Global | Publication | March 2019
First published on Thomson Reuters Regulatory Intelligence on March 04 2019.
The crypto asset market is becoming more institutionalised with a number of the larger financial players entering the space. The media reported that cryptofund assets under management increased significantly last year, juxtaposing the significant fall in crypto market capitalisation, which fell from a peak of $830 billion in January 2018 to $191 billion at the end of August 2018.
The dilemma facing most regulators is that at the moment the crypto asset market is not sufficiently large to cause concern from a financial stability viewpoint. Given the speed with which this market is developing, however, they also recognise that vigilant monitoring is needed. That was the Financial Stability Board's (FSB) conclusion in its report on crypto assets published in October.
In 2018, the press reported that Europe had emerged as the leading crypto hub, overtaking the Asian and U.S. crypto markets in crypto asset sales. In September, fund manager Olymp Capital announced the launch of the first European investment fund to cover the entire blockchain and crypto asset ecosystem. The fund includes blockchain-related private equity, initial coin offering (ICOs) activity and fund-of-fund activity centred on crypto hedge funds. The fund accepts investment both in fiat and cryptocurrencies.
In terms of EU regulatory developments, in October 2018, the Securities and Markets Stakeholder Group provided an own initiative report on ICOs and crypto assets. It advised the European Securities and Markets Authority (ESMA) to issue Level 3 guidelines or work toward supervisory convergence on a number of topics including the need to clarify whether transferable asset tokens which have features typical of transferable securities are subject to the Markets in Financial Instruments Directive II (MiFID II) and the Prospectus Regulation.
The EU began the New Year focussing on the regulation of cryptocurrencies, with a pair of reports finding that neither EU banking nor securities laws are currently up to the task of overseeing these new financial assets.
On January 9, 2019, ESMA published its advice to the EU institutions (the European Commission, the Council of the EU and the European Parliament) on ICOs and crypto assets. The next day the European Banking Authority (EBA) published a report containing the results of its assessment of the applicability and suitability of EU law to crypto assets.
The ESMA advice followed a survey conducted last year by the European regulator among member state national competent authorities (NCAs). The survey was designed to determine the way in which a given member state had transposed MiFID II into its national law and, based on that transposition, whether a sample of six crypto assets issued in an ICO qualified as "financial instruments" under their respective national laws.
"Our survey of NCAs highlighted that some crypto assets may qualify as MiFID II financial instruments, in which case the full set of EU financial rules would apply" said Steven Maijoor, chair of ESMA. "However, because the existing rules were not designed with these instruments in mind, NCAs facechallenges in interpreting the existing requirements and certain requirements are not adapted to the specific characteristics of crypto assets."
As for crypto assets that do not qualify as financial instruments under MiFID II, ESMA is concerned that the lack of regulatory requirements may expose investors to substantial risks. To address this, ESMA recommends that, at a minimum, all transactions in crypto assets be subject to anti-money laundering (AML) requirements. In addition, ESMA recommends the use of appropriate risk disclosures to alert customers to relevant risks prior to entering into transactions in crypto assets.
ESMA also stated that, while certain EU member states were adopting rules at a national level with respect to transactions in crypto assets, issues relating to crypto assets "would be best addressed at the European level" to "have a level playing field and to ensure adequate investor protection across the EU".
The EBA's report is in response to the Commission's request in its Fintech Action Plan 2018. The EBA mapped the applicability to crypto assets and crypto asset activities of the EU Fourth Anti-Money Laundering Directive, the Capital Requirements Directive and Regulation, the second Electronic Money Directive and the second Payment Services Directive. The EBA concluded that crypto assets typically fall outside the scope of EU financial services legislation and specific services relating to crypto asset custodian wallet provision and crypto asset trading platforms do not constitute regulated activities under EU financial services law. Moreover, divergent approaches to the regulation of these activities are emerging across the EU, giving rise to potential issues, for example, in terms of consumer protection and operational resilience.
The EBA called on the Commission to carry out a cost/benefit analysis to assess whether EU-level action is appropriate and feasible. It also advised the Commission to have regard to AML standards and guidance issued by the Financial Action Task Force and take steps where possible to promote consistency in the accounting treatment of crypto assets. In addition, the EBA will take forward in 2019 certain action which includes the development of a common monitoring template which NCAs can issue to institutions to monitor the level and type of crypto asset activity underway.
The Commission now faces the task of finding the right moment to move the supervision of crypto assets from member state level to EU level, as proposed by both reports. Given that diverging supervisory practices come with significant downsides this may not be too difficult a decision, but finding consensus among member states as to the EU approach may not be easy. ESMA found that while most NCAs agreed that crypto assets should be subject to some form of regulation there was little consensus as to whether a bespoke regime for those crypto assets that do not qualify as financial instruments should be designed within the scope of MiFID II or outside it.
Moving outside the European Union, the Swiss Financial Market Supervisory Authority (FINMA) issued the country's first cryptocurrency asset management licence, allowing a firm legally to offer a range of collective investment products that track both Bitcoin and other notable crypto assets that include domestic funds. It is also reported that FINMA believes banks should estimate the risks associated with cryptocurrency assets at eight times their market value. The Swiss regulator also wants to limit cryptocurrency trading activities to 4 per cent of the total capital of financial institutions and has said that this should be reported when the ceiling is reached.
The UK-based financial consultancy firm deVere Group has launched a new actively managed crypto-currency fund, geared particularly toward experienced investors. The deVere Digital Asset Fund will invest in a diversified portfolio of digital assets via algorithmic trading over different platforms, including cryptocurrency exchanges and OTC markets, as well as arbitrage opportunities.
In terms of the regulatory framework, change is afoot. In October, a final report on crypto assets was co-produced by HM Treasury, the UK Financial Conduct Authority (FCA) and the Bank of England (the Crypto assets Taskforce). The final report stated that the UK authorities considered there to be three broad types of crypto assets: exchange tokens, utility tokens and security tokens.
The final report said that how each token will be regulated could only be decided on a case-by-case basis, although security tokens (which are commonly used as a capital-raising tool or for direct or indirect investment) would generally find themselves within the regulatory perimeter. The final report sets out a number of steps that the UK authorities are to take which include
The first of these papers was published near the end of January, when the FCA issued Consultation Paper 19/3: Guidance on Crypto assets (CP19/3). In its report, the UK Crypto assets Taskforce set out a commitment to provide firms with extra clarity about where current crypto asset activities are regulated. The FCA is consequently consulting in CP19/3 on guidance to fulfil that commitment.
As previewed in the October report, CP19/3 considers the existing regulatory perimeter and how crypto assets interact with it. Specifically, it looks at where crypto assets would be considered "specified investments" under the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (RAO), "financial instruments" such as "transferable Securities" under MiFID II, or captured under the Payment Services Regulations 2017 (PSRs) or the E-Money Regulations 2011 (EMRs). It also covers where crypto assets would not be considered "specified investments" under the RAO.
Perimeter guidance is provided in chapter 3 of CP19/3: the FCA uses the framework developed by the Crypto assets Taskforce for different types of crypto assets, explaining whether they are within the FCA's regulatory remit and, if so, what this means for market participants. A Q&A section is provided setting out the common questions that the FCA is asked with regard to regulation and specific crypto assets. The main crypto assets addressed within CP19/3 are
At 3.72 of CP19/3, the FCA has produced a table indicating some of the main market participants that are likely to be carrying out regulated activities in the crypto asset market. It has also provided a high-level overview of some of the more common services they are likely to provide, and the permissions required to carry these out.
The FCA's table is not exhaustive and should only be used as an indicative aid. We have reproduced this table below; firms should note that they might also carry on a number of these activities, not just one.
The deadline for responses to CP19/3 is April 5, 2019, with the final guidance text expected in the summer.
In the United States, how cryptocurrency is viewed depends upon the regulator. For example, it can be a security, a commodity, property, or used as a form of money transmission.
The U.S. Securities and Exchange Commission (SEC) has rejected applications to list and trade shares of Bitcoin trusts because it believes that the exchanges in question would be unable to address concerns about the potential for fraudulent or manipulative acts and practices in the market for the shares. For example, on delegated authority, in August 2018, the SEC Trading and Markets Division denied proposals by two exchanges to list and trade Bitcoin-related exchange-traded funds. The decisions have been enjoined and are under review by the SEC commissioners. As of mid-February 2019, there had been no final decisions issued. Applications to list and trade shares of Bitcoin trusts are, however, still being filed with the SEC and as of February 2019, at least two such applications were pending.
Virtual currency meets the definition of a "commodity" under the Commodity Exchange Act. The Commodity Futures Trading Commission (CFTC) primarily regulates commodity derivatives contracts that are based on underlying commodities. Regulatory oversight authority over commodity cash markets is limited, but the CFTC has general anti-fraud and manipulation enforcement authority over virtual currency cash markets as a commodity in interstate commerce. The CFTC has approved commodity futures products currently being traded on different commodities exchanges and through swap execution facilities.
Both the SEC and the CFTC have issued investor bulletins urging consumers to be cautious when deciding whether or not to invest in cryptocurrency and to be aware of the considerable risks involved.
The CFTC has approved commodity futures products currently being traded on different commodities exchanges and through swap execution facilities.
Both the SEC and the CFTC have issued investor bulletins urging consumers to be cautious when deciding whether or not to invest in cryptocurrency and to be aware of the considerable risks involved.
In 2014, the Internal Revenue Service characterised Bitcoin and other virtual currencies as property for purposes of the application of the U.S. federal tax rules. As a result, a taxpayer who receives virtual currency as payment for goods or services must, in computing gross income, include the fair market value of the virtual currency, measured in U.S. dollars, as of the date that the virtual currency was received, and calculate a capital gain or loss accordingly.
If the fair market value of property received in exchange for virtual currency exceeds the taxpayer's adjusted basis of the virtual currency, the taxpayer has taxable gain. The taxpayer has a loss if the fair market value of the property received is less than the adjusted basis of the virtual currency.
The IRS became concerned that account holders who were U.S. taxpayers were not properly reporting their virtual currency transactions as required, and in November 2016, a U.S. federal district court issued an order granting the IRS's request to serve a summons on cryptocurrency exchanger Coinbase Inc for the names of its Bitcoin account holders and their associated transaction records for calendar years 2013 to 2015. Because Bitcoin transactions are pseudonymous, the IRS did not know the names of the relevant individual accountholders and so asked the court for permission instead to serve the summons on Coinbase.
After a battle that lasted well over a year, in November 2017, a U.S. federal judge ordered Coinbase to turn over certain limited identifying information on a smaller pool of their account holders and in February 2018, Coinbase notified a group of approximately 13,000 customers about the IRS summons and that certain information regarding their accounts would be provided to the IRS.
In March 2013, an issuance from the U.S. AML agency, the Financial Crimes Enforcement Network (FinCEN), stated that persons who engaged in the business of accepting and transmitting, or buying or selling, virtual currency, are considered to be "money transmitters" and required to register as "money services businesses" (MSBs) for purposes of the U.S. AML regulations. Registration triggers the requirement to, among other compliance responsibilities, establish an AML compliance program and report suspicious transactions.
While there is a need for such an MSB to register with FinCEN, money transmitters are licensed by individual states. Once FinCEN issued its determination, states started to take note, beginning with New York State Department of Financial Services (DFS), which issued final regulations in June 2015 setting out a comprehensive "BitLicense" licensing and supervision regime for persons engaged in "virtual currency business activity".
"Virtual currency business activity" is defined as conducting certain types of activities involving New York or a New York resident: generally, receiving virtual currency for transmission or transmitting virtual currency, acting as a custodian of virtual currency; buying, selling or exchanging currency as a customer business; or controlling, administering, or issuing a virtual currency.
As of mid-February 2019, DFS had approved 16 limited purpose trust company charters or Bitlicenses to engage in virtual currency business activity. Other states have taken a variety of approaches, some to revise their money transmission statutes to specifically include cryptocurrency and some to specifically exclude it. At least one state is establishing a process for a business to pay state taxes in cryptocurrency.
Canada is on its way to ensuring that virtual asset service providers are subject to anti-money laundering/counter terrorist financing (AML/CFT) regulations. In line with recommendations from the Financial Action Task Force that jurisdictions should ensure virtual asset service providers are subject to AML/CTF regulations, the Canadian House Finance Committee (the Committee) recently suggested significant changes to the way in which crypto assets should be regulated by the Canadian government.
The Committee's proposed recommendations would bring markets into compliance with AML/ CTF regulations, ultimately helping to prevent illegal activity. These recommendations come as part of a five-year statutory review of the Proceeds of Crime (Money Laundering) and Terrorist Financing Act (PCMLTFA).
In its report reviewing the PCMLTFA, the Committee first indicated that exchanges in which cryptocurrency is converted from fiat currency should be subject to the same regulations as MSBs. This change would make these exchanges subject to the extensive compliance regime and financial reporting guidelines of the PCMLTFA, which would help to protect users' funds. The report noted that within exchanges considered to be MSBs, "any persons or entities dealing in virtual currencies will need to implement a full AML/CTF compliance program and register with FINTRAC [Financial Transactions and Reports Analysis Centre of Canada]".
Secondly, the Committee recommended that cryptocurrency exchanges be required to be licensed to operate in Canada, similarly to other jurisdictions such as New York. This would require exchanges to pass rigorous screening and to comply withminimum operational standards to become licensed.
Finally, the Committee recommended that the Canadian government regulate cryptocurrency wallet companies, which provide software that allows one to store, send and receive digital currencies. Specifically, the Committee found that regulating cryptocurrency wallet companies would help to ensure that "Bitcoin purchases of real estate and cash cards are properly tracked and subjected to AML regulation" by enabling law enforcement bodies to "identify and track illegal crypto-wallet hacking and failures to report capital gains".
The Canadian government is required to table a response to the Committee's recommendations in the House of Commons by early 2019.
Cryptocurrency and blockchain investment fund managers such as First Block Capital Inc (First Block), which provide qualified investors in Canada with access to Bitcoin exposure, are reminded of the Committee's proposed changes and its potential impact. These funds have been regulated from a securities law perspective since 2017, through a cooperative approach to registration called the CSA Regulatory Sandbox. This initiative allows financial firms to obtain individualised exemptive relief from securities law requirements that may be an impediment to their innovative business models, subject to conditions of registration that are tailored to protect investors. Thus far, these conditions have been strict, and include: (i) restrictions on what cryptocurrencies constitute permitted investments; (ii) the requirement to use the services of an independent custodian and audit the custodian annually; (iii) reporting requirements with respect to the fund's investors and inflows, outflows and net value of capital; and (iv) regulatory approvals for material changes to the fund.
In September 2018, First Block's innovative Bitcoin Trust became available to be purchased and redeemed by accredited investors and their investment advisors on NEO Connect, a fund distribution platform that enables daily settlements and removes the 30-day redemption clause that previously hampered crypto asset investment in Canada. First Block's Bitcoin Trust have since achieved mutual fund status in Canada, giving investors the opportunity to place funds in tax-free savings accounts and registered retirement savings plans.
On June 25, 2018 the Abu Dhabi Global Market (ADGM), the International Financial Centre in Abu Dhabi, launched its regulatory framework for spot crypto asset activities, including those undertaken by exchanges, custodians and other intermediaries in ADGM. From a UAE regulatory perspective this has been the most significant relevant recent development.
The new ADGM crypto framework codifies the governance, oversight and transparency with regard to crypto asset activities.
This follows the completion of the public consultation on the introduction of a crypto asset regulatory framework by ADGM Financial Services Regulatory Authority (FSRA) on May 28, 2018.
The framework is designed to address the risks associated with crypto asset activities, including risks relating to money laundering and financial crime, consumer protection, technology governance, custody and exchange operations. This new framework is one of ADGM's projects illustrating its continuing commitment to bolster the economic diversification of the UAE through new and sustainable initiatives.
In June last year the FSRA also published its "Guidance: Regulation of Crypto Asset Activities in ADGM" and application form to operate a crypto asset business within ADGM. The guidance elaborates on ADGM's approach toward the regulation of crypto asset activities and is a useful resource for potential applicants.
The UAE's Securities and Commodities Authority (SCA), which supervises and monitors the markets, has approved ICOs as securities and will work with the Abu Dhabi Securities Exchange and Dubai Financial Market to develop trading platforms for ICOs this year. The current UAE wide initiative is for rules for ICOs to be finalised by the middle of the year.
Significant activity in the crypto asset sector in Hong Kong has attracted the attention of regulators, and the Securities and Futures Commission (SFC) has voiced concerns at the growing investor interest in gaining exposure to crypto assets via funds and unlicensed trading platform operators in Hong Kong.
On November 1, 2018, the SFC released a statement outlining significant risks associated with investing in crypto assets, and announced certain changes in relation to the regulation of virtual assets which aims to bring virtual asset portfolio managers and distributors of virtual asset funds under its regulatory net. It also sets out a conceptual framework for the potential regulation of virtual asset trading platforms.
In the light of the significant risks virtual assets pose to investors, the SFC will adopt new measures within its regulatory remit to protect those who invest in virtual asset portfolios or funds. The SFC will impose licensing conditions on firms which manage or intend to manage portfolios investing in virtual assets (where 10 per cent or more of the gross asset value of the portfolio is invested in virtual assets), irrespective of whether the virtual assets meet the definition of "securities" or "futures contracts" under the securities legislation.
In an accompanying circular, the SFC provided detailed guidance and reminded firms which distribute funds investing in virtual assets that they should be registered with or regulated by the SFC and comply with its regulatory requirements, including the suitability obligations, when distributing these funds.
The SFC commented that this framework will bring a "significant portion of virtual asset portfolio management activities into its regulatory net".
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