ESMA: Bubble fears confirmed for virtual currencies

Maria Nikolova

The latter months saw an extraordinary rise and subsequent fall in prices of virtual currencies, as well as growing issuance of ICOs, ESMA notes.

The European Securities and Markets Authority (ESMA) has noted the recent price fluctuations of virtual currencies in its Report on Trends, Risks and Vulnerabilities.

The regulator says that bubble fears for virtual currencies have been confirmed. Virtual Currencies (VCs), such as Bitcoin and Ether, have seen an extraordinary rise in prices in recent months but, recently, their value plummeted by more than 60% compared to the December 2017 peaks.

Buying and trading cryptocurrencies remains very high-risk, ESMA warns, as consumers could lose most or all of the capital invested. Moreover, as virtual currency platforms are not regulated under European Union law, consumers cannot benefit from any of the specific safeguards and legal protections that are associated with regulated financial services. Other risks include the lack of a robust secondary market and price transparency as well as operational disruptions.

ESMA stresses that virtual currencies at present do not fully meet the three traditional functions of money: i) medium of exchange (money is used as an intermediary in trade to avoid the inconveniences of a barter system); ii) store of value (money can be saved and retrieved in the future); and iii) unit of account (money acts as a standard numerical unit for the measurement of value and costs of goods, services, assets and liabilities).

This stance echoes the comments made by Mark Carney, Governor of the Bank of England in a speech delivered earlier in March.

ESMA has noted that cryptocurrencies have a limited function as a medium of exchange because they have a low level of acceptance among the general public. On top of that, the high volatility of their exchange rates relative to fiat currencies – and, therefore, in terms of most goods and services – renders VCs uncertain as a store of value even over short time periods, let alone for the purpose of acting as a longer-term savings instrument. Finally, both the low level of acceptance and the high volatility of their exchange rates and thus purchasing power make them unsuitable as a unit of account.

ESMA also highlighted the growth in Initial Coin Offerings (ICOs), prompting attention from the perspective of investor protection in particular. The regulator is actively analysing the market to assess how the sector evolves and whether some adjustments to the existing rules may be needed to address some of the specific aspects of ICOs. Many ICOs are launched overseas but more recently the phenomenon has gathered pace in the EU.

ESMA reminds investors that ICOs are extremely speculative investments, vulnerable to the risk of fraud and illicit activities. The risk to investors of losing all the money that they have invested is very high. Meanwhile, firms involved in ICOs should give careful consideration as to whether their operations constitute regulated activities. In particular, depending on their business models and the features of the tokens being issued, firms involved in ICOs may need to comply with the requirements laid down in the Prospectus Directive, the Markets in Financial Instruments Directive, the Alternative Investment Funds Managers Directive and the Anti-Money Laundering Directive.

Because of their anonymity and the capacity to raise large amounts of money in a short timeframe, ICOs are vulnerable to the risk of fraud or money laundering, the regulator warns.

One more type of fraud appears to be accompanying ICOs – identity theft. For an extreme example of this scam, check out Paul Orford’s guest editorial.

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