Are you seeing an increased appetite from institutional investors for digital assets?
Siân Jones: There are clear signs of an increasing appetite from institutional investors for digital assets to form part of their portfolios. During 2020 and into 2021, more companies started including digital assets as part of their treasury management strategy. Overstock and MicroStrategy have $2 million and $3.2 billion worth of digital assets. More recently, London-based asset manager Ruffer allocated a percentage of one of its funds to digital assets and, of course, Tesla’s recent $1.5 billion dive into digital assets caught headlines and the public imagination.
Digital assets have come under fire a few times with critics saying they can be used for illegal activities, exchange rate volatility, and vulnerabilities of the infrastructure underlying them. With this in mind, do you think there needs to be a regulation in place across Europe?
Ana James: As use and significance of digital assets and their underlying technology increases; as the value of digital assets climbs; and as global bigtech continues to engage with digital assets — such as Diem, initiated by Facebook and formerly called Libra — so, too, the interest of policymakers and regulators around the world is being aroused.
A host of policy issues are being considered, such as monetary sovereignty, financial stability, consumer protection, market integrity, money laundering, and so on.
You can see this in recent statements made by Biden’s pick for Secretary of the Treasury, Janet Yellen, and the President of the European Central Bank (ECB), Christine Lagarde. Similarly, there is increased scrutiny, driven by the G20, by multinational government organisations such as the Financial Stability Board, the Bank for International Settlements, the Organization for Economic Cooperation and Development (OECD), the International Organisation of Securities Commissions (IOSCO), the Financial Action Task Force. This scrutiny is mirrored across EU institutions and bodies — at the European Commission, in the Parliament, at the ECB, the European Banking Authority (EBA), the European Securities and Markets Authority (ESMA) — and in member states. While many acknowledge the innovative potential of digital assets, such as improving financial inclusion, improved efficiency in market infrastructures, and greater transparency, the primary focus is on identifying and mitigating risks. Inevitably, such scrutiny leads to increased regulation, in many cases emulating the sort of regulation that exists in traditional finance.
One can always cite money laundering and terrorist financing concerns across all asset classes and sectors. Digital assets are, of course, not immune, but data suggests money laundering involving digital assets is markedly lower than for traditional assets and fiat money. For example, a recent study published by Chainalysis showed that the overall percentage of criminal activity in all cryptocurrency transactions in 2020 accounted for only 0.34 per cent, down from 2.1 per cent the previous year.
Despite the inherent pseudonymity in many blockchain systems, digital assets are not a particularly smart means to launder money due to the equally-inherent ability to instantly track and trace transactions. Following the money in traditional systems takes considerably longer, with investigations often taking months and years.
It is true some digital assets — most notably, crypto-currencies — are characterised by high volatility. For this reason, they are mostly used for speculative investment. But, at the other end of the spectrum, there are digital assets whose value is pegged to fiat currencies — often termed stablecoins. In between, lies a broad array of digital assets whose value is referenced to baskets of currencies and other assets or whose value is determined by more fundamental drivers such as the utility of a service or application. Central banks, too, have launched digital versions of their currencies, such as Sweden and China with Central Bank Digital Currency pilots of the e-krona and digital yuan (the DCEP). Even the European Central Bank recently launched a consultation on proposals for a digital euro which it expects to be piloted soon.
There can be no doubt regulation is coming to digital assets. It already is, and there will be more on the way. In September 2020, the European Commission proposed a Markets in Crypto Asset (MiCA) Regulation which seeks to bring all forms of digital assets (what they call crypto-assets) and related activities within scope. The EU-wide regulation is already working its way through the legislative process, and it is only a matter of time until it comes into force. Another proposal, published at the same time, is the European DLT Pilot Regime for market infrastructures (PRR). The PRR seeks to relax restrictions on the use of distributed ledger technology by traditional market infrastructures and, so, enable broader use of digital assets to potentially drive market efficiency. In time, this could significantly impact the way that markets operate and the range of assets traded in traditional markets.
Pursuing its digital finance strategy, on 24 September 2020, the EC adopted legislative proposals for a Regulation on MiCA. What is being proposed with the regulation?
Jones: MiCA is intended to provide a legal framework for all digital assets that are not already covered in EU financial services legislation, and all activities involving these digital assets.
It sets rules relating to digital asset issuance and their offering to the public. It lays down more stringent prudential requirements relating to stablecoins, which it categorises as either e-money tokens or asset-referenced tokens, and yet more robust requirements for those deemed significant — those considered to be systemically important.
MiCA also provides for the licensing of crypto-asset service providers. These are firms that provide trading platforms and other intermediation services, similar to that in traditional financial services governed by the Markets in Financial Instruments Directive (MiFID).
What benefits could MiCA bring?
James: MiCA will bring much needed legal certainty to the sector and, with a single regulatory approach across the whole European Economic Area (EEA), it will reduce market fragmentation and regulatory arbitrage. It will help legitimise digital assets and service providers, opening up the sector to a broad range of institutional players. Digital asset businesses will be able to passport their activities across the single market. Clear rules will make it easier to raise funds and trade digital assets. Public trust will grow, setting the way for continued growth in the use of digital assets. They will become normalised.
However, without a more innovative approach to achieve regulatory outcomes, some of the advantages and innovative potential of digital assets (and their underlying technology, blockchain) will be diminished or, even, eliminated. This will represent a significant lost opportunity; a huge shame. Sadly, the commission’s aim of supporting innovation is not the same as promoting it.
Do you think the EU wants to tackle the regulatory obstacles posed by the decentralised nature of the networks by integrating DLT into the existing EU legal framework?
Jones: You ask a fascinating question. First and foremost, one needs to understand that not all digital assets are decentralised, and not everything that is labelled decentralised is so. Very few digital assets are truly decentralised.
Most financial services regulation is designed to hold individuals accountable. Regulators need people to achieve desired regulatory outcomes, and they need intermediaries to ensure those outcomes can be met. The challenge with truly decentralised finance is that, by definition, there are no accountable persons and no intermediaries. Regulators will, generally, consider substance over form, so digital assets that are not genuinely decentralised will be regarded as anything else. A security token will, mostly, be regarded as a financial instrument and treated accordingly. But a genuinely decentralised digital asset, without a traditional, identifiable issuer cannot be regulated as if it had one.
MiCA, as currently proposed, seeks to capture decentralised finance (DeFi) as far as possible by, for example, requiring issuers to be legal entities if a digital asset is to be offered to the public or traded on a market platform in the EU. At the same time, it acknowledges that digital assets without an issuer fall outside regulatory scope. It will be interesting to see if some of the proposals currently being discussed by the council (comprising Member State governments) reshape this thinking.
What are the current challenges with this regulation? The existing financial services regulation was not created with DLT in mind, could this be an issue?
James: There are challenges at the intersection between MiCA and MiFID, particularly in how different member states interpret financial instruments. This has a bearing on what, in some cases, constitutes a crypto-asset.
There is probably unnecessary complexity in some digital assets being supervised both at national and pan- European levels.
And there are challenges and some confusion in the proposed transitional arrangements for stablecoin issuers.
Importantly, MiCA provides scant legal certainty for DeFi. This innovation needs to be addressed in equally innovative ways if the stated aim of providing a level playing field is to be achieved.
Now that the UK is no longer part of the EU, would it come down to the FCA to create a regulation like this in the UK? Would it be a case of the regulators filling in the details of the perimeter that the government has set?
Jones: Primarily, this is a matter for the UK Government. Digital asset service providers were brought into the UK’s anti-money laundering (AML)/combating the financing of terrorism (CFT) regime at the beginning of 2020.
Currently, HM Treasury is running a consultation on the UK’s regulatory approach to digital assets and stablecoins.
The consultation proposes a regime for stable tokens used as means of payment and to bring certain DeFi activities within the regulatory framework.
The UK-EU Trade and Cooperation Agreement, which sets out the future relationship between the UK and the EU, does not include financial services.
It will be interesting to see whether or not, going forward, the UK pursues a policy of aligning with the EU on financial services, with a view, perhaps, of securing equivalence.
We may know in the next few months. Whether or not this has an impact on digital assets very much depends on the political direction.
At this time, it is too early to say what this may mean.
Do you think new regulations in this area could heighten the barrier of entry to this category?
James: Regulation nearly always creates barriers to entry in every sector. While regulations such as the PRR seek to remove some obstacles, it will inevitably become harder and more expensive for digital asset issuers and service providers to operate in Europe and elsewhere.
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