Caveat Emptor - The risks of crypto-assets
03 May 2022
Bitcoin, Litcoin and Ethereum are just some of the better known cryptocurrencies. It is however estimated that there are more than 17,000 types of crypto-assets 1. Despite their increased use and appeal 2 , consumers need to be aware of the inherent risks related to said type of assets. To this end, the European Supervisory Authorities 3 (the "ESA") recently issued a notice regarding the risks surrounding crypto-assets.
I. What are crypto-assets?
Crypto-assets are "a digital representation of value or rights which may be transferred and stored electronically, using distributed ledger technology or similar technology." 4 Similarly, the Luxembourg Law of 12 November 2004 defines virtual currency as "[…] a digital representation of value that is not issued or guaranteed by a central bank or a public authority, is not necessarily attached to a legally established currency and does not possess a legal status of currency or money, but is accepted by persons as a means of exchange and which can be transferred, stored and traded digitally." 5
II. The risks associated with crypto-assets:
The ESA's notice warns consumers about the possible risks of losing their investments. Crypto-assets are deemed unsuitable for most retail consumers due to their risk and speculative nature. Moreover, misleading advertisements, including social media, have to be considered due to the absence of protection under the European Union's financial services rules.
In light of the above, the ESA indicated that consumers need to take into account (i) the possibility of losing their entire investment, (ii) the price volatility in a short time period, (iii) the prospect of being victim to a scam, fraud or other type of attack and (iv) the lack of rights or compensation, should there be a complication. For this reason, the ESA enumerates a series of questions, geared notably towards suitability, which consumers ought to consider before acquiring crypto-assets.
Furthermore, the ESA identified the following risks:
- Extreme price movements, particularly due to their speculative nature;
- Misleading information which implies that materials may be unclear, incomplete, inaccurate or even purposefully deceitful;
- The absence of protection under European Union laws as they are unregulated assets;
- The product's complexity;
- The fraudulent and malicious activities from third parties who attempt to scam consumers;
- The market manipulation, lack of price transparency and low liquidity; and
- The operational risks and security issues from possible cyber-attacks.
On 16 February 2022, the Financial Stability Board (the "FSB"), which coordinates at the international level the work of national financial authorities and international standard-setting bodies, issued a report on the risks relating to crypto-assets. It stated that "crypto-assets markets are fast evolving and could reach a point where they represent a threat to global financial stability due to their scale, structural vulnerabilities and increasing interconnectedness with the traditional financial system. The rapid evolution and international nature of these markets also raise the potential for regulatory gaps, fragmentation or arbitrage." 6 The FSB also shared the concerns raised by the ESA, inter alia, investor and consumer knowledge regarding these instruments 7.
III. What can we expect in terms of practice and regulation?
Given the absence of safeguards offered by bank deposits or other types of financial instruments coupled with the absence of legislation, the European Commission, in an attempt to provide an initial framework, submitted a proposal: Regulation of the European Parliament and of the Council on markets in crypto-assets 8, which has yet to come into force. It has four objectives: (i) legal certainty to implement a sound legal framework, (ii) the support of innovation which entails the establishment of a safe and proportionate framework, (iii) the implementation of adequate levels of consumer and investor protection as well as market integrity and (iv) financial stability. The concerns referred to in ESA's notice have been considered by the regulation as it states that issuers of crypto-assets, other than asset-referenced tokens or e-money tokens, shall notably (a) act honestly and fairly, (b) communicate clearly with the holders of crypto-assets, (c) prevent, identify and disclose any conflict of interest and (d) maintain their systems and security access protocols according to the applicable standards 9.
The concerns regarding misleading advertising have also been observed in the United Kingdom. Indeed, on 18 January 2022, Her Majesty's Treasury department announced that the government aims to adopt legislation which would address the misleading promotion of crypto-assets 10. According to the notice, it is estimated that around 2.3 million people in the United Kingdom own crypto-assets, but that this figure does not correlate with a complete understanding of said instruments.
The increasing rise of crypto-assets is also present in Luxembourg. On 29 November 2021, the Commission de Surveillance du Secteur Financier, Luxembourg's financial supervisory authority, issued notices on virtual assets 11. The notice provides a series of explanations regarding the use of virtual assets, inter alia, in the context of undertakings for collective investments. Interestingly, on 31 January 2022, the Luxembourg Stock Exchange admitted security tokens on a public distributed ledger technology in its Securities Official List 12.
While the European Union's proposal has yet to come into force, the regulation surrounding crypto-assets is definitely being considered by governments in an attempt to implement a sound legal framework given the current situation.
1. European Supervisory Authorities, "EU financial regulators warn consumers on the risks of crypto-assets", ESA 2022 15.
2. According to the Financial Stability Board's report "Assessment of Risks to Financial Stability from Crypto-assets", the market capitalisation of crypto-assets grew by 3.5 times in 2021 to $2.6 trillion.
3. The European Supervisory Authorities comprises the European Securities and Markets Authority, the European Banking Authority and the European Insurance and Occupations Pensions Authority.
4. Proposal for a Regulation of the European Parliament and of the council on markets in crypto-assets, and amending Directive (EU) 2019/1937, article 3(2).
5. Law of 12 November 2004 on the fight against money laundering and terrorist financing transposing Directive 2001/97/EC of the European Parliament and of the Council of 4 December 2001 amending Council Directive 91/308/EEC on prevention of the use of the financial system for the purpose of money laundering, article 1(20a).
6. Financial Stability Board, "Assessment of Risks to Financial Stability from Crypto-assets", 16 February 2022, p. 1.
7. Id.
8. Proposal for a Regulation of the European Parliament and of the council on markets in crypto-assets, and amending Directive (EU) 2019/1937.
9. Proposal for a Regulation of the European Parliament and of the council on markets in crypto-assets, and amending Directive (EU) 2019/1937, article 13(1).
10. HM Treasury, "Government to strengthen rules on misleading cryptocurrency adverts", 18 January 2022, online: <https://www.gov.uk/government/news/government-to-strengthen-rules-on-misleading-cryptocurrency-adverts>.
11. Commission de Surveillance du Secteur Financier, CSSF guidance on virtual assets, Virtual Assets-FAQ (UCIs and Credit institutions), updated on 4 January 2022, online: <https://www.cssf.lu/en/2021/11/cssf-guidance-on-virtual-assets/>
12. Luxembourg Stock Exchange, "LuxSE admits security tokens issued by Société Générale", online: <https://www.bourse.lu/pr-luxse-admits-security-tokens-by-societe-generale>; see also: Ashurst, "The Luxembourg Stock Exchange admits distributed ledger financial instruments (security tokens) on its SOL", online: <https://www.ashurst.com/en/news-and-insights/legal-updates/the-luxembourg-stock-exchanges-admits-distributed-ledger-financial-instruments-on-its-sol/>.
