This article is the third instalment of a series on the custody of crypto assets. Read the first article here, and the second article here.
The Markets in Crypto-Assets regulation (MiCA) is the world’s first comprehensive framework for the regulation of stablecoins. For custodians of crypto assets, MiCA settles the conditions for authorisation and operation in the EU. The new legislation also prescribes the rules to be followed by custodians of funds, financial instruments and other assets used to underpin/stabilise the prices of stablecoins.
With rules on liability and holdings drawn heavily from EU investment funds legislation, MiCA will have an impact on both the custody of digital assets based on distributed ledger technology (DLT) and traditional financial intermediation.
This article, which concludes a three-part series on custodians and crypto assets, looks at the requirements to which custodians will be subject when they hold the reserve assets of stablecoins under MiCA.
The background to MiCA
The EU was compelled to create MiCA by two events involving stablecoins, both of which have left deep imprints in the legislation. The first was the attempt by Meta (then called Facebook) to lead the creation of a digital token for global payments, originally known as Libra. This project highlighted the risks posed to fiat currencies from privately issued stablecoins — a politically charged issue in the EU, which regards the euro as a cornerstone of European integration.
The second was the failure of the TerraUSD stablecoin, which triggered the ‘crypto winter’ of 2022, exposed the weak market infrastructure for crypto assets, and led to investment losses of tens of billions of euros. The collapse of TerraUSD — which was notionally pegged to the US dollar but was backed, in part, by a second crypto token, called Luna — brought home to investors and legislators the flawed nature of some stablecoin structures.
In 2019, the European Commission and European Council had seen the potential for stablecoins to disrupt monetary policy and sovereignty. They issued a joint statement, temporarily warning against the issuance of stablecoins before the EU could regulate the sector. The statement noted the institutions’ intention to act “swiftly” to move forward with new rules, but it took until April 2023 — spurred on by headline-grabbing scandals, including the failure of the FTX crypto exchange — for the text of legislation to be settled.
Significantly, the part of MiCA that will come into effect first, and that is subject to the most detailed arrangements, provides for the regulation of stablecoin issuers and stablecoin-related custody services.
The reserve of assets
Stablecoins are crypto assets backed by fiat currencies or other assets. These may comprise commodities, such as gold; bank deposits, treasuries or other liquid assets; or other crypto assets. Some resemble exchange-traded funds (ETFs), as far as they provide financial exposure to assets that investors might not wish to hold directly.
Others are pegged to a nominated fiat currency, such as the US dollar (e.g., tether, represented by the trading symbol, USDT) and serve as an instrument for settling crypto asset transactions at specialised digital exchanges. They may be native to a DLT network or represent entitlements to off-chain assets.
The structure and use-functions of stablecoins are limited only by the imaginations of issuers and the capabilities of developers. The principal feature that unites them — and separates them from the wider class of unbacked crypto assets (e.g., bitcoin, represented by the trading symbol, BTC) — is the intention to underpin/stabilise their market prices by providing token-holders with recourse to a reserve of assets.
In order to protect investors, promote market stability, and limit contagion risks, MiCA contains detailed requirements on the ways in which reserve assets must be held and made available to meet claims by token holders. The reserve requirements under MiCA depend on the category of stablecoin concerned. For the purposes of the regulation, stablecoins fall into two classes: Asset-Referenced Tokens (ARTs), which are backed by two or more fiat currencies or by any number of non-currency assets; and Electronic Money Tokens (EMTs), which are backed by a single fiat currency.
Asset-Referenced Tokens
The issuer of an ART is required to maintain a reserve of assets which is sufficient to meet all claims by token-holders. The reserve must be legally and operationally segregated from the issuer’s own assets, any claims by creditors against it, and any other reserves of assets maintained by the issuer. To support that, within five working days of the date of issuance, the reserve of assets must be held in custody by an eligible custodian. To ensure independence, the custodian must be a different legal entity than the issuer.
The creation of the new role of crypto asset service provider (CASP) under MiCA means that, when the reserve of assets for an ART contains crypto assets, issuers can use either a CASP or a credit institution to hold them in custody. To the extent that they consist of financial instruments, however, only credit institutions and investment firms authorised to provide the ancillary service of “safekeeping and administration of financial instruments for the account of clients” under MiFID II will be eligible.
All other reserve assets for the ART will need to be held by a credit institution (when they can be recorded in a custody account or held in physical custody) or recorded by them (when they cannot). Issuers will be responsible for allocating the reserve of assets among eligible custodians in a way that avoids concentration risks and for performing due diligence on them.
Electronic Money Tokens
MiCA takes a different approach to EMTs, relying on the framework for safeguarding the money of payment services users under the E-Money Directive (EMD) and the Payment Services Directive (PSD). EMTs are deemed to be e-money under MiCA, which leads directly back to the provisions of the EMD and PSD prescribing the segregation of client funds, and insolvency remoteness or insurances to compensate clients from losses due to the insolvency of the e-money institution.
Those rules require funds to be swept to segregated accounts at credit institutions or invested in certain “secure, liquid low-risk assets”, as determined under national rules. MiCA adds to these requirements, for EMTs, that at least 30% of the funds received in exchange for EMTs must be deposited in segregated accounts in credit institutions. Meanwhile the balance is to be invested in assets which qualify as a defined class of “highly liquid financial instruments with minimal market risk, credit risk and concentration risk”, in common with the reserve assets of ARTs. The assets must be denominated in the same official currency as the EMT.
Neither the PSD nor EMD specifically require the appointment of a custodian for the qualifying assets invested in by an electronic money institution, and MiCA does not add such a requirement for the issuer of an EMT. In some EU member states, national rules implementing the EMD have provided for financial instruments held instead of cash to be placed with independent custodians.
As only electronic money institutions and credit institutions are eligible to issue EMTs under MiCA, the extension of rules implementing the PSD and EMD and requiring custody arrangements for financial instruments ought not to be a step change for authorised firms. Any such requirements will, in any event, apply to the reserve assets for ARTs and not to financial instruments linked to EMTs.
Contracts and custodians’ duties
The appointment of each custodian for the reserve assets of an ART must be reflected in a contract that documents the roles, responsibilities, rights and obligations of the issuer and the custodian. It must regulate the flow of information between the issuer and each custodian, in order to enable them to perform their functions “as custodians”. This is a requirement borrowed, with slight changes, from Undertakings for the Collective Investment in Transferable Securities V (UCITS V) and the Alternative Investment Fund Managers Directive (AIFMD); however, the drafting is likely to raise questions, as the issuer of an ART does not act “as custodian” in the MiCA scheme.
Similarly, MiCA requires appointed custodians to “act honestly, fairly, professionally, independently and in the interest of the issuers of the asset-referenced tokens and the holders of such tokens”. This language, too, is derived from the UCITS V and AIFMD texts, but those precedents direct the fund depository’s duties towards the fund and fund investors, rather than the fund manager or adviser.
A novel question is whether the issuer of an ART, which is responsible to maintain the reserve of assets, stands closer to the position of a fund or its manager or adviser; and, therefore, whether the extension of the custodian’s duties to it are fully consistent with the approach under EU funds legislation.
Holdings of reserve assets
MiCA prescribes the manner in which reserve assets for ARTs are to be held. Funds are to be held by a credit institution in its own books. Financial instruments are to be held in securities accounts in the custodian’s books or through physical delivery. Crypto assets that can be held in custody are to be held by CASPs directly or through control of the means of access (e.g., private keys which are part of public-private key pairs).
For all other assets, the credit institutions charged with holding the assets are required to verify the issuer’s ownership and maintain a record of them, based upon information or documents provided by the issuer and available external evidence.
The cash accounts and securities accounts used to hold funds and financial instruments must be: (a) segregated in accordance with national laws implementing Art 16 of the original MiFID Org Directive; and (b) in the name of the issuer for the purpose of managing the reserve of assets of the relevant ART, in order to distinguish the funds and financial instruments from those of the issuer in its own account capacity and any other reserves. CASPs are required to maintain their register of positions using the same naming convention.
Liability
Should any of the reserve assets held in custody for an ART be “lost”, then the custodian will be liable to “compensate, or make restitution, to the issuer” with a financial instrument or crypto asset of the same type or value. The custodian can be excused from this liability only if it can prove that the loss “occurred as a result of an external event beyond its reasonable control, the consequences of which were unavoidable despite all reasonable efforts to the contrary”.
This approach, which effectively reverses the burden of proof in cases of “lost” assets, is taken from the UCITS V/AIFMD models, but a point of distinction immediately arises: if the “lost” reserve assets are crypto assets, then a custody CASP could also be responsible under a provision that charges it to have a custody policy to “minimise the risk of a loss of clients’ crypto assets or the rights related to those crypto assets or the means of access to the crypto assets due to fraud, cyber threats or negligence”.
This does not apply to custodians for other reserve assets, such as funds or financial instruments. Claims arising in cases of “lost” reserve assets may, therefore, take different shapes depending on the nature of the asset.
Conclusion
Custodians are expected to play an important role under MiCA, quite apart from the possibility of providing specialised services as custody CASPs. The obligation on issuers to appoint eligible custodians to hold reserve assets for ARTs is intended to protect token-holders against misappropriations. It is also designed to guard against the loss of assets due to the insolvency of the issuer. However, it remains to be seen whether custodians will be discouraged from services in respect of reserves when they are subjected to liability standards borrowed from UCITS V/AIFMD depository rules.
The same challenge does not arise in the case of financial instruments used as investments for EMT funds, due to MiCA deeming EMTs as e-money and the EMD and PSD lacking similar custody obligations.
The regulation of stablecoins by the EU took time to formulate, and it is world-leading in its ambition, but the result is not fully coherent. When looked at from the perspective of a custodian, MiCA appears as a patchwork of rules that, in places, have been transposed inconsistently from differently oriented precedents. The duties and liabilities of custodians, in particular, would benefit from further clarification. It is little wonder that thought is being given to MiCA II before the regulation has taken effect.
Etay Katz (left) is a partner, and Simon Helm is counsel at law firm Ashurst.
