MiCA Marks a Milestone for Digital Assets

Following the publication of the European Union’s (EU) Markets in Crypto-Assets Regulation (MiCA) in the Official Journal (OJ), on 9 June 2023¹, the legislation has now entered into force. This milestone marks a decisive step towards entry into application in the next 18 months, when the new rules will progressively apply across the EU. Justin Chapman, Global Head of Digital Assets and Financial Markets at Northern Trust commented:

“As Distributed Ledger Technology (DLT) and digital assets gain mainstream acceptance, the EU has taken strides in fostering an environment that balances innovation whilst ensuring financial stability and investor protection is maintained. The finalisation of the EU’s first dedicated financial services regulatory framework, MiCA, marks a significant milestone globally with a major market acknowledging that crypto assets, a sub-category of digital assets, are here to stay.

Crypto assets continue to be marked by sharp volatility, market turmoil and enforcement actions by regulators who seek to protect consumers and restore trust. However, not all digital assets (which include crypto assets) are created equal and as of yet, have lacked regulatory clarity. Regulation within this rapidly evolving landscape can support firms to implement minimum standards, contributing to better market practices.

As a custodian bank, Northern Trust is a regulated financial institution, but we are also always looking for ways to make the market more efficient and transparent whilst supporting new opportunities for our clients. We believe innovative technologies like those underpinning crypto assets can meet these objectives but to achieve scale and maturity, they need an appropriate regulatory regime. The clarity and certainty legislation will bring, is a welcome step to allow for more market players to enter the landscape, underscored by safer market practices, which will contribute to its maturity and development at scale.

We believe that in the long run digital assets will modernise the way financial instruments are issued, custodied, and exchanged; regulated institutions can bring expertise and know-how. This all starts with regulatory certainty.”

The market for digital assets has witnessed remarkable growth in recent years with several countries reporting significant parts of the population investing or owning digital assets, such as cryptocurrencies which include Bitcoin. As of 24 July 2023 the global market capitalization of the cryptocurrency market stands at just over US$1 trillion, with a peak at just under US$3 trillion as of November 2021.⁶ This estimated reduction of US$2 trillion in market capitalisation⁷ can partly be attributed to the poor conduct of certain crypto exchanges, such as FTX which collapsed in November 2022, and the volatile nature of the asset class. However, despite the recent downturn and the sharp market swings, both retail and institutional investors have shown interest in digital assets. In April 2023, a survey published by Ernst & Young of 250 plus institutions on their sentiment use and plans regarding digital assets, indicated that 25% increased their digital asset holding in 2022, with 69% expecting to increase their allocation in the next two to three years and a further 93% believing in the long-term value of digital assets.⁸

The surge in popularity of digital assets can be attributed to various factors, such as increased awareness, technological developments and the potential for significant returns. However, all digital assets are not created equal and could present significant risks if not properly understood, as witnessed over recent months. Despite the technology being around for some time (the white paper at the origin of bitcoin’s creation – from the eponymous Satoshi - was first published in 2008)⁹ regulators are only just getting their arms around the developing landscape. This means regulated entities could not easily participate, whilst unregulated entities engaged in a grey legislative area. However, as the use case for digital assets becomes increasingly compelling, it also has become an increasingly pressing matter for regulators to develop appropriate safeguards.

For many years regulators have attempted to introduce new rules to regulate digital assets but striking the right balance between harnessing their potential whilst mitigating risks, such as investor protection and market integrity, has proven to be a challenge. This can partly be attributed to their virtual nature, the pace of evolution and resulting knowledge gap, varied risk profiles and regional views in terms of how to approach regulation. This was the context under which MiCA was first proposed, in 2019, one of the key proposals by the European Commission (EC) to make the EU a global hub for digital finance.

Some of key questions underpinning MiCA:

• What are the main use cases for digital assets? How can they be classified?
• What key risks do they pose? How can their benefits be harnessed whilst mitigating risks?
• To what extent can financial services regulation apply? What might be the changes/adaptations needed? What gaps, impact and level of coordination?

Recognising the need to establish a comprehensive regulatory framework for digital assets, to address regulatory fragmentation and gaps in regulatory applicability, in 2019 the EC proposed two dedicated legislations as part of the EU Digital Finance Package.¹⁰

The first is a pilot regime for market infrastructures based on Distributed Ledger Technology (DLT) which has been open for applications since March 2023. The ‘DLT pilot regime’ is in effect a regulatory sandbox which allows eligible applicants to operate a DLT-based trading facility and/or settlement system for financial instruments, under a flexible regulatory environment.

The second, MiCA, is a comprehensive and harmonised regulatory framework for the issuance, sale and custody of certain types of digital assets.

The scope of MiCA focuses on crypto assets, a subset of digital assets, where they are defined as ‘a digital representation of value or rights which may be transferred and stored electronically, using distributed ledger technology or similar technology’. MiCA seeks to avoid regulatory overlaps by carving out crypto assets that would otherwise be regulated as traditional financial instruments, e-money (except when qualified as e-money tokens under MiCA), deposits, structured deposits or securitisations. MiCA establishes a separate framework in respect of three distinct categories: Asset-Referenced Tokens (ARTs), Electronic Money Tokens (EMTs) and an ‘other group’ (which include crypto assets that are not considered ARTs or EMTs, such as utility tokens) and applies significant portions of the financial services regulatory framework.

Once MiCA is fully implemented, it will provide extensive requirements to firms engaging in crypto asset activity, thereby promoting trust, and moving the landscape closer to consumer protection, and market integrity; by enforcing market transparency, enhancing risk management practices and safeguarding assets under custody.

Whilst comprehensive, not all crypto assets fall under MiCA’s purview. For instance, Security Tokens (qualifying as transferrable securities), DeFi (Decentralised Finance), most Non-Fungible Tokens (NFTs) and Central Bank Digital Currencies (CBDCs) fall out of its scope.

In a competitive and dynamic landscape, digital assets which encompass crypto assets, could present opportunities for institutional investors, as long as risks are identified and where possible mitigated. For example, through the careful selection of the organisations you partner with to provide services, custody banks can play a pivotal role in safeguarding digital assets whilst providing additional value-added services to investors.

Regulated financial institutions such as Northern Trust will be integral to supplying core services to institutional investors looking to engage in digital assets. Simplifying the diversity and complexity of traditional and digital assets to provide a comprehensive suite of solutions. For instance, Northern Trust has been involved in projects for digital assets and ecosystems since 2017 and has ongoing research and interest in the following areas:

• Fund Administration for crypto backed funds
• Support for the Tokenisation of funds and other traditional assets
• Custody of digital assets either natively issued or tokenized

With the introduction of MiCA, market players looking to engage in digital asset activity will be subject to harmonised rules at an EU level, ensuring a level playing field and consistent standards are applied across the region; thus, unlocking opportunities.

• Regulatory clarity and harmonisation: MiCA aims to bring regulatory clarity and legal certainty by creating a comprehensive set of rules, for crypto assets, on par with existing financial services regulation. The new set of rules will encompass a large number of activities spanning issuance, intermediation and dealing. As the rules apply across EU Member States, MiCA will also reduce regulatory arbitrage and facilitate cross-border activity within the region. An asset manager authorised in one EU Member State will be able to offer their services across other Member States without requiring a separate authorisation, thus improving market access.
• Investor protection and market integrity: Specifically, the regulation includes provisions to increase investor protection and market integrity by introducing requirements for issuance and trading including transparency and disclosure requirements. A licencing regime will apply to crypto asset service providers, issuers of Asset References Tokens (ARTs) and Electronic Money Tokens (EMTs) and provide obligations for consumer protection. MiCA also introduces measures to promote market integrity as it incorporates a market abuse regime, prohibits market manipulation and insider dealing, thus reducing the risk of fraud and other misconducts. All of these measures will contribute to a more transparent and reliable market, fostering trust and confidence. MiCA also clarifies the scope, powers and sanctions available to regulatory authorities to safeguard this space.
• Risk management and resiliency standards: MiCA introduces minimum standards for crypto asset service providers, such as trading platforms or custody providers. These requirements encompass capital requirements, governance arrangements, risk management (including cybersecurity), safe custody and measures to stabilise the value of tokens. For instance, issuers of ARTs, will need to hold in custody reserve assets on certain prescribed terms and can only be invested in highly liquid financial instruments. Or, for EMTs, funds received by issuers must be invested in assets denominated in the same currency as EMTs to ensure claims on the issuer can be redeemable at par. Regarding custody, MiCA introduces liability requirements in relation to potential losses, requiring custody providers to return identical assets or their value to investors without undue delay.

Regulated financial institutions will play a pivotal role in the evolution of the digital assets market. A strong commitment to regulatory compliance, trust, security, investor protection and market integrity could enable financial institutions develop comprehensive end-to-end digital assets solutions to meet the imperatives of security, reliability and cost-efficiency of institutional investors.

As the EU continues to develop a comprehensive regulatory agenda to support digital finance, financial institutions must continue to adapt and innovate to meet the evolving needs of clients. By leveraging expertise, infrastructure, and industry collaboration, they can support institutional investors navigate this complex ecosystem, contributing to the long-term growth and development of the digital asset landscape.

¹ Source: https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32023R1114
² Source: Transforming the Investment Lifecycle: the Future is Digital | Northern Trust
³ Source: https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32023R1114
⁴ Source: Northern Trust Cryptocurrencies: What you need to know (northerntrust.com)
⁵ Source: Northern Trust https://www.northerntrust.com/insights-research/2023/cis/beyond-asset-tokenisation
⁶ Source: https://www.forbes.com/advisor/investing/cryptocurrency/crypto-market-outlook-forecast/
⁷ Source: https://www.weforum.org/agenda/2023/01/future-of-cryptocurrencies-davos2023/
⁸ Source: https://www.ey.com/en_us/financial-services/how-institutions-are-investing-in-digital-assets
⁹ Source: https://nakamotoinstitute.org/bitcoin/
¹⁰ Source: https://finance.ec.europa.eu/publications/digital-finance-package_en