United Arab Emirates: The Dubai Financial Services Authority introduces a regulatory framework for recognized crypto

In brief

Over the last few years, the UAE has taken steps to regulate the volatile crypto industry, as seen in the recent crypto winter, and to anticipate global crypto regulatory developments including in the US and in the UK that have been called upon to regulate the sector through regulations rather than enforcement, to protect retail investors that ultimately were the major victims of the crypto winter (extended period of depressed cryptocurrency asset prices).

In 2020, the Financial Services Regulatory Authority (FSRA) of the Abu Dhabi Global Market (ADGM) issued guidance in relation to the regulation of digital securities activities in the ADGM, followed in 2022 by the issuance of the Guidance on the Regulation of Virtual Asset Activities. The Securities and Commodities Authority (SCA) also issued the Crypto Assets Activities Regulation (CAAR) in 2020 that regulates key aspects of dealing in crypto assets in the UAE, from issuance and promotion to operating an exchange and custody. In early 2022, the Emirate of Dubai also introduced the Virtual Assets Law and established the Virtual Assets Regulatory Authority (VARA) as Dubai’s primary virtual assets regulator.

The Dubai Financial Services Authority (DFSA) of the Dubai International Financial Centre (DIFC) had started its foray into regulating the crypto sector by introducing investment tokens in September 2021. The spotlight is now on the DFSA as it looks to make sweeping changes to its regulatory regime concerning recognized crypto tokens as of 1 November 2022.

This client alert provides an overview of the various categories of crypto tokens and expectations on firms dealing with crypto tokens in light of the impending DFSA regulations.

In more detail

What are investment tokens versus crypto tokens?

An investment token (“Investment Token“) is either a security token (such as a share, a debenture, a warrant, a certificate, a unit or a structured product) or a derivative token (such as an option or a future).

A crypto token (“Crypto Token“), on the other hand, is defined by the DFSA as a token that has either of the following characteristics:

1. It is used, or is intended to be used, as a medium of exchange or for payment or investment purposes.
2. It confers a right or interest in another token that meets the requirements in (a).

It could also be useful to determine a Crypto Token via negativa (i.e., by determining what it is not), that is, if a token is any of the following:

1. Excluded token
2. Investment Token (as defined above)
3. Another type of investment

Simply put, a Crypto Token is not any of the following:

1. A security
2. A derivative
3. A non-fungible token (NFT)
4. A utility token
5. An UAE Central Bank Digital Currency (CBDC)

A Crypto Token is also neither an unrecognized token nor a prohibited token (that are privacy tokens or algorithmic tokens).

More importantly, only recognized Crypto Tokens may be transacted in or from the DIFC as per the DFSA regulations.

What are recognized Crypto Tokens and how will they be assessed by the DFSA?

The DFSA’s assessment of recognized Crypto Tokens will be somewhat similar to the FSRA’s assessment of accepted virtual assets. The DFSA may recognize a Crypto Token based on the following criteria:

1. The regulatory status of the Crypto Token in other jurisdictions, including whether it has been assessed or approved for use by a regulator in another recognized jurisdiction.
2. Whether there is adequate transparency relating to the Crypto Token, including sufficient detail about its purpose, protocols, consensus mechanism, governance arrangements, founders, key persons, miners and significant holders.
3. The size, liquidity and volatility of the market for the Crypto Token globally.
4. The adequacy and suitability of the technology used in connection with the Crypto Token.
5. Whether risks associated with the Crypto Token are adequately mitigated, including risks relating to governance, legal and regulatory issues, cybersecurity, money laundering, market abuse and other financial crime.

The most common types of Crypto Tokens are cryptocurrencies and stablecoins (i.e., Crypto Tokens that aim to maintain a stable price with their value determined by reference to the value of a currency, commodity, gold or other asset). Cryptocurrencies do not usually provide the holder with a bundle of rights similar to those commonly attached to investments. More generally, cryptocurrencies serve as the virtual currency of their native blockchain, where the transaction validation takes place through various forms of decentralized consensus mechanisms.

Importantly, derivatives, such as futures contracts or options, may also be issued as cryptocurrencies. However, these derivatives will be considered Investment Tokens rather than Crypto Tokens. Similarly, if the arrangements relating to a token constitute a collective investment fund, then the token will be considered a unit and therefore a security, rather than a Crypto Token.

What are the financial activities that could be practiced with both Investment Tokens and Crypto Tokens in or from the DIFC?

Investment Tokens may be traded on a trading facility or cleared through a clearing house. They could be transacted by a dealer acting as principal or as agent, or arranged by a financial adviser in arranging deals in investments in relation to Investment Tokens or in managing assets.

Recognized Crypto Tokens may be dealt by a principal or agent or considered in arranging deals in investments. They may also be managed by asset managers, or advised on by financial advisers and may be held in custody. Trading recognized Crypto Tokens requires a Multilateral Trading Facility (MTF) license and an endorsement from the DFSA. They can also be traded via a clearing house.

However, Crypto Tokens cannot be offered by a crowdfunding operator, cannot be used by money service providers in connection with their money services business, except in limited circumstances, and cannot be traded on an Organized Trading Facility (OTF) or promoted by a representative office.

What are prohibited tokens and excluded tokens and related financial activities that cannot be practiced in or from the DIFC?

Financial promotion in relation to Crypto Tokens that are not considered recognized Crypto Tokens by the DFSA is prohibited. Algorithmic tokens and privacy tokens are considered prohibited tokens.

A privacy token is a prohibited Crypto Token where the technology used has features to hide, anonymize, obscure or prevent the tracing of information on the identity of the holder, cryptographic keys, parties to and value of the transaction, or beneficial owners.

An algorithmic token is also a prohibited Crypto Token that uses an algorithm to increase or decrease the supply in order to stabilize or reduce price volatility.

Staking in Crypto Tokens and decentralized finance (DeFi) need to be considered appropriately by licensed firms, as staking may only be offered to non-retail clients and the lending is solely for the purpose of the borrower participating in the proof-of-stake mechanism.

NFTs and utility tokens are considered excluded tokens. However, issuers of these tokens will be considered Designated Non-Financial Businesses & Professions (DNFBPs) and will be subject to the UAE Anti-Money Laundering Law and regulations.

What do firms that intend to deal in recognized Crypto Tokens have to do in compliance with the DFSA regulations?

From 1 November 2022, all firms that are currently providing or want to provide financial services in relation to recognized Crypto Tokens in or from the DIFC will need to obtain the appropriate license from the DFSA. To obtain this, firms will first need to submit a pre-application to the DFSA via the DFSA website. For the avoidance of doubt, this applies to existing DFSA authorized firms that wish to obtain a variation of their license to include dealing in recognized Crypto Tokens.