Reverse solicitation and classification of cryptoassets as financial instruments

June 2024 | SPOTLIGHT | BANKING & FINANCE

Financier Worldwide Magazine

June 2024 Issue

On 29 January 2024, the European Securities and Markets Authority (ESMA) published two consultation papers, one on reverse solicitation and the other on the conditions and criteria for the qualification of cryptoassets as financial instruments.

These two consultations comprise significant aspects of the emerging regulatory framework for cryptoassets in the European Union (EU). This article examines the new draft guidelines under each consultation paper.

Background

The Regulation on Markets in Crypto-Assets (MiCA) was published in the ‘Official Journal of the European Union’ on 9 June 2023. Under MiCA, ESMA was empowered to develop technical standards and guidelines relating to certain provisions under MiCA. ESMA has been mandated to publish the guidelines by 30 December 2024 and they are intended to provide additional clarity to national competent authorities (NCAs) and markets on how to comply with the rules – and how to enforce them.

The consultation paper on reverse solicitation published on 29 January 2024 sets out ESMA’s proposals in relation to draft guidelines on reverse solicitation under MiCA (the Reverse Solicitation CP). The second consultation paper provides draft guidelines on the conditions and criteria for the qualification of cryptoassets as financial instruments under MiCA (the Financial Instruments CP).

ESMA’s aim with both consultation papers is to collect views, comments and opinions from stakeholders and market participants on the appropriate implementation of MiCA and particularly in relation to the mandates that have to be developed by December 2024.

Reverse solicitation

The so-called ‘reverse solicitation exemption’ refers to the case where the provision of cryptoasset services or activities by a third-country firm is strictly limited under MiCA to cases where such service is initiated at the own exclusive initiative of a client. ESMA emphasises the extremely narrow nature of the exemption and says that its use must be regarded as the exception. As ESMA says, “it cannot be assumed, nor exploited to circumvent MiCA” and measures will be taken by NCAs to prevent its misuse, following the proposed ESMA guidelines.

The starting point is, therefore, a prohibition: third-country firms are prohibited from soliciting clients in the EU, unless the cryptoasset service was requested at the own exclusive initiative of the client. The rationale is that clients shall not be excluded from using third-country firms if they choose to do so without having been solicited by such firms.

In its guidelines, ESMA states that the term “solicitation” should be construed in the widest possible way and will include banner advertisements, sponsorship deals and solicitation by any kind of affiliate such as influencers and celebrities. This broad interpretation of the term “solicitation” reflects the fact that cryptoassets and services are essentially offered online.

A broad interpretation is also given to the person soliciting, and may be the third-country firm or any entity or person acting on its behalf. The relationship between the person soliciting and the firm need not be contractual but may be explicit or implicit.

While a very broad interpretation is given to the term “soliciting” and those who may be doing so, a very narrow interpretation is given to the term “on their own exclusive initiative”, with the assessment being based upon the specific underlying facts. Contractual arrangements or disclaimers cannot supersede facts to the contrary.

Timing is similarly important when a firm is relying on the exemption. If the firm meets all the conditions set out in MiCA to rely on the exemption, it may only do so for a very short period of time. For example, if an EU client requests a purchase of a cryptoasset, the firm may at this time market cryptoassets of the same ‘type’ to the client, as permitted under MiCA, but may not do so a month later.

The draft guidelines set out a non-exhaustive list of the types of cryptoassets which should not be included as belonging to the same ‘type’. These include: (i) utility tokens; (ii) asset-references tokens or electronic money tokens; (iii) cryptoassets not stored or transferred using the same technology; (iv) liquid and illiquid cryptoassets; and (v) electronic money tokens not referencing the same official currency.

The guidelines also provide guidance on the supervisory practices that should be employed in order to detect and prevent the circumvention of the reverse solicitation exemption. NCAs should focus on monitoring online activities or third-country firms, as cryptoassets are almost exclusively offered online.

ESMA provides an example of how NCAs should monitor entities targeting clients in the EU. NCAs may search for third-country firms with telephone numbers starting with local country codes or mailing, email or website addresses indicating or hinting at their presence (at least virtually) in the EU, such as having a website with a URL ending with ‘lu’, ‘de’, ‘fr’ and so on.

The draft guidelines require NCAs to work closely with other authorities (national or foreign) that might have insight into whether third-country firms are offering services in the relevant market. Such authorities may include the police and local tax authorities.

In addition, NCAs should follow up on complaints from clients or information from whistleblowers, indicating that a third-country firm might have been soliciting clients in its jurisdiction.

Cryptoassets as financial instruments

The differing approaches to the transposition of the Markets in Financial Instruments Directive II (MiFID II) across EU member states result in there being no commonly adopted application of the definition of ‘financial instrument’ under MiFID. While this has long been a concern under both MiFID II and MiFID before it, practical consequences may arise under MiCA regarding the classification of cryptoassets as financial instruments.

Therefore, ESMA is consulting on its proposed guidelines, with the aim of ensuring consistent approaches at national level regarding which cryptoassets should be considered to be financial instruments and subject to the sectoral regulatory frameworks and in particular, MiFID II.

The guidelines

Guideline 1: general. A technology-neutral approach should be taken when assessing the classification of cryptoassets. Similar activities and assets are to be subject to the same rules, irrespective of their form.

Guideline 2: classification as transferable securities. ESMA states that a substance over form approach should be adopted. A cryptoasset is a transferable security if it confers on the holder similar or equivalent rights to those granted by shares, bonds or other forms of non-equity securities of other negotiable securities. In order to qualify as transferable securities, cryptoassets should fulfil certain criteria, in that they should not be an instrument of payment, should be ‘classes of securities’ and should be negotiable on the capital market. The Financial Instruments CP provides detailed guidance on each of these criteria.

Guideline 3: classification as money-market instruments. A cryptoasset is a money-market instrument if it is a class of instruments typically traded within the money market, with the exception of payment instruments.

Guideline 4: classification as units in collective investment undertakings. A cryptoasset is a unit in a collective investment undertaking if the project attached to the cryptoasset involves pooling capital aimed at providing investors with the benefit of a pooled return generated by the pooled risk from the capital being invested in accordance with a defined investment policy. If the unit holders and smart contracts collectively have day to day discretion or control over operational matters relating to the management of the assets, the cryptoasset is unlikely to be a collective investment.

Guideline 5: classification as derivative contracts. A cryptoasset will be considered to be a derivative contract where the rights of the holders are contingent upon a contract based on a future commitment and the cryptoasset’s value is derived from an underlying asset that has an underlying reference point (for example, rates or indices). There should also be a contractual agreement between parties.

Guideline 6: classification as emission allowances. A cryptoasset is an emission allowance if it represents a right to emit a certain quantity of greenhouse gases and is recognised for compliance with the EU Emissions Trading Scheme. If it is not recognised, the cryptoasset could qualify as a voluntary carbon credit and would fall outside the definition of a financial instrument.

Guideline 7: classification as a cryptoasset. A cryptoasset consists of a digital representation of value or rights, capable of being transferred and stored using distributed ledger technology, including whether such value or rights represent a right against the issuer. A cryptoasset accompanied by an expectation of profit does not in itself qualify as a financial instrument.

Guideline 8: cryptoassets that are unique and not fungible with other cryptoassets. A cryptoasset is unique and non-fungible where the value primarily stems from the unique characteristics of each individual asset and the utility and benefit it offers to its holder, the interconnection of various types of cryptoassets influences the value of another one whereby the non-fungible token has no value of its own, and its unique characteristics distinguish it from other cryptoassets. Tradability of the cryptoasset does not affect the classification.

Guideline 9: hybrid cryptoassets. ESMA states that in order to classify hybrid cryptoassets, a hierarchical approach must be taken. An assessment must be made of whether the cryptoasset meets the criteria of a financial instrument. If the cryptoasset has the features of a financial instrument, this should take precedence, before considering other classifications. Priority should be given to the inherent attributes, rather than labels provided by issuers.

Next steps

Both consultations close for responses on 29 April 2024. ESMA is required under MiCA to issue final guidelines by 30 December 2024 at the latest. However, ESMA has said that it will consider the feedback it receives during the course of Q2 2024 and aims to publish its reports in Q4 2024.

Charlotte Hill is a partner at Taylor Wessing LLP. She can be contacted on +44 (0)20 7300 7011 or by email: c.hill@taylorwessing.com.

Charlotte Hill

Taylor Wessing LLP