EU Crypto Regulation Outlook – The Cryptonomist

Europe wants to become crypto’s global standard setter (and they might well succeed)

2022 was a big year for crypto, although probably not in the sense that most people were initially hoping for.

The crypto space saw an incredible uptake in institutional adoption and developments but also witnessed some of the biggest scandals, hacks and frauds to date.

Optimism about the future vied with, amongst other things, the risks associated with unregulated crypto markets.

If there was already general agreement, at the global level, on the need to introduce rules to protect consumers and avoid systemic risk and contagion effects, the events of 2022 have reinforced calls by regulators for jurisdictions all around the world to rapidly rein in the sector.

The European Union (EU) is taking a lead in doing so via its the Markets-in-Crypto-Assets (MiCA) Regulation, which sets out rules for issuers of crypto assets and the entities providing related services in the EU, as well as for stablecoins and other relevant types of tokens.

As a consequence, it is worth understanding a little more about the approach of this European economic powerhouse, with its nearly 500-million consumers and a commitment to being a global regulatory superpower.

Focusing on service providers and stablecoin issuers

The EU’s push to regulate crypto-assets started in 2019 with the Markets-in-Crypto-Assets (MiCA) Regulation. Initially, its sole focus was on rules for those crypto-assets service providers (CASPs)[1] which were trying to provide their services in the EU market.

Then, the Libra stablecoin was launched and those rules were quickly considered to be inadequate. Countries such as Germany and France were very hostile towards Libra and its goal to launch a private payment alternative to Europe’s main fiat currency, the Euro.

In the face of this new, digital “Zuck Buck” politicians across Europe pushed for the inclusion of stablecoins in the EU’s new rules and also accelerated the development of a Digital Euro by the European Central Bank.

The resulting MiCA text was modified to link rules for stablecoins (or e-money tokens (EMTs) in European terms) to existing banking, payments and e-money rules.

The new rules also banned the granting of interest rates on stablecoins, as these are not considered equal to bank deposits. Only licensed institutions, such as banks or e-money providers, were allowed to issue stablecoins in Europe.

Complexities and exceptions then emerged, as you might expect. Algorithmic stablecoins were excluded from MiCA’s framework. That means they can still be listed on regulated exchanges but cannot be marketed as “stablecoins”, as the claim of a stable value needs to be demonstrated and backed by reserves.

For non-EU based stablecoins, such as USD-denominated ones like USDC or USDT, there are additional restrictions, although the final details of these are still to be decided in the technical debates post-implementation.

The outcome of these debates will be essential for the well-being of the crypto-market in Europe, as EUR-denominated stablecoins will not be able to provide enough liquidity by the time MiCA enters into force.

The EU’s light(er)-touch on DeFi and NFTs

Stablecoins are not the only topic which played a disruptive part in the formulation of the final MiCA text. Over the last three years, Decentralised Finance (DeFi), Non-fungible Tokens (NFTs) and the environmental footprint of proof-of-work projects such as Bitcoin have also become important in the EU’s legislative debates.

The original aim of MiCA was to provide a legal framework allowing centralised regulated entities to passport their services across Europe, while protecting EU investors, consumers, market integrity and financial stability.

On the one hand, the DeFi industry managed to ensure a broad exemption from MiCA (in case of “true decentralisation”), to encourage the future growth of a promising space.

On the other hand, the collapse of Terra/Luna meant that policy-makers came to see algorithmic stablecoins as largely unstable and highly risky financial instruments, not to be trusted in absence of reserves clearly backing them.

In the case of NFTs, which are key to the future token economy, there was a clear divide between EU institutions. Whereas EU Member States, such as France or Germany, were clearly in favour of a complete exemption of NFTs, the European Commission steadfastly and successfully pointed out that NFTs issued in a “large collection or series” should not fall outside the scope of MiCA, as that would be an indicator of their potential “fungibility”. The final definition of NFTs is still to be determined, as it is not yet clear what the EU will consider as “non-fungible tokens”.

EU is clearly trying to lay out the groundwork for NFTs to flourish in Europe, recognising that a specific and fine-tuned policy approach is needed to ensure that NFTs’ vast range of technological applications are not dragged wholesale into the realm of financial regulation.

The environmental impact of Bitcoin and how the EU reacted

The environmental impact of Bitcoin and other proof-of-work (PoW) projects has been a source of growing concern for the EU. During the MiCA negotiations at the end of March 2022, the EU was extremely close to banning PoW-based cryptocurrencies from being listed on regulated exchanges as of 2025.

Luckily, the industry managed to highlight the potentially catastrophic consequences that such a decision would have had on the EU crypto market, for example forcing EU citizens to rely on unregulated and decentralised exchanges to trade Bitcoin and other PoW tokens.

Creating a parallel and unregulated trading market and completely undermining the objectives of MiCA was not ideal but nonetheless, in order to appease green-minded policymakers, the final compromise means issuers of crypto-assets will be required to provide information about their project’s environmental impact in the whitepaper they would need to publish.

The specific criteria on how to provide this information will be defined by the European Security and Markets Authority (ESMA) in its “level 2” legislative work.

The fear of money-laundering and terror financing still looms strong

Another key aspect of the negotiations was the link between MiCA and Anti-Money Laundering (AML) rules, especially with regards to personal, or self-hosted, wallets.

This issue was debated in a separate, but highly interconnected, piece of legislation which was meant to implement the so-called “Travel Rule” as part of the EU’s compliance with the FATF Recommendations.

The debate was, once again, highly polarised. On one side, crypto-sceptic policy-makers pushed for verification requirements for transfers to self-hosted wallets, which would have forced regulated entities to verify the identity of users behind each wallet they interacted with, effectively going further than FATF’s own recommendations.

On the other side, industry-friendly policymakers argued that such requirements would not only have been unfeasible, as the verification would have been based on self-provided information, but also contrary to the overall objective of AML rules.

Once again, the EU was wrestling with instincts that if implemented could have simply pushed users into unregulated spaces with little or no oversight from regulators and law enforcement authorities.

Fortunately, the final political agreement recognised that going down this path could push users to only transact crypto-assets between self-hosted wallets, using peer-to-peer transactions that remained outside of the regulatory scope rather than going through regulated exchanges.

This would effectively create a parallel system of less than well-illuminated transactions. Instead a clear risk-based approach to the AML and KYC requirements was imposed on regulated entities.

The MiCA timeline

The rules described in this article will start applying as of mid-2024, for the issuers of stablecoins, and six months later for the issuers of all other tokens and for crypto-asset service providers.

However, several open questions may well need to find answers by then, e.g. how to classify NFT collections to understand whether they are “in scope”, how to provide information about the environmental impact of consensus mechanisms, and how to assess the risks connected to transfers to self-hosted wallets.

The industry will have to engage with ESMA and the EBA to ensure these questions are answered in the right way.

A step in the right direction with potentially far-reaching global consequences

MiCA may not be perfect but it is here and will be coming into force soon enough.

The crypto industry should embrace what is a clear set of rules from the EU. It will, finally, provide needed legal clarity for companies that want to set up shop and provide services to those almost 500 million EU citizens. Although measuring the real impact of MiCA will take a few years, jurisdictions around the world are likely to begin copy-pasting the EU’s principles into their regulation.

This is the so-called “Brussels’ effect”, sometimes also called “regulatory contagion”, which underpins the EU’s rise to being a global regulatory superpower.

None of this has stopped, however, a fierce debate started in Europe about whether MiCA would have prevented an FTX-like collapse. 

There are calls for MiCA to be brought in sooner, for DeFi to be folded into its rules, for entities from third countries to be held to higher standards if they provide services to EU citizens.

For now, the line from the European Commission is, “We should first fully adopt MiCA before starting to call for a MiCA 2”. As Blockchain for Europe, we could not agree more. One step at a time is the best way for Europe to avoid unintended consequences and to judge how any future regulation will need to be adapted to rapidly evolving technologies and business models.

Footnotes:

1. CASPS are globally referred to as VASPs, as defined by the Financial Action Task Force (FATF)