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The Two-Class Regulatory System Plaguing Europe
The following is a guest post by Sebastian Heine, Chief Risk and Compliance Officer at Northstake.
In the rapidly evolving landscape of digital finance, the emergence of cryptocurrencies has introduced unprecedented challenges and opportunities for regulators providing proactive frameworks around the world. The European Union is the largest government body that has done this through the Cryptocurrency markets regulation (MiCAR); however, it is now at a critical stage, faced with the task of navigating the complexities introduced by non-custodian cryptocurrency service providers.
Non-custodial cryptocurrency service providers, often operating in the decentralized finance sector (DeFi) offer services related to cryptocurrencies without actually taking custody of them. These cryptocurrency service providers now 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 framework of prudential and commercial conduct for crypto-asset services, defines CAS providers as legal persons or other businesses engaged in the professional provision of one or more crypto-asset services to clients. The regulation outlines different types of crypto-asset services, including the operation of trading platforms, custody and administration of crypto-assets, and crypto-asset advice, among others.
However, the current MiCAR definitions and provisions do not include non-custodial cryptocurrency service providers. This omission highlights a critical gap in the EU regulatory framework as the definitions within MiCAR and the interconnection with other regulatory policies have the effect that non-custodial cryptocurrency service providers are not obliged to follow AML laws or sanctions and, therefore, creating large gaps for financial crime.
Without the obligation to operate and comply with EU anti-money laundering (AML) laws or MiCAR, these entities operate in a space where the potential for fraud, financial loss and illicit financial activity has significantly increased for investors and consumers.
Innovation before caution
The rise of non-custodial service providers in the cryptocurrency space is a testament to the innovative spirit of digital finance. However, this innovation has outpaced the speed at which current regulatory frameworks are updated. For this reason, the European Union, with its commitment to consumer protection and financial stability, now finds itself having to address these shortcomings.
A central debate is whether non-custodial providers should be subject to anti-money laundering laws. The Financial Action Task Force (FATF) acknowledges the potential illicit risks of DeFi, while the EU proposal excludes these entities, leaving loopholes. Similarly, the European Banking Authority (EBA) guidelines also highlight the anti-money laundering risks associated with Crypto Asset Service Providers (CASP) transactions.
Specifically, the EBA highlights the risks associated with transactions involving transfers to or from self-hosted addresses, decentralized platforms, or transfers involving unauthorized or regulated crypto-asset service providers.
The MiCAR framework, while a cornerstone of the EU strategy for cryptocurrency regulation, focuses primarily on providers that take custody of clients’ assets or operate under traditional financial models. As such, it neglects a significant part of the cryptocurrency ecosystem.
This highlights the urgent need for a more comprehensive and forward-looking regulatory framework like MiCAR 2 and an updated AML regulation. These exclusions were made at the time to reduce difficult-to-discuss topics like DeFi regulation, but ultimately only served to delay these discussions without providing a path to compliance.
Charting a safe path
Cryptocurrency regulation is not a challenge unique to the European Union. This is a global effort that requires international collaboration and harmonization of standards to effectively manage the risks associated with digital finance. Insights from 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 to assess the benefits and challenges of DeFi, which could lead to future legislation. This move is part of a broader, more cautious approach to regulating emerging cryptocurrency sectors, prioritizing market understanding and 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 AML and risk management for consumer protection, however, for now, the two-class system remains.