Regulation
The two-speed regulatory system that is eating away at Europe
The following is a guest post by Sebastian Heine, Director of Risk and Compliance at Northstake.
In the rapidly evolving landscape of digital finance, the emergence of cryptoassets has introduced unprecedented challenges and opportunities for regulators providing proactive frameworks across the world. The European Union is the largest government body to have done so through the Crypto-asset markets regulation (MiCAR); however, it now finds itself at a critical juncture, faced with the task of navigating the complexities introduced by non-custodial crypto asset service providers.
Non-custodial crypto asset service providers, often operating in the decentralized finance sector (Challenge) offer crypto-asset-related services without actually supporting the assets themselves. These crypto asset service providers now represent a large and growing segment of the crypto finance ecosystem, managing approximately $100 billion in locked value according to defillama.com/.
The MiCAR Regulation, which aims to introduce a harmonised prudential and business conduct framework for crypto-asset services, defines CAS providers as legal persons or other undertakings engaged in the professional provision of one or more crypto-asset services to clients. The Regulation describes several types of crypto-asset services, including the operation of trading platforms, the custody and administration of crypto-assets and the provision of advice on crypto-assets, among others.
However, the current MiCAR definitions and provisions do not encompass non-custodial crypto asset service providers. This omission highlights a critical gap in the EU regulatory framework, as the MiCAR definitions and the interconnection with other regulatory policies result in non-custodial crypto asset service providers not being required to comply with anti-money laundering or sanctions laws, thereby creating vast loopholes for financial crime.
Without the obligation to operate and comply with EU Anti-Money Laundering (AML) laws or MiCAR, these entities operate in a space where the potential for fraud, financial loss and illicit financial activities is significantly increased for investors and consumers.
Innovation before caution
The rise of non-custodial service providers in the crypto-asset sector is a testament to the innovative spirit of digital finance. However, this innovation has outpaced the pace at which current regulatory frameworks are being updated. As a result, the European Union, concerned about consumer protection and financial stability, is now faced with the need to fill these gaps.
One of the major debates is whether non-custodial providers should be subject to anti-money laundering 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 anti-money laundering risks associated with crypto asset service providers (CASP) transactions.
The EBA highlights in particular the risks associated with transactions involving transfers to or from self-hosted addresses, decentralised platforms or transfers involving crypto-asset service providers that are not authorised or regulated.
The MiCAR framework, despite being the cornerstone of the EU’s strategy for regulating cryptoassets, focuses primarily on providers that support customer assets or operate under traditional financial models. As such, it neglects an important part of the cryptoasset ecosystem.
This underscores the urgent need for a more comprehensive and forward-looking regulatory framework, such as MiCAR 2, and updated AML regulation. These exclusions were made at the time to narrow down difficult topics for discussion, such as DeFi regulation, but ultimately only delayed these discussions without paving the way for compliance.
Charting a safe course
Cryptocurrency regulation is not a challenge unique to the European Union. It is a global undertaking that requires international collaboration and harmonisation of standards to effectively manage the risks associated with digital finance. Insights from international organisations will be invaluable in addressing the challenges and opportunities presented by this dynamic sector.
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 is part of a broader, cautious approach to regulating emerging crypto sectors, prioritizing market understanding and evolution over immediate blanket regulation.
It therefore seems only a matter of time before non-custodial platforms that offer services such as staking will need additional management of anti-money laundering and consumer protection risks. However, for now, the two-class system remains.