The good, the bad and the ugly of the EU’s crypto rules

While United States regulators such as Securities and Exchange Commission Chair Gary Gensler make bad-faith claims that “there’s been clarity for years” when it comes to cryptocurrency, the European Union took real action in April when it passed the Markets in Crypto-Assets (MiCA) regulatory framework. While imperfect, it was a crucial move in the right direction for our industry and a signal to the U.S. that it will be left behind if it continues to stand still and rely on antiquated regulations.

Similar to how Bitcoin (BTC) took old technological, economic and financial concepts to build something new, regulators must rework existing regulatory and financial security frameworks to create a successful environment for participants. There are many useful and valid elements in our existing financial and regulatory frameworks.

On the other hand, there are many problems with the blockchain industry that the traditional regulatory framework does not address sufficiently — this leads to frustration and wasted resources as lawyers bicker over potential interpretations of statements instead of abiding by clearly defined legislation.

While Web3’s practical applications have shown great potential, it remains a remix of this traditional financial system — albeit a remix dedicated to improving efficiency, openness and fairness for all participants.

MiCA: A necessary but mediocre step forward for regulation

Despite the complex language around financial and securities regulations, the situation is really more simple than it appears. In short, our regulations attempt to prevent people from doing bad things to other people. Examples could include terrorists sending or receiving money to facilitate acts of terrorism or fraudsters making fraudulent claims to investors. It also includes ensuring that licensed individuals and entities are held accountable to a set of operating standards developed over the history of our modern financial markets.

In the more technical sense, the laws governing these operating standards are:

Anti-Money Laundering and Counter-Terrorist Financing laws
Securities and commodities laws
Market infrastructure regulation

Despite the SEC’s insistence that existing regulations cover these three issues broadly, many elements manage to fall through the cracks of these roughly 100-year-old definitions, rules and penalties. We can largely attribute that problem to two things.

One is the categorization of digital assets. Are they commodities or securities, or do they fall under an entirely new category? Digital tokens often exhibit characteristics of one, both or neither, creating a significant dilemma for existing frameworks.

*An overview of MiCA’s key points. Source: Circle*

The second is that the pace of innovation far outstrips the rate at which slow and sophisticated traditional finance regulatory frameworks can adapt. Governments have the responsibility of establishing regulations that are robust enough to prevent misconduct and protect stakeholders, yet flexible enough to accommodate the advancements promised by this burgeoning industry. How are these authorities supposed to compete with a smart contract that can be deployed in minutes and then upgraded that same day to have a completely different set of logic and parameters?

To those of us in this fast-moving industry, it is glaringly obvious that we need new regulations and guidelines that are compatible with the unique benefits and challenges Web3 offers.

MiCA constitutes one promising attempt, though the framework will struggle as the individual member-states of the EU test the framework in their native courts and build a patchwork example of cases with varied outcomes. That being said, here’s the good, the bad and the ugly of MiCA.

MiCA: The good

The best part of MiCA? Tighter rules and larger punishments for crypto asset service providers who lose customer funds! This is a longstanding issue within crypto where the exchanges and wallets have no liability when they are hacked or compromised and lose users’ funds, and has led to tens of billions of dollars lost with no options for users. This is unacceptable and has directly contributed to many individuals being irrevocably destroyed in our industry by bad actors.

MiCA: The bad

Although it states a primary goal of preventing market manipulation, the majority of manipulation is happening outside of the EU (via offshore entities), so it doesn’t really help many people directly. It may help indirectly, though, as it signals to the market the direction regulators are moving toward — though this also depends on the punishments levied when cases come to a judge.

Noticeably excluded are decentralized finance and future central bank digital currencies. Although it might be seen as a positive that DeFi is not included, the vast majority of on-chain transactions and activity are DeFi, and it is frustrating that this was skipped.

MiCA: The ugly

Unfortunately, there are many concerning or otherwise “ugly” elements present in MiCA that readers must be aware of, and not only if they’re EU citizens.

The “Travel Rule” greatly increased the surveillance and recording of financial transactions and online activity in an unprecedented manner by forcing service providers to identify the recipient as well as the sender for every transaction.
A very low threshold of 1,000 euros for reporting leads to increased surveillance, as compared with the traditional threshold of $10,000 in the United States for banks. It’s irritating to have regular people be subjected to these Orwellian levels of scrutiny, given that the vast majority of financial malfeasance is done by larger banks and institutions via money laundering and other fraudulent activities.
It requires official approval from lawmakers before launching tokens or liquidity. This will dramatically stifle the number of legitimate projects launched within the EU, both directly and indirectly. It’s hard to assume that the queues will be short and the process expeditious — governments have proven time and time again that they are slow and inefficient, especially where new technologies are concerned.

There’s another core problem inherent in any regulation by the European Union that bears repeating: The fragmented nature of the EU’s court system makes it difficult to draw meaningful conclusions about the impact of individual future rulings. In short, this is a minor win for Web3 and requires much more work around the world by regulators.

This is in stark contrast to the U.S. court system, which is — traditionally, albeit not with Web3 — a unified and solid foundation of legal rulings. A fragmented series of rulings makes it very unlikely that other countries will really follow MiCA full-steam ahead; instead, they will likely wait for the U.S. to come out with its own substantial framework and regulatory guidelines.

Regulators, exchange operators and founders all say that until the U.S. has a substantial set of regulatory guidelines, they will be proceeding very cautiously and slowly. Although they may take some inspiration from MiCA, it is not the North Star they need.

The blockchain industry is at a crossroads, for both regulators and users. Countless individuals have had their life savings ruined by fraud and scams, while regulators have struggled to keep up with the rapid pace of innovation in the industry.

Mike Sarvodaya is the founder of the Galactica Network, a layer-1 protocol that leverages zero-knowledge cryptography to achieve Sybil resistance, compliant privacy and infuse robust reputation primitives into DeFi and DAOs. He graduated first in his class from Utrecht University with an MsC in financial econometrics. Before Galactica, he spent the majority of his career as a risk manager and analyst at global hedge funds focused on proprietary trading in currencies, stocks, commodities, and digital assets.

This article is for general information purposes and is not intended to be and should not be taken as legal or investment advice. The views, thoughts and opinions expressed here are the author’s alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.