Part I - Of MiCA and Men: A Clear Regulatory Capture by TradFin Aiming to Put Crypto at a Disadvantage and Nip DeFi in the Bud

The E.U. Commission’s Legislative Agenda and Timeline

On 24 September 2020, the European Commission (EC) adopted an expansive new Digital Finance Package with which it hopes to transform the European economy in the coming decades.

The stated aim of the package is to improve competitiveness of the continent’s Fintech sector and technologies, while mitigating risk and ensuring the financial stability of the European economy.

The new regulatory framework also included the a comprehensive new legislative proposal on crypto-assets referred to as the Markets in Crypto Assets (“MiCA”) regulations.

This 168-page MiCA document focused strongly on rules to regulate currently “out-of-scope” (i.e. outside existing financial services rules) crypto-asset types such as stable coins - issuance of which will be strictly controlled - as well as Crypto-Asset Service Providers, referred to as CASPs.

On the 14th of March 2022, the European Parliament adopted its negotiating position on MiCA, proposing a number of amendments.

The MiCA draft is now set to go to the next stage of the legislative process – a “trilogue” between the European Parliament, the European Commission (call it Europe’s executive branch) and the European Council, the latter representing its Member States.

It is expected that it may take up to 4 years for the proposal to become law which means the proposals could become law as early as 2024.

If adopted, the new regulation will directly apply to all Member States without the need for implementation in national laws, contrary to an E.U. Commission Directive which needs to be implemented by each Member State after adoption.

We identified 4 areas which would significantly impact the crypto industry in the European Union:

1. Proposed ban on Proof of Work

Earlier language banning Proof-of-Work (and therefore Bitcoin and other PoW blockchains) was left out.

However, the draft text leaves the door open for a reintroduction of a ban by specifying that PoW mechanisms deployed by crypto-assets would still have to be subject to minimum environmental sustainability standards set by the E.U. environmental legislation and more specifically, the E.U.’s Taxonomy Regulation.

This taxonomy sets out a classification system for sustainable activities,. which are to include crypto-asset mining activities that contribute substantially to climate change by 1 January 2025.

Whilst Ethereum by then is likely to escape those, Bitcoin most certainly is not.

This could lead to a ban on PoW mining in Europe.

2. Controls on stable coin and e-money tokens issuance

The draft legislation differentiates between:

• crypto assets in general;
• stable coins, called Asset Referenced Tokens (ARTs) in E.U-speak; and
• e-money tokens primarily used for payments.

Most of the 168-page proposed rules deal with a new regime for the issuance and supervision of ARTs, which will require authorization by the European Securities and Markets Authority (ESMA), whilst the European Banking Authority (EBA) is put in charge of supervising electronic money tokens.

This means that two key innovations in DeFi are placed under the supervision of incumbent regulatory authorities that have historically been tasked with - and hence heavily influenced by - the traditional finance sector.

3. Crypto-asset issuance curtailed

Furthermore, despite being “out-of-scope” i.e. considered non-financial instruments under the MiCA definition, as with their TradFin counterparts who are obliged to issue a prospectus in order to offer securities to the public, issuers of all crypto-assets in Europe will be required to first publish a whitepaper (in English or an E.U. state’s official language) which must contain the core information on the characteristics, rights and obligations and underlying technology of their project.

This whitepaper must be shared with authorities at least 20 days before publication and whilst it is not subject to approval, national authorities may suspend an offering if they feel issuers do not have strong enough cybersecurity in place to safeguard investors’ funds.

Once published on the issuer’s website, the offering can be marketed throughout the whole European Economic Area (EEA).

Issuers will be made liable for the information they provide in their white paper, and consumers will have a 14-day right to withdraw from purchasing a “non-listed” crypto-asset token if they bought it directly.

There are a number of “safe harbors” which exempt crypto-asset issuers from the requirement to publish a whitepaper if the offering:

• targets only qualified investors or less than 150 investors per member state;
• doesn’t exceed 1 million Euros (USD 1.17m) over 12 months;
• gives free crypto-assets, in other words “airdrops” (unless recipients have to provide personal data or the issuer earns commission or benefits from other parties);
• issues mining rewards;
• issues crypto-assets already previously available in the EU (excluding stable coins).

4. A very broad definition of who is a Crypto-Asset Service Provider

Under the proposed text, CASPs would include:

any person whose occupation or business is the provision of one or more crypto-asset services to third parties on a professional basis.1

Such crypto asset service is then defined as any of the services and activities listed below relating to any crypto-asset:

(a) the custody and administration of crypto-assets on behalf of third parties;

(b) the operation of a trading platform for crypto- assets;

(c) the exchange of crypto-assets for fiat currency that is legal tender;

(d) the exchange of crypto-assets for other crypto- assets;

(e) the execution of orders for crypto-assets on behalf of third parties;

(f) placing of crypto-assets;

(g) the reception and transmission of orders for crypto-assets on behalf of third parties

(h) providing advice on crypto-assets;

This definition is broader than the Financial Action Task Force’s (FATF) virtual asset service provider (VASP) definition2.

Each of the above activities will require authorization by the regulatory authority of the E.U. country where the relevant activity is conducted from.

As a result, crypto-asset services within the EU can only be provided by legal persons that have a registered office in a Member State of the E.U. and that have been authorized as Service Providers under MiCA.3

In addition, the proposed regulations will be applicable to any non-European CASPs (including those based in post-Brexit Britain) seeking to market to E.U. clients.

Such non-E.U. CASPs will now need a legal entity in an E.U. country and a license, and other potential requirements may apply such as additional licensing for what is deemed to be advisory functions, depending on the type of activity undertaken.

Similar to financial services providers, any CASPs that operate in the E.U. will be subjected (depending on their size and associated risk) to further requirements which pertain to their capital requirements, governance model, staff training, insurance coverage and more.

Conclusion: Regulating innovation out of existence

In our assessment, and for reasons detailed in Part III, the proposed regulations if adopted as they stand may effectively be the death knell for DeFi in Europe.

In addition, the requirements of local presence and license has a very dramatic extra-territorial effect and will erect significant barriers to entry into the European market by non-E.U. crypto players.

All in all, under the guise if creating a level-playing field between TradFin and DeFi, and using consumer protection as a fig leaf to cover up for the political promiscuities of the traditional finance lobby, the E.U. does what it does best: regulating innovation out of existence.

In Part III, we provide a summary of objections raised so far against the proposed MiCA and TRF (see Part II) regimes by other industry players and add our own grounds why we believe they represent regulatory overkill at its worst.