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29 May 2022

AFME: Ensuring crypto-assets regulation is fit for the digital age

Crypto-assets, such as Bitcoin, harness DLT and are seen by many to have plausible value for future generations.

Distributed ledger technology (DLT) has the potential to fundamentally change the financial services landscape. The underlying technology itself holds great potential for existing financial markets including, accelerating payments, improving fraud prevention and allowing banks to clear and settle trades much more efficiently. Both banks and new market entrants in the Fintech space have been developing DLT based solutions to reduce costs, transform their offerings , and respond to growing demand by customers for the tokenisation of traditional assets (e.g. real estate, fine art) as well as the inclusion of the emerging asset class of crypto-assets.  

Crypto-assets, such as Bitcoin, harness DLT and are seen by many to have plausible value for future generations. As the industry looks to implement the technology across their business lines, and crypto-asset markets continue to expand, global regulators are also reviewing and developing  the regulations required to manage the risks arising from these new assets to financial stability, investors, and consumers.
MiCA (Markets in Crypto-assets), the framework proposed by the European Commission, aims to create EU-wide minimum requirements for all crypto-assets issuers and service providers. It is currently being discussed by the European Parliament and the Council of the EU and is expected to be adopted later this summer.

However, while good progress is being made towards implementing a standardised European framework that brings regulatory protection, concerns remain.

The most critical is related to the requirements imposed on custodians of crypto assets, and, in particular, to what extent they are responsible if something goes wrong. ‘Crypto custody’ refers to the securing of crypto assets by a third party, which is important to protect investors from theft or hacks. Custodians are essential for secure crypto-asset adoption by both consumers and institutional investors. However, despite the enhanced protection that custody offers, things can still go wrong. For instance, there may be circumstances beyond the custodians control, such as sanctions. 

In this respect, the drafting of MiCA causes concern, because as currently proposed, banks providing custody services are liable for crypto-asset losses that are outside of their control, for example, in the event of regulatory or government action (e.g. banning or outlawing a particular crypto-asset). This is inconsistent with current global liability regulation for other asset classes, and would strongly disincentivise traditional finance institutions from offering crypto-asset custody solutions. If unresolved, MiCA may inadvertently cause the opposite impact of its stated intent – i.e. protecting investors from loss by driving clients to look for unregulated solutions in other jurisdictions or self-custody in the EU. These solutions ultimately put them at a greater risk of loss, and also outside of all courses for redress.   

As with the risks that may arise from the current drafting of the broad liability requirements, there are other pieces of the proposal that may inadvertently drive crypto-asset investors to conduct their business outside of regulated providers. For example, further consideration should also be given to risks concerning decentralised finance (known as DeFi). The European Commission proposed MiCA in September 2020, when other crypto-asset developments such as Non Fungible Tokens (NFTs) and DeFi offerings (such as Decentralised Autonomous Organisations or DAOs) were still nascent. Since then, they have evolved rapidly with billions in DAOs globally. Policy makers are considering whether these innovations also deserve a home in MiCA, but if DeFi and its associated activities are in fact regulated products (such as securities) it is critical that they are brought within the regulatory perimeter in an appropriate way to manage risks to market integrity, financial stability and end users.

The EU is taking a leading role in regulating crypto-assets and the finalisation of MiCA will undoubtedly harmonise the regulatory approach across the EU, and make it an attractive and competitive market for crypto-assets . However, in order to implement an EU framework that protects investors from severe losses, regulators must be mindful of the potential unintended consequences that could arise if the framework disincentivises  banks from offering crypto-asset services and forces clients to seek out new players outside of the protection MiCA should guarantee them. 

It is also crucial that both EU and global regulators work cooperatively to build a balanced and harmonised framework, fit for the digital age, where market participants can engage with crypto-assets from within the regulatory perimeter.



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