Digital Assets, MiCA and EU Investment Fund Law

The Markets in Crypto-asset Regulation (Regulation (EU) 2023/1114 – ‘MiCA’) aims at furthering the uptake of distributed ledger technology (DLT), with crypto-assets being one of the main DLT applications. At the same time, it seeks to ensure financial stability, an adequate degree of investor protection, market fairness and integrity, and fill the gaps existing in traditional EU financial regulation. We explore the EU legal framework for Digital Asset Funds and the trade-offs regulators face when regulating crypto-asset funds in our new paper.

What Could Investment Funds Add to the Crypto Industry?

With assets under management (AuM) close to 20 trillion euros, collective investments represent one of the three most significant EU finance industries. Given their size, investment funds could play an important—and direly needed—role in enhancing the governance and risk management of the crypto industry, in at least the following five ways:

1. Venture capital funds can fund crypto developers;
2. Investment funds can function as liquidity providers on crypto exchanges and lending platforms;
3. Investment funds can invest in crypto-assets;
4. Investment funds can hold stakes in (systemically important) crypto intermediaries (which may be listed companies themselves) or mining and trading firms; and
5. Units of investment funds can take the form of crypto-assets.

Why is There No Big Market for Digital Asset Funds Yet?

Some studies have estimated an overall market volume of tokenized assets will be close to 10% of the world’s GDP by 2027. Surprisingly, investments of Undertakings for Collective Investment in Transferable Securities (UCITS) and Alternative Investment Funds (AIFs) in digital assets do not seem to follow this trend and have remained small so far. Two main reasons for this reluctance towards crypto have been identified by a survey across the Luxembourg fund industry on the status of Digital Asset Funds prior to MiCA: an undesirable degree of operational risk; and a lack of legal certainty. The same applies in most other EU jurisdictions.

Our paper, Digital Assets, MiCA & EU Investment Fund Law, analyzes the extent to which these two reasons persist after the coming into force of MiCA in June 2023.

The Interaction of MiCA, UCITSD and AIFMD

MiCA, as a matter of fact, refers to the Directive relating to undertakings for collective investment in transferable securities (UCITS) and the Alternative Investment Funds Manager Directive (AIFMD) in merely five provisions. The relationship between MiCA and UCITSD/AIFMD is not self-evident and requires users of EU financial regulation to think quite far ahead when dealing with the topic.

Our paper suggests an analysis of the interaction of MiCA and the EU investment fund legal framework in three steps. First, we inquire into the extent to which decentralized finance (DeFi) applications might constitute collective investment undertakings (CIUs), and AIFs in particular. Second, the paper identifies three different regulatory setups, namely UCITS exposed to crypto-assets governed by the UCITSD framework; AIFs investing in crypto-assets and related derivatives governed by AIFMD; and AIFs investing in crypto-assets and crypto-derivatives governed by AIFMD and MiCA. There are various conditions that need to be satisfied in order to understand how, and within what limits, investment funds can invest in crypto-assets, either tokenized MiFID financial instruments, or MiCA-covered assets. The first and second setups provide for little new, in practice, while in the third setup the interactions among different regulatory frameworks are indeed complex. Some activities relating to Digital Asset Funds are regulated by UCITSD and AIFMD, while others are regulated by MiCA, and coordination between the different texts is far from easy. The last section of the paper discusses the particularities of this third setup and identifies in which cases AIFMD or MiCA would apply, and what this regulatory framework means for investment funds.

Key Findings of the Paper: Innovation vs Investor Protection

The paper concludes that the presence of Digital Asset Funds is desirable for digital asset markets, yet potentially exposes investors to operational risk and fund intermediaries to liability.

In the crypto world, Digital Asset Funds can represent stable, professional intermediaries that are key to any mature financial market. Whether or not Digital Asset Funds develop on a large scale will hinge on whether the risk and opportunity profile is beneficial to the intermediaries involved. So far, both operational and legal risks have discouraged prominent fund manager firms from offering Digital Asset Funds. The absence of large, prominent depositaries is indeed telling in this regard.

The coming into force of MiCA has clarified many legal questions. It has also unveiled that now three different options exist to generate exposure to digital assets under EU collective investment schemes law.

Yet, the core question of whether the overall risk and opportunity profile is beneficial for fund intermediaries cannot yet be answered with certainty: the fund depositary is, in all setups, potentially liable for the losses of the fund’s assets and the lack of oversight over other service providers. Yet, the likelihood of liability varies among the three setups explained in the paper. Even if regulators clarify this further as part of the forthcoming Level 2 legislation, the conundrum concerning MiCA’s scope originating from the delimitation between ‘transferable security’ and ‘financial instrument’ will also impact on the depositary’s liability.

Given the sheer number of DLT malfunctions and asset misappropriations (through cyberattacks or inside jobs), the potential liability poses a significant deterrent for well-financed intermediaries as these are the most likely entities to be held accountable by the fund and its investors. In this regard, EU regulators face a dilemma: should they prioritize investment fund stability and investor protection or dynamic innovation and growth in Digital Asset Funds? The way forward will be about finding the right balance.

The author’s complete article can be accessed here.

Dirk A. Zetzsche is a Professor of Financial Law at the University of Luxembourg.

Filippo Annunziata is an Associate Professor of Law at Bocconi University.

Julia Sinnig is a Postdoctoral Researcher at the University of Luxembourg.