Switzerland has made waves in the world of cryptos and digital assets. Its "crypto valley" in Zug is now one of the more recognised centres of this space. Industry figures are becoming concerned about how the regulator intends to enforce new legislation. We talk to parties on all sides in this detailed feature.

Switzerland has pivoted from being a secretive international banking centre. As it adapted, the European nation pushed its credentials as a fintech powerhouse. And that’s included becoming one of the world’s hottest places for cryptocurrencies and digital assets. 

But there’s a potential fly in the ointment. 

With the European Union having recently unveiled its Markets in Crypto Assets Regulation (MiCA) – Swiss authorities know they can’t rest on their laurels. And it seems that the industry in places such as Zug’s “crypto valley” face a potentially significant regulatory challenge to do with what is called “staking”.

"Staking" refers to depositing a certain amount of cryptocurrency to support the operation of a Proof of Stake – a consensus mechanism. 

FINMA, the Swiss financial regulator, is considering a change to its current practice, which means that crypto service providers offering staking services shall hold a banking licence, arguing that digital and traditional banking risk factors should be treated equally. FINMA fears that assets may not be available to be always used during the staking process – creating the risk of a potential breakdown. Given some of the high-profile scandals and problems in the crypto world, such as the collapse of the FTX crypto-exchange, regulators want to be careful. FINMA intends to interpret 2021 Swiss legislation, the “DLT Act”, to mean that bank licences must be involved in the system. (“DLT” is “distributed ledger technology,” aka blockchain.)

In principle, Swiss crypto service providers are not subject to licensing by FINMA, but are affiliated to a self-regulatory organization that carries out anti-money laundering controls.

While in some ways a technical financial sector issue, the controversy shows how financial jurisdictions such as Switzerland are trying to balance risk management, safety, and healthy innovation. A parallel kind of debate can be seen around AI. 

The danger that Swiss enforcement might push providers out of the business is not a trivial matter at a time when financial hubs are trying to capture a slice of this business. However, with memories of the 2008 financial crisis still in the background, more recent episodes such as the FTX scandal and the meltdown of certain "stablecoins," regulators are mindful of avoiding problems. (There are also anti-money laundering and know-your client concerns about the use of cryptos and the way in which this sector operates.) This publication has written a number of articles (see here and here) about Switzerland's digital assets space, and banks that operate in this sector, such as SEBA Bank. (See an interview here.)

The problem
Raphael Züger, Zurich-based attorney-at law at LINDEMANN LAW, who leads its digital assets practice interprets FINMA’s intended new practice as follows:

“The core of the new approach envisaged by FINMA is the potential temporary blocking of digital assets during the staking process (so-called lock-up period) and the possible confiscation of digital assets in the event of false validation (so-called `slashing'). In FINMA’s view, this characteristic of staking means that the digital assets are no longer available at all times, which is required under Swiss laws for segregation purposes of digital assets. Following this interpretation, staked digital assets do not qualify as held in custody, but as deposits from the public which triggers a licensing requirement.”

In Züger’s view the "slashing" risk as well as potential lock-up periods truly present a certain risk for investors, but he said FINMA’s technical interpretation jeopardises legal certainty and restricts Switzerland's innovative strength and competitiveness in international comparison. He warned that this new interpretation might lead to Swiss customers staking their digital assets with foreign crypto service providers with a lower level of investor protection.

FINMA’s proposal is not in response to specific problems that have arisen in the market, but rather a new general interpretation of staking under Swiss banking law, Züger said. 
 
FINMA’s position
WealthBriefing quizzed the regulator. 

“The DLT Act provides legal clarity on a risk-based and comprehensive approach. It brings legal clarity in the use of blockchain solutions on different aspects related to financial regulation, but also on questions such as the treatment of bankruptcy with regard to crypto assets or the validity of transactions under private law,” a spokesperson at the regulator said. “Legal clarity and mitigation of the specific risks linked to crypto and DLT enhance the protection of clients, their trust in these products and at the end the competitiveness of serious service providers and the Swiss fintech.”

The regulator said new legislation distinguishes between different kinds of crypto-custody on a risk-based approach, it said. 

“The higher the risks, the stricter are the licensing requirements (banking licence, fintech-licence or AML licence). The treatment of the DLT Act under financial regulation is also consistent with the treatment under bankruptcy law,” the spokesperson said.

Blow to competition
Jesper Johansen, CEO and Founder of Northstake, a custodial, digital asset service provider helping institutions mitigate risk and take part in staking, said competition will suffer, and rival centres such as in the EU could profit. 

“We’re seeing increased inbound inquiries from Swiss based crypto investors, who do not have an EU-onshore regulated staking provider. While FINMA has not yet enforced its updated interpretation of the DLT Act they now strongly underline that staking service providers are required to hold a banking licence in the jurisdiction and should be able to make the asset available at any time.” Johansen said in a statement. 

“This represents several challenges from a risk management perspective for the banks, which they are unlikely to accept. This also risks creating a capital inefficient system – weakening the Swiss digital asset landscape. The Swiss Blockchain Federation and Crypto Valley Association have pushed back, so far unsuccessfully. A timeline for enforcement has not yet been established,” Johansen continued. 

Concerns
“Our current pool of Swiss based clients has been increasingly expressing concerns about this change in practice from FINMA. We continue to work with our Swiss based clients to ensure the implications are limited, however, it does demonstrate that investors need to price in the regulatory risk when assessing their counterparties in crypto,” Johansen continued. 

“EU-onshore regulated VASPs [Virtual Asset Services Providers] will not face similar issues, because EU law (MiCA) defines virtual currencies broadly, unlike the narrow definition by Swiss law. This is not set to change within the foreseeable future even with full implementation Markets in Crypto Asset regulation set to take full effect in 2024,” he added.

Dr Rolf Weber, Zurich-based attorney-at law, Bratschi, and member of the Swiss Blockchain Federation, was asked by WealthBriefing if he thought the way FINMA will enforce the DLT Act will squeeze the number of providers.

“The DLT Act contains several chapters and only a certain part concerns financial market (for example DLT Trading Facilities). Whether a service provider needs a licence for an activity depends on the Banking Act or the Financial Institutions Act (not the DLT Act). The key question is, which crypto activities are bank-like and consequently can only be offered by a firm having a banking licence,” he said. “The DLT Act was implemented with the objective to make the Swiss financial markets more attractive for crypto businesses. A good example is the surrender of digital assets from the bankruptcy estate of a service provider. A similar effect can be seen in the possibility of implementing DLT Trading Facilities (so far no license granted, but to be expected soon).”

“The staking approach of FINMA being very restrictive would jeopardise the attractiveness of Switzerland. In contrast to FINMA, SBF [Swiss Blockchain Federation] is of the opinion that most of the staking services are not bank-like services,” he said. 
 
The EU’s MiCA regime isn’t more liberal than the Swiss one but it does realise a different regulatory approach, Dr Weber said. 

“The EU is rules-based…Switzerland principles-based. The extremely detailed MiCA rules give a high degree of legal certainty which is partly liked by financial services providers, but the Swiss regulations are more flexible and open to discussion with FINMA,” he said. “The competitive “disadvantage” can occur over time since MiCA does not contain market access rules, i.e. Swiss offerors cannot directly contact EU customers and have to look for alternative, indirect solutions.”

Getting the balance right
This news service asked FINMA how it is trying to balance regulatory risk control with the need for innovative vigour? 

“The DLT Act and the approach `same business, same risks, same rules’ (which can also mean sometimes `higher risks, stricter rules’, for example in the AML field) fosters legal clarity, risk mitigation and client protection, but also enhance the trust of clients in such products and the competitiveness of serious service providers as well as the whole Swiss fintech,” it added.