ESMA’s SMSG publishes report on ICOs and crypto assets
On 19 October 2018, ESMA’s Securities and Markets Stakeholder Group (“SMSG”) published an own initiative report, giving advice to ESMA on potential measures it can take to contain the risks of crypto assets and initial offerings of crypto assets (“ICOs”), on top of existing regulation. SMSG acknowledges that crypto assets do not currently pose a threat to financial stability and the main focus of its report is on investor protection. The report is published in a context where an increasing amount of crypto assets are issued in jurisdictions with little or no regulation.
1. Crypto assets
The term ‘crypto assets’ collectively refers to crypto currencies, virtual currencies, virtual assets and digital tokens. SMSG’s advice is based on the classification of crypto assets first introduced by the Swiss Financial Market Supervisory Authority which takes into account the assets’ economic function. In its report, SMSG identifies the benefits and risks of each type of crypto asset, and assesses whether the type of asset/token is currently within the scope of regulation under the Second Markets in Financial Instruments Directive (“MiFID II”), the Prospectus Regulation, and/or the Market Abuse Regulation (“MAR”).
- Payment tokens – Payment tokens are used as a means of payment for acquiring goods or services. The holder has no claim on the issuer. Whilst payment tokens can encourage competition in the payment markets and empower financial inclusion, payment tokens can also turn into speculative investments therefore necessitating additional investor protection and market abuse restrictions. The lack of centralisation also means that the market price of these tokens is not subject to rational assessments, is affected by high volatility and will not benefit from any central authority intervention.
- Utility tokens – The issuance model of utility tokens is comparable to traditional venture capital funding. Utility tokens provide digital access to an application or service, typically via a blockchain-based infrastructure. The issuer is able to transfer project risk to the token holders without diluting ownership. Token holders face counterparty risk and performance risk. Often, the value of utility tokens hinges on the willingness of users to pay for future services. In the presence of a secondary market, utility tokens can also turn into speculative investments.
- Asset tokens – Asset tokens can act as digital identifiers for physical assets. A digital identifier allows for an automatic recording of provenance. Additionally, a particular object can be traced in a supply chain and enables a secure transfer of title. With smart contracts, letter of credit payments to the supplier could automatically be triggered once performance has been proven by a token. Note however that an ICO smart contract in itself does not automatically enforce an entitlement. Unless a smart contract is designed to automate delivery of another crypto asset, a smart contract (whereby the entitlement is to a physical asset) may need to be enforced via conventional means. SMSG considers that token holders may not always be alert to the contractual relationship between them and the issuer. Alternatively, asset tokens could represent a monetary claim on the issuer. Similar to securities, token holders face counterparty risk, dilution risk and custody risk.
2. Regulation of ICOs
In its report, SMSG identifies the regulatory approaches towards ICOs of 36 jurisdictions across the EU, EEA and other European jurisdictions. SMSG’s findings are set out in Annex 1 of the report, and are summarised in the table below:
| Regulatory approach | Countries | |
| Evident and proactive | Have expressly legislated or provided assessment guidelines on how and to what extent ICOs could fall under their respective framework of financial services legislation. | Malta, Switzerland, Lithuania, Gibraltar, Jersey, Isle of Man, France. |
| Measured and case-by-case | Do not specifically restrict or prohibit ICOs or crypto asset initiatives, but would take a measured approach to related proposals on a case by case basis and in full consideration of legislative instruments within their territory and the EU. | Austria, Belgium, Bulgaria, Denmark, Estonia, Finland, Germany, Ireland, Luxembourg, Netherlands, Portugal, Spain, United Kingdom, Lichtenstein and Guernsey. |
| Undefined and/or unidentifiable | Securities authorities have not provided clear information as to their stance. | Croatia, Czech Republic, Greece, Hungary, Italy, Latvia, Poland, Republic of Cyprus, Romania, Slovakia, Slovenia, Sweden, Norway and Iceland |
3. Sandboxes and innovate hubs
To keep up with industry practices, supervisory authorities have taken the initiative to create ‘regulatory sandboxes’ or ‘innovation hubs’ to facilitate the testing of innovative products in a ‘live’ environment. On 5 September 2018, the FCA announced its collaboration with 11 financial regulators to create the Global Financial Innovation Network (“GFIN”), following its proposition for a ‘global sandbox’.
According to SMSG, regulatory sandboxes and innovation hubs are positive developments, however it is important that ESMA sets minimum criteria for national authorities to ensure transparency, investor protection and minimum regulatory capture.
4. UK developments
The Chancellor of the Exchequer launched the Cryptoassets Task Force in March 2018 as part of the Government’s Fintech Sector Strategy. The Cryptoassets Task Force includes HM Treasury, the FCA and the Bank of England in relation to developing an approach to cryptoassets and distributed ledger technology. On 30th October 2018, the Cryptoassets Task Force published its final report, including its conclusions and plans for financial regulation in this area in the UK. We will publish a separate article outlining the final report in more detail shortly.
Co-authored by Yan Lim.
