Investment based crowdfunding and crypto assets – Challenges ahead

Crowdfunding Regulation

With the aim to overcome existing divergences in national frameworks on crowdfunding, in October 2020 the EU has adopted and published the long awaited final text of the Regulation on crowdfunding service providers (Regulation (EU) 2020/1503), the European Crowdfunding Service Provider Regulation “ECSPR”). The ECSPR provides a level-playing field for crowdfunding platforms in the EU, by introducing a harmonized set of rules that will be enable European crowdfunding service providers (CSPs) to explore the full potential of the EU single market.

The ECSPR covers two main types of practices used by crowdfunding platforms:

  1. Facilitation of granting loans (lending based crowdfunding)
  2. Placement of transferable securities within the meaning of Art. 4 para. 1 Nr. 44 MiFID II and/or instruments admitted for crowdfunding purposes that basically refer to shares in private limited companies that are not subject to restrictions that would effectively prevent them from being transferred (investment based crowdfunding)

Offers of financial instruments, either transferable securities or above-described instruments admitted for crowdfunding purposes under national law, of a single project owner whose total consideration is not exceeding 5.000.000 EUR will be eligible to be treated as crowdfunding offers and thereby will be exempted from more onerous requirements stipulated by EU and national rules on securities prospectus and securities issuing requirements.

The ECSPR will start to apply as of 10 November 2021. Crowdfunding service providers operating already under national regimes are provided with a 12-month transitional period within which they will have to ensure compliance with new rules.

Given that the ECSPR is primarily aimed to regulate crowdfunding service providers, the exact scope of application of the investment based crowdfunding in respective EU Member State can only be assessed based on relevant provisions of national law that implement MiFID II definition of transferable securities and define instruments that may fall under the definition of instruments admitted for crowdfunding purposes.

Investment based crowdfunding with crypto-assets – the new frontier?

In the wake of the ever increasing use of crypto-assets for fund raising, the legitimate question that can be raised is whether the crypto-assets can also be used for the purposes of fund raising in accordance with the new regime on investment based crowdfunding under the ECSPR.

Currently, most EU Member States do not stipulate de jure the possibility of issuing transferable securities via DLT or similar technology. However, majority of supervisory authorities across the EU tend to assess the legal status of each crypto-asset on a case by case basis by assessing its features based on various criteria like the level of standardization, tradability on financial markets etc.

  • Debt securities

In relation to crypto-assets with features of debt financial instruments (bonds, derivatives etc.) most supervisory authorities in the EU have taken pragmatic approach by assessing their legal status on a case by case basis and by treating them in accordance with applicable rules on issuance of financial instruments within the meaning of MiFID II. Nevertheless, there are also certain potential impediments to the issuance of debt transferable securities in tokenized form. These are particularly related to requirements under CSDR (e.g. requirement for transferable securities to be registered with CSD in book-entry form) as well as potential obstacles in national legislation like requirement for transferable securities to be represented in the form of a global certificate in physical form.

  • Equity securities

In addition to above mentioned challenges to tokenization of debt securities, the issuing of equity securities in tokenized form (in their literal meaning) has been prevented in most EU Member States due to open legal questions arising from company law that is barely harmonized at the EU level. Therefore, the possibility of using the new crowdfunding regulatory framework for the issuance and placement of equity based transferable securities depends largely on provisions of company law and securities law at national level. The recently published German Act on Electronic Securities (eWpG), which has for the first time allowed the issuing of securities in Germany in electronic or even crypto-form, is also one good example of how the issuing of tokenized shares can hardly be enabled by amendments of securities legislation. Due to related company law issues, German legislator has decided to make new provisions of eWpG solely applicable to debt instruments and units in investment funds, by leaving companies shares out of the scope of its application for the time being.

  • Reform of the MiFID II definition of financial instruments

With the intention to overcome the regulatory uncertainty around the application of MiFID II framework to crypto assets with features of financial instruments the European Commission has proposed in September 2020 a Directive that shall, among other, amend the MiFID II definition of financial instruments.

The new definition will be covering all types of financial instruments under MiFID II (including transferable securities) issued via DLT or similar technology as well. Due to the fact that MiFID II is a Directive, the revised definition will still need to be implemented into national law and currently significant divergences exist in national definitions of financial instruments across the EU. Last but not least, previously mentioned company law issues that prevent issuance of tokenized shares in many EU Member States and new laws on issuance of crypto-securities that fall short of covering all types of financial instruments in certain Member States (like in Germany) will represent challenges that will still need to be addressed. Until the new regime based on the expanded MIFID II definition becomes operational prospective the issuers of security tokens will still need to rely on national laws and the wide interpretative discretion of national supervisory authorities.

  • Instruments admitted for crowdfunding purposes

Looking into the issuing of instruments admitted for crowdfunding purposes (shares in private limited companies) in tokenized form, the picture doesn’t seems to be brighter either. The ECSPR stipulates explicitly that its definition and scope of application in relation to admitted instruments for crowdfunding purposes applies without prejudice to requirements under national laws that govern their transferability, such as the requirement for the transfer to be authenticated by a notary. To that end, EU Member States have a final say when it comes to deciding whether shares in private companies will be eligible to be used for crowdfunding purposes under the new regime. There is a fairly big chance that certain Member States will exclude shares in private limited companies from the scope of application of the new regime at national level by stipulating gold-platting provisions in national law. For instance, heavily criticized national transposition law in Germany, which was published in March this year, stipulates such an exclusion that will prevent shares in private limited companies of being used for crowdfunding offers under the new regime. Despite the fact that such measure would most probably just result in incorporation of fund raising SPVs in other EU jurisdiction (whose shares can still be offered on crowdfunding platforms anywhere in the EU) it cannot be excluded that some other EU Member State will follow similar approach.

Conclusion

Against the backdrop of everything mentioned above, it is fair to conclude that prospective fund raisers intending to leverage the new regime on crowdfunding as a less onerous regulatory framework comparing to regime under Prospectus Regulation will still largely need to ensure compliance with national laws in respective Member States from where they are intending to operate / set up an SPV for fund raising. The proposed EU Regulation on markets in crypto-assets (MiCAR) doesn’t seem to provide any further clarity to this topic either, because its scope of application will be limited solely to crypto assets that do not qualify as financial instruments under the MiFID II framework.

Therefore, despite the fact that the ECSPR has achieved significant progress in harmonization of rules on crowdfunding in the EU, there are still many challenges ahead that will need to be addressed before the crowdfunding as an alternative finance model starts to leverage DLT and crypto-assets in full capacity.


FinTech Action Plan and EBA Road Map: Part 3

As outlined in Part 1 and Part 2 of this series of posts giving updates on the European FinTech regulation agenda, there is a political will to create a comprehensive and harmonized regulatory framework for financial innovation within the Single Market. Part of the Road Map to a regulatory framework is a FinTech Knowledge Hub, which is meant to facilitate the exchange of information between European and national regulators, innovators and technology providers. The Knowledge Hub will foster a better understanding of the innovative landscape within the financial market.

Three and a half months after laying out its FinTech Road Map, EBA delivers first products that form part of the FinTech Knowledge Hub.

The two documents published on 3 July 2018 are reports on the impact of FinTech on incumbent credit institutions’ business models  and on the prudential risks and opportunities arising for institutions from FinTech . Both reports contain an analysis of the impact of FinTechs on the current financial landscape and aim to raise awareness within the supervisory community and the financial industry of potential prudential risks and opportunities from current and potential FinTech applications. EBA wants to convey an understanding of the main trends that could impact incumbents’ business models and pose potential challenges to their sustainability.

The first report, on the impact of FinTech on incumbent credit institutions’ business models, is an overview of the current market situation. It identifies four drivers for changes in current business models which are i. customer expectations and behaviour, ii. profitability concerns in the current low interest rate environment, iii. increasing competition and iv. regulatory changes such as PSD2 and GDPR. EBA identifies two main trends among the different digitalisation projects of the established institutions, namely digital transformation of internal processes and digital disruption by use of innovative technologies that aim to enhance customer experience. In the current FinTech ecosystem the prevailing model of interaction between FinTechs and incumbent institutions is one of collaboration and establishment of new relationships. In this way FinTechs can provide knowledge and ideas incumbent institutions have yet been too reluctant or too slow to establish themselves.

The second report, on prudential risks and opportunities arising for institutions from FinTech, is intended to raise awareness of and to share information on current and potential FinTech applications. The report focuses on seven use cases without making recommendations. The seven use cases are:

  1. Biometric authentication using fingerprint recognition,
  2. Use of robo-advisors for investment advice,
  3. Use of big data and machine learning for credit scoring,
  4. Use of Distributed Ledger Technology (DLT) and smart contracts for trade finance,
  5. Use of DLT to streamline Customer Due Diligence processes,
  6. Mobile wallet with the use of Near Field Communication (NFC),
  7. Outsourcing core banking/payment systems to a public cloud.

EBA focuses mainly on operational risk aspects, but also considers opportunities that may arise from the seven applications. The report is informative and provides a good overview for competent authorities and institutions alike of the current landscape and the inherent prudential risks that the market should be aware of.