MiCAR vs. MiFID II: A Comprehensive Guide to EU Crypto Regulations

The interplay between MiCAR (Markets in Crypto-Assets Regulation) and MiFID II (Markets in Financial Instruments Directive II) is crucial for understanding the regulatory treatment of crypto assets and crypto asset services in the European Union. This article examines the roles and interactions of MiCAR and MiFID II, particularly in the classification of crypto-assets and how firms already authorized under MiFID II can leverage their existing authorizations to offer crypto-asset services in the EU. Finally, it provides a concise comparative analysis of MiCAR and MiFID II with other global regulatory frameworks.

Understanding the Roles and Interaction of MiCAR and MiFID II 

MiCAR, or the Markets in Crypto-Assets Regulation, is a new regulatory framework in the European Union designed to provide clear legal guidelines for crypto-assets, their issuance, and related services. Its goal is to establish comprehensive rules for crypto-asset issuers and service providers, addressing aspects such as authorization, consumer protection, prudential requirements, and market abuse. As a regulation, MiCAR will be directly applicable in all EU member states once adopted, ensuring consistent rules across the entire EU.

MiFID II, or the Markets in Financial Instruments Directive II, is an established regulatory framework in the European Union that governs financial markets. Its objectives are to increase market transparency, improve investor protection, and enhance market integrity. MiFID II applies to traditional financial instruments and services, including trading venues, investment firms, and market operators. It includes rules on trading transparency, reporting requirements, and the conduct of investment firms. Unlike MiCAR, MiFID II is a directive, meaning it sets goals that all EU member states must achieve, but each country can decide how to incorporate these goals into their national laws, leading to some variation in implementation.

Both MiCAR and MiFID II are integral components of the EU's broader financial regulatory framework. Like other EU legislation, they naturally coexist and may apply simultaneously; however, one may take precedence over the other. Understanding the interaction between MiCAR and MiFID II is crucial, especially in determining whether certain crypto-assets fall under MiFID II rather than MiCAR. Additionally, it is important to know how existing MiFID II firms can leverage their current authorizations to offer crypto-asset services.

MiCAR and MiFID II: Delineation

MiCAR applies to (1) e-money tokens, (2) asset-referenced tokens, and (3) other crypto-assets (a catch-all category), unless they are exempt or fall under the existing regulatory framework in the EU. 

According to the principles of "same activities, same risks, same rules" and "technology neutrality," MiCAR targets only those crypto-assets not already regulated by existing EU legislation, particularly MiFID II. Article 2 of MiCAR outlines its scope, and paragraph 4 specifically lists the types of crypto-assets excluded from MiCAR. It states that MiCAR "does not apply to crypto-assets that qualify as [...] financial instruments as defined in MiFID II." 

Consequently, some crypto-assets, particularly those classified as financial instruments under MiFID II, are governed by existing EU financial services regulations. MiCAR does not apply to these assets as they continue to be governed by the corresponding framework, with a comprehensive set of EU rules already in place for their issuers and related activities. Understanding which crypto-assets could be classified as financial instruments under MiFID II is crucial, as this determines whether they fall under MiCAR or existing EU legislation.

Criteria for Classifying Crypto Assets as Financial Instruments

The European Securities and Markets Authority (ESMA) has been authorized to develop technical standards and guidelines to delineate the boundaries between MiCAR and MiFID II, particularly regarding the classification of crypto-assets. On January 29, 2024, ESMA published a consultation on this matter. The consultation outlines conditions and criteria for classifying crypto-assets as financial instruments, including categories such as:

(1) Transferable Securities, 

(2) Money-Market Instruments, 

(3) UCITs, 

(4) Derivative Contracts, and 

(5) Emission Allowances. 

These guidelines provide a structured yet flexible framework to determine whether a crypto-asset falls under the definition of a financial instrument according to MiFID II.

 Challenges In Interpreting MiFID II Criteria 

As previously mentioned, MiFID II is a directive, which means it sets goals that all EU member states must achieve, but each country has the flexibility to incorporate these goals into their national laws. This flexibility leads to some variation in implementation. When transposing MiFID II into their national laws, member states have not defined the term "financial instrument" in a fully harmonized manner. Some use a restrictive list of examples to define transferable securities, while others use broader, conceptual definitions. 

Consequently, there may be slight differences among National Competent Authorities (NCAs) regarding what constitutes a financial instrument. This lack of a common definition and shared criteria for all financial instruments complicates the adoption of a holistic approach in these draft guidelines and the establishment of a standardized test applicable to all types of financial instruments. 

Furthermore, MiFID II itself does not provide a one-size-fits-all definition for financial instruments. Instead, it delineates the concept through a list of instruments outlined in Annex I, Section C, rather than through a distinct set of conditions and criteria.

Guiding Principles for Classifying Crypto Assets

When classifying crypto-assets, it is essential to adhere to certain guiding principles:

Substance Over Form Approach: The classification of crypto-assets as financial instruments should be based on their specific characteristics and nature. To determine whether a crypto-asset qualifies as a transferable security or another type of financial instrument under MiFID II, one must consider its specific features, design, and associated rights. Each case should be assessed individually to legally qualify crypto-assets. This requires a “substance over form” approach, focusing on the actual substance of the asset rather than its form.

Technology Neutrality: The legal qualification of a product should not be determined by its technological wrapping. Instead, the economic reality of the asset should be the focus. When assessing a crypto-asset, it is important to set aside the technological aspects and analyze the asset and its features. Crypto-assets that qualify as financial instruments should be regulated as such, regardless of the technology used to create them. The application of financial market legislation should be independent of the technology or its type.

This is largely in line with the IOSCO Recommendations that emphasize the economic substance of a crypto-asset and its substitutability vis-à-vis traditional financial instruments, regardless of the crypto-asset's intended use case or purpose as described in its marketing or distribution materials.

Classifying Utility Tokens and NFTs as Financial Instruments

Importantly, according to the Consultation, utility tokens may also be regarded as financial instruments if: 

(1) a utility token gives financial rights that would be related to a company’s profits, capital, or liquidation surpluses, thus representing an ownership position in a company’s capital (e.g. unit of equity ownership in the capital stock of a corporation), 

(2) a utility token gives voting rights which would lead the investor to participate in the company's decision-making process (e.g. token giving the right to vote on matters of corporate policy making), 

(3) the sole objective is to participate in the performance of one or several underlying assets without directly investing in these assets, which is a feature of derivative contracts or units in collective investment undertakings. 

Merely calling a token a “utility” token or structuring it to provide some utility does not prevent the token from being a security.

While most NFTs are not considered financial instruments, they can be classified as such under specific conditions, particularly when structured or marketed in ways similar to traditional financial instruments. Therefore, when assessing and classifying crypto-assets, competent authorities and businesses should adopt a substance over form approach. This means the features of the crypto-asset should determine its classification, not its designation by the issuer.

Understanding Hybrid Tokens: Multiple Classifications

Some crypto-assets may fall under more than one legal classification. These "hybrid" tokens can combine multiple characteristics, components, and purposes (e.g., serving as a means of payment, utility, or investment) and may perform distinct functions after issuance. Hybridization of crypto-assets can occur at various stages of their lifecycle, either at creation or during their lifetime, making classification particularly challenging.

According to MiCAR, the primary factor for classifying a crypto-asset, including hybrids, is whether it exhibits characteristics of a financial instrument as defined in MiFID II. When a hybrid token displays features of a financial instrument, this characteristic should take precedence in its classification. Therefore, the classification process for hybrid tokens should prioritize their identification as financial instruments where applicable.

Providing CASP Services under MiCAR

Similar to MiFID II, crypto-asset services under MiCAR are defined through a list of specific activities. These activities include: 

(1) Providing custody and administration of crypto-assets on behalf of clients, 

(2) Operating a trading platform for crypto-assets, 

(3) Exchanging crypto-assets for funds, 

(4) Exchanging crypto-assets for other crypto-assets, 

(5) Executing orders for crypto-assets on behalf of clients, 

(6) Placing crypto-assets, 

(7) Receiving and transmitting orders for crypto-assets on behalf of clients, 

(8) Providing advice on crypto-assets, 

(9) Providing portfolio management for crypto-assets, 

(10) Providing transfer services for crypto-assets on behalf of clients.

Offering any of these services professionally requires authorization.

Authorization Requirements for Crypto-Asset Service Providers

A person must not provide crypto-asset services unless they are: a natural person, a legal entity, or another type of undertaking authorized as a crypto-asset service provider under MiCAR, or if they are a regulated entity such as a credit institution, central securities depository, investment firm, market operator, electronic money institution, UCITS management company, or an alternative investment fund manager permitted to provide crypto-asset services under specific conditions.

MiCAR allows firms already compliant with EU financial services legislation, such as Investment Firms under MiFID II, to offer crypto-asset services without requiring additional authorization. While these firms are treated as Crypto Asset Service Providers (CASPs) and must adhere to MiCAR's relevant rules, they are exempt from certain requirements like additional authorization and own funds because they are already subject to these regulations.

Leveraging MiFID Authorization for Crypto-Asset Services

These firms must notify their regulatory authority at least 40 days before beginning to provide such services for the first time.

In its Consultation Paper, ESMA considers notification adequate and sufficient, rather than an additional authorization process which could theoretically be limited to the new crypto-asset services. The rationale is that these financial entities are already strictly regulated and have the necessary infrastructure to provide financial services. Therefore, expanding the license through a new authorization is not deemed necessary or appropriate.

MiCAR stipulates that entities already authorized by the National Competent Authority (NCA) of their home member state do not need to undergo the entire authorization process again. Since these entities are already known to the NCA and much of the relevant information has already been accepted as adequate, there is no need to resubmit this information. However, information specific to the newly intended provision of crypto-asset services must still be submitted to the relevant NCA to allow for effective supervision.

MiCAR and MiFID: Equivalent Services

Organizations authorized under MiFID II will be allowed to operate under MiCAR without needing a MiCAR-specific authorization. However, MiFID firms are exempt from the authorization requirement only for the equivalent services they are already authorized to provide under MiFID.

MiCAR provides examples of MiFID activities that are considered equivalent:

• Safekeeping and administration of financial instruments for the account of clients under MiFID II is equivalent to providing custody and administration of crypto-assets on behalf of clients under MiCAR.
• Operating an Organized Trading Facility (OTF) or a Multilateral Trading Facility (MTF) under MiFID is equivalent to operating a trading platform for crypto-assets under MiCAR.
• Dealing on own account under MiFID is equivalent to exchanging crypto-assets for funds and other crypto-assets under MiCAR.
• Execution of orders on behalf of clients under MiFID is equivalent to executing orders for crypto-assets on behalf of clients under MiCAR.
• Reception and transmission of orders in relation to one or more financial instruments under MiFID is equivalent to reception and transmission of orders for crypto-assets on behalf of clients under MiCAR.
• Providing investment advice under MiFID is equivalent to providing advice on crypto-assets under MiCAR.
• Providing portfolio management under MiFID is equivalent to providing portfolio management for crypto-assets under MiCAR.

If a MiFID II firm wishes to offer crypto-asset services that are not equivalent to its current MiFID services, the firm will likely need to expand and modify its existing MiFID II authorization rather than apply for additional authorization under MiCAR.

Role of MiFID II Firms: Custody of Reserve Assets for Asset-Referenced Tokens (ARTs)

The reserve assets for asset-referenced tokens (ARTs) must be held in custody no later than five working days after the issuance date. However, the custody rules for the reserve assets depend on the type of assets held in reserve. If the reserve consists of financial instruments, they can be held in custody by a MiFID II investment firm that provides the ancillary service of safekeeping and administration of financial instruments for clients.

Regulating Decentralized Services under MiCAR and MiFID II

MiCAR exempts fully decentralized models from its regulatory scope (read more in our blog Is DeFi Truly Exempt from MiCA Regulations?). In contrast, MiFID does not offer such an exemption for fully decentralized crypto-asset services. The primary criterion for MiFID's applicability is whether a crypto-asset is classified as a financial instrument.

If a fully decentralized protocol provides custody services or facilitates the trading of crypto-assets that qualify as financial instruments, it engages in regulated activities under MiFID II. Consequently, such a protocol (or, ‘Responsible Person’) must obtain authorization as an investment firm.

While MiCAR's regulatory framework excludes fully decentralized models, MiFID II subjects them to regulatory oversight if they handle financial instruments. This creates a complex regulatory landscape where fully decentralized protocols might be regulated under MiFID II but not MiCAR, depending on the nature of the crypto-assets involved.

Comparing EU MiCAR with Global Regulatory Frameworks

United States

The relationship between the Howey Test and security tokens is fundamental in determining the regulatory treatment of these digital assets in the United States. The Howey Test originates from a 1946 U.S. Supreme Court case, SEC v. W.J. Howey Co., and it establishes a criterion for whether a transaction qualifies as an "investment contract," and thus would be considered a security under U.S. federal law. 

The Howey Test states that a transaction is an investment contract (and therefore a security) if it meets the following four criteria: 

(1) Investment of Money: There must be an investment of money or some other form of capital,

(2) Common Enterprise: The investment is in a common enterprise, meaning there is a pooling of money or assets, 

(3) Expectation of Profits: The investor has an expectation of profit from the investment, 

(4) Efforts of Others: The profit is derived from the managerial efforts of others, not the investor.

The U.S. Securities and Exchange Commission (SEC) issued Guidance where they provide a framework for analyzing whether a digital asset has the characteristics of an “investment contract.”

Switzerland

The FINMA will base its determination as to whether tokens qualify as securities on the following legal definitions. Securities in the sense of the Financial Market Infrastructure Act (FMIA) are: 

(1) standardized certificated, 

(2) uncertificated securities, 

(3) derivatives and  

(4) intermediated securities which are suitable for mass standardized trading.

FINMA also  treats asset tokens as securities. Asset tokens represent assets such as a debt or equity claim on the issuer. Asset tokens promise, for example, a share in future company earnings or future capital flows. In terms of their economic function, therefore, these tokens are analogous to equities, bonds or derivatives. Tokens which enable physical assets to be traded on the blockchain also fall into this category. Furthermore, if a utility token additionally or only has an investment purpose at the point of issue, FINMA will treat such tokens as securities.

United Kingdom

The FCA defines security tokens as tokens with specific characteristics that mean they provide rights and obligations akin to specified investments, like a share or a debt instrument as set out in the Regulated Activities Order (RAO). The FCA in Guidance on Crypto Assets Feedback and Final Guidance to CP 19/3 explicitly confirmed that these tokens fall within the existing regulatory perimeter.

Malta

The MFSA introduced a Financial Instrument Test with the objective to determine whether a DLT asset, based on its specific features, is encompassed under:

(1) the existing EU legislation and the corresponding national legislation, 

(2) the Virtual Financial Assets Act 

or (3) is otherwise exempt.

The Financial Instrument Test can be viewed here.

Conclusion

In conclusion, the regulatory landscape for crypto-assets in the EU is complex, with both MiCAR and MiFID II playing crucial roles. MiCAR establishes a comprehensive framework for crypto-assets not covered by existing EU legislation, ensuring consistent regulation across Member States. Meanwhile, MiFID II continues to govern traditional financial instruments, even those utilizing new technological formats. MiCAR’s substance over form approach to classifying crypto assets aligns with IOSCO Recommendations and is consistent with other regulatory frameworks, such as those in Switzerland and Malta, which emphasize the economic substance of the assets.

For firms already authorized under MiFID II, leveraging existing authorizations to offer equivalent crypto-asset services without obtaining new MiCAR-specific authorization is a significant advantage. This streamlined approach allows firms to efficiently expand their services while maintaining regulatory compliance.

As with any new regulation, practical issues are bound to emerge over time. It will be crucial for regulatory authorities to offer further guidance on distinguishing between crypto-assets under MiCAR and those governed by other frameworks, such as MiFID II, particularly in cases of conflict. This clarity is essential for the industry, as it will aid firms in understanding and navigating the complexities between MiCAR and MiFID II. Such guidance will enable firms to effectively manage their regulatory obligations and capitalize on opportunities within the evolving crypto-asset landscape.