-assets and crypto-asset service providers”.
MiCA is part of a broader EU digital finance package and should be read in conjunction with the Digital Operational Resilience Act (DORA) and the DLT Pilot Regime Regulation.
Braithwate’s perspective on the future of digital assets and crypto businesses
While it’s difficult to predict how such an innovative marketplace will evolve, we expect that this series of regulatory developments to result in some material changes:
The US is a hostile regulatory environment for crypto projects, especially DeFi. We expect to see a ramp of up enforcement action as the SEC rolls out its revised definition of “Exchange”. This is likely to be prejudicial for smaller projects and alt-coins, but may be beneficial for larger players who can afford, should they choose, to fall in-line with the regime.
Across the world, including the US, we are seeing a standard regime emerging for stablecoin issuers, based largely on the European “electronic money” regime. This is a welcome development, although we expect only a small number of stablecoin issuers to be authorised. Systemic risk concerns may result in caps on volume or penal prudential requirements that spoil the economics of stablecoin issuance.
The EU’s dedicated MiCA regime has been contrasted positively with the US approach. However, as veterans of the past 15 years of EU regulatory reform, we are sceptical about the degree to which the new regime will represent a sea change in EU regulators’ approach to crypto businesses. Similar to how the UK FCA’s Crypto AML registration has worked, we expect successful firms to be larger CeFi firms and TradFi firms branching out into crypto.
The next six months will be critical to the development of digital assets and crypto businesses; watch this space for further analysis on the emerging regulatory clarity – next up should be the UK’s proposed regime for crypto-assets.
