Cryptoassets, the rush to regulation, and what to do, and the merits of being a duck.
What’s happening? Well, crypto assets are getting (more) regulated. Soon.
There’s nothing new about Cryptoassets. Born in 2009, Bitcoin was followed by a plethora of cryptographically secured processes, publicly recorded using distributed ledger technology (DLT). There is now a panoply of DLT uses – from cryptocurrencies, but now also including central bank digital currencies (CBDC), non-fungible tokens (NFT), to Decentralised Autonomous Organisations (DAO) that make decisions themselves. This mass of innovation has the potential to turn the financial system on its head as anything and everything of value could be digitised. It has also created unfavourable outcomes for some, especially in retail. It’s about to be regulated head-on around two aspects, the industry itself, and cryptoassets financial instrument role.
Why is regulation needed?
Crypto assets have been regulated only so far as they fall into the scope of existing regulations, mainly AML/CTF/financial crime/market abuse. However cryptoasset proliferation and level of interconnectedness are such that whilst not yet systemic, they may well be soon enough. The volatility and the risk of harm mean regulation is stepping in with boundaries and guardrails.
So what regulations are emerging?
Gathering pace, major jurisdictions are now accelerating legislation, with likely completion around 2023/24. Some jurisdictions are more advanced (in UAE and Asia). Elsewhere, meantime, there is guidance – including Dear CEOs – and indeed un-subtlety such as UK FCA retail crypto derivatives ban.
In the EU, the Markets in Crypto Assets Regulation (MiCA) will consolidate and unify crypto asset regulation, with a harmonized framework for issuance, provision & services. It defines crypto assets, crypto services, cryptoasset service providers, and how custody and trading platforms operate. There is a legal framework for Cryptocurrencies, Asset Reference Tokens (Stablecoins), and E-Money Tokens, like payments. There’s legislation around consumer protection, market abuse and financial crime. This is all part of the EU Digital Finance Package (Digital Operational Resilience Act), which also mandates ITC risk mitigation.
During its evolution, MiCA recently included proposals to “ban Bitcoin”, due to the seriously energy-hungry Proof of Work (PoW) consensus mechanisms. The March 2022 version now going into trialogue (EU Parliament, Council and Commission negotiations) stops short of this, but expects that crypto assets will be subject to the EU Taxonomy for Sustainable Activities. In the UK the concern is shared – a year of bitcoin mining uses the electricity needed to boil all the tea consumed in UK in three decades. So, this leads to a greener crypto race! Ethereum 2.0, under Proof of Stake, is around a thousand times more efficient than PoW. There are DLT consensus protocols tens of thousands more efficient, but they are not yet proven and may lack scalability or security. Final and ongoing regulation can be expected to favour sustainability.
A UK HM Treasury Taskforce kicked off in 2018, leading to 2021’s UK regulatory approach to cryptoassets and stablecoins: consultation and call for evidence. Spring 2022 saw the assertive launch of UK as a Global Crypto Hub. The BoE published FPC’s Focus paper, and responses to a consultation on New Forms of Digital Money. The FCA has written a reminder around governance, and the PRA released a Dear CEO to regulated firms about cryptoasset exposures. The FCA completed a cross-industry collaborative cryptosprint (May 2022), to inform the development of crypto asset regulations. UK consultations will roll on.
The direction of travel of these EU and UK developments, and those emerging in Q1 2022 in the USA (Biden’s Executive Order on Ensuring Responsible Development of Digital Assets) is the same. They seek to balance tighter regulatory perimeters around issuers and service providers, whilst not stifling innovation – rather, to support and stimulate it.
Who’s impacted? Take note issuers, service providers, and firms taking cryptoasset exposures…
Incoming regulation has two dimensions. One is the industry actors, the crypto asset issuers and services providers. The other is how crypto assets play in the balance sheets of regulated financial institutions, regarding liquidity and capital requirements to support them and on the changed reporting to identify cryptoasset exposures and cash flows.
The Dear CEO noted for Pillar 1 that just about every crypto asset exposure has to be 100%. When there is benchmarking data, and calibration, there can be more fine-tuned financial treatments, but not yet. Pillar 2 must include new risk types (fraud, cyber, outsourcing as these pertain to cryptoasset exposures). Financial, prudential, operational and reputational risks need to be subject to enhanced monitoring; models will have the wrong inputs and outputs; risk tolerances should be prudently reduced – and any number of stress tests run. Senior management needs to be involved in every step.
When does this all happen? Now!! Don’t wait for the regulations…
Digital finance, and DLT as the underlying technology providing decentralised verifiability and security – alongside Web 3.0 of course – is going to upend the way everything (everything, not just finance!) is done, and the jurisdictions that get this more right than wrong, and in a timely fashion, will be global strategic winners.
But how to deal with the fact that crypto is moving, frankly, faster than regulations?
Many regulators are on catch-up and challenged for resources, and the crypto industry is evolving around them.
So, if it looks like a duck, and walks like a duck, it’s a duck. This is a pretty reliable rule.
It’s obvious where this is going – crypto assets are arriving, not going anywhere and will in due course be a massive percentage of everything. So, the best guidance must be to behave as if your firm or its cryptoasset business line is already regulated before it is. Quack.
James Phillips
Regulatory Strategy Advisor