Asset-Referenced Tokens Under the EU’s Proposed Markets in Crypto Assets Regulation

Introduction

On 24 September 2020 the European Commission adopted a digital finance package, including a digital finance strategy and legislative proposals on crypto-assets and digital resilience. One key component of the Commission’s proposal was a legislative regime to comprehensively regulate crypto-assets within the EU. This proposed regulation, known as the EU Markets in Crypto-assets Regulation, (“MiCA”) is on course to be the first large-scale and mainstream regulatory regime that aims to govern and regulate crypto-asset issuers and service providers in the world. MiCA is currently progressing through the EU’s legislative process and once enacted will be directly applicable in all EU member states.

MiCA divides crypto assets into different categories and outlines regulatory requirements for crypto-asset issuers and service providers. The first step therefore in interpreting how MiCA will affect a crypto-asset issuer is to identify the category into which an issuer’s respective crypto-asset falls.

MiCA specifies three categories of crypto-assets: (1) asset-referenced tokens, (2) e-money tokens and (3) utility tokens, and also acknowledges that certain crypto-assets qualifying as financial instruments and as a result fall under pre-existing legislation. The scope of MiCA is however limited to crypto-assets that do not qualify as financial instruments, deposits or structured deposits under EU financial services legislation.

This article aims to examine how MiCA proposes to regulate issuers of MiCA’s first category of crypto-asset: (1) asset-referenced tokens. MiCA’s provisions relating to the other categories of crypto-assets will be examined in separate posts.

What Constitutes an Asset Referenced Token (“ART”)?

Under MiCA, a crypto-asset is an “asset-referenced token” if it 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 crypto-assets, or a combination of such assets”.

The question therefore stands: what exactly falls under the definition of an ART? ARTs are a type of stablecoin designed to hold its value; however, unlike dollar-pegged stablecoins, ARTs are backed by a basket of different fiat currencies, commodities or crypto-assets. The most famous example is Facebook’s Libra Coin which in fact has not been issued, and likely never will. It seems another example of an ART would be any crypto-asset that tracks the price of a commodity — for example a token tracking the price of gold.

Libra / Diem Project

It has been speculated that MiCA’s particular focus on ARTs is a direct result of Facebook/Meta’s Libra project, as it was then called. The Libra Project included the proposal of a global digital currency to be used in collaboration with Facebook’s social network and involved the development of a Libra token whose value would be derived from a weighted basket of real world fiat currencies. The project aimed to invest a new type of digital global currency that would operate as a settlement coin in cross-border transactions.

The regulatory concerns about the Libra Project goes some way to inform the provisions of MiCA aimed at ARTs. It appears that the scope of Facebook’s plans to design a new multi-jurisdictional currency backed by an array of currencies sparked concerns that the traditional monetary system would be undermined. Through such a lens, MiCA’s significant emphasis on regulating ARTs can be more clearly understood.

Facebook’s Libra coin was designed to be backed by a basket of several currencies which, due to its cross-border capabilities, regulators saw as threatening the sovereignty of regional fiat currencies.

Stablecoins as ARTs?

The mention of “stable value” tokens seemingly pegged to fiat currencies suggested within the ART definition could easily be misinterpreted. It is easy to see how one might be confused into thinking that popular stablecoins pegged to and backed by the US Dollar (such as USDT, USDC, BUSD) might fall into MiCA’s ART category. However, due to MiCA’s description of an ART as “referring to the value of several fiat currencies” or one or several commodities or one or several crypto-assets, MiCA appears to rule out US Dollar backed stablecoins from the ART category.

Stablecoins however that are backed by reserves in fiat currency qualify as “electronic money tokens” or “e-money tokens”. These are crypto-assets that aim to maintain a stable value by referring to the value of a fiat currency that is legal tender.

Furthermore, under MiCA’s ART definition it appears that stablecoins backed by crypto-assets, such as MakerDao’s DAI, will also fall under the ART category. In DAI’s case, this is as a result of the stablecoin being collateralised by crypto-assets — namely ETH and USDC.

Issuer Governance and Policies

One of the primary objectives of MiCA is to regulate crypto-asset issuers, effectively the organisations which issue and define the features of a given crypto asset and how the asset is distributed. The reasons for this is the unregulated nature of the crypto industry/market currently with effectively no consumer protection. Regulators are concerned with risks such as fraud and deceptive practices on the part of issuers. In light of this it makes sense that MiCA aims to scrutinise and regulate the internal policies of ART issuers.

In its current proposal form MiCA requires ART issuers to maintain robust governance arrangements. Such arrangements include clear organisational structures and effective processes to report and manage risks that an issuer might be exposed to.

MiCA further requires ART issuers to establish a business continuity policy aimed at ensuring the performance of their operations and core payment activities in the case of an interruption to their systems and procedures. ART issuers will also be required to have a strong internal control and risk assessment mechanism, as well as a system that guarantees the integrity and confidentiality of information received through their activities.

MiCA will also require ART issuers to have a registered office in the Union, with the purpose of ensuring the proper supervision and monitoring of offers to the public of ARTs.

Management Body and Shareholder Requirements

A further area of regulatory focus for MiCA are the people who own and manage the organisations that issue ARTs. MiCA requires the management body (effectively the top executives) of an ART issuer to meet specific standards. Where an ART issuer organisation is a company, the issuer’s controllers and shareholders are also require to meet certain standards.

Members of the management body of ART issuers must be of good repute and have the necessary skills and qualification to perform their duties[1]. The members of such a management team are also required to be fit and proper for the purpose of anti-money laundering and combatting the financing of terrorism.

Shareholders of ART issuers with more than 20% of the share capital or voting rights (or those who exercise control over an issuer) must also be of good repute and competence[2]. Furthermore, neither the management body, the owners, or those exercising control of an issuer are permitted to be convicted of any financial crime.

Prohibition on Granting of Interests

MiCA states that to ensure that ARTs are mainly used as a means of exchange and not as a store of value, ART issuers (and crypto-asset service providers) are not permitted to grant interests or other benefits to users or holders of an ART.

This effectively deprives ARTs from having the ability to be bestowed with rights, interests or powers that might otherwise be instilled in the ART in question.

Given their flexibility, crypto-assets can be designed to have a myriad of functions. Tokens can be used to grant access or a right to use a platform, these tokens are often referred to as utility tokens. Filecoin, for instance, is a token that functions as a reward for users providing storage space to the Filecoin network and can itself be spent to store and retrieve data. It appears that ARTs are not permitted to be designated with such functionalities, interests or benefits.

Prohibition on Earning Interest

Under MiCA, issuers of ARTs, or crypto-asset service providers, are not permitted to provide for interest or any other benefit related to the length of time during which a holder of an ART holds the token in question. This appears to prohibit a token holder from earning interest on an ART.

Requirement for Authorisation Prior to Public Offer

An ART issuer is prohibited from offering its ART to the public (or attempt to admit the ART to a trading platform) within the EU, until an issuer has been authorised to do so by its relevant competent authority[3]. MiCA also clarifies that only legal entities that are established within the EU can be granted such an authorisation. A key feature of the MiCA proposal is that an authorisation granted by the competent authority will be valid across the Union[4].

Notably, privately issued ARTs, and also ARTs with market caps below a certain threshold, are permitted to offer their tokens to the public without receiving an authorisation from their relevant competent authority.

Furthermore, if an ART issuer is authorised as a credit institution (under the 2013 ‘Capital Requirements Directive[5]’) they are also exempt from the requirement to be granted authorisation. In such cases however, where such an issuer is exempt, the issuer is still required to complete and submit a white paper (akin to a token prospectus) to its relevant competent authority. The requirements in respect of the ART white paper is discussed in greater detail below.

Application for Authorisation

To be authorised to operate in the Union, issuers of ARTs must be incorporated in the form of a legal entity established in the EU. No ART can be offered to the public in the EU or admitted to trading on a trading platform if the issuer is not authorised in the EU and the issuer does not publish a crypto-asset white paper approved by its competent authority.

It is only when an ART issuer has been authorised by its competent authority that it can offer its ART to the public. Authorisation can only take place after the issuer’s white paper has been approved.

ART issuers are required to submit their application for authorisation to the competent authority of their home Member State. This application is required to contain certain information about the issuer, including the issuer’s business model; governance arrangements; a programme of operations; a legal opinion that the ART does not qualify as a financial instruments, electronic money, deposit or structured deposit; and information relating to the individuals involved in the running and controlling of the issuer. Further evidence of compliance with the provisions of MiCA will also need to be provided.

Once a competent authority has received an application for authorisation from an ART issuer, it will first immediately notify the applicant whether the application is complete. The competent authority will then, within 3 months, assess whether the applicant issuer complies with MiCA’s requirements and publish a draft decision granting or refusing authorisation. This draft decision will be sent to the applicant issuer and to the European Banking Authority (“EBA”), the European Securities and Markets Authority (“ESMA”) and the European Central Bank(“ECB”). Applicant issuers will have the right to provide their competent authority with comments on their draft decision.

Within 2 months after having received the draft decision and the application, the EBA, ESMA, the ECB will issue non-binding opinions on the application which will be sent to the competent authority concerned. That competent authority will then duly consider those non-binding opinions, as well as comments of the applicant issuer. Competent authorities will then, within one month, make a fully reasoned decision granting or refusing authorisation to the applicant issuer who will be notified within 5 working days.

Authorisation Refusal

MiCA states that a competent authority may refuse authorisation to offer an ART to the public if there are any risks that sound business practices will not be carried out by the respective management team of the ART issuer in question. Such conduct might be practices that may affect the interests of an in issuer’s clients or the integrity of the market. Authorisation may also be refused if it is anticipated that an issuer is not likely to comply with all provisions within MiCA. In alignment with us, authorisation can also be retroactively withdrawn should an issuer be granted authorisation and then subsequently be found to infringe MiCA or other requirements of the authorisation application.

Furthermore, where an applicant issuer’s business model could be believed to pose a serious threat to financial stability, monetary policy transmission or monetary sovereignty, authorisation may be refused.

The ART White Paper

Prior to being granted authorisation, MiCA provides that an ART issuer must submit a white paper to its relevant competent authority (usually the primary financial services authority or central bank of the issuer’s relevant member state). Such a white paper is akin to a token prospectus and not entirely dissimilar to the white papers that are commonplace in the crypto industry today. However the white paper required by MiCA is required to provide specific details about the issuance of the ART in question and further details about how the issuer itself is governed. It is a requirement that all information provided in the white paper must be complete, fair and not misleading.

Details of the different information that must be provided in the white paper are set out below:

Reserve assets

The reserve assets of an ART take a particular focus of the white paper. Where reserve assets are being invested, a detailed description of the investment policy for those reserve assets will also need to be provided in the white paper. Information relation to any third party service providers involved in the custody of the reserve assets of an issuer must also be provided.

Redemption rights and stabilisation mechanism

Seemingly with consumer protection in mind, details of a consumer’s redemption rights in relation to an ART must also be included within the white paper. Details of how the redemption procedure will operate in the case of an insolvency scenario must also be provided. Where redemption rights are only granted to a select group of holders, the white paper must unambiguously state that all holders do not have a claim on the reserve assets, or cannot redeem those reserve assets at any time.

Where the issuer does not offer a direct right on the reserve asset must establish and provide detailed information on the stabilisation mechanism[6], in respect of the value of the ART in question will need to be provided in the white paper. If an issuer is not providing for a direct right on the reserve asset, the issuer must put in place mechanisms to ensure the liquidity of the ARTs that function to ensure any third party service providers post firm quotes at competitive prices on a regular and predictable basis. The ART issuer must ensure that a sufficient number of crypto-asset service providers are required to post firm quotes at competitive prices on a regular and predictable basis.

Where the market value of ARTs varies significantly from the value of the reference assets or the reserve assets, the ART holders will have the right to redeem the crypto-assets from the issuer of crypto-assets directly. In that case, any fee applied for such redemption will be proportionate and commensurate with the actual costs incurred by the issuer.

White Paper Approval and Publication

MiCA states that where an applicant issuer is authorised, its crypto-asset white paper will be deemed to be approved. The proposed regulation provides that the EBA and ESMA will develop draft regulatory technical standards to specify the exact procedure for the approval of a crypto-asset white paper.

Once such technical standards are adopted and in the case where a competent authority approves an issuer’s white paper (and their marketing communications if applicable), the white paper must be published on the issuer’s website where it must remain accessible for as long as the ARTs are held by the public[7].

Marketing Communications

Any marketing communications published by an issuer in respect of its ART must be in alignment with the details provided in the white paper. Such marketing communications must also be identifiable as such. The information in the marketing communications must be fair, clear and not misleading. The marketing communications must clearly state that a crypto-asset white paper has been published and indicate the address of the website of the issuer of the crypto-assets.

Furthermore, where no direct claim or redemption right has been granted to all the holders of an ART, any marketing communications are required to contain an unambiguous statement to such an effect — namely, that all the ART holders do not have a claim on the reserve assets or cannot redeem those reserve assets with the issuer at any time.

MiCA also provides that issuers need to provide relevant information to token-holders on their ART in question on the issuer’s website, on an ongoing basis.

Musings on the ART White Paper

The impact statement that was published alongside MiCA proposal included cost estimations in relation to the preparation and submission of a white paper to a competent authority. These suggest that the costs an issuer might face, for the preparation of a white paper alone, would be in the region of €35,000 — €75,000. This cost estimation excludes any other new compliance costs that might arise with MiCA’s new proposed requirements. It seems that the imposition of these new financial and administrative burdens could prove repressive to market participants — especially for newer entities entering the market.

Commentators on the current crypto market have labelled it as potentially more egalitarian than other investment markets (such as the stock market). This is in part due to the fact that the crypto market does not have particularly high entry barriers. It is relatively easy, for example, for ordinary citizens to invest in crypto-assets without being subject to accredited investor standards. It is also relatively easy for flexible crypto start-ups to launch in the space, helped by accessibility of funding and the open-source nature of much of the blockchain technology underpinning cryptocurrencies. As a result, there are concerns that MiCA’s provisions will prove at least highly-burdensome to innovation in the crypto space, particularly for its smaller players. In this vein there are also concerns that the increased barriers to entry that MiCA proposes will be disproportionately beneficial to the big players in the space who will have funds to comply with requirements and/or surmount regulatory obstacles.

Reserve Assets

In order to stabilise the value of their ART, issuers are required to constitute and maintain a reserve of assets backing those crypto-assets at all times. MiCA also provides that where an issuer is issuing multiple categories of ARTs, then separate reserves of assets for each category of ART must be maintained. An ART issuer must also ensure that the creation and destruction of an ART is always matched by a corresponding increase or decrease in the reserve assets.

Custody of Reserve Assets

Under MiCA, ART issuers are required to establish custody policies, procedures and contractual arrangements (if applicable) in respect of the custody of an issuer’s reserve assets. Such measures should function to ensure any reserve assets are segregated from the issuers’ own assets at all times[8]. The measures should further ensure that ART issuers have easy and timely access to their reserve assets should the issuer need to meet any redemption requests from holders.

Where reserve assets take the form of crypto-assets, the custody of these crypto-assets must be retained by a crypto-asset service provider authorised to provide the relevant services by a competent authority[9].

Where a reserve asset, is an asset of a form other than a crypto-asset, custody of that reserve asset must be retained by a credit institution[10].

Investment of Reserve Assets

An ART issuer is also required to establish an investment policy if the issuer is investing its reserve assets. Issuers that invest a part of the reserve assets are only permitted to invest those reserve assets in highly liquid financial instruments with minimal market and credit risk.

MiCA states that the EBA and ESMA and the European System of Central Banks will develop regulatory technical standards in respect of the investment of reserve assets for ART issuers.

Third Party Reserve Asset Custodians

Furthermore, if third party reserve asset custodians or crypto asset service providers lose their operating authorisations, competent authorities must notify ART issuers. In such cases, an issuer’s authorisation may be withdrawn where a competent authority where it believes that the management body of issuer’s good reputation has been affected or where it has been indicated that there has been a failure in governance and/or internal control arrangements[11].

Issuers of ARTs that use third-party entities to perform reserve asset custody functions must establish and maintain contractual arrangements with those third-party entities. Such arrangements must precisely set out the roles and obligations of both the issuer of Arts in question and of each of those third-party entities. This must be a contractual arrangement with cross-jurisdictional implications and is required to provide for an unambiguous choice of law[12].

Stabilisation Mechanism Policy

Issuers are required to have a clear and detailed policy describing the value stabilisation mechanism in respect of an ART. The policy must identify the reference asset(s) whose value the ART is being pegged to. The policy must also describe the type of assets that comprise the reserve assets and the precise allocation of same. A detailed assessment of the risks involved in relation to the stabilisation mechanism must be included in the policy. Such risks in relation to the ART and the stabilisation mechanism that should be considered include credit risks, market risks and liquidity risks.

The procedure by which an ART is created and destroyed, and the consequence of such creation or destruction on the increase and decrease of the reserve assets must also be included in the policy. A procedure must be established for the redemption of an ART as against its respective reserve asset and there must be defined list of the person who are entitled to do so[13].

The policy must further state whether the reserve assets are invested and, where that is the case, describe the investment policy and contain an assessment of how that investment policy can affect the value of the reserve assets.

Own Funds Requirements

ART Issuers are required to have funds over €350,000 at all times, or hold in funds 2% of the average amount of the reserve assets — whichever is the higher amount[14].

Where 2% of the average amount of the reserve assets is being calculated, the average amount of the reserve assets will mean the average amount of the reserve assets at the end of each calendar day, calculated over the preceding 6 months. Similarly, where an issuer is issuing more than one category of ART, the amount used in the calculation in question, will be the sum of the average amount of the reserve assets backing each category of ART[15].

The Regulation further specifies that the own funds referred to in this section must be made up of Common Equity Tier 1 items and instruments, as are outlined in the Capital Requirements Regulation (№575/2013)[16].

After assessing the risk related to an ART issuer a competent authority may require an issuer to hold an amount of own funds which up to 20 % higher or lower than the amount resulting from the calculation outlined above. MiCA also states that the EBA, in close cooperation with ESMA, will develop further regulatory technical standards in relation to the funds ART issuers must hold at all times[17].

Notification Requirements

MiCA requires ART issuers to notify their relevant competent authority in certain situations or where where certain events occur. Such notification requirements are triggered in insolvency or wind-down events in respect of an issuer, when a change takes place to an issuer’s management body and when any significant change takes place in an issuer’s business model which is likely to influence a purchase decision of an issuer’s ART token. Where appropriate an issuer is also required to modify its white paper and marketing communications in accordance with any such changes that have taken place.

Furthermore where share transactions occur that grant considerable shareholdings or voting rights to involved parties, MiCA provides for notification and approval requirements. Such requirements effectively involve probity and risk assessments of the intended acquirer who is taking a significant interest in the issuer.

Issuer General Obligations

ART issuers are required to act honestly, fairly and professionally and to communicate with token holders in a fair and not misleading manner[18]. Issuers are also required to act in the best interests of its token-holders and are also required to treat all token-holders equally; that is, unless any preferential treatment is disclosed in the crypto-asset white paper and/or marketing communications[19].

Issuers will also be required to establish a clear complaint handling procedure. The EBA, in close cooperation with ESMA, will develop draft regulatory technical standards to specify the requirements, templates and procedures for complaint handling.

Significant ARTs

MiCA proposes that when specific ARTs surpass certain threshold, those ARTs will be categorised as significant and be subject to stricter regulatory requirements. MiCA sets out the various criteria and thresholds, which if exceeded by an ART, will result in that ART being categorised as significant.

The criteria the size of the customer base of an ART, the value of the market cap of all issued ART, the amount or value in transactions of the ART in question, the size of an ART issuer’s reserve assets, the extent of the cross-border activities of an ART issuer and the interconnectedness with the traditional financial system[20].

The specific levels of the above criteria that need to be met by an ART issuer to qualify as ‘significant’ are to be specified by the EBA and ESMA at a later date.

ART issuers who are applying for authorisation from their competent authority can indicate their preference to classify their ART as ‘significant’.

Stricter Requirements

If an ART is categorised as significant, its issuer is subject to greater requirements under MiCA. For example, issuers of significant ARTs are required to maintain stricter remuneration and risk management policies. They are required to ensure their tokens can be held in custody by different authorised crypto-asset service providers unconnected to the issuer in question. ART issuers are also required to closely monitor their token’s liquidity to ensure it can meet redemption requests and/or exercise the rights prescribed to holders of the ART in question. In light of this, such issuers must maintain liquidity management policies to maintain a liquidity profile that ensures normal operations are maintained during liquidity-stressed scenarios.

Furthermore, issuers of significant ARTs are required to maintain a higher level of ‘own funds’ than those ART issuers not categorised as such. Issuers of significant ARTs are required to maintain their own funds equal to €350,000 — or alternatively, if a higher value, 3% of the average amount of the reserve assets (an increase up from 2% for non-significant ARTs [21]).

The EBA and the ESMA, will develop further standards that will apply to significant ARTs and their issuers in relation to governance arrangements and own funds requirements[22].

MiCA’s Legislative Status

The European Commission is the only EU institution empowered to initiate EU legal acts, as it has done with the MiCA proposal in September 2020. Following this, the next step was for MiCA to go through its first readings by the European Council and Eurpoean Parliament. Following this, In November 2021 the European Council adopted its position on MiCA. This agreement forms the Council’s negotiating mandate for trilogue negotiations with the European Parliament in respect of the proposed regulation to regulate crypto-assets. Trilogues are informal tripartite meetings on legislative proposals between representatives of the European Parliament, the Council of Ministers and the European Commission. MiCA is currently at the trilogue stage of the legislative process.

Amendments to MiCA

It is very possible that MiCA’s final draft will be altered from its proposed form as published by the European Commission. Already Members of the European Parliament have tabled hundreds of amendments to the proposed regulation — sometimes proposing more and sometimes less stringent amendments to the regulation. However, MiCA’s provisions in their current form do align with existing regulations regulating traditional financial investment firms; it might therefore be speculated that MiCA’s provisions, as proposed, are unlikely to be drastically changed. This admittedly however remains to be seen.

MiCA’s Technical standards

Furthermore, broadly speaking, MiCA proposes a general framework of how a regime regulating crypto-assets within the EU might operate. However, at times MiCA does not delve into detail about the exact technical specifications that will eventually dictate how the regulation’s provisions will operate. Conscious of this, MiCA frequently states that the EBA and ESMA will be responsible for developing the technical standards which will be submitted to the commission for approval at a later stage. What is of note is that MiCA in fact states that after it is enacted its provisions will not come into force for another 18 months to permit such regulatory technical standards to be finalised and adopted.

MEP’s Position on ARTs

On 17 March 2022, the European Parliament’s Economic and Monetary Affairs Committee (ECON) published its draft legislative resolution on the European Commission’s MiCA proposal. Within ECON’s adopted version of the proposed regulation — that will form the Parliament’s negotiating position on the Regulation — it is proposed that the definition of asset-referenced token should include crypto-assets that purport to maintain a stable value by referring to any other value or right. This is a far more broad deviation from the ART definition contained in the Commission’s draft of MiCA. This is therefore one area to keep an eye and likely be up for debate during the next stage of MiCA’s legislative process: the trilogue negotiations between members of the three EU institutions on finalising MiCA’s provisions.

Conclusion

It appears that Regulator’s concerns about the disruption of the existing monetary system has provoked a particular emphasis on ARTs within the MiCA proposal. MiCA’s provisions spend a considerable time on ARTs in comparison to provisions relating to other categories of crypto-asset.

What will be of further note is what effect if any the amendments introduced to MiCA as the proposed regulation progresses through the legislative hoops of the EU.

[1] Art 30(2)

[2] Art 30(3)

[3] Art 19(1)

[4] Art 15(5)

[5] Art 8 of Directive 2013/36/EU

[6] As mentioned in Article 35(4)

[7] Art 24

[8] Article 2(1), points (a), (b) and © of Directive 2002/47/EC of the European Parliament and of the Council 57

[9] Article 3(1), point (10)

[10] Art 33(2)

[11] Art 20(3)

[12] Art 30(5)

[13] Art 32(4)

[14] Art 31(1)

[15] Art 31(1)

[16] Art 31(2)

[17] Art 31(4)

[18] Art 23(1)

[19] Art 23(2)

[20] Art 39(1)

[21] Art 41(4)

[22] Art 41(5)

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