Solving the Puzzle of Crypto Legislation

An interest in digital assets by traditional financial service institutions (FSIs) has been developing across Europe, with banks exploring the opportunities it can offer. However, until now traditional FSIs have  adopted to a limited extend the use of crypto assets, and the market instability in 2022 illustrated the shortcomings of the crypto market. The year 2023 paves the way for digital assets solutions for FSIs thanks to the regulatory implementation:

1. The Markets in Crypto Assets Regulation (MiCA)  will support further development of the crypto asset industry  by introducing protection for investors and requirements for market participants through a common EU regime that focuses on stablecoins, unbacked assets and crypto asset service providers (CASPs).
2. The Distributed Ledger Technology (DLT) Pilot Regime will support the developments surrounding digital assets in areas that are not covered by MiCA. The DLT Pilot Regime provides a so-called ‘regulatory sandbox’ to allow financial institutions to experiment with their core services (financial instruments e.g., trading, settlement) and this new technology in a safe environment.

The MiCA will be applicable from 30 December 2024 onwards (and some parts July 2024 onwards), and applications for the DLT Regime started on the 23rd of March 2023. The combination of these regulations provides an opportunity to engage more safely in the crypto market for regulated institutions and consumers, and some banks in Europe are already preparing. Moreover, traditional financial institutions have an advantageous position compared to unregulated crypto companies thanks to their wide-ranging experience with risk management, operational resilience and duty of care. Deloitte can provide support in defining the best strategy for creating a product and be a partner in preparing for the DLT PR application process.

The EU’s Regulatory Approach

Identifying the regulatory scope is one of the main challenges for regulated financial institutions when deciding to launch a crypto solution. Crypto assets are not that novel anymore (the Bitcoin whitepaper was published in 2008) but crypto regulation remains in the design stage while implementation is pending. The regulators have often decided to leverage on traditional regulation as a quick solution to prevent market risks and to address consumer protection, but the results are not as effective as expected. The EU came up with the Digital Finance Package containing several pieces of legislation (including MiCA & DLT Pilot Regime) to address this issue.

The MiCA focuses on digital assets (such as unbacked assets and stablecoins), with the exception of those that qualify as financial instruments. For more information on MiCA, please refer to our point of view here. The focus of the DLT Pilot Regime is the development of digital assets that qualify as financial instruments under the Markets in Financial Instruments Regulation and Directive (MiFIR/MiFID II) and the Central Securities Depositories Regulation (CSDR). In a ‘regulatory sandbox’, financial institutions can experiment with the application of DLT to their core services.

What’s at Play in the Regulatory Sandbox?

The DLT Pilot Regime makes it easier for market participants to experiment with applying DLT to financial instruments. Subject to conditions, safeguards and approval, applicants can receive temporary derogations from current legislation. These derogations will boost the development of new products/services in a blockchain environment and create significant opportunities. In turn, lessons learned will contribute to potential future legislation on DLT-based financial instruments. In the Netherlands, the Authority for Financial Markets oversees the application process.

This unique sandbox approach illustrates a milder attitude and openness from the side of the Commission, embracing the potential of transformative technologies such as DLT in the financial sector. Applicants are exempted from legal requirements that could otherwise prevent them from developing digital financial solutions by means of DLT. This exemption is valid throughout the EU (allowing ‘passporting’). Parties who are already subject to MiFIR/D and CSRD can request derogations, but also new market entrants are welcome to do so, granted that they are capable of adhering to the other relevant parts of the MiFIR/D and CSRD that the derogation does not cover.

A Case-by-Case Assessment

The digital representation, or “tokenization”, of financial instruments or traditional assets is expected to bring increased efficiency and increased trust to financial institutions. However, it is inevitable that regulation remains somewhat fragmented by the type of token, as not every token can be regulated in the same way. As a result, the only feasible approach is a case-by-case assessment, based on which the starting point is the identification of the underlying instrument and token. Several groups of tokens can be identified:

• tokenized financial instruments: the digital representation of financial instruments, which are financial rights that can be traded, such as bonds and loans
• stablecoins or asset referenced tokens: tokens that are stabilized by reference to a fiat currency such as dollar and euro or other assets such as gold
• unbacked tokens: tokens that are not backed by anything and rely only on the market value, such as Bitcoin and Ethereum
• utility tokens: tokens that provide the right to use something, or vote in something

Each category of token is suitable for a different solution, e.g. asset-referenced tokens are suitable for payments, whereas tokenized financial instruments are the traditional financial instruments managed via blockchain mechanisms, etc. For every token group, the core applicable regulation can be determined: if the underlying instrument is a crypto asset that qualifies as a financial instrument under MiFID II then it will be subject to the MIFID II / CSDR, and can be further developed in the regulatory sandbox under the DLT Pilot Regime. If the instrument is an E-Money token, asset-referenced token or when Initial Coin Offerings (ICOs) come into play, then MiCA is the right framework to focus on.

Crypto asset service providers (CASPs) are also covered by MiCA, even if the underlying asset they are offering is an unbacked crypto asset. All current EU regulatory texts on crypto are now final, therefore 2023 will be the year in which increasing regulatory clarity will help traditional FSIs shape their strategies. Furthermore, throughout Europe, regulators are providing their opinions and drafting guidance.

Designing the Future in a Responsible Way: How Can We Help Navigating Digital Assets in 2023?

To develop the product in a responsible way, it is important to mitigate the risks and involve the risk and compliance department from the beginning. At the same time, it is particularly useful to start an ongoing dialogue with the regulatory bodies. Because of factors such as consumer protection and financial stability, regulators and supervisory bodies are critical of crypto-assets. Yet, it is also recognized that technology supports current and future technological developments, and it is key to continue identifying potential opportunities provided by regulators.

Thanks to our experience we are able to help you with every step of this process: we offer a holistic approach that includes other relevant regulations (e.g., MIFID II, TFR, DORA, SFDR), the preparation for the dialogue with regulatory bodies, the application process and assistance during the implementation process. Our focus is to help you understand how the changing regulatory landscape impacts your strategy and what opportunities and threats are rising. The multi-lens approach of Deloitte can assist you in deep diving each of these areas. Let’s talk.