A Brief Introduction to Crypto-assets and their Regulation
By: Martin Hergovič
Tags: Regulation, Cryptoasset, Bitcoin, Cryptocurrency

In the course of last years and months, many people came across the terms cryptocurrency, Bitcoin or crypto-assets. The goal of this brief paper is to describe what a crypto-asset is, what different kinds of crypto-assets are currently known, and why are they different from digital money and the future EU project, the digital euro.

What are crypto-assets?

Crypto-assets represent a new separate category of assets different from fiat money, commodities, such as gold or securities. Their characteristics the new kind of asset class has been clearly and progressively set by European Banking Authority due to their specific nature as being private digital asset recorded in a distributed ledger, which can be used as a means of exchange and/or for investment purposes and/or to access a good or service, while not being guaranteed by a central bank or public authority, and therefore distinctive not only from fiat money but also different from commodities and securities as we know them today. In layman terms, crypto-assets, in general, are assets that exist only in digital format embodying various rights and obligations which its holder or rightful owner can exercise, and such execution of rights and/or obligations is forever recorded into the distributed ledger.

Currently, the most know crypto-asset is bitcoin (as a currency of Bitcoin network) which functions as a privately and digitally owned payment solution and as a store of value which took the media attention mainly during the 2017 price craze. Although Bitcoin originally considered to be a plaything for tech people, found other rivals operating on the crypto-asset scene, some with the updated use case, but others with use case significantly different from the original idea of pseudonymous Bitcoin creator — Satoshi Nakamoto. Firstly all the crypto-assets have been generally named as cryptocurrencies, based on the purpose of the first generation of crypto-assets such as Bitcoin, being the transaction medium and store of value. In the highest stage of Bitcoin fame, other types of crypto-assets appeared with aims to use the distributed ledger technology for other areas besides the use as money, such as storing information on supplier relations or others projects aiming even higher with goals being the new Internet.

Initially, all these other crypto-assets have been collectively named as altcoins, (as alternatives to Bitcoin’s currency). However, due to their variety, such denomination is no longer sufficient and alongside the rise of stablecoins (as privately tokenized fiat money) the clear taxonomy of various crypto-assets based on their distinctive functions and use cases can be established giving the market at least some level of necessary clarity.

Types of crypto-assets and their functions

Generally, the most known (and historically first) type of crypto-assets are cryptocurrencies named and categorized by their use as a payment method. However, currently there exist also other types of crypto-assets that possess other functionalities besides their potential to buy coffee for it. One of the other types of crypto-assets are utility tokens. Utility tokens in addition to their potential to be transacted (similarly like crypto-currencies), possess another utility function, e.g. right to use the network maintained by the issuer of such token. Ether, the second most valuable crypto-asset by market capitalization, belongs to this type of crypto-assets. For example Ether tokens might be used as a payment fee (“gas”) for use of the Ethereum network by the network users. The third type of crypto-assets — stablecoins aim to resolve the volatility of other crypto-assets (cryptocurrencies, utility tokens…) by pegging their to the value of another asset, typically fiat money such as the United States dollar and therefore are developed for transactional purposes only. The last known type of crypto-assets are security tokens, which deem to represent “tokenized” rights and obligations similar to those present in shares, ownership interests, or other kinds of securities.

In the last months, crypto-asset space gained a second breath by the combination of results of COVID-19 pandemic, economic stimulus packages, and fear of inflation. The most significant difference between current price escalation across the crypto-asset space and the 2017 mania is in the nature of todays investors. In contrast to the last bull run powered mainly by retail which wanted to get rich quickly, this year’s price gains are fueled in the majority by smart money, the professional investors, as an inflationary hedge. As crypto-assets historically transformed from being a toy to being a speculative investment vehicle to an underdog challenger to legacy monetary and financial systems, many regulatory questions are opening up.

Regulating crypto-assets and crypto-asset service providers

Even though crypto-assets are quite young asset class, in the course of their existence they have been quite strong regulatory head-scratchers. Initially due to their use in criminal activities such as payment device for the internet’s dark market or as a vehicle for money laundering. Later, as a new puzzle piece which should be regulated because of the increase of its significance in terms of price, volume, recognition, and therefore potential fiscal interests of governments. This coincided with a sequence of instances when and how authorities dealt with crypto-assets. One of the first major regulatory questions was taxation of income from crypto-assets, in which bitcoin has been famously cited in the famous Hedquist case. This regulatory input was later followed by the only uniform set of regulatory rules regarding activities in crypto-asset space embodied in AMLD 5, the fifth amendment of the Directive on prevention of the use of the financial system for the purposes of money laundering or terrorist financing.

Meanwhile, the core regulatory questions on nature, qualities of crypto-assets, and questions regarding the issuance of this new asset class and activities of subjects operating in this space have been overlooked or left for regulation on the level of EU Member States. This approach led to various viewpoints on crypto-assets across the whole EU from their classification as commodities, electronic money, or securities or in some more progressive jurisdictions, such as Malta or EEA member — Liechtenstein, crypto-assets fall under bespoke regulatory category tailored specifically for them.

Future of crypto-assets and use of distributed ledger technology by central banks

Luckily the regulatory landscape of crypto-assets is moving forward. The best example of the new regulation is a proposal of MiCA — Market in Crypto Assets Regulation which aims to unify the crypto-asset regulation on EU level and to provide the market participants much needed legal clarity, not only regarding classification of crypto-assets as an asset class but also necessary guidance and rules regarding the operation of business and investor protection rights in this novel field. Adoption of MiCA, as one of the most detailed pieces of regulation and its principles on crypto-asset regulation, may help propel the EU to the position of leader in this regulatory field and home to a multitude of innovative projects operating in the crypto industry. MiCA might bring light to the currently grey area of provision of crypto-asset services, but the more significant step which presumably has more power to change the daily lives of people around the EU is brewing around the European Central Bank’s project of digital euro that plans to embrace some of the functionalities of crypto-asset, namely distributed ledger technology, for purpose of creation of the digital equivalent of fiat cash money, as money suitable for the digital age, which would complement currently existing fiat payment methods of cash or card payments, and lead to faster transaction speeds, lower fees and even potential for their programming.

Therefore, the next installment of the digital revolution might be the way how we pay and use our money, be it central bank digital currencies or privately owned crypto-assets.

Sources: