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Maryna Chernenko, UFG Capital
Maryna Chernenko, UFG Capital

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Classification of digital assets poses challenges to regulators

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Maryna Chernenko, Managing Director of UFG Capital, writes that a fully-fledged work of funds with crypto assets is only possible once the regulators agree on their classification.

While crypto companies are left in limbo after the US Securities and Exchange Commission (SEC) Chair’s statement on most digital assets being securities, the world of investment funds suffers in its own way. Until a clear international regulatory framework is in force, funds remain in the dark at what level it is legal to interact with crypto assets.

Why digital assets’ classification is pressing to investment funds?

Crypto assets, also known as cryptocurrencies, are digital tokens that use cryptography to secure transactions and control the creation of new units. The regulatory classification of crypto assets as commodities or securities has been debated for several years.

An unambiguous classification can significantly impact the alternative investment funds (AIFs) and the fund industry overall. If classified as commodities, crypto assets may be subject to less regulatory oversight, making investing easier for funds. On the other hand, if classified as securities, they may be subject to stricter regulations, making it more challenging for funds to invest but offering investors more protection and transparency along the process.

A tradable financial asset (i.e. security) is subject to registration with regulatory authorities, disclosure and investor protection requirements, price transparency, and greater reporting demands in general. These regulations can increase accompanying costs and complexity for alternative investment funds dealing with digital assets.

Digital assets classified as commodities may be subject to fewer regulations, providing less investor protection, but lead to a new spectrum of controversies for investment funds. Due to particular investment strategies and policies, most funds do not trade commodities and work exclusively with securities. In this case, the classification directly affects whether the fund can invest in digital assets. 

Thus, alleviated regulations can, in theory, make AIFs’ operations with digital assets easier, but only if those funds are initially engaged with commodities. Due to the high market risk associated with the economic nature and the increased volatility of crypto assets, even significant fund investments can result in a dramatic price deterioration

The current debate around digital assets’ classification: the U.S. example

Some experts argue that crypto assets should be considered commodities, like gold or oil, since they are not backed by any government and have no intrinsic value. Others argue digital assets should be classified as securities as they are often used as investment instruments, and their value is subject to market fluctuations. 

The Commodity Futures Trading Commission (CFTC) and SEC have taken a case-by-case approach to classifying crypto assets. Both regulators agree that Bitcoin is a commodity, and CFTC extends this classification to Ethereum. In 2020, SEC filed an ongoing lawsuit against blockchain developer Ripple Labs, arguing that XRP, Ripple’s native token, is a security. Additionally, a Kraken case made some crypto CEOs believe that SEC is going after crypto staking for U.S.-based customers. If so, numerous leading crypto companies may start looking into other markets to settle in.

Along with the rest of the world, several proactive regulatory steps were made by the EU regulatory bodies aiming to integrate crypto assets in European financial markets.

Regulatory standpoint in the EU and implications for AIFs

As crypto assets become more mainstream, European regulators are increasingly scrutinising these investments to ensure they adhere to traditional investment standards.

The Fifth Anti-Money Laundering Directive (5AMLD), introduced in 2018, includes regulations of crypto asset service providers (CASPs) such as exchanges and wallets. According to the directive, CASPs must follow basic requirements to prevent money laundering: register with their local regulatory authority, conduct due diligence on their customers, and report any suspicious activity.

Moreover, the European Securities and Markets Authority (ESMA) qualifies crypto assets as financial instruments. Therefore, alternative investment funds operating in Europe may, in fact, invest in any traditional or alternative assets as long as the AIFM can ensure compliance with the AIFM Directive. In this way, investing in crypto assets, from the AIFM’s point of view, does not differ much from managing other types of assets, with no additional licence needed. 

Luxembourg’s regulator, The Commission de Surveillance du Secteur Financier (CSSF), in turn, states that an AIF may invest directly and indirectly in digital assets under the condition that its units are marketed only to professional and not retail investors. Investments in derivatives and transferable securities with underlying virtual assets are also considered as indirect investments in virtual assets. Additionally, each Luxembourg-authorised AIF investing in virtual assets needs to obtain prior authorisation from the CSSF for the strategy “Other-Other Fund-Virtual assets.”

Despite the regulatory challenges, the EU remains an attractive market for crypto asset funds due to its large and diverse investor base, solid financial infrastructure, and supportive startup ecosystem. To do so, the AIFM needs to be granted permission from the regulatory body for particular management strategies to invest in companies at their early stages.

Final words

The classification of crypto assets is not quite evident to grasp, as there has yet to be a clear regulatory consensus. While regulators worldwide struggle to come to a unified conclusion, investment funds engaged in the crypto industry find their operations complicated by the lack of clarity. 

Investment experts can expect heated debates regarding crypto assets’ classification and management in the following year. From the perspective of AIFMs, there is hope that recommendations of investment industry participants will be noted during the discussion and adoption of new regulations in the EU and worldwide.

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