Regulation
The Two-Class Regulatory System Plaguing Europe
Below is a guest post by Sebastian Heine, Chief Risk and Compliance Officer at Northstake.
In the rapidly evolving landscape of digital finance, the emergence of cryptocurrencies has introduced unprecedented challenges and opportunities for regulators to provide proactive frameworks across the globe. The European Union is the largest government body that has done so through the Cryptocurrency markets regulation (MiCAR); however, it is now at a critical stage, faced with the task of navigating the complexities introduced by non-depository cryptocurrency service providers.
Non-custodial cryptocurrency service providers, often operating in the decentralized finance sector (DeFi) offer cryptocurrency-related services without actually taking custody of the cryptocurrency. These cryptocurrency service providers now represent a significant and growing segment of the crypto finance ecosystem, managing approximately $100 billion in locked value according to defillama.com/.
MiCAR, which aims to introduce a harmonized framework of prudential and business conduct for crypto-asset services, defines CAS providers as legal entities or other businesses engaged in the professional provision of one or more crypto-asset services to clients. The regulation outlines different types of crypto-asset services, including the operation of trading platforms, custody and administration of crypto-assets, and advice on crypto-assets, among others.
However, the current MiCAR definitions and provisions do not include non-custodial cryptocurrency service providers. This omission highlights a critical gap in the EU regulatory framework, as the definitions within MiCAR and the interconnection with other regulatory policies have the effect that non-custodial cryptocurrency service providers are not required to comply with the laws AML or Sanction and, therefore, create large loopholes for financial crimes.
Without the obligation to operate and comply with EU anti-money laundering (AML) laws or MiCAR, these entities operate in an area where the risk of fraud, financial loss and illicit financial activity is significantly increased for investors and consumers.
Innovation before caution
The rise of non-custodial service providers in the cryptocurrency space is a testament to the innovative spirit of digital finance. However, this innovation has outpaced the speed at which current regulatory frameworks are being updated. As such, the European Union, with its commitment to consumer protection and financial stability, is now faced with the need to address these shortcomings.
A central debate is whether non-custodial providers should be subject to AML laws. The Financial Action Task Force (FATF) acknowledges the potential illicit risks of DeFi, while the EU proposal excludes these entities, leaving gaps. Similarly, the European Banking Authority (EBA) guidelines also highlight the AML risks associated with Crypto Asset Service Provider (CASP) transactions.
Specifically, the EBA highlights the risks associated with transactions involving transfers to or from self-hosted addresses, decentralized platforms, or transfers involving unauthorized or regulated crypto-asset service providers.
The MiCAR framework, while a cornerstone of the EU’s strategy for regulating cryptocurrencies, primarily focuses on providers who take custody of customer assets or operate within traditional financial models. As such, it overlooks a significant part of the cryptocurrency ecosystem.
This highlights the urgent need for a more comprehensive and forward-looking regulatory framework like MiCAR 2 and an updated AML regulation. These exclusions were made at the time to reduce difficult-to-discuss topics like DeFi regulation, but ultimately only served to delay these discussions without providing a path to compliance.
Chart a safe route
Cryptocurrency regulation is not a challenge unique to the European Union. It is a global initiative that requires international collaboration and harmonization of standards to effectively manage the risks associated with digital finance. The insights of international organizations will be invaluable in addressing the challenges and opportunities this dynamic sector presents.
The European Commission is currently tasked with producing a report to assess the benefits and challenges of DeFi, which could lead to future legislation. This move is part of a broader, more cautious approach to regulating emerging cryptocurrency sectors, prioritizing market understanding and evolution over immediate comprehensive regulation.
Therefore, it seems to be just a matter of when non-custodial platforms offering services such as staking will require additional AML and risk management for consumer protection, however, for now, the two-class system remains.