The financial sector is undergoing a transformation, not only as a result of digitalisation and new consumer behaviour, but also linked to a disruptive element that is presenting itself as an alternative to the conventional financial system: crypto-assets.
The crypto-assets market has undergone an exponential evolution in recent years, and is no longer limited to financial professionals, but now reaches the public at large. Thus, according to the “III Informe sobre conocimiento y hábitos Fintech” (III Report on Fintech Knowledge and Habits), published by Asufin in November 2021, it is estimated that around 4.4 million Spanish people, 11.2% of the total population, have invested or invest directly in crypto-assets, of which 70.6% invest more than 1,000 euros. This is a global trend.
As the use of crypto-assets becomes more widespread, the impact on the financial sector is increasing, opening up a range of new opportunities and challenges. In this context, regulators warn of the importance of agreeing a global regulatory framework for their control, which provides the needed legal security.
Is this a short-term trend or a paradigm shift?
In this section we have the views of several experts specialised in this field.
“Despite still being in their early stages, crypto-assets – an umbrella term that encompasses utility tokens, crypto currencies, non-fungible tokens, stable coins, and digital securities – are garnering increasing interest in financial markets and beyond. So much so, that certain types of digital assets are now being considered an important step towards the digitalisation and modernisation of financial capital markets.
Gaining momentum across Luxembourg’s financial industry
According to a PwC survey carried out across Luxembourg’s financial sector earlier this year, almost half (43%) of participants said they expected crypto assets to become a strategic priority over the next two years, while 18% already considered them a strategic priority.
The evolution of the regulatory framework – an indication of crypto assets becoming mainstream
The growing popularity of crypto assets – and digital securities in particular – is also reflected in the acceleration of market digitalisation using blockchain technology, as well as the evolution of the regulatory framework. Some European Union (EU) member states have taken steps towards amending their local securities laws or issuing specific new laws covering digital securities.
Luxembourg has been playing a leading role in that respect through the adoption of its two Blockchain Laws in 2019 and 2021. The country’s financial sector regulator, the CSSF, has also been pro-active through the issuance of FAQ documents on this subject and, more recently, the publication of a white paper on distributed ledger technology (DLT) and blockchain, sharing its advice on assessing the risks when designing or implementing a project using DLT.
At EU level, the proposal for a regulation on a pilot regime for market infrastructures based on distributed ledger technology (EU Pilot Regime) is expected to enter into force in 2023 and last between three and six years, permitting the processing of security tokens through market infrastructures in application of a sandbox regime allowing for certain adaptations required by the new technology to applicable EU regulations.
This EU Pilot Regime will mark a significant step in the EU’s ambitions to modernise and prepare capital markets for a digital future, and, more importantly, provide a legal framework that supports and strengthens digital innovation while protecting the interest of investors.
Increasing transparency across public markets
While public markets already benefit from well-established and automated market infrastructures, the gradual adoption of blockchain technology is expected to help further increase transparency, flexibility and deliver significant efficiency gains to market participants, ultimately leading to lower operational risks and costs.
An opportunity to modernise and automate private markets
In contrast, private markets do not usually benefit from existing financial infrastructures, and are very fragmented and constrained by manual-intensive and error-prone operational processes. In that respect, blockchain technology can help provide a common infrastructure that offers the flexibility, automation and digitalisation processes required to efficiently administer these complex instruments.
Governments and corporations to help determine the longevity of crypto assets
In order to prove their longevity, crypto assets will need to be adopted and become standard across the industry, respecting the evolving regulatory framework in the process.
While the rollout of the EU Pilot Regime will facilitate on paper the gradual adoption of DLT in capital markets, and in turn help other industries follow suit, leading institutions and market participants will need to set this transition in motion, with the support of local authorities and regulators where needed.
Shaping new trends in capital markets
Earlier this year, the Luxembourg Stock Exchange (LuxSE) announced the admission of the first financial instruments registered on a public DLT on its Securities Official List (LuxSE SOL).
This constitutes a major step towards the digital transformation of LuxSE, and a very first building block in the exchange’s contribution towards price dissemination, data and transparency of financial instruments issued using DLT – one that may stimulate others to capitalise on this disruptive technology, and help meet their evolving business needs in tomorrow’s digital economy.”
Member of the Executive Committee at Luxembourg Stock Exchange
Rarely a day goes by where the upsides or downsides of various crypto assets are not discussed and debated by financiers, regulators, or technologists in the worlds leading newspapers and social media. And the debates can be intense. For some, crypto assets come close to a technological panacea. Cryptocurrencies such as bitcoin, or smart contracts on the Ethereum platform, promise to swiftly disintermediate traditional finance, and usher in technological revolutions comparable to the rise of the internet. Meanwhile, for others, crypto assets are at best fraudulent, and at worst sources of financial instability.
Differences in my opinion starts with the very name of just what to call these new financial products. If we think crypto assets as an investment product, utility, or payment instrument, what you call an instrument can necessarily lead to conclusions about whether (and how) one should regulate it. If its an asset, commentators immediate opine, should it be taxed like property? Or if you call it currency (such as “crypto currency” or “virtual currency”), then conceptually, you think about it just as that – and with all the attendant economic, tax, and regulatory consequences for finance ministries and others.
And if you call it something else – say a “derivative” to the extent to which any transaction requires time for the delivery of a crypto asset due to mining or data processing – another regime or framework will come to mind. In all, if you are not careful, the question one poses about crypto assets quickly becomes the answer, even when you are just grappling with defining what you are trying to study.
For a common ground point what crypto assets have in common is that they depend primarily on cryptography and “distributed ledger” technologies to memorialize and track transactions. Cryptography refers to algorithmic techniques used to protect information by encrypting it into formats accessible to individuals only if they possess a special key. Distributed ledgers, meanwhile, are databases that store records through a peer-to-peer network of computers that is not confirmed by any
one entity and is manager by multiple participants.
We should highlight some concepts first, in this regard crypotassets are used in many ways and are generally catalogued as comprising either a medium of exchange (“digital money” or “cryptocurrency”), devices for accessing an online service (“utility token”), or investments – or all three at once. As a medium of exchange cryptoassets can take the form of digital monety and as such may be accepted by persons and market participants in commerce. By contrast, as utilities cryptoassets are like tokens in a pinball machine in an arcade – you use them to access something you want to use, whether it be an online game or cloud storage facility. Cryptoassets can also constitute investments and are even used to raise capital through for example initial coin offering (“ICO”). Finally, cryptoassets have an operating system driving the way cryptoassets are transferred, and records stored, is a special kind of distributed ledger system called a blockchain, which links transactions together as time goes on and more transactions can take place1.
Regulation at EU Level
In September 2020 the European Commission (the “Commission”) adopted a legislative proposal for Regulations for markets in cryptoassets2 and on a pilot regime for market infrastructures based on distributed ledger technology3 (the “Regulations”). The proposed Regulations are part of a broader digital finance package introduced by the Commission to enable and support the potential of digital finance to boost innovation and competition, while at the same time mitigating risks stemming from it. This proposal takes into consideration advice received from the European Banking Authority (EBA) and the European Securities and Markets Authority (ESMA). For both cryptoassets and distributed ledger technology (DLT) market infrastructures the Regulation has four overarching objectives:
- To create legal certainty – a robust legal framework that clearly defines the regulatory treatment of all cryptoassets not covered by current legislation is required.
- To support innovation – a safe and proportionate framework that supports innovation and fair competition is needed to promote the development of cryptoassets and use of DLT.
- To ensure appropriate levels of consumer and investor protection and market integrity – as most cryptoassets are unregulated, this is of particular importance.
- To ensure financial stability – some cryptoassets bear the potential to become widely accepted and embedded in the financial system. Consequently, safeguards are required to address risks to financial stability and policy that could arise from these cryptoassets.
The Regulation will cover all cryptoassets not currently caught under existing financial services regulations. The Regulation lists them as follows:
- Utility Tokens – a type of cryptoasset that is intended to provide digital access to a good or service, available on DLT, and is only accepted by the issuer of that token.
- Asset-Referenced Tokens – a type of cryptoasset that purports to maintain a stable value by referring to the value of several fiat currencies that are legal tender, one or several commodities or one or several cryptoassets, or a combination of such assets.
- E-Money Tokens – a type of cryptoasset the main purpose of which is to be used as a means of exchange and that purports to maintain a stable value by referring to the value of a fiat currency that is legal tender. They will be treated and regulated as e-money under the Electronic Money Directive 2009.
After such Regulation was enacted by the Commission, Luxembourg and most of the EU members states have opted to self-regulate with different administrative proposals by their home public authorities before any directive is enacted for mandatory transposition by the Commission. The self-regulation has been very cautious and conservative (most for crypto currencies and tokens) and for the Luxembourg case the virtual assets and the exposure of investment funds4 for being the Europe’s number one international fund distribution platform with international outreach.
Cryptoassets are if nothing else, controversial. They pose considerable risks regarding volatility and market integrity as common concerns by all the skeptics.
From my perspective, cryptoassets advocates cite several potential benefits associated with cryptoassets that if realized could prove transformative for the payments industry. Blockchains, for example, are often described as immutable – unable to be edited or deleted – thereby allowing in some (though not all) instances greater security than traditional banking systems. Furthermore, because cryptoassets leverage peer to peer infrastructure, they enable applications across borders at low costs, and are poised to transform international remittances.
Crypotassets are also supported by highly decentralized blockchains and operating processes, enabling open and transparent points of access for stakeholders; all the while, nongovernmental and private cryptoassets operate independently of central banks, and as such are subject, according to proponents, to less political manipulation.
The puzzle becomes even more difficult given the virtual nature of there assets, and the fact that they are digital instruments, tradeable and transferable online. Cryptoassets are routinely released and traded throughout the world and can be accessed in terminals strewn across jurisdictions and to far fling parts of the world. Different countries may, furthermore, have very different conceptions as we have seen to just define what a cryptoassets is, and how it should be categorized and regulated. Galvanizing a global, coordinated strategy is difficult, if not impossible, with stakeholders and even countries initiating the regulatory process from very different vantage points.
Finally, I contend that cryptoassets have as one of the bast potentials to disintermediate an oligopoly of intermediates dominating the legacy of the financial system challenging the longstanding economic models and regulatory strategies in order to shift the paradigm in the near future.