On 8 March 2022, the Dubai Financial Services Authority ("DFSA") released its much-anticipated Consultation Paper No. 143 ("CP 143"), setting out its proposals for the regulation of crypto assets that are outside the scope of existing rules. The consultation closes for comments on 6 May 2022 and gives those affected a valuable opportunity to provide their input into the regulatory treatment of this important and rapidly developing sector. CP 143 can be accessed on the DFSA's website by following this link.
We have prepared the below Q&A to provide a selective, high-level overview of those parts of the proposed regime we expect to be of general interest. While it does not summarise the entirety of the (significant) details set out in the proposals, we hope it serves as a useful starting point in understanding whether, and how, they may impact your planned business or activities in this area.
What is the purpose of CP 143?
In October 2021, the DFSA launched its regulatory framework for Investment Tokens. This was phase one of the DFSA's Digital Assets regime (as discussed in its Consultation Paper No. 138 ("CP 138")). This clarified and extended the DFSA's regulatory regime to cover Security Tokens or Derivative Tokens (collectively known as Investment Tokens). Investment Tokens are essentially crypto assets that are the same as, or substantially similar in purpose or effect to, the pre-existing categories of conventional, regulated investments.
The regulations proposed in CP 143 will cover a broader scope of crypto assets and bring them, and those who conduct specified activities in respect of them, within the DFSA's regulatory perimeter. The DFSA considers this necessary in order to mitigate the risks posed by crypto assets, which go beyond AML/CFT risks, to include those relating to consumer protection, market integrity, safe custody and the adequacy of a service provider's financial resources.
What crypto assets are dealt with in CP 143?
CP 143 introduces proposed new, defined categories of "Crypto Tokens", "Excluded Tokens" and "Prohibited Tokens" as summarised in the table below.
What are examples of Crypto Tokens?
The definition of Crypto Tokens is deliberately broad and will cover cryptocurrencies such as Bitcoin, Ethereum and Solana, as well as stablecoins with an asset-linked value, and other asset referenced Tokens such as spot price-based commodity Tokens.
While Utility Tokens are generally outside the scope of the proposed regulations, they will be captured by the definition of Crypto Tokens where they have relevant hybrid features that go beyond the scope of a pure Utility Token. Pure Utility Tokens operate in a closed ecosystem to give access to products, services or discounts provided by their issuer (or a member of the issuer's group). Relevant hybrid features that go beyond a pure utility use case may include, for example, the Utility Token being used as a more widely accepted medium of exchange, or it developing a secondary market. Well-known, hybrid Utility Tokens cited by the DFSA include the Basic Attention Token and Filecoin.
While many examples of stablecoins will fall within the definition of a Crypto Token, the DFSA proposes to prohibit any stablecoins which use an algorithmic mechanism to adjust the supply or demand of the Token to maintain a stable price. CP 143 also cautions more broadly that asset referenced Tokens may, depending on their design, take on characteristics of regulated investments (such as commodity derivatives, or units of a fund), in which case they will be treated as such.
What is the process for a Crypto Token to be "accepted"?
As in some other crypto regulatory regimes, including that already in place in the Abu Dhabi Global Market ("ADGM"), the DFSA proposes that only Crypto Tokens approved as Accepted Crypto Tokens will be permitted for use in the provision of financial services in or from the DIFC. The application for acceptance may be made by a DFSA authorised person (or applicant for authorisation), or the creator/developer of the Crypto Token. The applicant will have to submit an assessment of the Crypto Token against specified criteria (discussed below). The DFSA will then consider whether to designate it as "accepted" following its consideration of that assessment.
Interestingly, and in contrast to the ADGM regime, once a Crypto Token is designated as "accepted", it will be added to a centralised register, maintained by the DFSA, and it will be open to anyone with the required permissions to provide regulated services in respect of that Token. The ADGM's regime currently involves maintaining an individual list of accepted crypto assets for each person providing relevant regulated services, which permits only that person to use the crypto assets on that list.
It is also worth noting that providing financial services in respect of a derivative of a Crypto Token, will only be permitted where the Crypto Token referenced by the derivative is an Accepted Crypto Token.
What are the criteria for Accepted Crypto Tokens?
Acceptance of Crypto Tokens will be decided by the DFSA on a case-by-case basis, taking account of the following factors (each of which will need to be considered and explained in the applicant's assessment):
- Regulatory status of the Crypto Token in other jurisdictions;
- The appropriateness of centralised or decentralised governance arrangements;
- Size, liquidity and volatility of the market for the Crypto Token;
- Whether there is sufficient transparency relating to the Crypto Token (including in its technology, protocols, key persons and significant holders);
- Adequacy and suitability of the technology used in connection with the Crypto Token;
- The risks associated with the Crypto Token (including AML/CFT risks), and whether they are adequately managed or mitigated; and
- Where it is an asset referenced Token, whether: (i) there are adequate arrangements to ensure reserves are in place and protected, (ii) a person is clearly responsible and liable to investors, and (iii) the Token will principally be used in the DIFC in connection with financial services.
The DFSA has proposed detailed guidance on the matters it may consider in assessing the above factors, which gives some insight into what would make a strong case for a Crypto Token to be accepted. The factors are not given specific weights, however, and do not operate as a pass/fail checklist, so there will be an element of judgment involved in reaching a wholistic view on the application.
What regulated activities will be permitted?
The DFSA proposes that the following services in relation to Crypto Tokens will be permissible:
- Dealing in Investments as Principal;
- Dealing in Investments as Agent;
- Arranging Deals in Investments;
- Managing Assets;
- Advising on Financial Products;
- Operating an Exchange;
- Providing Custody;
- Arranging Custody;
- Operating a Clearing House; and
- Operating an Alternative Trading System.
Conducting permitted activities in respect of Crypto Tokens will, broadly speaking, be subject to the existing regulations applicable to those financial services, adapted to reflect risks and features specific to Crypto Tokens.
However, in order to maintain a clear distinction between regulated and unregulated crypto asset activities, no authorised person will be permitted to provide services in relation to both Crypto Tokens and Excluded Tokens. The one caveat is that the DFSA has specifically invited comments on whether custodians (i.e. digital wallet providers) should be allowed to do so.
The financial promotions regime will also be extended to apply to Crypto Tokens in the same way as for other specified financial products. It will be prohibited for financial promotions to be made in respect of Crypto Tokens that are not "accepted", Privacy Tokens and Algorithmic Tokens.
Who can offer these services?
Only entities incorporated in the DIFC will be permitted to carry on regulated activities in respect of Crypto Tokens. Branches of entities established in other jurisdictions will not be allowed to offer these services, and Representative Offices (branches of firms regulated outside the DIFC, with a licence to perform limited marketing activities) will not be permitted to conduct any marketing activities in respect of Crypto Tokens.
The DFSA has, for the time-being, excluded the possibility of crowdfunding platforms in the DIFC using Crypto Tokens, although it will reassess this position as part of a planned review of the crowdfunding regime.
Existing money services providers will only be permitted to use Crypto Tokens for limited purposes, in the context of performing back-office functions where the originator and beneficiary of the transactions operate in fiat currency.
Existing DFSA authorised persons will be able to seek to vary or amend their DFSA licence in the usual way, to perform the above financial services for Accepted Crypto Tokens, insofar as this wouldn’t be restricted under any of the limitations of the regime.
How will trading venues for Crypto Tokens be regulated?
Operating a trading venue for Accepted Crypto Tokens, including those that allow direct market access to retail clients, would be permitted with the appropriate permissions. Such activity will be subject to additional requirements, disclosures and limitations compared to operating a trading venue for conventional investments, many of which are carried across from the proposals for Investment Tokens implemented following CP 138.
Three notable, new limitations proposed are as follows:
- The DFSA is not minded to allow the same operator to offer trading in both Crypto Tokens and Investments/Investment Tokens (although it will consider applications to do so if the risks can be properly managed);
- The operator will be expressly prohibited from trading on its own venue for its own account; and
- Operators will not be eligible to participate in the innovative testing licence program.
Operators will also have to give careful thought as to the clearing and settlement arrangements that will be appropriate, and CP 143 contains a discussion of the DFSA's current thinking in this regard.
To address market integrity risks, the DFSA proposes to apply all existing market abuse provisions (set out in Part 6 of the Markets Law) and the Code of Market Conduct to all persons using Crypto Tokens. Operators of trading venues who provide a discussion forum will have a duty to monitor it for any behaviour that might constitute market manipulation.
Will there be additional requirements when providing Crypto Token services to retail clients?
The DFSA has proposed introducing a number of protections that will apply when financial services relating to Crypto Tokens are provided to retail clients, many of which will be familiar to those who followed last year's introduction of requirements relating to restricted speculative investments.
They include the introduction of an "appropriateness test" before allowing a retail client to transact on an execution only basis, prohibiting the use of credit cards by retail clients to fund their trading accounts, and restricting the leverage offered to a retail client engaging in derivative transactions.
Will issuing new Crypto Tokens be permitted in the DIFC?
The DFSA does not propose to allow for the issuance of new Crypto Tokens in or from the DIFC at this stage. It states that it will, however, keep that policy position under review as it gains experience of regulating Crypto Tokens.
Get in touch
If you would like to discuss how the CP 143 proposals may impact your business, or have insights to share that may be appropriate for us to reflect in our own response to CP 143, please do reach out to your usual contact at Stephenson Harwood, or any of the key contacts listed.