It is undeniable that there is a Nigerian Crypto Assets Market (“Crypto Assets Market”), which is part of the Global Crypto Assets Market which is estimated to be worth about 350 Billion Dollars.
As the Securities and Exchange Commission (“SEC”) considers setting up a regulated Crypto Assets Market, it is essential that the framework for regulating this market be set out in extensive detail and carefully considered against the international order for regulation of these assets. This may be somewhat challenging since there is no universal global approach for regulating the Crypto Assets Market, nevertheless there are classifications, infrastructure, rules, procedures and practices common to most jurisdictions which will guide SEC in formulating an indigenous regulatory regime.
This paper shall analyze the structures, systems, processes, participants and licensing regime that need to be put in place to effectively regulate the Crypto Assets Market.
2. REGULATORY APPROACH TO CRYPTO ASSETS MARKET
While the regulation of the Nigerian Capital Market by SEC does provide basic pointers for the regulation of the Crypto Assets Market, there are numerous features of the Crypto Assets Market that do not match the Capital Market and so the framework for regulation of the latter may not be applicable to the former. Therefore, SEC must take a position as to its regulatory approach to the Crypto Assets Market. In our view it may approach this issue in any of the following ways:
(i) Regulation Through Existing Laws and Regulations: The key consideration for SEC if it wants to apply this approach is whether the Investments and Securities Act 2007 (“ISA”) and the Regulations made pursuant thereto are effective to regulate the stakeholders, activities, functions and systems that comprise the Crypto Assets Market.
(ii) Regulation Through Amended Laws and Regulations: Again SEC may decide to amend the ISA and the Regulations with a view to extending their scope to cover the regulation of the hitherto unregulated Crypto Assets Market. For example, Estonia amended its Money Laundering Act and Terrorism Financing Prevention Act, respectively, to bring Crypto Wallets and Exchanges under its regulatory regime.
(iii) Regulation through New Laws and Regulations: SEC may on the other hand, seek the enactment of bespoke legislation that will target specifically, all aspects of the Crypto Assets Market, thereby providing for a comprehensive regime of regulation able to address the peculiarities of the market. For example, Malta took this approach when it enacted the Virtual Financial Assets Act.
In our view SEC should as a matter of urgency enact new regulations for the Crypto Assets Market under its existing powers in Sections 13 and 313 of the ISA.
3. CLASSIFICATION OF CRYPTO ASSETS
This is fundamental to the regulation of the Crypto Assets Market as whatever regulations SEC enacts must define the type of crypto assets that will fall within its regulatory ambit. Global best practices tend to classify crypto assets into 3 functional models, i.e. assets that are investment tools (Security Tokens), assets that operate as a medium of exchange (Payment Tokens) and assets that give a right to participate in digital resources (Utility Tokens). In terms of SEC’s statutory jurisdiction, it would appear that by virtue of Sections 13 (a) and 315 of the ISA that Security Tokens could fall within the definition of Collective Investment Schemes and Securities (i.e. under subsection (d)). With regards to Payment Tokens and Utility Tokens, it is our view that where these are not hybrid in nature, i.e. there is no aspect of them that can be deemed to be an investment tool or a security, then they should not fall under the regulatory jurisdiction of SEC.
4. REGULATION OF ACTIVITIES AND PARTICIPANTS IN THE CRYPTO ASSETS MARKET
The Crypto Assets Market comprises a number of activities and participants which SEC will need to properly capture within the regulatory framework it shall adopt and issue appropriate licenses to. In broad terms these activities can be divided into On-Chain Activities, i.e. activities which occur on the Block chain platform and Off-Chain Activities, i.e. activities which occur off the Block chain platform. By extension the participants can also be divided along the same lines. Examples of On-Chain Activities/Participants are as follows:
(i) Mining of Crypto Tokens: This refers to the continuous process of creating new tokens through special nodes or computers called record producers through a transparent and pre-specified procedure on the protocol that runs the block chain. The individuals performing the function of mining are called miners. It is our opinion that SEC cannot seek to license miners as their operations are pure technical/technological and solely within the global block chain infrastructure. In our view they are well outside SEC’s territorial and jurisdictional competence and have no relationship with any of the entities which SEC will regulate in the Crypto Asset Market.
(ii) Distribution of Crypto Tokens: On-Chain distribution of tokens also occurs through mining (i.e. the tokens are distributed as rewards to the miners upon the discovery of the proof of work contained in the block); airdrop or fork.
(iii) Decentralized Digital Exchange Services: This refers to Exchanges operating on the block chain which facilitate peer to peer trade of Crypto Assets without taking custody of the said assets. They have a significant disadvantage of slowness and inapplicability for inter block chain trade, but have the advantage of safety and price integrity. In our view Decentralized Exchanges should be licensed and regulated by SEC because the platform they provide for trading in securities is within SEC’s territory and they deal directly with entities within SEC’s purview. Also these Exchanges can provide AML/CFT reporting and compliance functions to SEC.
(iv) Hot Crypto-Wallet Services: This refers to the service of storing public and private keys of Crypto Assets online. These type of wallets could be connected to the block chain as a fully validating node while others run as third party applications. In our view, Hot Wallet Services should also be licensed and regulated by SEC since they are principal participants within the Crypto Asset Market, operating almost like banks and as part of the payment infrastructure for crypto assets.
(v) Block chain Payment Platforms: These are gateways that facilitate the use of Crypto tokens for payment for goods and services. These in our view should not be licensed by SEC as they fall under digital payment systems utilized for Payment Tokens and may not have any features that support Investment Tokens.
Off-Chain Activities on the other hand include the following:
(i) Pre-mining Sale of Crypto Tokens: This refers to the private offering of pre-mined tokens usually on block chains that have not become operational. Under this arrangement these tokens are usually non-transferable or locked up for a certain period. Where these tokens are issued as Investment Tokens or for investment purposes, SEC should regulate their issuance and issuers.
(ii) Initial Coin Offering: This refers to the offer of new tokens in exchange for fiat currency or existing Crypto tokens, with a return on investment upon the secondary appreciation of the token. Where these tokens are issued as Investment Tokens or for investment purposes, SEC should regulate their issuance and issuers.
(iii) Cold Crypto-Wallet Services: This refers to the service of storing public and private keys of Crypto Assets on hardware devices like USBs or mobile phones which can be connected to computer or other device to enable permission for block chain transactions. In our view they are outside SEC’s jurisdictional competence as what they provide is a technical/technological function for users of the crypto assets and as such should not be licensed.
(iv) Centralized Digital Exchange Services: Centralized Digital Exchanges are platforms for trading in Crypto Assets not on the block chain, where the Exchange takes custody of the said assets and trade on behalf of the holder. They have the advantage of speed and being able to trade assets across different block chains but are prone to security attacks and market manipulations. In our view, these Centralized Exchanges should be licensed and regulated for the same reasons as the Decentralized Exchanges.
(v) Crypto Assets Market Services: There are a number of services provided off chain that are critical the effective function of the market and identical to those offered in the Capital Market. These services include asset management, collective investment schemes, investment advisory, brokerage services, security audit, ratings services, compliance services, legal services and data services. Some other services like block chain analytics, however, are peculiar to the Crypto Assets Market and based entirely on block chain related activity. In our view persons offering services to the Crypto Assets Market should be licensed and regulated to ensure the highest standards of professionalism, skill and experience in these services are what is available in the Crypto Assets Market.
5. COMPARATIVE REGULATION OF CRYPTO ASSET MARKETS
Below are the regulatory approaches adopted by some countries for the regulation of their respective Crypto Assets Market:
France is in the process of enacting the Business Growth and Transformation Action Plan Law. In that law, tokens are defined as intangible assets representing rights in digital form which may be issued, registered, transferred or retained on a Distributed Electronic Register which identifies the owner of the assets. The law also defines Digital Assets as a digital representation of value not issued by a central bank or public authority, not necessarily linked to legal tender and not possessing status of currency but is accepted as a means of exchange and can be transferred, stored or exchanged, electronically. Essentially these definitions fall within the classification of Investment Tokens and Payment Tokens, respectively.
In terms of regulated activities, persons providing payment platforms for crypto token payment to third party vendors require a license to operate. Also Initial Coin Offerings (ICOs) for Security Tokens are regulated under the Financial Instrument Law. There is also an optional regime under the soon to be enacted Business Growth and Transformation Action Plan Law to ensure compliance with Anti-Money Laundering requirements by different entities, which include Custodial Wallet Service Providers; Trading platforms that exchange crypto tokens for fiat currency; Trading platforms that exchange crypto tokens for different crypto tokens; Digital Assets Portfolio Management Providers and Digital Assets Subscription Providers.
Israel enacted its Financial Services Law in 2016, including virtual currencies in its definition of financial assets. Furthermore, in 2017, Israel’s tax authorities defined virtual currencies as a means of virtual payments and as financial assets used for the purpose of bartering.
Under the Financial Services Law, there is a mandatory licensing regime for providers of financial assets. The criteria for obtaining the mandatory licenses differ between individual and corporate applicants and the license granted could be basic or expanded. Entities already regulated by other financial laws (like banks) and individuals serving solely as brokers are exempt from the license regime.
In 2018, the Israel Securities Authority (ISA) published an interim report on ICOs which essentially adopted the standard classification of this activity, i.e. into Currency Tokens, Investment/Security Tokens and Utility Tokens and stated that it would only regulate Investment/Security Token Offerings (but would apply a substantive test to determine if investment/security component was contained in other offerings).
In terms of AML/KYC compliance, the Ministry of Finance published draft amendments to the Financial Services Law which required Crypto Asset Service providers to publish IP addresses of its clients and public addresses of Crypto Asset Wallets and to maintain full documentation of crypto asset activity for at least 5 years.
Malta, in classifying crypto tokens, Malta has enacted bespoke legislation (i.e. the Virtual Financial Assets Act) providing for different aspects of crypto token infrastructure like Crypto Exchanges, Initial Coin Offerings, Crypto-Wallet Advisers, Virtual Finance Asset Agents and so on. The legislation classified Distributed Ledger Technology Assets into Financial Instruments, Electronic Money, Utility Tokens i.e. digital tokens for acquisition of goods and services on the block chain and Virtual Financial Asset i.e. digital tokens used as medium of exchange, unit of account or store of value (but which do not fall into any of the other categories).
The Virtual Finance Assets Act introduced a 3 stage test called the “Financial Instrument Test” to determine the classification of DLT Assets prior to an Initial Virtual Finance Offer (Initial Coin Offer), or the admission of a Virtual Finance Asset into trading or the conduct of Virtual Finance Asset related services. The test first determines whether the DLT Asset is a Virtual Token (i.e. a Virtual Asset used for limited trading purposes within a closed DLT system and not on a DLT Exchange) as these type of assets are not regulated by the VFAA. Secondly the test determines whether the asset, though not a Virtual Token is however subject to existing regime of Financial Services Legislation as it will have to comply such existing legislation. Lastly if the asset is not a Virtual Token and is not required to comply with existing Financial Services Legislation, then it will be deemed to be a Virtual Finance Asset regulated by the provisions of the VFAA.
The VFAA therefore regulates ICOs and secondary trading of Virtual Financial Assets; the provision of professional and investment services in relation to Virtual Financial Assets and Virtual Financial Asset Agents. The VFAA also imposes the AML/KYC obligations on the above regulated entities.
The imminent regulation of the Crypto Assets Market is something that must be done by SEC as the primary regulator for securities and investments in Nigeria as market regulation that ensure market soundness/integrity and the protection of the real investing public.
The opportunities to structure the market and formalize its operations can only come with regulation which is focused on investment/securities activity, comprehensive enough to regulate all players in the value chain and dynamic enough to respond to the peculiarities of the market and the undergirding block chain technology.