Regulation of the Virtual Assets Market: BC opens public consultation to obtain contributions on relevant topics for Virtual Assets Market in Brazil

On December 14, 2023, the Central Bank of Brazil (“BC”) placed for public consultation, as a public call for contributions, through Notice No. 97 (“ECP 97”), an extensive set of questions with the aim of obtaining contributions and information on important topics relating to the virtual assets market in Brazil, which will enable it to develop the respective regulation in compliance with the provisions of the Legal Framework for Virtual Assets (Law No. 14,478/22).

Through the public call for contributions, in accordance with ECP 97, the BC aims to increase the efficiency, security, and development of the market for the provision of virtual asset services in Brazil, as well as to obtain information that will enable the development of an appropriate regulatory framework for the activities of virtual asset service providers (“VASPs”).

The main topics covered by ECP 97 include:

• Asset segregation and risk management

The segregation of clients’ assets from VASPs is the first topic addressed by the BC, given its relevance, especially in the event of a crisis. This topic was not expressly provided for in the Legal Framework for Virtual Assets, which poses legal challenges for its application based on a subordinated regulation. Indeed, Bill No. 3,706/2021 is currently being processed by the Brazilian Congress, which seeks not only to criminalize the activity of financial pyramiding, but also to amend the Legal Framework for Virtual Assets to provide for asset segregation, in order to ensure that the funds of investor-consumers deposited and held in custody at VASPs are not commingling with the VASPs’ own funds, as evidenced in their financial statements, so that they are not integrated into their assets.

As for risk management, ECP 97:

• • Raises questions about the possibility of using clients’ funds held in a VASP to guarantee the client’s own transactions that are underway on that platform as well as the potential limits for such use.
  • Considers whether asset security mechanisms or guarantee funds should be created to protect clients/investors in this market, such as the Credit Guarantee Fund (“FGC”) – and what insurance could be applied to the segment.
  • Inquires about measures that could be adopted to protect investors who lock their virtual assets in a blockchain for staking purposes, considering the operational risks and loss of virtual assets involved in this type of transaction.

The BC also raised questions on the topics of cross-border payments settled with virtual assets and the use of virtual assets in foreign direct investment (FDI) and foreign credit transactions, as well as what measures could be adopted to guarantee sufficient funds to honor derivative transactions with crypto assets.

• Negotiated activities and virtual assets

ECP 97 inquires:

• • whether VASPs should submit a request for authorization to the BC for the numerous activities provided for in the Legal Framework for Virtual Assets or whether the authorization should be specific for each activity (i.e. negotiation, custody, third-party management, etc.);
  • whether financial and payment institutions could carry out this activity or whether they should be linked to a specific and exclusive type of institution authorized to operate by the BC; and
  • what could be the minimum criteria for VASPs to select the virtual assets to be offered on their platforms.
• Contracting essential services

The BC raises questions about:

• • The minimum guarantees required to be granted in Brazil by the VASPs that use institutions located abroad for the provision of custody services for virtual assets of clients, in order to preserve client funds and ensure compliance with legal demands on these assets.
  • Criteria for mitigating the risks involved in contracting third-party services, such as other service providers in the virtual asset market, intermediaries, custodians, as well as portfolio and liquidity providers.
  • What specific controls and procedures could be adopted by VASPs and liquidity providers, in order to ensure compliance by these agents with the regulations on the prevention of money laundering and terrorism financing (“PLD/FT”).
• Governance and conduct regulations

In ECP 97, the BC formulated 12 relevant questions on the subject of “governance and conduct”. The questions concern:

1. Storage and management of private keys, storage procedures, including decentralized procedures and the responsibilities of the holders of pieces of information, as well as the risks associated with these procedures, and what mechanisms could be adopted for the constitution of encumbrances and judicial blocking of virtual assets.
2. What are the price formation references for virtual assets traded on exchange platforms.
3. Mechanisms to be adopted to identify and curb market manipulation.
4. What the settlement flow is for buying and selling virtual assets on exchanges and how it differs from the settlement flow in the traditional market.
5. What measures can be adopted to provide clients with clearer information about the transaction fees charged and the high volatility of virtual assets.
6. The logic behind defining a minimum percentage of assets to be held in cold wallets and what the technical basis for defining the percentage would be.
7. The possibility of VASPs acting as liquidity providers in their clients’ transactions, acting as counterparties in these transactions, and what parameters should be adopted to limit risks.
8. How to characterize control (ownership) over virtual assets most appropriately and how to handle cases of key sharing.
9. What would be the minimum organizational structure for the proper governance of virtual asset service providers, taking into account systems for processing and controlling transactions, information security, and compliance with regulations, as well as the need for certifications.
10. How VASPs could act to curb illicit transactions with virtual assets.
11. What tools and mechanisms VASPs have been using to identify ultimate beneficial owners (UBO) and how they can ensure compliance with the Travel Rule, in accordance with Recommendation 16 of the Financial Action Task Force (“FATF/GAFI”).
12. How suspicious transactions with virtual assets should be addressed by VASPs and how monitoring the prevention of money laundering and terrorism financing (“PLD/FT”) should be carried out.

• Cybersecurity

ECP 97 broadly discusses what the market considers to be a necessary requirement for maintaining cybersecurity in the virtual asset market and what would be the cyber risk mitigating factors in the segment.

• Provision of information and client protection

According to the BC, VASPs must provide appropriate information to clients through the implementation of policies and procedures that ensure the suitability of services and virtual assets to the clients’ profiles. Thus, in ECP 97, the BC inquires as to what elements would be necessary for the implementation of these policies, particularly in the case of VASPs allowing transactions with “digital instruments representing value, with a stabilization mechanism in relation to a specific asset or a basket of assets” (i.e. stablecoins).

• Transition regulations

Finally, the BC calls for suggestions regarding the transition regulation established in article 9 of the Legal Framework for Virtual Assets. The BC inquires whether there should be phases for VASPs to adapt to the new rules, over what period of time, and under what criteria, in compliance with the minimum period of six months established in the federal law.

ECP 97 is a reflection of the BC’s new approach on developing regulations for the virtual assets segment, with a more action-oriented bias and open to suggestions, based on pertinent questions from the market. Nevertheless, it also implies an in-depth study as well as greater knowledge by the BC about this market.

Contributions on ECP 97 must be submitted by January 31, 2024, upon completion of the form available at the BC website (general profile menu “Financial stability”, “Standards”, “Public consultations”, “Active consultations”). Contributions sent by other means or in other formats will not be considered.

Demarest’s Banking and Finance team is available to assist in formulating statements to the BC on this topic, as well as to provide any clarifications that may be necessary.