Cryptocurrencies: the first regulations from CySEC

CySEC, one of the world’s leading financial regulators, issued its first cryptocurrency regulations at the end of November, specifically addressing the compliance of Cypriot Investment Firms (CIFs).

On November 25, 2020, the Cyprus Securities and Exchange Commission (CySEC), the Cypriot financial regulator, published Circular C417 on “Prudential Treatment of Crypto Assets and Enchantment of Risk Management Procedures Associated with Crypto Assets.” In this document, it formulated the first regulation regarding cryptocurrency.

Its aim is to provide Cypriot investments firms, the Cyprus Investment Firm better known by the acronym CIF, guidelines on the conduct of issues related to crypto assets, specifically:

1. Calculation of own funds and capital adequacy ratio (Pillar I)
2. Internal Capital Adequacy Assessment Process or ICAAP (Pillar II)
3. Disclosures (Pillar III)
4. Improved procedures for managing risks associated with cryptographic assets

Circular C417

The new rules set out in C417 are designed to protect the clients of Cypriot investment firms (CIFs) to ensure that they are provided coverage on cryptocurrency investments, which regulations currently do not distinguish from other types of investments. CySEC requests that particular attention is to be paid to the risks involving cryptocurrencies and that these are managed in the best possible way.

It will also be up to CySEC to authorize investment firms to be able to conduct transactions in cryptographic resources, once all appropriate safeguards have been received as there are currently no other safeguards in this regard.

The circular partially fills the legislative gap on this subject and allows CIFs to safely invest in cryptocurrency, after their funds and capital adequacy ratio have been calculated.

For CIFs that trade in crypto assets and/or financial instruments related to cryptographic assets, there is talk of reviewing the procedures in use and risk management strategies in order to ensure that all risks associated with this product are duly taken into account.

Strategies and processes should be subject to periodic internal review to ensure continuity in risk monitoring.

In addition, according to the circular, “considering the nature of cryptographic assets, CIFs should also consider adopting measures that minimize operational, cybersecurity and reputational risks.”

Some Key Points of the Circular: The Three Pillars

Calculation of own funds and capital adequacy ratio (Pillar I)

The European Banking Authority (EBA) is responsible for overseeing the European banking market. As noted in the EBA’s report on crypto assets, there are no precautionary measures in relation to cryptographic assets. Until a common application of the current rules is developed, CIFs will have to follow the guidelines of the CySEC regulation to calculate their funds and capital adequacy ratio.

Accordingly, under Circular C417:

1. A direct investment in cryptographic assets on a non-speculative basis (bank portfolio exposure) should involve activating a direct capital deduction from its own funds.
2. A direct investment in cryptographic assets on a speculative basis (trading book exposure) should be treated as an investment in a derivative product, subject to counterparty credit risk, i.e., a CIF should use the market-to-market method and apply a potential 10% percentage future exposure (PFE) and to commodity market risk.
3. In the case of a direct investment by CIF clients in cryptographic assets and/or financial instruments related to cryptographic assets, with the CIF acting as a counterparty to the transactions, the CIF is subject to counterparty credit risk and commodity market risk (risk of loss arising from adverse movements in commodity prices), as it acts as a market maker for its clients.

Internal Capital Adequacy Assessment Process: ICAAP (Pillar II)

According to the Internal Capital Adequacy Assessment Process (ICAAP), CIFs should assess the risks arising from trading in cryptographic assets and/or in financial instruments related to cryptographic assets, on their own or on behalf of their clients. The assessment and discussion of risks associated with trading in crypto assets should be accompanied by an analysis showing how the identified risks affect CIF projections. Additional capital should be held based on the identified risks.

Disclosures (Pillar III)

CIFs should disclose within their disclosures any significant crypto asset holdings and include information on:

• the amount of exposure of a crypto asset,
• the capital requirement for such exposures,
• the accounting treatment of such exposures.

Definition of Crypto Assets

CySEC has specified, for the purpose of Circular C417, and until further notice, that the term “cryptocurrency” will be referred to and understood as that included in the EBA report.

“A crypto asset qualifies as electronic money only if it meets each of the following requisites:

• it is stored electronically;
• it has monetary value;
• it represents a claim against the issuer;
• it is issued upon receipt of funds;
• is issued for the purpose of making payment transactions;
• is accepted by entities other than the issuer.”

CySEC and Cryptocurrencies

CySEC, staying true to its role as a financial regulator, began monitoring cryptocurrencies in 2018, when it became apparent that they were in fact more than a service for a select few and when blockchain technology began to show its full potential.

It subsequently amplified controls over cryptocurrencies, and related assets, by integrating EU anti-money laundering rules into Cypriot laws.

Even after Circular C417 was introduced, cryptocurrency investments continue to pose major risks to investors as the sector remains largely unregulated.

Currently, cryptographic platforms face strict Anti-Money Laundering (AML) rules, but CySEC had already announced that it wants to go beyond the requirements set out in the fifth directive, AMLD5, and enforce new activities that are not included under AML/CFT (Combating the Financing of Terrorism) obligations.

When it comes to AML legislation, the CySEC has put further regulation of cryptocurrencies on its agenda.

If this topic is of interest to you, or if you believe that your investments are not safe, do not hesitate to contact our Forex Litigation Department lawyers or any lawyer from Boccadutri International Law Firm. We can offer you advice and, should you need it, expert assistance.