Lecture 10 Regulating DLT-based Finance PDF

Lecture 10 Regulating DLT-based finance Diego Valiante, Ph.D. Adj. Prof. Bologna University & Team Leader Europ...

Lecture 10 Regulating DLT-based finance Diego Valiante, Ph.D. Adj. Prof. Bologna University & Team Leader European Commission Disclaimer: The views expressed are personal and not necessarily those of the European Commission.  Agenda What’s the Distributed Ledger Technology? – The Bitcoin blockchain – Some technical features and blockchain typologies DLT-based finance – Smart contracts – Asset tokenisation – Decentralised finance The emerging regulatory framework – A legal taxonomy and categorisation in EU law – EU vs US approaches to crypto asset regulation © Valiante Diego – 2  What is Distributed-Ledger Technology (DLT) or the blockchain? © Valiante Diego – 3  Centralised vs Distributed (trustless) system © Valiante Diego – 4 Source: IMF.  What is the blockchain? In a nutshell… “A blockchain is essentially a distributed database of records, or public ledger of all transactions or digital events that have been executed and shared among participating parties. Each transaction in the public ledger is verified by consensus of a majority of the participants in the system. Once entered, information can never be erased. The blockchain contains a certain and verifiable record of every single transaction ever made.” (M. Crosby et al., “Blockchain Technology: Beyond Bitcoin”, Applied Innovation Review, n. 2, June 2016) With Blockchain, we can imagine a world in which contracts are embedded in digital code and stored in transparent, shared databases, where they are protected from deletion, tempering and revision. In this world, every agreement, every process, every task and every payment would have a digital record and signature that could be identified, validated, stored and shared. Intermediaries, like lawyers, brokers and bankers, might no longer be necessary.” (Harvard Business Review, ”The Truth about Blockchain”, January- February 2017) © Valiante Diego – 5  The Bitcoin blockchain © Valiante Diego – 6  Key components of the Bitcoin blockchain Satoshi Nakamoto’s blockchain (October 2008 White Paper) brings together a number of technological developments in computer science that were already well known in a unique combination of them. 1. Cryptography (communication in the presence of adversaries) a. Hash function (digital fingerprint of any data; SHA256 & RIPEMD160) b. Public/private key (asymmetric cryptography) plus digital signature c. Timestamped append-only logs (blocks) d. Block headers and merkle trees e. BTC addresses 2. Consensus mechanism (who gets to amend the database) a. Consensus through Proof of Work b. Transaction validation c. Network of nodes (around 10k nodes) d. Native currency 3. Ledger (any record of economic activity or financial relationship) a. Transaction inputs and outputs b. Unspent transaction output (UTXO) © Valiante Diego – 7  Key components of the Bitcoin blockchain Satoshi Nakamoto’s blockchain brings together a number of technological developments in computer science that were already well known in a unique combination of them. 1. Cryptography (communication in the presence of adversaries) a. Hash function (digital ‘fingerprint’ of any data; e.g. SHA256) b. Public/private key (asymmetric cryptography) plus digital signature c. Timestamped append-only logs (blocks) d. Block headers and merkle trees e. BTC addresses 2. Consensus mechanism (who gets to amend the database) a. Consensus through Proof of Work (PoW) b. Transaction validation c. Network of nodes (around 10k nodes) d. Native currency 3. Ledger (any record of economic activity or financial relationship) a. Transaction inputs and outputs b. Unspent transaction output (UTXO) © Valiante Diego – 8  1. Preimage resistant: hard to determine x from Hash(x) (1/104 probability) 2. Avalanche effect: change x a bit and Has(x) will change significantly 3. Collision resistant: very low prob x and y were Hash(x)=Hash(y) 4. Puzzle friendliness: knowing Hash(x) and part of x does not allow you to find rest of x 5. Deterministic: given the same input, the output will always remain the same. Hashing is not encryption (it cannot be decrypted or at least it requires an insanely high computational power) HSA256 creates alphanumerical hashes of 64 hexadecimal characters (numbers/letters with fixed length) It means you need to make 2256 attempts (more than the numbers of atoms in the universe) to retrieve the original message. Even images can be hashed. Check this HSA256 hash calculator out https://www.lambdatest.com/free-online- tools/sha256-hash-calculator For the maths behind it https://medium.com/swlh/the-mathematics-of- bitcoin-74ebf6cefbb0 © Valiante Diego – 9 Source: From Turcanik and Javurek, Hash function generation by neural network, 2016.  Key components of the Bitcoin blockchain Satoshi Nakamoto’s blockchain brings together a number of technological developments in computer science that were already well known in a unique combination of them. 1. Cryptography (communication in the presence of adversaries) a. Hash function (digital fingerprint of any data; e.g. SHA256) b. Public/private key (asymmetric encryption) plus digital signature c. Timestamped append-only logs (blocks) d. Block headers and merkle trees e. BTC addresses 2. Consensus mechanism (who gets to amend the database) a. Consensus through Proof of Work (PoW) b. Transaction validation c. Network of nodes (around 10k nodes) d. Native currency 3. Ledger (any record of economic activity or financial relationship) a. Transaction inputs and outputs b. Unspent transaction output (UTXO) © Valiante Diego – 10  Cryptography The hashed information is then encrypted before being propagated. Cryptography ensures: 1. Confidentiality. Encryption encodes the message's content. 2. Authentication. Decryption verifies the origin of a message. 3. Integrity. Decryption proves the contents of a message have not been changed since it was sent. 4. Nonrepudiation. Decryption prevents senders from denying they sent the encrypted message. Symmetric encryption requires a single key (also called cypher) to decrypt the message. Asymmetric encryption requires two different (but logically linked) keys (cyphers), one to encrypt and another one to decrypt (respectively private and public). – They are created together with the wallet holding the crypto asset Cryptography solved the ‘double spending’ problem (e.g. re- use)! © Valiante Diego – 11  Public-private key encryption, digital signature and network validation Everybody trading on a blockchain needs a wallet. This wallet will have an address (like the IBAN for bank accounts) and will create a unique pair of private and public keys. The (1) private key (a 256-bit hash generated with the wallet and it is only known to the owner) cannot be derived from the public key (which can thus be publicly distributed), but the (2) public key is derived from the private key through elliptic curve multiplication (ECM). The (3) wallet address is 160 bits hash derived from the public key, it usually consists of around 25 to 40 alphanumeric characters. Asymmetric encryption to validate transaction a. Each transaction is protected through a digital signature created by encrypting the hash of the transaction via the private key (SHA256 hashing of the hash) of the one sending the asset. b. The hash of the transaction hash is then decrypted it via the public key (received from the sender) for validation by the network (after propagation via the Gossip protocol) that the transaction hash is coming from that specific wallet. © Valiante Diego – 12  Public-private key encryption, digital signature and network validation (single transaction) Hash of the hash done with the private key Public key decrypts the signature, so created together with the wallet address revealing the transaction hash without revealing the private key © Valiante Diego – 13  Key components of the Bitcoin blockchain Satoshi Nakamoto’s blockchain brings together a number of technological developments in computer science that were already well known in a unique combination of them. 1. Cryptography (communication in the presence of adversaries) a. Hash function (digital fingerprint of any data; e.g. SHA256) b. Public/private key (asymmetric cryptography) plus digital signature c. Timestamped append-only logs (blocks) d. Block headers and merkle trees e. BTC addresses 2. Consensus mechanism (who gets to amend the database) a. Consensus through Proof of Work (PoW) b. Transaction validation c. Network of nodes (around 10k nodes) d. Native currency 3. Ledger (any record of economic activity or financial relationship) a. Transaction inputs and outputs b. Unspent transaction output (UTXO) © Valiante Diego – 14  The chain of blocks (timestamped append-only logs) Source: NIST. Append-only is a property of computer data storage such that new data can be appended to the storage, but where existing data is immutable (Wikipedia). These blocks are linked to each-other (like a chain) in a proper linear, chronological order with every block containing the hash of the previous block from its creation (03-01-2009). Since then, 812,806 blocks have been mined (October 2023). By convention, the longest chain (since the so-called Genesis block) is considered to be the current status of the blockchain. The information in the block header contains a hash of: (1) the previous header, timestamp, mining difficulty value, proof of work nonce and root hash for the Merkle tree (Ralph Merkle 1979) containing the transactions for that block (see next slides). You can see all the bitcoin blockchain here and live demonstration on how it works here. An example of bitcoin block is here. © Valiante Diego – 15  (for info) Merkle Tree © Valiante Diego – 16  Key components of the Bitcoin blockchain Satoshi Nakamoto’s blockchain brings together a number of technological developments in computer science that were already well known in a unique combination of them. 1. Cryptography (communication in the presence of adversaries) a. Hash function (digital fingerprint of any data; e.g. SHA256) b. Public/private key (asymmetric cryptography) plus digital signature c. Timestamped append-only logs (blocks) d. Block headers and merkle trees e. BTC addresses 2. Consensus mechanism (who gets to amend the database) a. Consensus through Proof of Work (PoW) or Proof of Stake (PoS) b. Transaction validation c. Network of nodes (around 10k nodes) d. Native currency 3. Ledger (any record of economic activity or financial relationship) a. Transaction inputs and outputs b. Unspent transaction output (UTXO) © Valiante Diego – 17  The Byzantine Generals problem Source: https://bit.ly/3fndOCD At least half of them needs to attack simultaneously to win They don’t trust each other and communication can only happen via messengers on a horseback with no way to verify authenticity of the message (i.e. time to attack) How can consensus be reached for block validation? – Before Bitcoin, only solution if 2/3 of generals are loyal. © Valiante Diego – 18  The Proof of Work ‘solution’ 1. The Generals agree the first plan received by all Generals will be accepted as the plan. 2. A General solves the PoW problem and creates a block: – By modifying a nonce (a 32-bit arbitrary random number, which goes from 0 to roughly 4.3 billion), combined with the other information in the block (including previous block’s hash), after trials and errors, the successfully mined block will have a unique hash (of the information above) with (currently) 19 zeros out of 64 characters The 19 zeros represent the level of difficulty, which increases over time. More zeros more difficult to mine, i.e. to compute a hash function of the new block with 19 zeros). 3. The newly generated block will be broadcasted to the network and can be easily verified by the other Generals/miners (in the same way a public key is used to verify a message hashed with the corresponding private key; in this case verifying the content of the header hash of the previous block with the info in the block). 4. The commitment required (e.g. investments) in creating that block signals that the ‘General’ can be trusted. © Valiante Diego – 19  The Proof of Work ‘solution’ 5. Each time a General solves a PoW problem, a block is generated and the chain begins to grow. In time, any General working on a different solution will switch over to the longest chain. This is the one most Generals are contributing to and therefore has the greatest chance of success 6. As the Generals know roughly how long a PoW solution takes to solve, after a set amount of time they will know if enough of the other Generals are also working on the same chain 7. Through this process, the Generals can arrive at a consensus of when to attack, can estimate their chances of successfully doing so, and can prevent multiple different ‘signals to attack’ being sent simultaneously. (Proof of Work and how it solves the Byzantine Generals Problem | The Radix Blog | Radix DLT) Adam Back’s Hashcash in 1997 → a cryptographic hash-based proof-of-work algorithm that requires a selectable amount of work to compute, but the proof can be verified efficiently (Wikipedia). © Valiante Diego – 20  Proof of work – Incentive structure The first miner to solve the computational issue will get a reward of roughly 3.125 BTC (halved every 4 years due to limited supply), plus fees of transactions in that block (typically less than 1 BTC). – Recent halving (April 19th) has led to a major restructuring of computing infrastructure or relocation in countries with low energy costs The probability that a miner mines a new block depends on the ratio between the computational power he devotes to this task (ever increasing) and the total instantaneous computational power by all miners connected to the network. In order to keep each block generation within 10 minutes on average (to achieve 21 million BTC in 2140), difficulty is adjusted over time to reflect the total computing power in the system in order to generate that block in 10 minutes. It is usually amended every 2016 blocks (more or less 2 weeks). Currently, it is equivalent to 436 ExaHashes (quintilions hashes) per second. © Valiante Diego – 21  This is how the chain is built… © Valiante Diego – 22  Outcome hash © Valiante Diego – 23  Other consensus mechanisms © Valiante Diego – 24  Proof of work (PoW) vs proof of stake (PoS) As PoW is expensive and wastes too much energy, an alternative consensus mechanism for processing transactions and creating new blocks has emerged → the Proof of Stake (PoS). – Proof-of-stake reduces the amount of computational work needed to verify blocks and transactions, by simply using the machines of those who pledge an amount of native tokens (coin owners), so there doesn't need to be as much computational effort as in PoW to solve complex mathematical problems. The owners offer their coins as collateral—staking—for the chance to validate blocks and then become validators. The ‘stake’ being deposited acts as a mechanism to signal trust. – For instance, Ethereum requires 32 ETH to be staked before a user can become a validator. Validators are then rewarded based on assigned duties. Once the coin is staked, validators are selected randomly to confirm transactions and validate block information. This system randomizes who gets to collect fees rather than using a competitive rewards-based mechanism like proof-of-work. Blocks are validated by more than one validator, and when a specific number of the validators verify that the block is accurate, it is finalized and closed. © Valiante Diego – 25  The emerging Proof of Authority (PoA) consensus Proof of Authority (PoA) is designed to optimize the PoS mechanism and be used, ideally, in permissioned networks. Instead of choosing block miners on the basis of their stakes in cryptocurrency tokens, PoA selects a small group of authorities as transaction validators by their identity or reputation in the network. A PoA-based system also rewards authorities for certifying and ordering transactions to incentivize honest behaviour in providing service and moderating the network. PoA does not require intensive computation to complete hard tasks and only relies on a small number of validators to reach consensus. These features help improve transaction processing and energy efficiency compared with PoW and PoS-based systems. However, PoA also forgoes decentralization by concentrating mining power among a group of trusted authorities. As a result, this model can introduce censorship into the public network where one or more authorities may blacklist or deny all transactions from a particular user. © Valiante Diego – 26  Key components of the Bitcoin blockchain Satoshi Nakamoto’s blockchain brings together a number of technological developments in computer science that were already well known in a unique combination of them. 1. Cryptography (communication in the presence of adversaries) a. Hash function (digital fingerprint of any data; e.g. SHA256) b. Public/private key (asymmetric cryptography) plus digital signature c. Timestamped append-only logs (blocks) d. Block headers and merkle trees e. BTC addresses 2. Consensus mechanism (who gets to amend the database) a. Consensus through Proof of Work (PoW) b. Transaction validation and confirmation c. Network of nodes (around 10k nodes) d. Native currency 3. Ledger (any record of economic activity or financial relationship) a. Transaction inputs and outputs b. Unspent transaction output (UTXO) © Valiante Diego – 27  Transaction validation, in a nutshell… 1. Transaction validation (see previous slide on public/private keys) – A node starts a transaction by first creating and then digitally signing it with its private key (created via cryptography). A transaction often represent transfer of value between users on the blockchain network (including relevant rules, source and destination addresses, and other validation information). – A transaction is propagated (flooded) by using a flooding protocol, called Gossip protocol (for inter-node communication), to peers that validate the transaction based on preset criteria (ownership of the digital asset and for the sufficient amount, via the public key, as shown in previous slides). Usually, more than one node is required to verify the transaction. In May 2021, there were 9,815 Bitcoin nodes around the world. 2. Transaction confirmation with block validation – Once the transaction is validated, it is included in a block, which (once is mined by the one who gets there first) is then propagated onto the network. At this point, the transaction is considered confirmed. – The newly-created block now becomes part of the ledger, and the next block links itself cryptographically back to this block. This link is a hash pointer. At this stage, the transaction gets its second confirmation and the block gets its first confirmation. 3. Final confirmation – Transactions are then reconfirmed every time a new block is created. Usually, six confirmations in a network are required to consider the transaction final (1 hour). © Valiante Diego – 28  Key components of the Bitcoin blockchain Satoshi Nakamoto’s blockchain brings together a number of technological developments in computer science that were already well known in a unique combination of them. 1. Cryptography (communication in the presence of adversaries) a. Hash function (digital fingerprint of any data; e.g. SHA256) b. Public/private key (asymmetric cryptography) plus digital signature c. Timestamped append-only logs (blocks) d. Block headers and merkle trees e. BTC addresses 2. Consensus mechanism (who gets to amend the database) a. Consensus through Proof of Work (PoW) b. Transaction validation c. Network of nodes (around 10k nodes) d. Native currency 3. Ledger (any record of economic activity or financial relationship) a. Transaction inputs and outputs b. Unspent transaction output (UTXO) © Valiante Diego – 29  (for info) Different types of nodes A full node is a complete copy of the bitcoin blockchain and can verify all transactions since the beginning. This requires about 337.98GB of drive space (May 2021). It can be, but it does not need to be a miner. Pruned node prune transactions after validation and aging to run a full node-like on any device (with reduced storage requirement of few GBs). – Simplified Payment Verification nodes only store the Blockchain headers Mining nodes are only responsible for creating blocks to add to the blockchain, they are not responsible for the maintenance or validity of future blocks (unlike full nodes). But they need to run a full node to identify the criteria (consensus) for valid transactions and to connect the correct block to the network. Mining pools exist to pool hashrate from multiple sources/users and redistribute revenues. Wallets allow to store, view, send and receive transactions and create key pairs. Mempool is a pool of unconfirmed (yet validated) transactions © Valiante Diego – 30  Nodes interaction and ‘forks’ Blockchains might be subject to so called ‘forks’ when there is no longer unanimous consensus among the network nodes on the rules of the blockchain. Only some may continue to mine with the new rules, which will de facto create a second blockchain. There are three types of forks: 1. Soft Fork: when the blockchain protocol is altered in a backwards- compatible way 2. Hard Fork: when the blockchain protocol is altered in a non backwards-compatible way 3. Temporary Fork: when two miners mine a new block at the same time © Valiante Diego – 31 © Valiante Diego – 32  Key components of the Bitcoin blockchain Satoshi Nakamoto’s blockchain brings together a number of technological developments in computer science that were already well known in a unique combination of them. 1. Cryptography (communication in the presence of adversaries) a. Hash function (digital fingerprint of any data; e.g. SHA256) b. Public/private key (asymmetric cryptography) plus digital signature c. Timestamped append-only logs (blocks) d. Block headers and merkle trees e. BTC addresses 2. Consensus mechanism (who gets to amend the database) a. Consensus through Proof of Work (PoW) b. Transaction validation c. Network of nodes (around 10k nodes) d. Native currency 3. Ledger (any record of economic activity or financial relationship) a. Transaction inputs and outputs b. Unspent transaction output (UTXO) © Valiante Diego – 33  Unspent Transaction Output (UTXO) You need to find previous unspent transaction outputs to be input for the new transaction There are roughly 77 million unspent transactions. It does not mean 77mn BTC, since these unspent transactions, are usually a fraction of a single BTC) → 18.7mn BTC out of 21mn BTC (cap!) Validation condition → Inputs ≥ Outputs Ethereum uses, instead, a more traditional ‘balance-based’ approach © Valiante Diego – 34 Infographic designed by fractalphia.com © Valiante Diego – 35  TO SUM UP: Key components of a blockchain Satoshi Nakamoto’s blockchain brings together a number of technological developments in computer science that were already well known in a unique combination of them. 1. Cryptography (communication in the presence of adversaries) a. Hash function (digital fingerprint of any data; SHA256 & RIPEMD160) b. Public/private key (asymmetric cryptography) plus digital signature c. Timestamped append-only logs (blocks) d. Block headers and merkle trees e. BTC addresses 2. Consensus mechanism (who gets to amend the database) a. Consensus through Proof of Work (PoW) or other proofs (PoS or PoA) b. Transaction validation c. Network of nodes (around 10k nodes) d. Native currency 3. Ledger (any record of economic activity or financial relationship) a. Transaction inputs and outputs b. Unspent transaction output (UTXO) © Valiante Diego – 36  Cryptocurrencies by market cap Source: Coin.dance © Valiante Diego – 37  Cryptocurrencies by market cap Source: Coin.dance © Valiante Diego – 38  Money flow into Bitcoin To compare with the traditional financial system, Euronext’s daily turnover (excl. auctions) is roughly EUR 6bn (in 2022) vs $627mn from yesterday for Bitcoin exchanges. www.blockchain.com © Valiante Diego – 39  Some references Blockchain 101: Visual Demo for Alternative Finance. Videos and demo blockchain M. Crosby et al., “Blockchain available here Technology: Beyond Bitcoin”, https://andersbrownworth.com/bl Applied Innovation Review, n. 2, ockchain/ June 2016. Bitcoin Blockchain Explorer Harvard Business Review, ”The https://www.blockchain.com/ex Truth about Blockchain”, plorer January-February 2017. Satoshi Nakamoto, Bitcoin: A https://www.radixdlt.com/post/ Peer-to-Peer Electronic Cash what-is-proof-of-work System, available at https://medium.com/@blairlmar https://bitcoin.org/bitcoin.pdf shall/how-do-miners-validate- Zheng et al. (2018), Blockchain transactions-c01b05f36231 challenges and opportunities: A E. Schuster, Cloud Crypto Land, survey, International Journal of Modern Law Review, 2020. Web and Grid Services, October. M. Rauchs et al. (2018), Distributed Ledger Technology Systems: A Conceptual Framework, Cambridge Centre © Valiante Diego – 40  Benefits and risks of a ‘permissionless’ blockchain © Valiante Diego – 41  Key characteristics 1. Decentralisation & (consensus-based) governance – Validation of transactions and block mining is trustless – Governance has different degrees of flexibility (Bitcoin vs Ethereum) 2. Transparency – Embedded traceability of transactions and ownership vs reliance on third parties 3. Security – Role of cryptography to limit tampering 4. Immutability of records – Without relying on third parties (trustless) 5. Privacy – Anonymity 6. Scarcity (store of value) – Fixed supply at 21 mn BTC to be deployed by 2140 7. Transfer, lend and exchange value – Cryptography solved the double spending problem! © Valiante Diego – 42  Potential benefits Minimise information leakage Reduce transaction time Remove transaction costs of intermediaries Reduce risk of fraud by introducing fraudulent transactions and cybercrime – To introduce a fraudulent transaction, an attacker would need not only to generate a block by solving a mathematical puzzle, but it also has to race mathematically against the good nodes to generate all subsequent blocks in order for it to make the other nodes in the network accept its transaction and block as the valid one. This job becomes even more difficult since blocks in the blockchain are linked cryptographically together. – Intrinsic asset segregation (private key) Observe transactions in real time ‘Tokenisation’ of assets provides flexibility and seamless access to funding. © Valiante Diego – 43  Key technical/legal/economic challenges of BTC’s blockchain Scalability Security Decentralisation The Scalability Trilemma claims that blockchain systems can only, at most, have two of the following three properties: 1. Decentralization (defined as the system being able to run in a scenario where each participant only has access to O(c) resources, i.e. a regular laptop or small VPS) 2. Scalability (defined as being able to process many transactions) 3. Security (defined as being secure against attackers with up to O(n) resources) © Valiante Diego – 44  Key technical/legal/economic challenges of BTC’s blockchain 1. Scalability. Each block (around 1.2 MB) can fit around 2,700-2800 transactions on average in peak periods. Considering that a block is mined every 10-11 minutes, this implies that the blockchain can support around 4.5 transactions per second. Visa does around 1,736 transactions per second on average (based on a calculation derived from the official claim of over 150 million transactions per day). The key challenge of scalability is finding a way to achieve all three at the base layer of a blockchain - sharding is one such attempt at solving this challenge (see ETH 2.0). 2. Waste. PoW consensus solution may lead to centralisation, as miners compete on concentrating computational power. With 51% of mining infrastructures, miners could control and modify the blockchain. Moreover, BTC blockchain generates a lot of energy consumption (in May 2021 it was estimated at 121 TWh per Year, like Pakistan; Source: Digiconomist.net) 3. Synchronisation. The transactions in one block are considered to have happened at the same time (this creates a significant legal challenge together with irreversibility, so called synchronisation problem, Schuster 2019). – Only timestamp for the block creation (added by the node) – No timestamp for the transaction (only when it is received by the block) – Solana blockchain aims to solve this by creating a consensus clock and increase the speed of block creation to 400ms (still no timestamp per transaction). – Other option is a closed infrastructure with pre-selected nodes. © Valiante Diego – 45  Key technical/legal/economic challenges of BTC’s blockchain 4. Infrastructure. Platforms and other intermediaries (such as digital wallet providers) may have insufficient organisational requirements and lack KYC and AML procedures. 5. Liability. Distributed consensus (especially for permissionless DLT) and self- executing pieces of codes may lead to difficulty in establishing a clear responsible (legal or natural) person and liability. 6. Mining. There is risk of mining monopolization (51% attacks), induced by large coordination of miners in a single mining pool, which continuously increases the expected payoff of others if they join said mining pools. – Chinese pools control 65% of the network hash rate – Bitmain (Chinese company) controls around 25% of mining powers through ownership of 2 large mining pools. Source: BTC.com (last 12 month) © Valiante Diego – 46  Types of blockchains and key operators © Valiante Diego – 47  Types of Blockchains Source: Zheng et al. 2016 © Valiante Diego – 48  Key actors/gatekeepers Digital wallet providers – Hot (software) and cold (hardware) wallets Trading platforms – Centralised platforms (hold and control client’s assets [private keys], often off chain) vs decentralized platforms (on chain settlement directly between peers) Exchanges – To exchange cryptos or to convert in fiat currencies Miners and nodes (distributed consensus) – To ensure validation and to mine new blocks Others – Credit referencing agencies, auditing companies, media influencers, etc © Valiante Diego – 49  Smart contracts, asset tokenisation and decentralised finance © Valiante Diego – 50  Layer 2 solutions Layer 2 (facultative) (scalability, additional functionalities like smart contracts; e.g. lightning network for BTC] Layer 1 (mandatory) (transaction execution, consensus; e.g. Bitcoin & Ethereum) Layer 0 (facultative) (security, framework, interoperability; e.g. Polkadot) © Valiante Diego – 51  Smart contracts © Valiante Diego – 52  Smart contracts and tokens A ‘contract’ is a promise or performance given in exchange for promise or performance (Lessig) Contracts can be ‘dressed’ in many ways, including computer coding, as long as (in civil law) they have: 1. Object, (the specific obligations/rights in the contract) 2. Cause, (interest pursued by the parties with a contract) 3. Consent, and (binding agreement, also expressed by an action) 4. Form (where required by statutory law). Under US (common) law that would be offer, consideration [exchange for], consent. No specific form is statutorily required. Signature with private key is a valid offer and acceptance in the US. © Valiante Diego – 53  Smart contracts and tokens ‘Smart’ contracts, i.e. encoded computer codes representing a contract executed directly on the chain, needs to code all potential future contingencies (e.g. low probability events). – They can include a ‘go to court’ code line, but you still need to include all possible events that can lead to this option (e.g. from oracles). – With low specification costs (including verification costs of information determining the triggering of code lines; e.g. vending machine), smart contracts could be the best solution for their autonomy, safety, speed and accuracy. – With high specification costs (including verification costs) the ‘obscurity’ (e.g. ‘force majeure’ or ‘good faith’) of incomplete contracts is a value. © Valiante Diego – 54  Some Smart Contracts Ecosystems 1. Ethereum → by far the largest 2. Binance Smart Chain 3. EOS 4. Bitcoin 5. NEO 6. Stellar 7. Tezos 8. Solana 9. Cardano 10. Polkadot © Valiante Diego – 55  Potential risks with smart contracts Inability to foresee all future contingencies, which have to be coded. Currently there is no clear way to create the ambiguity needed for low probability future events that need to be resolved by Courts. Coding errors can lead to irreversible processes. Liquidity is shallow for non-native tokens and risk of frauds are high. © Valiante Diego – 56  Asset tokenisation © Valiante Diego – 57  What is a token? Tokens are digital assets that are recorded on a distributed ledger and can be transferred without an intermediary, and the structuring of the issuance, the pricing of the offer, and the distribution of these instruments do not [necessarily] involve the participation of any regulated entity such as, for example, an investment bank. (Gurrea-Martinez and Remolina Leon in Brummer 2019) © Valiante Diego – 58  What is a token? (2) Tokens can be classified in different ways and can certainly be a security/financial instrument, e.g. stocks (see next slides). Three main groups of tokens: 1. Coins (crypto asset; e.g. utility token) 2. Securities tokens 3. Tokenised securities Tokens are offered in an Initial Coin Offering and often through the use of a smart contract code. © Valiante Diego – 59  An Initial Coin Offering (ICO) Source: https://ico.readthedocs.io/en/latest/ © Valiante Diego – 60  An Initial Coin Offering (ICO) ‘Initial coins’ were usually issued before being functional. An ICO is typically sold as a utility instrument (no explicit rights to the ownership or the future cash flows of a firm/project), which does not warrant the same regulatory framework available for securities. Consideration is expressed in a cryptocurrency value (and not necessarily in fiat currency). Proceeds are typically used to develop an idea (ICO rating estimated it at 76% in 2018). Development of the idea is centralised. Promoters allocate to themselves part of the ‘newly minted’ coins. Tokens are typically fungible and fully transferable. Scarcity is created by monetary policies set ex ante (so called, ‘tokenomics’) © Valiante Diego – 61  ICOs (2016-2022) 8000 1400 7000 1200 6000 1000 5000 800 4000 600 3000 400 2000 1000 200 0 0 2016 2017 2018 2019 2020 2021 2022 Funds Raised ($mn) ICOs Published (rhs) Source: ICO Bench © Valiante Diego – 62  Biggest ICOs (2016-2019) © Valiante Diego – 63  A ’boom and bust’ in 2018 40% of all ICO destroyed value on the first trading day (Momtaz 2020) After the 2008 boom, Haffke and Fromberger (2020) found that: 1. After 30 days, only 30% of ICOs were above issuance price 2. After 180 days, 17.2% of ICOs were above issuance price 3. In July 2020, only 12% were above issuance price and 65% lost between 80 and 100%. © Valiante Diego – 64  Security Tokens Offering or Tokenised securities Security token (ST) vs Tokenised securities (TS) – ST are token designed with features resembling a security (key regulatory focus) → see next section – TS are tokens representing a digital wrapper of existing securities An STO clearly identifies the token as a security and therefore treats it as a regulated instrument. From dematerialisation (bookkeeping entries) to tokenisation (smart contracts). © Valiante Diego – 65  Top Securities Tokens Offerings The EIB completed the issuance of digital green bonds (through ETH network. © Valiante Diego – 66  Asset tokenisation (real world assets) Physical and dematerialised (financial and non-financial) assets’ representation on the blockchain. © Valiante Diego – 67  Decentralised finance (DeFi) © Valiante Diego – 68  Decentralised finance (DeFi) vs Traditional finance (TradFi) “Decentralised finance” (DeFi) is a general concept that refers to a range of applications in the crypto-asset space that seek to disintermediate the provision of financial services through reliance on self-executing computer code (“smart contracts”) [instead of financial intermediaries]. (Aquilina et al. 2023) – Blockchains – Smart contracts – DeFi protocols (combination of smart contracts and conditions; it creates the service, whether asset management pooling to invest in other projects or staking tokens for a return, ‘farming’) – Dapps (graphical interfaces for users to interact with protocols) Transactions can also directly connect issuer to investor (e.g. the token can be configured to issue dividends, share profits, voting rights etc) © Valiante Diego – 69  Decentralised Finance (DeFi) market Source: CoinGecko © Valiante Diego – 70  Additional references Nick Szabo (1994), Smart Contracts https://bit.ly/3hYmAZm 1996, Smart Contracts: Building Blocks for Digital Markets https://bit.ly/3fte57g ‘A next generation smart contract and decentralized application platform’ Ethereum What are smart contracts?, Cryptopedia https://www.gemini.com/cryptopedia/crypto-smart-contracts- explained © Valiante Diego – 71  A legal taxonomy of means of exchange and negotiable instruments © Valiante Diego – 72  1. Means of exchange © Valiante Diego – 73  Money Money is the most popular mean of exchange. It can be public (fiat) or private. Economic PHYSICAL Function CHARACTERISTICS Mean of - Acceptable (easy to exchange) payment - Portable Store of - Scarce value - Durable Unit of - Divisible account - Fungible © Valiante Diego – 74  Key legal definitions to establish the legal nature of a token (1) 1. ‘Legal tender’ (public), Commission Recommendation n. 2010/191/EU, has three characteristics: a. Mandatory acceptance (The creditor of a payment obligation cannot refuse euro banknotes and coins unless the parties have agreed on other means of payment) b. Acceptance at full face value (The monetary value of euro banknotes and coins is equal to the amount indicated on the banknotes and coins) c. Power to discharge from payment obligations (A debtor can discharge himself from a payment obligation by tendering euro banknotes and coins to the creditor) 2. ‘E-money’ (private), as defined by art. 2.1 Dir. 2009/110/UE, means electronically, including magnetically, stored monetary value as represented by a claim on the issuer, which is issued on receipt of funds for the purpose of making payment transactions (as def. in article 4.5 PSD2) and which is accepted by a natural or legal person other than the electronic money issuer. © Valiante Diego – 75  A taxonomy of ‘tokens’? BASELINE Money Security right Right in rem FIAT MONEY E-MONEY (public money; incl. (private money) CDBCs?) Mean of payment Mean of payment ‘Exchange’ purpose Claim on issuer at par (store of value) Mandatory acceptance Accepted by more Acceptance at full face than the issuer (but not value mandatory) Power to discharge Issued on receipt of payment obligations fiat currency Store of value (‘pegging’ and claim on issuer) Commission Recommendation n. Dir. 2009/110/UE 2010/191/EU AMLDDiego © Valiante 5 – 76  Central Bank Digital Currencies (CDBCs) © Valiante Diego – 77  ‘New’ fiat money Mark Carney on electronic currency (FT, 23 August 2019) “In the longer term, Mr Carney said the solution was to create a multipolar global economy rather than waiting for China’s renminbi to challenge the dollar. For this, he suggested more thought should be given to creating a global electronic currency that could act as “synthetic hegemonic currency... provided... perhaps through a network of central bank digital currencies”.” As of today, the attempt is to create CDBCs built on DLT (digital RMB) or DLT-ready (e.g. digital euro). If built on DLT, it will be issued on a permissioned blockchain. © Valiante Diego – 78  Macroeconomic rationales for CDBCs Monetary policies. The risk is about the effectiveness of monetary policies by central banks, as they will not be able to impact directly on the monetary base, as issuers of the fiat currency. The additional layer of intermediation over the key transmission channel of monetary policy is what can really make monetary policies less effective. As a result, there is a risk that conventional (e.g. official interest rates policies) and unconventional (e.g. asset purchases, like QE) monetary policies may have only a marginal impact on the macroeconomic variable of reference (e.g. nominal and real inflation rates and unemployment rate). Financial stability – Interconnectedness (contagion). The main concern would be if a significant crash caused losses of wealth that were large enough to affect consumer behaviour, or caused contagion through the financial system. How holders of VCs consume out of their perceived wealth and how much is built on leverage are crucial to determining the impact of a crash. – Illiquidity (run risk). If many investors want to withdraw their money from the virtual currency on a particular day, the exchange might struggle to meet the redemptions because they would struggle to sell off their basket of assets (in case of stable coins). © Valiante Diego – 79  Microeconomic rationales for CDBCs Consumer/Investor protection – Risk of stolen private keys. The DAO funds and other examples of private keys being stolen is growing fast. Market integrity – Money laundering risks. There is typically a high risk of money laundering associated with the lack of customer identification, the speculative pricing of VCs and the limited liquidity are some of the reasons why regulated institutions have refrained from getting involved in this asset class. The resellers that will ensure the conversion of fiat currencies into VCs will be the gatekeepers, i.e. the entities in charge of checking identity of the people transacting in VCs and check the origin of that transaction. The permissioned blockchain system may probably allow possibility to better trail the money. © Valiante Diego – 80  The rise of virtual currencies © Valiante Diego – 81  ‘Virtual currency’ baseline ‘Virtual currency’, as defined by art. 3.18 Dir. 2018/843 (AMLD 5), means a digital representation of value (UNIT OF ACCOUNT) that is not issued or guaranteed by a central bank or a public authority (no fiat), is not necessarily attached to a legally established currency and does not possess a legal status of currency or money, but is accepted by natural or legal persons as a means of exchange (MEAN OF PAYMENT) and which can be transferred, stored and traded electronically (STORE OF VALUE). Virtual currencies are a form of money and can include DLT- based native tokens (e.g. bitcoin)or non-native tokens, such as ‘stablecoins’ (e.g. USDT Tether). © Valiante Diego – 82  A taxonomy of ‘tokens’? BASELINE (for most tokens) Crypto asset (‘crypto-asset’ means a digital representation of value or rights which may be transferred and stored electronically, using distributed ledger technology or similar technology; art. 3.1.2 MiCAR) Money Security right Right in rem VIRTUAL CURRENCIES FIAT MONEY E-MONEY (private money; incl. native (public money) (private money) tokens or stablecoins) Mean of payment Mean of payment Mean of payment ‘Exchange’ purpose Claim on issuer at par (store of value) No mandatory Mandatory acceptance Accepted by more acceptance Acceptance at full face than the issuer (but not No claim on issuer (store value mandatory) of value?) Power to discharge Issued on receipt of Issued on receipt of fiat payment obligations fiat currency currency or crypto assets Store of value (‘pegging’ and claim on issuer) Commission art. 3.18 Dir. 2018/843 Recommendation n. Dir. 2009/110/UE (AMLD 5) 2010/191/EU art. 3.1.(6) &(7) MiCAR AMLDDiego © Valiante 5 – 83  Stablecoins © Valiante Diego – 84  The rise of stablecoins ($110 bn market cap; 7% tot.) Stablecoins are crypto assets that are (in theory) pegged to the value of an underlying fiat currency (or a combination of). A key function of a fiat currency is the ability to store value. They exist to build a bridge with the non-crypto financial system. In the non-crypto financial system, stabilisation can be mainly done in two ways: 1. Face value of the banknote (legal tender) 2. Pegging to a currency or to other assets, often combined with a legal claim on the issuer Different types of ‘stabilisation’ for crypto tokens (FCA Guidance 2019): 1. Fiat-backed → tokens backed by fiat currency, either a basket or a 1:1 peg to a single currency (e.g. Tether, BUSD, etc) 2. Crypto-collateralised → tokens backed with a basket of cryptoassets with the aim of spreading risk and reducing price volatility 3. Asset-backed → tokens backed with tangible or intangible assets with economic value 4. Algorithmicly stabilised → tokens stabilised through algos that control the supply of tokens to influence price. They either have no collateral or are partially collateralized by the native token (e.g. sUSD or UST) or they have a floating peg (RAI, FLOAT). © Valiante Diego – 85  The rise of the Stablecoins © Valiante Diego – 86 © Valiante Diego – 87  Tether and the USD peg Source: www.kaiko.com © Valiante Diego – 88  Most algo-stablecoins have failed to keep the peg © Valiante Diego – 89 © Valiante Diego – 90  2. Negotiable instruments © Valiante Diego – 91  Key legal definitions to establish the legal nature of a token (2) 3. ‘Transferable security’, as defined by art. 4.1(44) Dir. 2014/65/UE, means those classes of securities which are negotiable on the capital market, with the exception of instruments of payment. […] any other securities giving the right to acquire or sell any such transferable securities or giving rise to a cash settlement determined by reference to transferable securities, currencies, interest rates or yields, commodities or other indices or measures; © Valiante Diego – 92  ‘Security’ definition (EU) Transferable securities are not ‘instruments of payments’, but can be held in custody (bearer instruments). Non-transferable securities that are not included in annex I.C MiFID 2, as ‘financial instruments’, are left to national law. The assessment of whether a crypto asset is a transferable security can be broken down in two parts: A. Three criteria (art. 4(1)(44), MiFID 2): 1. Standardisation (fungibility/homogeneity) – All tokens of that class/issuer share similar rights and obligations 2. Transferability (assigned to another person; statutory or technical restrictions) 3. Negotiability on capital markets (secondary markets, like RMs and MTFs or even cryptoexchanges) B. Plus, the law refers to a list of examples of such securities, which include shares and bonds. To affirm, the typical rights of an investment (profits, ownership and control). The general approach is to look for similar rights to existing classes of transferable securities or financial instruments. © Valiante Diego – 93  Key definitions when assessing the legal nature of tokens (money or money-like) (3) 4. Other financial instruments – (2) Money-market instruments (e.g. treasury bills, certificates of deposit and commercial paper); – (3)Units in collective investment undertakings; CONTRACTS – (4)Options, futures, swaps, forward rate agreements and any other derivative contracts relating to securities, currencies, interest rates or yields, emission allowances or other derivatives instruments, financial indices or financial measures which may be settled physically or in cash; – (5)Options, futures, swaps, forwards and any other derivative contracts relating to commodities that must be settled in cash or may be settled in cash at the option of one of the parties other than by reason of default or other termination event; – (6)Options, futures, swaps, and any other derivative contract relating to commodities that can be physically settled provided that they are traded on a regulated market, a MTF, or an OTF, except for wholesale energy products traded on an OTF that must be physically settled; – (7)Options, futures, swaps, forwards and any other derivative contracts relating to commodities, that can be physically settled not otherwise mentioned in point 6 of this Section and not being for commercial purposes, which have the characteristics of other derivative financial instruments; – (8)Derivative instruments for the transfer of credit risk; – (9)Financial contracts for differences; – (10) Options, futures, swaps, forward rate agreements and any other derivative contracts relating to climatic variables, freight rates or inflation rates or other official economic statistics that must be settled in cash or may be settled in cash at the option of one of the parties other than by reason of default or other termination event, as well as any other derivative contracts relating to assets, rights, obligations, indices and measures not otherwise mentioned in this Section, which have the characteristics of other derivative financial instruments, having regard to whether, inter alia, they are traded on a regulated market, OTF, or an MTF; – (11) Emission allowances consisting of any units recognised for compliance with the requirements of Directive 2003/87/EC (Emissions Trading Scheme). © Valiante Diego – 94  A taxonomy of ‘tokens’? BASELINE (for most tokens) Crypto asset (‘crypto-asset’ means a digital representation of value or rights which may be transferred and stored electronically, using distributed ledger technology or similar technology; art. 3.1.2 MiCAR) Money Security right Right in rem VIRTUAL CURRENCIES SECURITY/FINANCIAL FIAT MONEY E-MONEY (private money; incl. native INSTRUMENT/TOKENISED (public money) (private money) tokens or stablecoins) SECURITY Investment (promise of Mean of payment Mean of payment Mean of payment financial return) ‘Exchange’ purpose Claim on issuer at par (store of value) No mandatory Rights and obligation Mandatory acceptance Accepted by more acceptance (control or profits) Acceptance at full face than the issuer (but not No claim on issuer (store Standardised value mandatory) of value?) Tradeable on capital Power to discharge Issued on receipt of Issued on receipt of fiat markets payment obligations fiat currency currency or crypto assets Transferable Store of value (‘pegging’ and claim on issuer) Commission art. 3.18 Dir. 2018/843 Dir. 2014/65/UE (annex Recommendation n. Dir. 2009/110/UE (AMLD 5) I.C) 2010/191/EU art. 3.1.(6) &(7) MiCAR National laws © Valiante AMLDDiego 5 – 95  ‘Security’ definition (EU) – Open questions Can profit expectation from exit through systematic secondary market activity (not simply theoretical negotiability) suffice, if the token also meets the three criteria? – No, according to prevailing interpretation of what is a security in a majority of EU Member States (ESMA survey 2018). Can the way a token is represented (marketed), by creating an expectation of profit or of the existence of any right or profit sharing, ultimately lead to classify that token as a security? Can ‘burning’ tokens (deflationary models) or redistribute them, de facto create a financial right (participation to the profits/revenues from burning)? © Valiante Diego – 96  A taxonomy of ‘tokens’? BASELINE (for most tokens) Crypto asset (‘crypto-asset’ means a digital representation of value or rights which may be transferred and stored electronically, using distributed ledger technology or similar technology; art. 3.1.2 MiCAR) Money Security right Right in rem VIRTUAL CURRENCIES SECURITY/FINANCIAL FIAT MONEY E-MONEY (private money; incl. native INSTRUMENT/TOKENISED UTILITY TOKEN (public money) (private money) tokens or stablecoins) SECURITY Investment (promise of Mean of payment Mean of payment Mean of payment Mean of exchange financial return) ‘Exchange’ purpose Claim on issuer at par (store of value) No mandatory Rights and obligation Mandatory acceptance Accepted by more Access to a good acceptance (control or profits) Acceptance at full face than the issuer (but not or service available No claim on issuer (store Standardised value mandatory) on DLT of value?) Tradeable on capital Power to discharge Issued on receipt of Accepted by the Issued on receipt of fiat markets payment obligations fiat currency issuer of the token currency or crypto assets Transferable Store of value (‘pegging’ and claim on issuer) Commission art. 3.18 Dir. 2018/843 Dir. 2014/65/UE (annex Recommendation n. Dir. 2009/110/UE (AMLD 5) I.C) Art. 3.1(9) MiCAR 2010/191/EU art. 3.1.(6) &(7) MiCAR National laws © Valiante AMLDDiego 5 – 97  TO SUM UP → ‘Digital Financial Assets’ (DFAs) Digital financial assets (DFAs) are digital representations (data in binary form stored on a computer or on the internet) of values that may or may not have the legal status of legal tender. They can be used either as a mean of exchange accepted by certain natural or legal persons (e.g. emoney) or can be used for investment purposes (giving right to a financial return) and can be traded, transferred and stored electronically (e.g. dematerialized securities). 1. Non-DLT based – E-money – Dematerialised securities (bookkeeping entries) – Other (digital fiat money, such as non-DLT CDBC? Digital euro?) © Valiante Diego – 98  TO SUM UP → ‘Digital Financial Assets’ (DFAs) (2) 2. DLT-based 1. Cryptocurrencies (native token, typically payment token) 1. Native token (Bitcoin, Ether, etc) 2. Fork native token (Bitcoin Cash, Ethereum Classic, etc) 2. Non-native tokens (on smart contracts platforms; often DeFi (Decentralised Finance) for Dapps (Decentralised applications, such as ERC20, BEP20, TRC20, etc) Securities tokens (e.g some stablecoins or DeFi tokens) or Tokenised securities Other crypto assets (non-qualifying as ‘security’) 1. Asset-referenced tokens (e.g. some stablecoins) → see section on MiCAR 2. E-money token (e.g. some other stablecoins) → see section on MiCAR 3. Utility tokens » Tokens that provide the right to use or to enjoy something (for platform specific services, playing games, NFTs, etc) 3. Central Bank Digital Currency (CBDC; permissioned) © Valiante Diego – 99  Some examples of unregulated tokens (FCA 2019) a. Filecoin (FIL) is a decentralized storage network that turns cloud storage into an algorithmic market. Filecoins can be spent to get access to unused storage capacity on computers worldwide. Providers of the unused storage capacity in turn earn filecoins, which then can be sold for cryptocurrencies or fiat money. (ESMA survey 2018) b. Crypterium (CRPT) aims to build up a “cryptobank” with vertically integrated services. It claims to be faster and less costly than existing banking solutions and stresses its international scaling opportunities. The crypto-asset sale ended in January 2019 and raised USD 51m from 68,125 crypto-asset purchasers. The crypto-assets may be used to pay for transaction fees when using the services of the cryptobank. In addition, they grant the right to receive a monthly share of the revenues derived from the transactions. In addition, services not known yet might be available to crypto-asset holders at a cheaper price or for free in the future. Crypto-asset holders are also granted ‘priority treatment’ (although the white paper does not specify what this priority treatment would entail). (ESMA survey 2018) c. A firm running an online casino issues tokens that allow players to play their games and to vote on which games to adopt by the platform (with no obligation for the platform to comply). No additional rights. d. A car company issue a token that gives a one hour test drive. This token can be sold in secondary market, but it does not give any additional reward or right than just one hour test drive. © Valiante Diego – 100  Key definitions when assessing tokens CBDC (legal Legal tender?) tender/cash Utility tokens E-money (real assets) 4. Transferable securities Stablecoins and 3. Financial other unclassified instruments (MiFID) cryptoassets 2. Financial products Cryptocurrencies (intangibles) Deposits and Securitised instruments 1. (Digital) Financial Assets (FAs) © Valiante Diego – 101  What then for token classification and applicable law? © Valiante Diego – 102  What then? Securities tokens or tokenised securities are captured under existing frameworks (e.g. MiFID 2). For all the rest, regulators and supervisors are leaning towards a case-by- case assessment of crypto assets (DLT-based). More generally: a. Stablecoins → no claim on issuer or agreed investment policy (not a security; US SEC disagrees) b. Native (decentralised) tokens → no identifiable issuer (e.g. Bitcoin, Ether) → commodity in the US c. Utility Tokens → ownership over a product or other physical asset or right to a service, but no financial return Speculative use is insufficient to define a security d. Non-Fungible Token (NFT) → tokenised proof of title to a unique digital version of (unique hash verifiable on DLT) a specific digital (e.g. image) or physical asset (e.g. paintings) → lacks fungibility to be a security More broadly, a utility token (right in rem) or other unregulated tokens generally lack the financial rights that are parts of an investment (e.g. control or profit over a project or company) or a mean of payment (e.g. largely accepted by other entity than the issuer). → It’s a more formalistic approach → The US regulator tends to classify most crypto assets as a security (going towards making it a presumption that reverses the burden of proof) © Valiante Diego – 103  Applicable legislation for securities tokens or tokenised securities Prospectus Regulation (OK) – Publication of prospectus with info on issuer and securities Transparency Directive (NO) – Limited to admission to trading on Regulated Markets Markets in Financial Instruments Directive and Regulation (OK) – Key services are placing, dealing on own account, operating MTF/OTF – Capital requirements, organisational requirements, trade and transaction reporting? – ”Responsible operator’ in a decentralised platform? Market Abuse Directive and Regulation (OK) AIFMD (for tokens qualifying as units of collective investment schemes) Settlement Finality Directive, CSDR and FCD – Is this a ‘system’ and who is the ‘system operator’ in a decentralised consensus- based infrastructure? Is it different for permissioned DLT networks? – Nature of securities account and book-entry methods are still defined nationally and so they may not be able to capture DLT uses – Safekeeping services need to be further defined ESMA’s preliminary view is that “having control of private keys on behalf of clients might be regarded as safekeeping services and that rules to ensure the safekeeping and segregation of client assets should apply to the providers of those services.” © Valiante Diego – 104  Financial instruments tokens – Applicable legislation AMLD 5 (custodian wallet providers and fiat-virtual currency exchanges are in scope) includes: – Registering themselves with complete ownership structure – KYC rules identifying the customer and verifying the customer’s identity identifying the beneficial owner and taking reasonable measures to verify that person's identity – Customer due diligence conducting ongoing monitoring of the business relationship including scrutiny of transactions undertaken throughout the course of that relationship – Each EU member country is obliged to Maintain a “Register of Ultimate Beneficial Owners” (UBOs) that will contain information of the beneficial owner. Registers of UBOs are to be made publicly accessible, and inter-connected at pan-EU level for exchange of information to strengthen their UBO verification mechanisms. Maintain a PEP List of prominent politically exposed public functions to make easier for smaller compliance teams or SMBs, to identify PEPs while screening risks. Maintain centralised registries or electronic data retrieval systems to identify entities holding or controlling payment accounts, bank accounts, and safe-deposit boxes. © Valiante Diego – 105  The emerging regulatory framework for DLT-based finance: EU vs US © Valiante Diego – 106  Key features of the new EU framework for crypto assets, DLT infrastructure and cybersecurity © Valiante Diego – 107  EU regulatory approach – Key principles Keep calm and carry on! The European Commission launched a consultation back in April 2017 on how to use FinTech to create a more competitive and innovative European financial sector. It established three principles: 1. Regulation should be technology-neutral, i.e. same service same risk same rule (functional approach). 2. Regulation should be proportional, i.e. considering the complexity and size of the business model. 3. Regulation should be integrity-enhancing (operational), i.e. increasing transparency without creating unwarranted risks (e.g. market abuse, cybersecurity issues) …and four key objectives: 1. Fostering access to financial services for citizens and businesses 2. Bringing down operational costs and increasing efficiency 3. Making the Single Market more competitive 4. Balancing data sharing and transparency with data protection © Valiante Diego – 108  The limits of ‘tecnological neutrality’ 1. ‘Decentralised’ infrastructures makes more difficult to identify the responsible legal or natural person – Organisational requirements on new gatekeepers, like fiat-virtual exchanges or digital wallet providers 2. Cybersecurity to deal with infrastructural issues 3. Open access to data (open banking) to overcome competition concerns © Valiante Diego – 109  Digital Finance Action Plan (DFAP) – September 2020 1. Regulation on Markets in Crypto-Assets (MiCAR), Reg. (EU) 2023/1114 (mainly stablecoins, utility tokens). 2. Regulation 2022/858 on a pilot regime for market infrastructures based on distributed ledger technology (DLTR). 3. An EU regulatory framework on digital operational resilience with a proposal for Regulation on digital operational resilience for the financial sector and an omnibus Directive amending several EU financial services legislations (DORA). – Regulation (EU) 2022/2554 and Directive (EU) 2022/2556 – Entered into force in January 2023 and will apply from January 2025. © Valiante Diego – 110  MiCAR – Key definitions Markets in Crypto-Assets Regulation (MiCAR) is mainly a regulation for stablecoins and utility tokens. Art. 3(1)(2) ‘crypto-asset’ means a digital representation of value or rights which may be transferred and stored electronically, using distributed ledger technology or similar technology; – §1(4) ‘asset-referenced token’ means a type of crypto-asset that purports to maintain a stable value by referring to the value of several fiat currencies that are legal tender, one or several commodities or one or several crypto-assets, or a combination of such assets; – §1(5) ‘electronic money token’ or ‘e-money token’ means a type of crypto-asset the main purpose of which is to be used as a means of exchange and that purports to maintain a stable value by referring to the value of a fiat currency that is legal tender; – §1(6) ‘utility token’ means a type of crypto-asset which is intended to provide digital access to a good or service, available on DLT, and is only accepted by the issuer of that token. © Valiante Diego – 111  MiCAR – Key definitions (2) Key difference with existing definitions: – No explicit claim on issuer (no rights?) – No explicit investment policy (MMF or alike) – Other crypto assets backing (undefined nature of investment or utility or donation) But the issuer exists… – §1(6)‘issuer of crypto-assets’ means a legal person who offers to the public any type of crypto-assets or seeks the admission of such crypto-assets to a trading platform for crypto-assets; – No issuance by natural persons allowed (made explicit condition in following articles). © Valiante Diego – 112  MiCAR – Key definitions (3) §1(8) ‘crypto-asset service provider’ (CASP) means any person whose occupation or business is the provision of one or more crypto-asset services to third parties on a professional basis; §1(9) ‘crypto-asset service’ (CAS) means any of the services and activities listed below relating to any crypto-asset: – (a)the custody and administration of crypto-assets on behalf of third parties; – (b)the operation of a trading platform for crypto-assets; – (c)the exchange of crypto-assets for fiat currency that is legal tender; – (d)the exchange of crypto-assets for other crypto-assets; – (e)the execution of orders for crypto-assets on behalf of third parties; – (f)placing of crypto-assets; – (g)the reception and transmission of orders for crypto-assets on behalf of third parties – (h)providing advice on crypto-assets; Title V (art. 53-75) discusses the sets of requirements for CASPs (incl. authorisation, prudential and organisational req., etc) © Valiante Diego – 113  MiCAR – SCOPE (art. 2) Only crypto assets that are not classified as: 1. MiFID financial instrument 2. Electronic money 3. Deposit 4. Structured deposit 5. Securitisation Exemption for targeted entities, like insurance companies and central banks. Selected articles exemption for credit institutions (mainly organisational and prudential) or MiFID investment firms providing ‘equivalent’ investment services (see table) MiCAR MiFID/R Operation of a trading platform for cryptos Operation of an MTF/OTF Exchange of crypto-assets for other cryptos or fiat Dealing on own account Execution of crypto orders on behalf of 3rd parties Execution of orders on behalf Placement with or without firm Placing of crypto assets commitment Reception and transmission of crypto orders Reception and transmission of orders Advice on crypto assets Investment advice © Valiante Diego – 114  MiCAR and Asset-referenced tokens (ARTs) (artt. 15-42) Asset-referenced tokens issuance/issuer must be authorised by the competent authority for offers or admission to trading on a trading platform for crypto assets – No authorisation if below €5 mn over past 12 months or addressed to qualified investors (art. 15 MiCAR; procedure in art. 19 MiCAR) Qualified investors are MiFID professionals and eligible counterparties (art. 2(1)(e) Reg. 2017/1129 on Prospectus) Authorisation shall include a white paper (including a summary) to be approved by the competent authority and reviewed when necessary. – Content (art. 17), for which the issuer is liable, includes: description of issuer’s governance arrangements, reserve assets composition, rights on referenced assets or alternative arrangements with CASPs (as explained in art. 35), a legal opinion that the ART is not a financial instrument, electronic money or (structured) deposit. © Valiante Diego – 115  MiCAR and Asset-referenced tokens (ARTs) (artt. 15-42) Key obligations for issuers of ARTs include: – Having reserve assets (art. 32) – Acting honestly, fairly and professionally in the best interest of ARTs holders (art. 23) – Disclosing rights granted to holders, including claim or redemption rights (art. 35)3 – Complaint handling (art. 27), Conflicts of interest procedures (art. 28), own funds (art. 31), etc Significant ARTs (art. 39), as classified by EBA, have additional obligations (e.g. custody, remuneration policies, capital surcharge, liquidity management, etc) – More than 2 million customers, €1bn value or market capitalisation, 500,000 transactions/€100m transactions per day, €1bn in reserve assets, and use in seven or more member states. – SARTs issuers are directly supervised by EBA © Valiante Diego – 116  MiCAR and E-money tokens (EMTs) (artt. 43-52) Mirrors requirements for ARTs, but – Pegging an EU currency means offering to the EU public – If provided by an e-money institution, it should be considered ‘e- money’ as per Directive 2009/110 – A claim on the issuer should be provided (art. 44), but no interests (art. 45). – Redemption at par (not later than 30 days) – Overall, similar obligation than for emoney – Issuers of Significant EMTs (SEMTs) will be under EBA’s direct supervision for some aspects (capital, remuneration, liquidity and so on), while remaining ones will be supervised by national authorities. © Valiante Diego – 117  MiCAR – Utility tokens and other crypto assets (art.4-14) No natural person’s issuance No application of rules (except the one of being a legal entity) for airdrops (for free tokens), NFTs, CAs created via mining, offers below to €1 million, offers to less than 150 persons per Member State, solely addressed to qualified investors (art. 4(2)). If not functional yet, public offer no longer than 12 months. No pre-approval for the white paper (art. 5(3))and no explicit civil liability for the issuer, even though it remains responsible for its content. Right of withdrawal (14 days) only if not listed on a trading platform for crypto assets and only for these tokens. © Valiante Diego – 118  What about trading platforms? © Valiante Diego – 119  Types of trading platforms under MiFID (ESMA Crypto Assets Advice, 2019 pp. 24-28) All subject to the classification of the token being traded as ‘financial instrument’ Centralised (off chain) vs decentralised exchanges (on chain) are crypto assets service providers. Platforms which would engage in trading of security tokens may fall under three main broad categories as follows: 1. Platforms with a central order book and/or matching orders could qualify as multilateral trading facilities; 2. Operators of platforms dealing on own account and executing client orders against their proprietary capital, would not qualify as multilateral trading facilities but rather as investment firms (e.g. OTF); and 3. Platforms that are used to advertise buying and selling interests and where there is no genuine trade execution or arranging taking place may be considered as bulletin boards and fall outside of MiFID II scope. © Valiante Diego – 120  Types of trading platforms under MiFID (ESMA Crypto Assets Advice, 2019 pp. 24-28) Examples of applicable requirements: – Capital requirements – Organisational requirements (e.g. business continuity arrangements, conflicts of interest procedures, objective criteria for order execution, circuit breakers) – Investor protection rules (e.g. info to clients and act in their best interest) – Access to the platform rules – Pre and post-trade transparency – Transaction reporting and record-keeping – Checks on members’ ability to trade, good repute and so on © Valiante Diego – 121  Source: CoinGEcko Cryptocurrency Report © Valiante Diego – 122  Source: CoinGEcko Cryptocurrency Report © Valiante Diego – 123  Source: CoinGEcko Cryptocurrency Report © Valiante Diego – 124  MiCAR – Crypto-Assets Service Providers (CASPs; art. 53 75) MiCAR MiFID/R 1. Operation of a trading platform for cryptos Operation of an MTF/OTF 2. Exchange of crypto-assets for other cryptos or fiat Dealing on own account 3. Execution of crypto orders on behalf of 3rd parties Execution of orders on behalf Placement with or without firm 4. Placing of crypto assets commitment 5. Reception and transmission of crypto orders Reception and transmission of orders 6. Advice on crypto assets Investment advice 2 → centralised exchanges? 1 → decentralised exchanges? Key requirements: – Authorisation (it can be a natural person; passporting regime included), prudential and organisational req, etc. – Specific ones for specific services (e.g. custody, platform operation, advice, etc) No third country regime. © Valiante Diego – 125  MiCAR – Other requirements Own (mirroring existing) Market Abuse framework (art. 76-80) Framework for competent authorities, ESMA and EBA (art. 81-91) – Minimum investigative powers and precautionary measures for CAs – Administrative measures and sanctions by CAs (art. 92-97) – EBA’s supervisory responsibilities and powers for significant ARTs and EMTs (art. 98-120) © Valiante Diego – 126  Open questions How do you deal with designation at national level of some crypto assets as transferable security, but not in all EU MS (risks of conflict)? Do decentralised exchanges fit the definition of trading platforms for cryptos? Is it the end for ‘meme coins’, created by natural persons? © Valiante Diego – 127  Other EU actions © Valiante Diego – 128  A DLT ‘Pilot’ regime © Valiante Diego – 129  Regulation for DLT market infrastructures (DLTR) – Pilot Regime 1. DLT MTF or… – Operated by investment firm or market operator under MiFID – It may also settle transactions (including finality) and provide safekeeping service in relation to the DLT securities on the DLT MTF (no CSD) But no direct designation under Settlement Finality Directive (Dir. 98/26/EC), as long as the DLT MTF defines “the moment from which transfer orders or other pre-identified instructions may not be revoked by a member, participant, issuer or client” → it would be suitable though! – Can admit to trading and settle DLT securities not recorded in a DLT CSD (if requested) 2. …a DLT securities settlement system (operated by CSD) – Settle transaction in DLT transferable securities against payment (DvP) Cap on size of admitted DLT securities (art. 3) – Shares (< €200 mn market cap) – Bonds (< €500 mn market cap) – No sovereign bonds Cap on size of DLT securities recorded in a given DLT CSD set at €2.5 billion, determined daily (art. 3). Regulation 596/2014 (MAR) applies. © Valiante Diego – 130  A Regulation on Cyber Resilience (for info) © Valiante Diego – 131  Regulation on Digital Operational Resilience for the financial sector (DORAR) (for info) The regulation covers all regulated entities in the financial sector, which make use of ICT risk management tools. They include: – Credit institutions – Insurance intermediaries – Payment institutions – Reinsurance intermediaries and – Electronic money institutions ancillary insurance – Investment firms intermediaries – Crypto-asset service providers – Institutions for occupational retirement pensions – Central securities depositories – Credit rating agencies – Central counterparties – Statutory auditors and audit – Trading venues firms – Trade repositories – Administrators of critical – Managers of alternative benchmarks investment funds and – Crowdfunding service providers management companies – Securitisation repositories – Data reporting service providers – ICT third-party service providers – Insurance and reinsurance undertakings © Valiante Diego – 132  DORAR key definitions and clusters of requirements (for info) “ To build, assure and review […] operational integrity from a technological perspective” (art. 3(1)) “ICT risk” includes any “malfunction, capacity overrun, failure, disruption, impairment, misuse, loss or other type of malicious or non-malicious event - which, if materialised, may compromise the security of the network and information systems” ICT risk management requirements (art. 5-14) ICT-related incident reporting (art. 15-20) Digital operational resilience testing (art. 21-24) ICT third-party risk (art. 25-39) Information sharing (art.40) Competent authorities (art. 41-49) © Valiante Diego – 133  The US approach: the ‘Howey Test’ © Valiante Diego – 134  The definition of ‘security’ 15 U.S. Code § 78c(a)(10) → 1933 Securities Exchange Act (10) The term “security” means any note, stock, treasury stock, security future, security-based swap, bond, debenture, certificate of interest or participation in any profit-sharing agreement or in any oil, gas, or other mineral royalty or lease, any