Crypto assets and the market abuse regulation: Main challenges

First published on Thomson Reuters Regulatory Intelligence on 31 October 2019.

This fourth article of a series on crypto assets considers which crypto assets are subject to the market abuse regulation (MAR), and the particular challenges that may present.

This is an important topic, as observed by the FCA in its guidance on crypto assets (PS19/22):

"A combination of market immaturity, volatility, and a lack of credible information or oversight raises concerns about market integrity, manipulation and insider dealing within crypto asset markets. This may prevent the market from functioning effectively and damage its reputation".

Which crypto assets are caught under MAR?

Since our third article, the FCA has clarified what it considers to be the three broad categories of crypto asset (see FCA PS19/22). The original categories were security tokens, utility tokens and exchange tokens. In the interests of making the regulatory perimeter clearer, the FCA revised the token categories to security tokens, e-money tokens and unregulated tokens. Of these, it appears that only certain security tokens may be directly caught by MAR depending on their individual characteristics.

Security tokens

Not all security tokens are securities:

• Security tokens that are securities or other financial instruments, and which are listed, traded, or admitted to trading on an EU trading venue (regulated market, MTF, OTF) or in respect of which a request for admission to trading has been made will fall within MAR scope.
• Financial instruments will also be caught if their price or value depends on or has an effect on the price or value of an in-scope security token, e.g., CDSs (Credit Default Swaps), CFDs ("related financial instruments").

Commodities 

Commodities under MAR exclude entirely intangible items, and therefore crypto assets would not be subject to the provisions applicable to spot commodity contracts under MAR.

Dealing in in-scope crypto assets: what behaviours could be considered abusive?

MAR prohibits insider dealing, unlawful disclosure and market manipulation (manipulating transactions, fictitious devices and dissemination of
information) in relation to all assets within scope of MAR.

Some abusive strategies such as spoofing and wash trades, which are clearly described in MAR, have been reported as commonly occurring in relation to crypto assets. However, as ESMA notes, the novel nature of the crypto-asset market may give rise to new forms of abusive behaviour not directly captured by MAR, or by current market monitoring arrangements. For example, some crypto asset market participants, such as miners and wallet providers, may hold forms of "inside" information which were not contemplated by MAR that could potentially be used to manipulate the trading and settlement of crypto-assets.

Some ways in which this could occur include:

Execution and settlement of transactions on blockchain rather than on the MTF/OTF itself

• Execution and settlement may be effected by participants on the blockchain operating in a non-transparent and discretionary manner. Depending on the consensus model of the blockchain, a miner may be able to choose which transactions to verify or decide on the order in which the transactions are executed.
• Other traders can, by taking advantage of particular consensus mechanisms, manipulate the price for, and time to, execution of transactions. This can result in situations of information asymmetry (or indeed, a general lack of clarity) in relation to volume and price of trades, leading to a range of adverse types of behaviour.

Crypto assets not captured by MAR: Main concerns

Many crypto assets that are outside the scope of the market abuse regime may be traded with the same purpose and intent as those within scope, but without any regulatory mechanism to ensure fair and orderly trading. Information, be that inside information or transparency in relation to pricing, may not be disclosed to all investors (or potential investors) on a timely, equal and simultaneous basis. Where certain persons benefit, or are perceived to benefit, from early or unique access to information, confidence in the crypto asset market may be harmed.

While HM Treasury is expected to consult on expanding the regulatory perimeter in relation to crypto assets, legislative action would also need to be taken at European level. The current ESMA consultation on the review of MAR does not address concerns specific to crypto assets.

National competent authorities are so concerned about the regulatory position in relation to crypto assets that, in their responses to ESMA survey questions in relation to licensing of FinTech business models, they provided comments on crypto assets despite ESMA expressly stating that these were out of scope for feedback.

Firm-specific considerations

Banks and investment firms

Market operators and investment firms operating a trading venue on which security tokens are traded will need to make sure that their arrangements, systems and procedures for effective and ongoing monitoring of all orders received and all transactions executed, for the purposes of preventing, detecting and identifying insider dealing, market manipulation and attempted insider dealing and market manipulation, remain effective in relation to transactions effected on blockchain.

Trades may be effected from wallets which themselves may be pseudonymous and not directly connected to real-world identities. Market operators and investment firms should have appropriate KYC in relation to those wallet holders to be able to comply with their suspicious transaction and order reporting (STOR) obligations, in so far as possible given that the fields within the STOR template were not drafted to take into account crypto assets. (Appropriate KYC will also be necessary to enable firms to comply with obligations under the Fifth Anti-Money Laundering Directive (5MLD)).

Firms advising issuers in relation to in-scope security tokens would need to make sure their insider list procedures are followed, as well as procedures in relation to disclosure of inside information. Firms providing clients with investment recommendations would also need to ensure that such information is objectively presented, which could be difficult where the markets concerned have limited trading volumes and/or concentrated ownership of certain crypto assets. Personal account dealing policies would also need to be followed (discussed further in our previous article).

Lastly, two points of caution to note. If UK-regulated firms market or offer unregulated crypto assets in such a way as to b considered ancillary to their regulated activities, those crypto assets would become subject to FCA's Principles for Businesses, principle 5: "A firm must observe proper standards of market conduct". Firms may choose not to extend the application of policies and procedures relating to market abuse to unregulated crypto assets, but will wish to exercise caution given the uncertain classification of such assets, their potential to change nature post issuance and the potential reputational damage that could arise from adopting a narrow approach.

Secondly, senior managers involved in decision-making in respect of crypto asset offerings will wish to take reasonable steps to ensure that the business for which they are responsible is compliant with regulatory requirements.

Crypto asset exchanges

Operators of MAR-scope trading venues are required to have in place systems and controls to prevent, detect and report market abuse (art 16(1) MAR). Unregulated crypto asset exchanges listing crypto assets that are outside the regulatory perimeter are not subject to such obligations. Some European countries, such as Malta and France, are developing bespoke national regimes for those crypto assets that are not covered by the existing EU framework. However, the current position of many crypto asset exchanges is concisely summarised in the "Virtual Markets Integrity Initiative Report" by the Office of the New York State Attorney General:

"Trading Platforms Have Yet to Implement Serious Efforts to Impede Abusive Trading Activity. Though some virtual currency platforms have taken steps to police the fairness of their platforms and safeguard the integrity of their exchange, others have not. Platforms lack robust real-time and historical market surveillance capabilities, like those found in traditional trading venues, to identify and stop suspicious trading patterns. There is no mechanism for analyzing suspicious trading strategies across multiple platforms. Few platforms seriously restrict or even monitor the operation of 'bots' or automated algorithmic trading on their venues. Indeed, certain trading platforms deny any responsibility for stopping traders from artificially affecting prices. Those factors, coupled with the concentration of virtual currency in the hands of a relatively small number of major traders, leave the platforms highly susceptible to abuse. Only a small number of platforms have taken meaningful steps to lessen those risks."

Whether or not in preparation for an expanded regulatory regime, tech start-ups reported earlier this year that a machine learning and artificial intelligence-powered trade surveillance platform for digital assets is being developed. A platform of this nature could potentially facilitate a reduction in manipulation and enable trust to be developed in these markets and could ultimately lead to expansion of the crypto asset market.