ESMA seeks market input on crypto-asset classifications under MiCAR

RegCORE Client Alert | Capital Markets Union | EU Digital Single Market

QuickTake

In the EU-27, the advent of the EU’s Markets in Crypto-Assets Regulation (MiCAR)See current and future coverage from our EU RegCORE available here, here and here as well as here.Show Footnote created a new chapter for how the EU’s Single Rulebook aims to provide greater legal and regulatory certainty. MiCAR introduces the world’s largest Single Market for crypto-assets, with uniform concepts and rules applicable to crypto-asset issuers (CAIs) as well as crypto-asset service providers (CASPs). 

As offerings of and trading activity in digital-assets, whether regulated or not as “crypto-assets” by MiCAR or traditional EU legislative and regulatory rulemaking regimes continues to grow, so too do the questions on when a digital asset will be treated for MiCAR purposes as a crypto-asset or instead be treated as a “financial instrument” and be subject to EU traditional financial services legislation notably MiFIR/MiFID II, IFR/IFD, AIFMD, UCITSD as well as EMIR, SFTR but also the Prospectus Regulation. 

On 29 January 2024, the European Securities and Markets Authority (ESMA) published a long-awaited consultation paperAvailable here.Show Footnote to seek input from the market on its proposed rules on the conditions and criteria for the qualification of digital assets as financial instruments. ESMA will consider all comments received by 29 April 2024. ESMA is also consulting on draft guidelines on when and on what basis reverse solicitation should be permitted under MiCAR (see separate coverage on that development). 

As discussed in this Client Alert, ESMA’s draft guidelines equally aim to clarify the lack of a commonly adopted application of the ‘financial instrument’ definition under MiFID II across EU Member States, and to provide a structured yet flexible approach for national competent authorities (NCAs) and market participants to classify crypto-assets. Once ESMA finalises the guidelines, by 30 December 2024 at the latest, NCAs are expected to adopt them into their supervisory approach. 

The draft guidelines avoid a one-size-fits-all guidance and focus on essential attributes for harmonised application across the EU, such as the legal rights and obligations of the parties, the transferability and fungibility of the crypto-assets, and the economic functions and purposes of the crypto-assets. The draft guidelines also address the classification of specific types of crypto-assets, such as asset reference tokens (ARTs), E-money tokens (EMTs), utility tokens, non-fungible tokens (NFTs), and hybrid tokens, and provide examples of how to apply the criteria for the qualification of crypto-assets as financial instruments. While the guidelines are aimed with crypto-assets in mind, they may also assist in advancing the much-needed harmonisation of the definition of financial instrument in the EU-27. 

Key takeaways from ESMA’s guidelines

Article 2 of MiCAR, which defines the scope of MiCAR, specifically excludes crypto-assets that qualify as financial instruments as defined in MiFID II. Article 3(5) of MiCAR defines crypto-assets rather broadly as “a digital representation of a value or of a right that is able to be transferred and stored electronically using distributed ledger technology or similar technology.” Academics and legislators commonly use a functional approach to categorise crypto-assets into three groups: utility tokens, currency/payment tokens, and financial/investment/security tokens. MiCAR partially aligns with this categorisation due to the diverse designs and associated rights of crypto-assets. MiCAR’s definition of crypto-assets is comprehensive, encompassing not just “cryptocurrencies”, but also “stablecoins” and utility tokens. The classification of crypto-assets under MiCAR is segmented into three sub-categories, each subject to specific requirements designed to address the corresponding risks they present: (i) ARTs; (ii) EMTs; and (iii) crypto-assets that do not fall into the ARTs or EMTs categories.

Recital 9 to MiCAR sets out principles of “technology neutrality” in that “same activities, same risks, same rules” means that MiCAR only applies to those crypto-assets that are not covered by existing EU legislation, in particular MiFID II or otherwise excluded from MiCAR such as crypto-assets qualifying as deposits, funds (except if they are EMTs), securitisation positions, pension, non-life or life insurance products as well as NFTs under certain conditions.

Rather frustratingly, MiFID II lacks a universal definition that applies to all categories of financial instruments including those issued using distributed ledger technology (DLT). The concept of financial instrument is defined by a comprehensive list of instruments provided in Annex I section C, rather than a separate set of conditions and criteria. Furthermore, the transposition mechanism of an EU Directive into Member State law fails to ensure complete alignment at the national level on the precise scope of the financial instrument definition. Rather frustratingly Member States have not achieved full harmonisation in defining the word “financial instrument” while incorporating MiFID II into their respective national legislations. 

ESMA conducted a survey of Member States throughout the summer of 2018. The survey emphasised the varying categorisations that can occur among NCAs for the same crypto-asset, based on their implementation of MiFID II and the list of financial instruments in Annex I Section C. Overall, national frameworks have either adopted MiFID II’s qualification criteria and conditions as they are (16 NCAs) or have interpreted the definition of “transferable security” in a broader or more limited manner (12 NCAs). The more stringent interpretation suggests that if there is an extra formal national requirement for a “compulsory book-entry register” of transferable securities (implemented by 3 to 4 NCAs), it would be more difficult to categorise a crypto-asset as a financial instrument. Another approach to restrictive interpretation is to view the list of transferable securities as comprehensive and adhere to a stringent standard of equivalent (known as the numerus clausus approach). Consequently, there may be minor differences across NCAs regarding the definition of a financial instrument generally but also, as indicated for when a crypto-asset is a financial instruments. 

The lack of a universally accepted definition and set of criteria for financial instruments complicates the implementation of comprehensive guidelines and the establishment of a uniform assessment that can be applied to all forms of financial instruments. Simultaneously, it is crucial to refrain from adopting a fragmented approach. 

Crypto-assets classification as transferable securities

Crypto-assets should be designated as financial instruments if they align with the MiFID II definition of “transferrable securities”. For a crypto-asset to be recognised as a transferable security under MiFID II, it must be negotiable, transferable, and encapsulate rights attached to securities this also applies to “other securities” or “securitised debt” which also includes investment as well as tracker certificates that give rise to a cash settlement determined by reference to transferable securities, currencies, interest rates or yields, commodities, or other indices or measures without granting ownership in the underlying instrument referenced or tracked. In applying technology neutrality, tokenised financial instruments also remain financial instruments in all regulatory contexts. 

Transferable securities, as defined by MiFID II, cover a wide range of instruments from shares and bonds to “other securities” which are related to other securities, currencies, interest rates, commodities, or other indices (i.e., securitised derivatives). Crypto-assets that grant rights similar to shares, bonds or other securities (e.g., embedding a derivative) must be treated as a transferrable security. This means that:

1. According to MiFID II’s Article 4(1)(44), three criteria must be satisfied for a crypto-asset to be deemed as a transferable security, it: (i) should be part of a “class of securities”, must be (ii) negotiable on the capital market and (iii) should not be an “instrument of payment”. 
2. For crypto-assets to form a class (such term is not uniformly defined in EU law), ESMA recognises that they must confer similar rights to investors, ensuring their tradability on markets. In order to form a class, crypto-assets are generally viewed as (i) interchangeable, (ii) issued by the same issuer (iii) having similarities and (iv) grant equal rights to is holders. 
3. Negotiability, absent a harmonised definition in EU law, implies that for crypto-assets to be transferable or tradable on markets (trading venues as well as OTC markets), even if certain (legal, market or technical) restrictions exist. ESMA also notes that negotiability also pre-supposes fungibility, which must be measures having regard to the capability of the crypto-asset to express the same value per unit. 
4. ESMA notes that “while, most Member States interpret negotiability as potential transferability or tradability, some others separate the notion of transferability and negotiability by considering the notion of being ‘negotiable’ as being ‘standardised’”, ESMA states that NCAs and market participants should broadly interpret the concept of negotiability, including crypto-assets, which are capable of being transferred or traded on markets. 
5. Importantly, “instruments of payment” are explicitly excluded from the scope of MiFID II and equally ESMA notes that the PSD2 definition of “payment instrument” is not fully aligned with the concept of “instrument of payment under MiFID II”. 

Crypto-assets classification as money markets instruments

The definition of financial instruments under MiFID II includes money-market instruments like treasury bills, certificates of deposit, and commercial papers characterised by their short-term nature. For a crypto-asset to be classified as a money-market instrument per Article 4(1)(17) of MiFID II, it must exhibit characteristics akin to traditional money-market tools. This involves (i) having a legal and residual maturity as required for in the Money Market Funds Regulation (MMFR), (ii) exhibiting stable value and minimal volatility and (iii) aligning returns with short-term interest rates. A crypto-asset that serves as a representation of a government-endorsed short-term debt commitment should be categorised as a money market instrument. The same principle should be applied to a crypto-asset that reflects a short-term tradable debt obligation issued by a bank or firm on the global money market.

Crypto-assets classification as units in collective investment undertakings

The definition of financial instruments under MiFID II applies to units in collective investment undertakings (i.e., fund units). A crypto-asset qualifying as a unit (shares, interests or participation rights) should represent the proportionate rights of investors in such undertakings. In order for a crypto-asset to qualify as such the crypto asset itself should qualify as a unit and the issuer of the crypto-asset should qualify as the collective investment undertaking, which would also trigger the full application of the UCITS Directives or AIFMD if the unit relates to such or can benefit from exclusions under those regimes.

Crypto-assets classification as derivative contracts

The definition of financial instruments under MiFID II applies to derivative contracts. Accordingly, derivative contracts relating to crypto-asset, a basket of or an index on crypto-assets as an underlying should be qualified as MiFID II financial instruments. This is because they fall under derivative contracts, which involve an underlying asset, rights, obligations, or indices. ESMA notes that since the term “asset” is not explicitly defined in MiFID II, it should be interpreted broadly to include assets like crypto-assets. This means that a derivative referencing MiCAR in-scope crypto-assets (whether single name, basket or indices) could also be considered a MiFID II financial instruments. ESMA will also publish guidance on crypto-assets bearing rights similar to derivatives but which are settled in crypto-assets, EMTs or ARTs instead of cash.

Crypto-assets classification as emissions allowances

The definition of financial instruments under MiFID II applies to any units recognised for compliance with the requirements of Directive 2003/87/EC” (the EU Emissions Trading Scheme). Emission allowances permit the emission of a designated amount of greenhouse gases and are tradable on specific platforms. To be categorised as an emission allowance, a crypto-asset must represent a right to emit a specified volume of greenhouse gases and comply with the EU Emissions Trading Scheme or an equivalent framework and be endorsed by the EU or Member States under the Directive as well as ultimately be tradable.

Clarifying basic inherent characteristics of utility tokens

“Utility tokens” grant holders access to a product, application, or service, or are necessary for engaging with a DLT’s ecosystem. Utility tokens possess a distinct purpose or function, either by providing specific utility or usage, or by granting consuming rights. The privileges conferred by a utility token may differ depending on the various economic models employed by DLT projects. Crypto-assets possess fungibility, meaning they conform to a standardised set of crypto-assets that share the same rights and attributes, allowing for interchangeability. 

A utility token is generally not considered a security or financial instrument. Even if utility tokens may have governance rights, they should not mirror the rights associated with financial instruments, particularly transferable securities as defined by MiFID II. 

Unlike shares, a utility token does not provide any financial rights associated with a company’s profits, capital, or liquidation surpluses. This means that it does not represent ownership in a company’s capital or give the investor voting rights in the company's decision-making process. The categorisation of an asset as a utility token will also be rejected if its sole purpose is to partake in the performance of one or more underlying assets without directly investing in those assets. This characteristic is typically associated with derivative contracts or units in collective investment undertakings, both of which are considered financial instruments under MiFID II.

Clarification on treatment of hybrid tokens

Crypto-assets may face further challenges if they fall under multiple legal classifications. Crypto-assets can be organised as “hybrids” with many characteristics and objectives (e.g. payment, utility, investment) that perform different tasks after issuance. Crypto-assets can also undergo hybridisation during their lifecycle, either during creation or during use. NCAs should evaluate hybrid crypto-assets regardless of their designation. Rights, functions, and, to a lesser extent, values linked with crypto-assets should be prioritised. A comprehensive taxonomy of crypto-asset arrangements is impractical due to their ever-changing nature. To determine a regulatory classification, each case must be thoroughly assessed for its unique circumstances and attributes. Although classification as financial instruments or utility tokens may provide an early indication of the crypto-asset's characteristics, hybrid token classification may be inconclusive in such cases.

MiCAR classifies crypto-assets, including hybrids, based on their financial instrument features as stated in Directive 2014/65/EU. The assessment of hybrid tokens should emphasise this crucial feature of MiCAR regulation to accord with its key principles. ESMA clarifies that the classification of hybrid tokens should prioritise their financial instrument properties as per these guidelines. Hybrid token classification should include their multidimensional nature and prioritise their identification as financial instruments when applicable. This guarantees regulatory clarity and alignment with MiCAR’s framework. Adopt a hierarchical approach to classification.

ESMA states that the first stage in this approach is to rigorously analyse if the asset meets the definition of a financial instrument. Alternative classifications, including utility tokens, should only be considered for assets that do not fit these criteria. As a result, national authorities and market participants should prioritise hybrid crypto-asset financial instruments. Document the instrument and promote materials properly, avoiding focusing on auxiliary aspects.

NCAs and market participants should prioritise substance over form when appraising unique, nonfungible, and hybrid crypto-assets. ESMA clearly states that classifying crypto-assets should be based on their attributes, not just the label provided by the issuer or offeror. The issuer or offeror may need to update their label to reflect this categorisation to avoid misleading investors.

Further clarity on NFTs

NFTs that cumulatively meet the criteria of uniqueness and non-fungibility remain exempt from MiCAR. Uniqueness and non-fungibility of a crypto-asset are determined by its traits and rights, which differentiate it from other tokens issued by the same issuer. In summary, MiCAR should regulate crypto-assets with equivalent and interchangeable qualities that lack actual distinctiveness. It is crucial to differentiate between truly distinct crypto-assets and those that may appear unique due to technical identifiers or standards. ESMA assesses that the criterion of uniqueness should not depend on the technical details of the crypto-asset. The existence of a unique identity does not guarantee nonfungibility of a crypto-asset. To assess the fungibility and uniqueness of crypto-assets, NCAs and market participants should not prioritise technical features such as token identification codes and unique token IDs, even though they may be indicators. 

Unique crypto-assets are defined by their unique qualities and benefit to their holders. A crucial factor to analyse is whether the value of one crypto-asset affects the valuation of another, showing a lack of uniqueness. An NFT depicting digital artwork may lose its originality if it is part of a larger collection and its value is influenced by other crypto assets in the series. A crypto-asset should not be excluded from MiCAR if its valuation is based on comparisons between similar assets that make them replaceable. Thus, MiCAR concepts of uniqueness and fungibility were separated from secondary market negotiability. 

ESMA also clarifies that NFTs in a series or collection might be considered crypto-assets under MiCAR if they are interchangeable. Crypto-assets with similar qualities may of course be interchangeable in practice. This can happen when the market regards NFTs as having comparable value despite their unique features. The presence and quantity of a series or collection can indicate fungibility, but it should not be the sole criterion. If a collection of NFTs, such as those portraying the same image with small variations, contains crypto-assets with questionable uniqueness, it should come under MiCAR. 

Alternatively, a sequence of NFTs, such numbered serigraphs or images, might be considered non-fungible due to its uniqueness and impact on value. NFT utility function can also matter. NFTs may offer equivalent utility or access privileges in some instances. Owning an NFT may provide access to special events or benefits. Different NFTs are interchangeable for practical uses due to their utility, making their individual qualities less important. 

Unique and non-fungible crypto-assets should not have fractional components. Fractional NFTs allow numerous investors to hold a portion by dividing one NFT into different crypto-assets. A fractionalised NFT varies from a collection of NFTs as each fraction indicates a fraction of ownership. This allows for the reconstruction of the full NFT by retaining all fractional components. Fractionalisation might result in identical features and no uniqueness for each fraction. The “interdependent value test” can aid in classifying crypto-assets. The European Commission will report on crypto-asset developments, market evolution of unique and NFTs and regulatory oversight by 30 December 2024 to the European Parliament and Council. 

What can CAIs and CASPs do now?

If a crypto-asset qualifies as a financial instrument, the issuer may need to comply with the prospectus requirements under the Prospectus Regulation, and the service provider may need to obtain an authorisation under the appropriate sectoral legislation. If a crypto-asset falls under MiCAR, the issuer may need to publish a white paper and comply with disclosure and governance rules, and the CASP may need to obtain an authorisation under MiCAR. 

While the draft guidelines’ contents may change slightly ahead of their final published form entering into force, both CAIs and CASPs may want to consider taking the following pre-emptive measures: 

• CAIs and CASPs should assess the legal rights and obligations attached to the crypto-assets they issue or provide services for, as this is the first step in determining whether they fall within the scope of MiFID II or MiCAR. CAIs and CASPs should also consider the transferability, fungibility, and negotiability of the crypto-assets they deal with, as these are key criteria for the classification of financial instruments under MiFID II;
• CAIs and CASPs should, together with counsel, assess the legal rights and obligations of the parties involved in the issuance, distribution, and trading of crypto-assets, as well as the economic functions and purposes of the crypto-assets, to determine whether they fall within the scope of MiFID II or not as well as any hybridisation and/or recharacterisation risks; 
• CAIs and CASPs should consider whether the crypto-assets they deal with are transferable, fungible, and negotiable on the capital market, and whether they confer similar rights to investors as shares, bonds, or other securities, as these are the main criteria for qualifying crypto-assets as transferable securities under MiFID II; 
• CAIs and CASPs should also examine whether the crypto-assets they deal with have a legal and residual maturity, a stable value and minimal volatility, and a return linked to short-term interest rates, as these are the main characteristics for qualifying crypto-assets as money market instruments under MiFID II; 
• CAIs and CASPs should be aware of the different interpretations and implementations of the definition of financial instruments across EU Member States, and the potential disputes that may arise from the NCAs regarding the classification of crypto-assets and the importance of relevant comprehensive legal opinions; 
• CAIs and CASPs should obtain a robust legal opinion on the categorisation of crypto-assets as to their type and how they are regulated or unregulated, and disclose it to the relevant stakeholders, such as trading venues, investors, and regulators; and
• CAIs and CASPs should participate directly or via counsel in responding to the consultation as well as monitor the finalisation and adoption of ESMA's guidelines by 30 December 2024 at the latest, and ensure that they comply with the updated supervisory approach of the NCAs. 

Outlook

ESMA’s guidelines aim to establish overarching criteria or general principles that can be employed to encourage consistent practices at the national level when classifying crypto-assets as financial instruments. The determination of whether a crypto-asset should be classified as a financial instrument should nevertheless be done on a case-by-case basis applying substance over form. ESMA specifically states that the legal qualification of a digital asset as a MiCAR crypto-asset or a MiFID II financial instrument should not be determined by “its technological envelope”. The purpose of the guidelines is to encourage consistent practices in this regard and to reinforce the technology agnostic approach that MiCAR and other EU financial markets legislation applies. 

Ultimately, ESMA takes the view that it is the responsibility of offerors or those seeking admittance to trading of crypto-assets (i.e. CAIs) to accurately classify these assets. ESMA specifically points out that the categorisation may be disputed by the applicable NCAs, either prior to the offer's publication or at any point subsequently. Accordingly, having a robust legal opinion may be useful and indeed many trading venues as well as investors may request one on the categorisation of crypto-assets as to its type and how it is regulated or unregulated. 

All regulated firms as well as CASPs and CAIs will want to (i) ensure if digital assets function like a financial instrument that they are treated as such or if not as MiCAR relevant crypto-assets and (ii) have reasoned evidence to explain the rationale for the basis of their categorisation. 

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