Is ADGM About to Revolutionize Digital Asset Regulations?

TLDR: Yes, and now is your time to act if you're seeking a license for your virtual asset business.

Consultation Papers are (to some at least) a timely and welcome Christmas gift, and the ADGM’s Financial Services Regulatory Authority (FSRA) delivered a welcome set of proposed amendments to its virtual asset legal framework last month. The proposed updates introduce several important developments that will translate to exceptional opportunity for virtual asset (VA) businesses, namely: 

• Introducing regulated staking services, margin trading and lending and borrowing services

• Updates to the venture capital fund manager license to specifically benefit firms investing into VAs.

• A self-certification process for VAs introduced into the ecosystem

• Reduced licensing fees and minimum capital requirements

Staking Services

Staking services have come a long way from DeFi primitives of cycles-prior and are an exciting addition to the ADGM’s VA legal framework. The regulator is considering permitting custody providers and stakeholders licensed to manage assets to offer staking services to clients. Acknowledging staking products’ DeFi provenance (and DNA in automated and disintermediated compostable financial products), it is important to delineate what falls within and outside the contemplated regulatory perimeter. Staking services will be regulated to the extent that an entity custodies staked virtual assets or maintains a discretion in respect of the deployment of that asset. Where staking occurs entirely through a customer’s engagement with self-executing smart contracts (solo staking and staking-as-a-service) then that activity will not be regulated. A question of fact and degree, it will be important to determine what degree of discretion over deployment of customer’s staked assets distinguishes a regulated staking service from one that is not. Technology providers that set up, operate and maintain staking infrastructure will ultimately need to determine which side of the perimeter they intend to fall on. As for those stakeholders that deliberately custodise customer assets, or do so as part of business as usual, we expect that a staking feature is a welcome opportunity. We are excited to see first movers embrace this opportunity and expect industry to respond positively to the intended protections the FSRA has contemplated, namely insurance, mandatory risk disclosures, due diligence on custodian’s and validators’ suitability in providing staking services to clients, and due diligence and risk assessments on PoS protocol.

We note that slashing risks, penalties and loss of staked assets are risks the regulator might require staking service providers to insure against. While we expect that insurers shall respond to this need if it were to emerge as a requirement, the practical challenges crypto businesses face in respect of obtaining insurance are well known. In reality products are not available well after the fact of being mandated and arrive to market with a often-times exorbitant premium attached. At the time of writing, we are not aware of any presently available insurance products that specifically insure against these specific risk items. We feel that this consultation would be enhanced greatly should the regulator engage with insurers, with a view to ensuring that broadly termed technology risk policies are developed to accommodate the risk heads identified, and that policies are affordable and accessible. 

Margin Trading / Lending and Borrowing Services

The ADGM's proposed addition of VA lending and borrowing services into its legal framework introduces long-awaited regulated leverage trading into the VA ecosystem. This is particularly exciting for exchanges, broker/dealers and custodians. The FSRA regards VA lending and borrowing similar to that of Securities borrowing and lending and is considering permitting licensed entities that deal in investments or that provide custody to be able to undertake these activities on behalf of clients. Importantly, extending the regulatory perimeter to borrowing and lending opens up the possibility of margin trading. This introduces new risks and exciting new opportunities for clients and stakeholders intending to offer these services, most notably counterparty risk, market risk in respect of leveraged trading, liquidity risk and conduct related risk (requirement to maintain margin calls and avoid position loss). 

We are enthusiastic advocates for the development of regulated trading in virtual assets and recognise the importance of leveraged trading and borrow/lend facilities. With these services comes operational efficiencies, exponential growth opportunities for the industry at large, as well as heightened responsibilities toward traders. The amplification of virtual asset trading risk and reward is widely available already, albeit in a mostly unregulated capacity. A measured approach toward such offerings is expected. Other jurisdictions and their regulators, such as VARA in Dubai, offer virtual asset lending and borrowing licenses and have adopted measures to cautiously introduce leveraged trading into its ecosystem. We are excited to see this development introduced and will be working with clients best positioned to introduce these services in a measured and responsible way. 

Venture Capital Fund Managers can invest into VAs

VCFMs will see a relaxation around restrictions with respect to the type of investments that they can make. Under the current legal framework crypto-centric VCFMs have encountered a critical restriction, undermining the utility of establishing VCFMs with a specific crypto investment interest within the ADGM. The current legal framework mandates that VCFMs invest in start-up companies by investing in and acquiring shares in those companies. However, this is not practical for VCFMs that invest into crypto projects. Most, if not all crypto projects raise and issue tokens, i.e. virtual assets and predicate instruments such as SAFTs and Token Warrants. Last year we successfully petitioned the FSRA that the restriction should be relaxed to permit crypto fund managers to invest in species native to our industry, and we successfully obtained the first VCFM license for our client in doing so. In initiating this specific change, we have first hand experience working with a regulator that has demonstrated the ultimate responsiveness toward industry needs - changing the laws our industry needs to operate - and we are excited to see this change pave the way for new business at the crucial incubation stage of ecosystem development. 

Self-certification for introduced virtual assets

This change intends to streamline the approval process whereby regulated entities introduce new virtual assets into their business (known as Accepted Virtual Assets or AVAs). Presently the regulator approves all virtual assets on a case by case basis i.e. each new asset is assessed in the hands of, and upon the application of each regulated entity and has approved 91 AVAs to date. 

It could be argued that the current approval process is particularly slow and cumbersome, particularly for those market participants that depend on speed and must maintain a high degree of confidentiality around this information, such is the case for Exchanges and token listings. Exchanges must, to maintain competitiveness, be in a position to promptly respond to market interest for new assets as they emerge. The self-certification process will shift responsibility for assessing suitability of new assets to regulated entities and amplify reporting requirements, but is a welcome and pragmatic move that will, if thoughtfully implemented, keep ADGM-domiciled Exchanges and other stakeholders both accountable and competitive with the increasingly sophisticated global virtual asset business. 

One concern that we have in respect of the operation of a self-certification regime relates to protection of prior knowledge of tokens intended to launch on Exchanges. Under the proposed self-certification regime, Exchanges would need to first notify the regulator before listing a token. The regulator proposes a 20 business-day window within which it can raise an objection to a listing. First, this is, in the crypto time-space continuum, a veritable eon in which the success or failure of a token might be won and done, and importantly, limits the competitiveness of an ADGM-regulated Exchange as against competitors positioned elsewhere. Second, this is, in our position, a too-broad window of opportunity in which prior knowledge of token listings can be abused, to the detriment of retail consumers and the market. Tokens marked for launch and pre-listing is highly confidential and extremely valuable insider information that is vulnerable to exploitation. Indeed, Solidus has assessed that 56% of crypto token listings since 2021 show signs of insider trading and the first SEC and DOJ insider trading cases against OpenSea and Coinbase personnel demonstrate the information protection challenges emanating from within Exchanges. Any expansion made in terms of time and to whom sensitive pre-listing information must be disclosed introduces misuse risk and must be carefully considered. 

We consider a more pragmatic approach to addressing this vector of risk would be to permit Exchanges (and stakeholders) in good standing with the regulator to adopt token listings by default, with a follow up requirement to notify the regulator of the listing and provide disclosure of risk assessments within a brief period of time following a token listing and on a periodic and ongoing basis in the event of material risk changes. In the event that a token were to fail a risk assessment in the eyes of the Regulator, then that token could be withdrawn from trade. Our thinking here is twofold; one, that tokens and their corresponding markets are dynamic and risk assessments ought to be also, and that if the regulator reposes trust in stakeholders to responsibly assess the suitability of tokens for their activities, then that trust should extend to responsible use without a final approval. In the case of Exchagnes in particular, who are required to and run well resourced market surveillance teams, they are best positioned to report in a dynamic manner ongoing risks posed by specific assets, not merely before launch. 

Power to halt dealings in a particular token - Complimenting the regulator’s deferral of asset assessment to stakeholders, the FSRA has proposed an enhancement to its supervisory powers, specifically to halt dealings in a specific token should the need arise. The product-specific power would apply not merely to licensed and regulated virtual asset stakeholders but to everyone within the ADGM. We think that it is not unreasonable to incorporate such a power within the current framework and that it could indeed be appropriate in certain circumstances. It is likely that this measure sits alongside stakeholders, particularly Exchanges’ own failsafe procedures for assets that pose a risk to the public. We envisage it would be appropriate to work with Exchanges and other stakeholders to discern appropriate conditions in which the power might be invoked, and to understand what flow-on consequences arise out of its exercise. For example, what would the responsibility of a custody provider be with respect to embargoed assets where customers have instructed an Exchange (who in turn must instruct their Custodian) to arrange for their immediate return? This question informs the consultation question of whether custody providers should be able to custodise virtual assets other than those that are approved (we see no reason why they should not, this is ultimately a commercial assessment involving risk, one Custodians are readily capable of making without regulator oversight).

 Lowered Fee and capital requirements

The FSRA has adjusted its assessment of appropriate minimum capital requirements (MCRs) and licensing fees downward, which is welcomed. Proposed changes to MCR thresholds will see crypto Exchanges operating under a MTF license generally required to maintain only 6 months’ OPEX, down from 12. Custodians of crypto assets will be required to maintain a base capital requirement (BCR) that aligns with requirements set for non-crypto Custodians (the higher of USD 250K or an Expenditure Based Capital Minimum of 6 months Annual Audited Expenditure). In terms of fees, virtual asset businesses are required to pay a license and annual supervision fee uplift on regulated activities conducted by non-crypto counterparts. This accounts for the additional supervisory and assessment resources the regulator dedicates toward virtual asset businesses. The proposed change will see this fee uplift charged once, regardless of the number of regulated activities a license applicant or continuing license holder performs.

Conclusion

All in all the proposed changes to the ADGM's legal framework for virtual asset businesses is immensely encouraging and testament to the fact that in the FSRA, VA businesses have an incredibly receptive, forward-thinking regulator. Responses to Consultation Paper No. 11 are due January 31, 2025. Whether you're presently licensed or looking to become a licensed VA Fund Manager, Exchange, Broker/Dealer, Custodian, or a technology partner interested in staking services, this is your chance to shape the future of digital asset regulation and your feedback is a valuable part of your participation in this future-shaping ecosystem. 

If you would like more information or support responding to the Consultation, get in touch today.