Regulatory uncertainty is hindering asset token take-up, but new EU proposals could create the first legal framework for crypto-assets.
Regulatory uncertainty is, at present, one of the biggest obstacles hindering the development of tokenization. The regulatory priority is to ensure tokenised markets are consistent with financial stability, market integrity and investor protection, which presents regulators with a quandary: how to foster innovation while containing the risks for investors, and preventing regulatory distortions between traditional actors and new ones?
“Yet, until regulators find new ways to keep up with evolving technology, while providing enough legal certainty on key issues such as the applicability of EU financial services legislation, asset managers and banks will remain reluctant to back tokenization fully”,Wladyslaw Unrug, Public Affairs – Strategic Analyst with BNP Paribas Securities Services
If utility tokens, cryptocurrencies, stablecoins, global stablecoins and security tokens are all crypto-assets and products of tokenization, they do not share the same function, characteristics, nor do they carry the same risks.
As such, crypto-asset classification is a key issue to determine the rules that should apply. For instance, under EU law, if a token qualifies as a financial instrument, the whole set of financial services rules should apply. From a regulatory point of view, it makes sense that security tokens would be subject to the same requirements and safeguards that apply to traditional securities. However, the decentralised nature of DLT systems, with their disintermediation and cross-border implications, raises a number of regulatory questions that existing rules do not cover or cover imperfectly, requiring regulators to rethink and clarify existing financial regulations.
Another significant challenge lies in finding a way for regulators and central banks to digitise the cash component of the token, to break down the barriers between the on-chain and off-chain worlds and to stimulate industry pick-up – a challenge most central banks are now carefully examining.
“As demand for crypto-assets services is rising and regulators have started tackling legal uncertainties, we can expect that once the cash leg problem is resolved, a whole new market will open up”, says Wladyslaw Unrug.
National regulatory patchwork
France has been in the vanguard of blockchain regulation. In 2016-17, it adopted two “Blockchain ordinances” and the Sapin II law that recognise the validity of the registration and transfer of some types of unlisted financial instruments on a blockchain. And in 2019, the country adopted the PACTE law, which establishes a licensing regime for companies seeking to conduct an initial coin offering (ICO) or act as Digital Asset Service Providers (DASPs) for crypto-assets that do not qualify as financial instruments under EU law.
“Regulating DASPs will enhance investor protection”, explains Wladyslaw Unrug. “Mandatory registration is also required for DASPs wishing to offer custody or purchase and sell crypto-assets in exchange for legal tender.”
Companies wishing to store, transfer and trade crypto-assets are similarly licensed and regulated under landmark legislation introduced in Germany in November 2019. The Dutch Central Bank also began regulating organisations offering crypto-related services in January 2020, with crypto wallet providers and firms offering crypto and fiat currency exchange services required to register with the regulator to operate.
In the United States, cryptocurrencies have been classified as securities by the Securities and Exchange Commission since March 2018, while the Commodity Futures Trading Commission (CFTC) considers Bitcoin a commodity and allows cryptocurrency derivatives to trade publicly.
Japan, another country at the forefront of crypto regulation, has required licenses for all crypto trading platforms since 2017. More recently, crypto custody has become subject to licensing, and new requirements have been introduced for crypto trading activities and crypto-assets qualifying as securities. The Bank of Japan also announced it will experiment with a Central Bank Digital Currency (CBDC) going forward. China may get there first though, after a new law adopted in October 2019 paved the way for it to become the first state to issue a CBDC.
EU progress: a regulatory framework in the making
Building on the findings of the Commission consultation launched in December 2019, the Commission proposed new legislation on crypto-assets on 24 September 2020, with the overall objective of having a comprehensive EU framework for crypto-assets put in place by 2024. These proposals aim to bring the much-needed legal clarifications and will be completed by legal guidance and other legislative proposals in order to ensure convergence at EU level, further clarify complex aspects and make sure that the legal framework effectively addresses new risks.
“It’s been a good year for crypto-asset regulation”, says Wladyslaw Unrug. The European Commission’s recent legislative proposals on crypto-assets will turn the EU into the first major jurisdiction to establish a comprehensive legal framework for crypto-assets.
These proposals – to be completed by legal guidance and other legislative proposals – aim to bring the much-needed legal clarifications and ensure convergence at EU level while making sure that new risks are properly addressed.
So far, two main proposals have been published by the Commission:
- The ‘Regulation on Markets in Crypto Assets’ (MiCA), which relates to crypto-assets which do not qualify as financial instruments under EU financial services rules, will replace existing national bespoke regimes and provide common requirements for crypto-asset issuers (with a specific regime for ‘global stablecoins ‘, e.g. Libra) and crypto-asset providers.
- The pilot regime – a ‘European sandbox’ approach – is also being proposed for DLT market infrastructures that wish to try to trade and settle transactions with security tokens. However, in order to allow innovation and experimentation in a sound regulatory environment while preserving financial stability, the scope of financial instruments admitted is limited to ‘simple and illiquid’ financial instruments. The review of the regime (at least five years after its entry into application) will then allow the regime to either be extended (for another period or to other types of financial instruments), amended or terminated.
“We really get the feeling that the EU regulatory environment is maturing in the right direction, although more cautiously for security tokens”, notes Wladyslaw.
“While some clarifications remain necessary, these proposals are a positive signal to the community and show a real willingness to establish a healthy crypto-asset ecosystem in the EU”.
The proposals will now be discussed in the weeks to come. This will be the opportunity for the crypto industry to voice its views on how best to promote the uptake of crypto-assets in the EU and address its risks.
The proposals, which will now be discussed between the Parliament, the Commission and the Council, represent a good compromise in providing sufficient legal certainty and safeguards for investors, while allowing a safe environment for experimentation and the crypto-asset markets to mature. As EU regulation seems to be moving faster for utility tokens, cryptocurrencies, stablecoins and e-money tokens, institutional actors may want to revisit their approach towards these forms of tokenization.
For security tokens, changes to securities regulation at EU level will require a bit more time to allow regulators and market players to experiment with DLT, as well as make sure that any changes to the current regulatory framework is sound, evidence-based, and does not pose any risks to financial stability.”
So, while the rollout of national and regional initiatives is laying the regulatory foundations for the market’s subsequent development, any remaining areas of regulatory and legal ambiguity need to be addressed to ensure the safe use of tokenization by market participants. Cross-border transactions pose a particular challenge, requiring international cooperation to promote the healthy development of decentralised technologies and their markets, says Wladyslaw Unrug.
“The Commission’s proposals could give the EU a first-mover advantage. It could inspire other jurisdictions to follow the EU in its path regarding crypto-asset regulation”, notes Wladyslaw Unrug. At the same time, global consistency is also a concern. Should other major jurisdictions plan to introduce similar legislation, diverging regulatory approaches could raise the spectre of regulatory arbitrage.
What is becoming clear from tokenization’s evolution is that custodians can play an important role in protecting consumers, especially given the risks around anti-money laundering, terrorism financing and the loss of private keys. “BNP Paribas is developing the capabilities required to operate in this new space. We are working with Curv on a solution to transfer security tokens securely between market participants, using Curv’s multi-party computation platform to ensure the security of the private keys”, says Johann Palychata, Head of Partnerships and New Platforms with BNP Paribas Securities Services.
An OECD report notes that asset tokenization will ultimately depend on the existence of a trusted and credible central authority that can guarantee a smooth connection between the off-chain world and distributed ledger environment.
“As a custodian, BNP Paribas Securities Services is well equipped to act as the trusted party to guarantee the backing of tokens issued by the real assets, as well as providing institutional-grade safekeeping of the crypto-assets at all times”, says Wladyslaw Unrug.
“Custodians will also need to ensure the asset’s digital representation on the ledger is unique and that the same asset is not being represented by multiple tokens on multiple platforms.”
With thanks to Wladyslaw Unrug, Strategic analyst – Public affairs, BNP Paribas Securities Services.
 Examples : Banque de France initiative
ECB report on a digital euro, Oct 2020 (https://www.ecb.europa.eu/pub/pdf/other/Report_on_a_digital_euro~4d7268b458.en.pdf)
 OECD (2020), The Tokenization of Assets and Potential Implications for Financial Markets, OECD Blockchain Policy Series (www.oecd.org/finance/The-Tokenization-of-Assets-and-Potential-Implications-for-Financial-Markets.pdf)