ESMA recommends tailored regulation of crypto-assets to secure investor protection

Fulfilling its obligation from the FinTech Action Plan (on which we reported here), last week the European Securities and Markets Authority (ESMA) published a recommendation for EU law and policy-makers for closing the regulatory gap on crypto-assets.

Crypto-assets are a type of private asset that depends primarily on cryptography and Distributed Ledger Technology. There are a wide variety of crypto-asset, their number is currently estimated to be around 2000. They range from  crypto or virtual currencies like Bitcoin, to so-called digital tokens issued through Initial Coin Offerings (IPOs) that allow businesses to raise capital for their projects, by issuing digital tokens in exchange e.g. for crypto-currencies. Consumers thus may use these assets as investment or as a means of payment, or both if the asset has hybrid features.

Crypto-assets are relatively new and the market is evolving, and poses challenges for regulators and market participants. In cooperation with National Supervisory Authorities, ESMA revealed that the current regulatory framework including MiFID with the rules on investor protection is either difficult to apply to these assets (and how the regulatory framework is applied may be vary between between Member States) or that it cannot be applied at all.

From a consumer protection perspective, these are risky instruments where protection is especially needed. Consumers are likely to have insufficient understanding of the risks involved in the transaction, especially the value of the investment, for example, how the price of the asset is going to change and how likely it is that the underlying project for which the investment is made in case of IPOs is likely to be successful. And then there is also the problem of the reliability of trading platforms. While some of these risks are pertinent to other consumer transactions, they are exacerbated here due to the nature of the products (as being highly abstract, diverse and subject to fast innovation), and to the regulatory gap. The additional practical problem is that consumers may not easily distinguish between those assets that are within the rules are those that are outside the scope of the regulatory framework.

To overcome the current regulatory gap and to ensure a consistent approach, ESMA calls for a special regulatory regime tailored for crypto-assets, that would ensure adequate information disclosure and enable consumers to make informed decisions. While information rules would certainly be helpful, we must urge EU law and policy makers to also consider more intrusive forms of regulation such as product regulation should this prove necessary to provide effective protection for consumers. At least, national legislators/regulators should be empowered to impose limits on product design e.g. price cap. Is opting for more intrusive regulation (or at least a balanced approach between information and product regulation) a preferred regulatory route compared to a mixture of more relaxed information rules with an option of banning products from the market when things get out of control (on which see here)? What do you think?

Recent study reveals surprising facts about automated financial advice

In September 2018 the EU supervisory authorities (ESAs)published a Joint Committee Report on the results of the monitoring exercise on ‘automation in financial advice that revealed surprising facts about automated financial advice in the EU.

Following the publication of a Discussion Paper on Automation in Financial Advice in 2015 and a Report in 2016 (on which we reported here) the ESAs  published the present follow up report on the evolution of automation in financial advice in the securities, banking and insurance sectors over the past two years. The report is based a survey with competent national authorities.

Surprisingly, the report shows that while the phenomenon of automation in financial advice (or 'robo-advice') seems to be slowly growing, the overall number of firms and customers using automated financial advise is still quite limited. In addition, while some new trends seem to emerge (such as the use of Big Data, chatbots for customer service and extension to a broader range of products) there seems to have been no substantial change to the overall market since the publication of the ESA Report in 2016. The Report identifies:

• cultural/psychological barriers as one of the main causes of lack of engagement, that can be traced back to low level financial literacy, and a lack of consumer trust and confidence in using digital tools;
• regulatory barriers such as the complexity of the applicable legislation (MiFID II/MIFIR, IDD, GDPR, PRIIPs) that pose special challenges for small, startup FinTech firms.

It therefore seems that the market for automated financial advice has not taken up, and that its full potential is yet to be explored. Given the above identifies barriers, one may wonder whether the time is not ripe for a shift to greater digitization in the financial sector or whether the regulatory environment needs to change both in terms of giving greater room for small Fintech firms to expand on the market, and in terms of the existing consumer protection tools. 

ESMA imposes first temporary bans on investment products

In June 2018 the European Securities and Markets Authrity (ESMA) for the first time formally adopted new, temporary rules on the provision of contracts for difference (CFDs) and binary options for retail investors. ESMA temporarily banned the marketing, distribution and sale of binary options to consumers (effective from 2 July 2018), and has restricted the marketing, sale and distribution of CFDs (effective from 1 August 2018).

Binary options and CFDs are high risk investment products unsuitable for average consumers. They allow 'betting' on financial indices such as the price of gold, or currency will rise or fall over a fixed period of time, with such an uncertain outcome that they can also be classed as gambling products (see also an interesting article here). Binary options and CFDs became specially dangerous when their online marketing consumers as a way to get rich quickly took up. Unfortunately, instead of getting rich, 74-89% of consumers suffered detriment. As a result, countries around the world started to regulate, and ban these products, and now the EU has joined these efforts.

ESMAs action is landmark because it is the first time that an EU supervisory authority (ESA) has used its product intervention power. The ESAs that have been established following the financial crisis, has been vested product intervention powers to protect EU consumers from the marketing and sale of dangerous products. This power is provided in Article 9 of the regulations establishing the authorities (Regulation 1093/2010, Regulation 1094/2010, and Regulation 1095/2010) and has been concretized in more specific legal acts, such as Regulation 600/2014 of Markets in Financial Instruments (MiFIR). In this case ESMA relied on Article 40 MiFIR.

With its decision from 24 August 2018 ESMA decided to extend the prohibition related to binary options for another 3 months (effective from 1 October 2018), this time refining its approach, and excluding some types of binary options that it found not to impose a sufficient degree of risk onto consumers. The decision is limited to binary options and makes no reference to CFDs, restriction of which came into force a month later than binary options.

While ESMAs actions is undeniably a positive step towards improving the protection of consumers on EU financial markets, one may wonder why are the powers of the EU supervisory authorities limited in time? Binary options (at least some kinds of binary options) are not going to get to be better products. Should the EU supervisory authorities have extended product intervention powers, powers that would enable them to ban products from the EU internal market permanently?

Is there a need to reform European financial supervision for the benefit of consumers?

The European Commission has recently closed its public consultation on the Operation of the European Supervisory Authorities (see the feedback statement here).

The supervision of financial firms in the EU is subject to a complex, multi layered system consisting of national and EU supervisory authorities that has became even more complex after the creation of the Banking Union. For us here most important are the European Supervisory Authorities (ESAs). The ESAs, the European Banking Authority (EBA), the European Securities and Markets Authority (ESMA), the European Insurance and Occupational Pensions Authority (EIOPA) has been created in 2010 as a response to the financial crisis. Although they are primarily concerned with prudential supervision (ensuring that financial firms have enough capital to operate, that they are safely and soundly), consumer protection is also on the list of their objectives.

Consequently, the recently held consultation asked whether the current tasks and powers of the ESAs are sufficient to protect consumers and how they could be improved in this respect.

Many stakeholders found that the scope of ESAs' tasks and powers is adequate and should not be extended. Instead, they should use their existing powers more efficiently, and should be more aligned with the problems at national level. However, some stakeholders saw room for extending ESAs' powers, e.g. by giving ESAs more powers for consumer protect purposes, want to see more work in the financial innovation space, including on virtual currencies, or on financial education, cross-border protection, big data etc. Finally, some, like Better Finance, advocate for the overhaul of the current system of supervision by opting for a 'twin-peak' model instead of the current 'silo' approach. The argument is that the current ESAs prioritise prudential matters over consumer protection matters (see their press release here).

Learning from the experience of the UK, the twin peak model could be an interesting option. In the UK, the former Financial Services Authority, having both the mandates of prudential supervision and consumer protection, failed to properly balance its two limbs of supervision. Although it is said to have paid more attention to conduct matters, having too much to do resulted in a number of conduct failures causing significant detriment to consumers (PPI, payday loans, etc).  The creation of a separate consumer protection authority (the Financial Conduct Authority) has improved consumer protection standards and practice, and the approach so far seems to work well for the UK. However, we must admit, that although the solution of having only one supervisory authority for the entire EU financial market sounds appealing, it is a radical suggestion that requires, among others, substantial background research.

What do you think, is there a need for an EU Financial Consumer Protection Authority, and is it a viable solution?