The European Securities and Markets Authority (ESMA) has published its advice to the European Union (EU) institutions on crypto-assets and initial coin offerings (ICOs) regulation, calling for a common EU-wide regulatory approach.

In its advice paper, ESMA notes that some member states have or are considering introducing crypto-assets related rules at the national level.

Though the financial regulator understands the desire to bring to the topic both a protective and supportive approach, ESMA is concerned that this does not provide for a level playing field across the EU. It believes that an EU-wide approach is relevant considering the cross-border nature of crypto-assets.

“Some crypto-assets may qualify as MiFID (Markets in Financial Instruments Directive) financial instruments, in which case the full set of EU financial rules would apply.

However, because the existing rules were not designed with these instruments in mind, National Competent Authorities (NCAs) face challenges in interpreting the existing requirements and certain requirements are not adapted to the specific characteristics of crypto-assets,” explained Steven Maijoor, chair of ESMA.

“Meanwhile, a number of crypto-assets fall outside the current financial regulatory framework. This poses substantial risks to investors who have limited or no protection when investing in those crypto-assets. In order to have a level playing field and to ensure adequate investor protection across the EU, we consider that the gaps and issues identified would best be addressed at the European level.”

Working with NCAs, ESMA analyzed the different business models of crypto-assets, the risks and potential benefits that they may introduce, and how they fit within the existing regulatory framework.

In the paper, the regulator gives its position on the gaps and issues in the current EU financial regulatory framework for consideration by EU policymakers. It classifies these in two categories:

• Though some crypto-assets may qualify as financial instruments under MiFID, there are still areas that require potential interpretation or re-consideration of specific requirements to allow for an effective application of existing regulations; and
• For crypto-assets that do not qualify as financial instruments, the absence of applicable financial rules leaves investors exposed to substantial risks. At a minimum, anti money laundering (AML) requirements should apply to all crypto-assets and activities involving crypto-assets. There should also be appropriate risk disclosure in place, so that consumers can be made aware of the potential risks prior to committing funds to crypto-assets.

Risks and issues

In the paper, ESMA outlines the risks and issues related to crypto-assets which it encourages regulators to consider meticulously. These include whether investors understand the risks they may be exposed to prior to investment, the early stage of development of most blockchain projects raising money through ICOs and the likelihood of failure, as well as fraudulent ICOs.

ESMA also notes the cybersecurity risks related to cryptocurrency exchange platforms and the increasing number of hacks occurring.

According to Eric Larcheveque, CEO of cryptocurrency hardware wallet manufacturer Ledger, the amount of stolen cryptocurrency from exchanges in 2018 increased 13 times compared to 2017. This amounts to US$2.7 million in crypto-assets being stolen every day, or US$1,860 each minute.

2018’s largest heists include Japanese Coincheck’s US$530 million hack, South Korean Bithumb’s US$31 million hack, and Bancor’s US$23.5 million hack.

Additionally, distributed ledger technology (DLT) poses very specific problems, notably due to the nascent nature of the technology. These include issues around governance, privacy and territoriality attached to the distributed character of DLT.

Potential benefits of ICOs and crypto-assets

Cryptocurrency, MaxPixel

Though ICOs and crypto-assets pose numerous risks, these also have many potential benefits. ICOs for instance can provide a useful alternative funding source for blockchain startups and other innovative businesses that would find it difficult or costly to raise capital through traditional funding channels.

More generally, the tokenization of assets has the potential to create beneficial outcomes for both market participants and investors, including enhanced liquidity of certain financial assets such as unlisted shares or syndicated loans, disintermediation and the use of smart contracts to automate the execution of contract obligations.

Research and Markets predicts the global tokenization market will hit US$2.25 billion by 2020 with a Compound Annual Growth Rate (CAGR) of 22.4%.

Featured image: European Union flag, by Håkan Dahlström, via Flickr.