The Two-Class Regulatory System Plaguing Europe

The following is a guest post by Sebastian Heine, Director of Risk and Compliance in Northstake.

In the rapidly changing landscape of digital finance, the emergence of crypto assets has introduced unprecedented challenges and opportunities for regulators to provide proactive frameworks around the world. The European Union is the largest government body to do so through Cryptocurrency markets (MiCAR) regulation; however, it is now at a critical juncture, faced with the task of dealing with the complexities introduced by non-custodial crypto asset service providers.

Non-custodial cryptocurrency service providers, often operating in the decentralized finance (DeFi) industry, offer services related to crypto assets without actually taking custody of the assets themselves. These crypto asset service providers currently 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 prudential and business conduct framework for crypto-asset services, defines CAS providers as legal entities or other enterprises engaged in the professional provision of one or more crypto-asset services to clients. The regulation defines several types of crypto-asset services, including, among others, operating trading platforms, custody and administration of crypto-assets, and crypto-asset consultancy.

However, the current MiCAR definitions and provisions do not cover non-custodial crypto asset service providers. This omission highlights a critical gap in the EU regulatory framework, as the MiCAR definitions and interplay with other regulatory policies result in non-custodial crypto asset service providers not being required to comply with anti-money laundering or sanctions regulations, and therefore creating large gaps in terms of financial crime.

Without the obligation to operate and comply with EU Anti-Money Laundering (AML) or MiCAR regulations, these entities operate in a space where the risk of fraud, financial loss and illegal financial activity is significantly increased for investors and consumers.

Innovation before caution

The rise of non-custodial service providers in the crypto asset space is a testament to the innovative spirit of digital finance. However, this innovation has outpaced the pace of updating the current regulatory framework. For this reason, the European Union, with its commitment to consumer protection and financial stability, now faces the need to address these shortcomings.

The main debate is whether non-custodial providers should be subject to anti-money laundering regulations. The Financial Action Task Force (FATF) acknowledges the potential illicit risks associated with DeFi, while the EU proposal excludes these entities, leaving loopholes. Similarly, the European Banking Authority (EBA) guidelines also highlight the AML risks associated with crypto asset service providers (CASP) transactions.

The EBA highlights the risks associated with transactions involving transfers from or to self-hosted addresses, decentralized platforms or transfers involving cryptoasset service providers that are not authorized or regulated.

The MiCAR framework, while a cornerstone of the EU’s strategy for regulating crypto assets, focuses primarily on providers who hold client assets or operate under traditional financial models, and as such neglects a significant portion of the crypto asset ecosystem.

This highlights the urgent need for a more comprehensive and forward-looking regulatory framework, such as MiCAR 2 and an updated AML Regulation. These exclusions were made at the time to limit difficult-to-discuss topics such as DeFi regulation, but ultimately only delayed these discussions while failing to provide a path to compliance.

Paving a safe path

Cryptocurrency regulation is not a challenge unique to the European Union. It is a global endeavor that requires international cooperation 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 presented by this dynamic sector.

The European Commission is currently tasked with producing a report assessing the advantages and challenges of DeFi, which could potentially lead to future legislation. The move is part of a broader, cautious approach to regulating emerging cryptocurrency sectors, emphasizing understanding and market 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 anti-money laundering and risk management to protect consumers, but for now a two-class system remains.