Crypto-assets versus financial instruments - How to tell them apart

On 29 January 2024, the European Securities and Markets Authority (“ESMA”) published a Consultation Paper on the Draft Guidelines on the delimitation of crypto assets from financial instruments. This distinction is important, given that MiCAR clearly stipulates that crypto-assets qualifying as financial instruments are not subject to MiCAR, but to the regulation of financial instruments (e.g., MiFID II).

MiCAR represents a significant milestone for the regulation of the crypto sector. A detailed description can be found in our Road to MiCAR. If you are interested in the second consultation issued end of January, please see here: ESMA guidelines on reverse solicitation under MiCAR.

With view to the differentiation between financial instruments and crypto-assets under MiCAR, this issue is all the more problematic given that MiFID II does not include a one-size-fits-all definition for all types of financial instruments. The concept of “financial instrument” itself is delineated in a list of instruments outlined in an Annex I to MiFID II, rather than by a distinct set of conditions and criteria. Moreover, unlike, for example, in the US (which applies the Howey test), EU jurisprudence has not yet dealt with the problem of the nature of financial instruments and their key features.

With this in mind, ESMA has prepared Draft Guidelines benchmarking crypto-assets against certain categories of financial instruments, which are (i.) transferable securities, (ii.) money-market instruments, (iii.) units in collective investment undertakings, (iv.) derivatives, and (v.) emission allowances.

Crypto-assets as transferable securities

The first class of financial instruments taken into consideration by ESMA is “transferable securities” as defined in MiFID II. Crypto-assets can be recognised as transferable securities if they grant rights similar to shares, bonds or other non-equity securities.

ESMA deems that crypto-assets may fall into this category if they are part of a “class of securities” that are negotiable on the capital market, and at the same time are not a payment instrument.

Crypto-assets usually might meet these criteria where tokens grant similar, interchangeable and equal (per unit) rights to their owners. The Daft Guidelines include a statement in relation to the rights that need to be embodied in the crypto-assets: There shall be “a distinction between crypto-assets granting their holders dividend rights comparable to those given by a share and those granting financial rights that are unrelated to company profits or liquidation surpluses.” This part of the Draft Guidelines might create certain uncertainties: in which cases does the financial right grated by a crypto-asset qualifies as similar or equivalent to those rights granted by traditional securities? Hopefully, the consultation process is utilised to find a clearer wording for the final version.

Furthermore, crypto-assets could be deemed negotiable, as they represent standardised rights that can be transferred between parties. Additionally, given that ESMA takes a broad approach to the term “capital market” – this criterion is usually met in the trading of crypto-assets.

Crypto-assets, then, may qualify as transferable securities under the MiFID II regime if they are transferable and negotiable, and if the rights attached to them are akin to those usually associated with securities.

Crypto-assets as money-market instruments

The classification of crypto-assets as money-market instruments is, as of now, unlikely. To be classified as such, crypto-assets should embed a monetary obligation with a predefined maturity or redemption date of no more than 397 days, and should be of a stable, determinable value while not being derivatives (in this regard, please see paragraph 4 below).

Crypto-assets as units in collective investment undertakings

Another example of financial instruments under the MiFID II regime are units in collective investment undertakings. Such undertakings pool together funds from investors in order to invest them to generate a pooled return for those investors, who do not possess and exercise day-to-day control over the undertaking.

Crypto-assets could be viewed as units in collective investment undertakings if they represent a share of rights of the investor (token-holder) in pooled funds for the purpose of investment to generate a pooled return for the benefit of the investors. Thus, if crypto-assets are issued and offered in order to raise capital that is subsequently invested in order to generate income for the benefit of the investors and the token-holders do not possess and exercise ongoing control over the investment vehicle, those crypto-assets could be regarded as units in a collective investment undertaking.

In practice, the similarities of asset-referenced token (ART) and investment funds are sometimes highlighted. ESMA, however, does not mention those in their Draft Guidelines. Perhaps, for ESMA, it is too obvious that ART only purport a stable value while investment funds invest their capital to generate a pooled return for the benefit of the investors.

Crypto-assets as derivatives

MiFID II does not introduce a single, general definition of derivatives, but establishes in Annex 1 Section C (4) to (10) of MiFID II a catalogue of examples of such contracts that qualify as financial instruments. These types of contracts derive their value from an underlying asset (e.g., commodities, currencies, indices, etc.), and are either settled in cash or by delivery of an underlying asset (known as physical settlement).

Assessing the link between crypto-assets and derivatives, ESMA highlights two aspects. Firstly, and not surprisingly, ESMA confirms that crypto-assets can act as underlying instruments for derivative financial instruments. The examples of derivative financial instruments in MiFID II have a wide range of possible underlying instruments from which they derive their value; this approach was earlier confirmed in 2018 by the French national competent authority (please see: L’Autorité des Marchés Financiers, Analyse sur la qualification juridique des produits dérivés sur crypto-monnaies). Secondly, crypto-assets can be viewed as derivatives themselves.

The Draft Guidelines point to three factors that may be key to qualifying crypto-assets as derivatives. The crypto-assets need to be the “digital representation” of a contract, having an underlying reference determining its value. ESMA highlights that if such a contract details the terms, maturity (if any), price and other conditions – this should be seen as an indicator towards qualifying a given crypto-asset as a derivative contract (financial instrument).

Nonetheless, the open question still remaining is how to qualify crypto-assets that resemble derivatives but are settled in a different way than by monetary performance (cash settlement) or by delivery of an underlying asset. To exemplify: this class of derivatives might be represented by a BTC/USD futures contract, which, upon maturity, is settled by delivery of a stablecoin (other than e-money tokens – EMT – which as funds could be regarded as “cash settlement” for the purposes of the MiFID II regime). Such contracts should be always assessed on a case-by-case basis.

Crypto-assets as emission allowances

Lastly, ESMA has considered the possibility of qualifying crypto-assets as a subset of financial instruments: emission allowances. Emission allowances represent the permission of their owner to emit a designated amount of greenhouse gases and are tradable on specific venues.

Therefore, given the specific right embedded in emission allowances, crypto-assets could be regarded as such if the rights represented therein allow the holder to emit a specific amount of greenhouse gases in compliance with the EU Emissions Trading Scheme. It could be feasible for a crypto-asset to represent such a right, provided that it represents a verifiable emission allowance that is tradable on a specific platform. Nevertheless, this is an unlikely use for crypto-assets.

Conclusions

Following MiCAR’s approach, the Draft Guidelines adopt a “substance over form” perspective when assessing the potential qualification of crypto-assets as financial instruments. Therefore, regardless of the form of a financial instrument – if a token registered on distributed ledgers resembles a financial instrument it should be treated as such, following the “same activities, same risks, same rules” principle.

The Draft Guidelines, while not providing a clear and comprehensive answer to all possible use-cases of crypto-assets, may be seen as valuable guidance for distinguishing between crypto-assets regulated by MiCAR and financial instruments. Its importance is even more visible given the fact that offerors, persons seeking admission to trading, or operators of trading platforms for crypto-assets other than asset-referenced tokens or e-money tokens must notify their crypto-asset white paper to the competent authority. The notification must explain why the crypto-asset in question should not be considered a financial instrument. A similar obligation arises in the case of ARTs, where the notification to the competent authority must include a legal opinion demonstrating that the token does not qualify as a financial instrument.

ESMA invites all stakeholders to submit their comments to the Draft Guidelines by 29 April 2024. The final and binding text of the Draft Guidelines is to be adopted by 30 December 2024.