Remaining Regulatory Challenges in Digital Finance and Crypto-Assets After MiCA

On April 20, 2023, the European Parliament adopted the new Markets in Crypto-assets Regulation (MiCA) and the revision of the Transfer Funds Regulation (TFR) to increase the transparency, disclosure, and supervision of crypto transactions. In particular, MiCA implements a bespoke regime for crypto-assets that do not qualify as “transferable securities” or “e-money” under existing definitions of EU financial law. 

Our recent study reviews global market developments to identify the risks and deficiencies remaining in EU crypto regulation after MiCA’s adoption and TFR’s revision. We present a suite of policy options to cover these remaining crypto-centric deficiencies. 

The Effect of Decentralized Finance 

We find that the degree of decentralization in DeFi varies wildly throughout the industry. Some DeFi platforms organize peer-to-peer finance by matching lenders and borrowers together in a decentralized manner. Other platforms pool users’ funds to bundle liquidity or book transactions on the balance sheet of an intermediary. Common to all these forms of DeFi is the risk of platform centralization arising from large market shares or roles as critical valuation services. 

Our findings indicate that concentrated DeFi platforms have led to the rise of systemically important crypto intermediaries (SICIs). This finding is of immediate concern given DeFi’s unusual idealization as a safer alternative to concentrated intermediaries in traditional finance and the consequential too-big-to-fail risks. Indeed, these fears materialized in the second half of 2021, beginning with widespread operational malfunctions and asset diversions and culminating in the collapse of the Luna/Terra stablecoin system. 

Supervisory and Regulatory Challenges of Crypto 

Although DeFi is innovative in its decentralized approach to finance, our paper argues that crypto risks closely resemble those associated with traditional finance. We identify various risks, including agency risks, conflicts of interest associated with the bundling of intermediary functions, hidden leverage in crypto lending, and stacking and concentration risks in SICIs—each justifies a regulatory response under the “same risks, same rules” principle. 

The decentralization of finance presents difficulties in defining regulatory scope, managing risks, and ensuring business continuity in insolvency. Furthermore, the severe negative environmental externalities unique to crypto evade traditional disclosure rules required under the Sustainable Finance Disclosure Regulation and Taxonomy Regulation. We thus suggest that these circumstances warrant further regulation under the complementary principle of “new risks, new rules.” 

Impact of MiCA and TFR 

Before the adoption of MiCA and the revision of the TFR, the EU financial regulation regime contained gaps that arose from its inconsistent application across Member States. Ambiguity and legal uncertainty in standard terms like “transferable security,” “financial instruments,” and “e-money” were often a source of regulatory arbitrage. The prevailing uncertainty in applying basic EU financial regulation and the opaqueness of business models render supervisory enforcement difficult. 

Against this background, we find that MiCA and TFR address the main challenges of centralized crypto service provision. This combined regime provides a robust framework for properly ordering crypto service providers if extended by bespoke implementing legislation. MiCA’s bespoke licensing scheme for centralized crypto-asset service providers, E-Money Tokens, and Asset-Related Tokens, enhanced disclosure requirements, and white paper registration scheme combine to fill the prior gaps in the pre-existing EU financial regulatory landscape. 

We note that several challenges remain, including a delineation between MiCA’s scope and the established terms of EU financial regulation, periodic disclosure and accounting of entities subject to MiCA, restructuring and resolution legislation, cross-border harmonization, and its exclusion of “fully decentralized services.” 

Remaining Challenges 

One of the inherent difficulties that MiCA and TFR have both met is the speed at which the crypto services environment outpaces the scope of existing regulation. The constant influx of innovative new crypto variants, notably illustrated by the rise of NFTs, clearly demonstrates this point. Despite its improvements, the crypto world no longer reflects the environment in which MiCA was drafted, leaving significant regulatory challenges to address. We identified various areas of concern. They are, in turn: 

1. legal uncertainty as to the applicability of EU law to different types of crypto assets; 

1. issues surrounding whether a national competent authority retains jurisdiction; 

1. difficulties in determining if a crypto asset qualifies as an NFT or “financial NFT;” 

1. a lack of coverage for fully decentralized crypto lending and staking; 

1. the evasion of energy-intensive decentralized platform protocols from existing reporting requirements; 

1. outstanding legislation that implements various MiCA rules, including business continuity concepts for both technical malfunctions and the bankruptcy of core intermediaries; 

1. narrow disclosure requirements, and 

1. the exclusion of private law matters from the scope of MiCA. 

Concerning the revised TFR, we find similar limitations in excluding “fully decentralized” crypto services and challenges regarding the feasibility of the proposed tracing rules. Techniques such as merging, repackaging, and reusing crypto-assets, decentralizing wallets, and transferring into non-cooperative jurisdictions will continue to be problematic and require an expansion of the scope of EU financial regulation. 

Five Key Policy Considerations 

As to addressing the main challenges remaining after MiCA and the revision of the TFR, our study recommends five key policy considerations. 

• the need to deal with reverse solicitation in a cross-sectoral, harmonized manner, potentially by the European Supervisory Authorities; 
• the desirability of a default rule that deems all crypto assets “transferable securities” subject to crypto service providers, proving that their conduct is exempt from the scope of EU regulation; 

• the need for cross-border cooperation among regulators beyond the EU; 
• the need for regulatory entity status for “Decentralized Autonomous Organizations” involved in financial services; and 
• the need to expand MiCA to address the additional operational and financial risks concerning NFTs. 

Compliance with EU financial law could also be furthered through a “EURO wallet” with key compliance features embedded in the technology applied. Such a “EURO wallet” could also pave the way for applications relating to the Digital Euro. 

 

Dirk A. Zetzsche is a Full Professor of Law, holds the ADA Chair in Financial Law (inclusive finance), and co-leads the House of Sustainable Governance and Markets at the University of Luxembourg. 

Ross P. Buckley is an ARC Laureate Fellow and a Scientia Professor at the University of New South Wales, Sydney. 

Douglas W. Arner is the Kerry Holdings Professor in Law at the University of Hong Kong.  

Maurits Van Ek is a Legal Research & Development Specialist at the ADA Chair in Financial Law (inclusive finance), University of Luxembourg. 

 

This post is adapted from their paper, “Remaining Regulatory Challenges in Digital Finance and Crypto-Assets After MiCA,” available on SSRN.