Regulators struggle to corral elusive crypto assets

Glob­al reg­u­la­to­ry author­i­ties don’t usu­al­ly make stern warn­ings that cer­tain assets may pose a threat to the glob­al finan­cial sys­tem. Wary of the unin­tend­ed con­se­quences of their cau­tion, they might avoid state­ments. But when it comes to cryp­to assets, those warn­ings have become increas­ing­ly famil­iar. 

Many glob­al reg­u­la­tors and Cen­tral Banks are increas­ing­ly uncom­fort­able with devel­op­ments in the cryp­to uni­verse and the rate at which cryp­to assets are grow­ing. 

The Finan­cial Sta­bil­i­ty Board (FSB) in Feb­ru­ary, added its voice to the cho­rus of inter­na­tion­al bod­ies wor­ried about the direc­tion in which the cryp­to mar­ket might go. It claimed that unless reg­u­la­tors take action, cryp­to assets could cause sig­nif­i­cant dis­tur­bance to the glob­al econ­o­my. 

The Bank of Eng­land, the UK’s Finan­cial Con­duct Author­i­ty (FCA), the Bank for Inter­na­tion­al Set­tle­ments and the US Fed­er­al Reserve are among oth­ers to have expressed sim­i­lar con­cerns in recent months. But what exact­ly is the threat and why are pol­i­cy­mak­ers so wor­ried?

Playing catch up

The cryp­to assets ecosys­tem is expand­ing rapid­ly, hous­ing a vast range of assets with dif­fer­ent and often com­plex under­ly­ing tech­nolo­gies and gov­er­nance char­ac­ter­is­tics.

The FCA defines cryp­to assets as “a cryp­to­graph­i­cal­ly secured dig­i­tal rep­re­sen­ta­tion of val­ue or con­trac­tu­al rights that is pow­ered by forms of dis­trib­uted ledger tech­nol­o­gy and can be stored, trans­ferred or trad­ed elec­tron­i­cal­ly.”

At its most basic, a cryp­tocur­ren­cy (such as Bit­coin, which launched in 2009) becomes an asset once it can be trad­ed by investors. There are thou­sands of dif­fer­ent types of cryp­to assets, includ­ing exchange tokens, util­i­ty tokens, secu­ri­ty tokens, and non-fun­gi­ble tokens (NFTs). NFTs have risen in pop­u­lar­i­ty and made head­lines over the past 12 months.

The rate at which the cryp­to assets ecosys­tem is evolv­ing is, for many, a source of fas­ci­na­tion and promise. Where­as, for those respon­si­ble for glob­al finan­cial over­sight and reg­u­la­tion it’s also a source of headaches. 

What exact­ly con­sti­tutes a cryp­to asset? Which cryp­to assets should be defined as secu­ri­ties? Who can cre­ate or issue one? Do investors under­stand how they work, let alone the risks? Where should the reg­u­la­to­ry focus be? These are just some of the many ques­tions occu­py­ing author­i­ties respon­si­ble for finan­cial reg­u­la­tion. 

Threat modelling

In pure­ly finan­cial terms, the mar­ket is not par­tic­u­lar­ly big for cryp­to assets. Mar­ket cap­i­tal­i­sa­tion grew 3.5 times in 2021 to $2.6tn (£1.9tn), accord­ing to the FSB.

But in its Feb­ru­ary paper, it said cryp­to assets mar­kets could grow to rep­re­sent a threat to glob­al finan­cial sta­bil­i­ty due to their “scale, struc­tur­al vul­ner­a­bil­i­ties and increas­ing inter­con­nect­ed­ness with the tra­di­tion­al finan­cial sys­tem.” The nature of cryp­to assets mar­kets cre­ates poten­tial for reg­u­la­to­ry gaps, frag­men­ta­tion or arbi­trage, said the FSB, adding that any sta­bil­i­ty risks could esca­late quick­ly. 

Although there have been bouts of severe price volatil­i­ty in cryp­to assets mar­kets, these haven’t so far impact­ed on tra­di­tion­al finan­cial mar­kets, not least because they aren’t wide­ly used in real world finan­cial ser­vices (such as pay­ments). And they oper­ate large­ly out­side finan­cial reg­u­la­to­ry perime­tres. But the knock-on effect could soon change giv­en the speed at which cryp­to assets are evolv­ing.

Cryp­to assets are in many ways dig­i­tal ver­sions of tra­di­tion­al finan­cial assets and are vul­ner­a­ble to sim­i­lar risks and scams, but the anonymi­ty of cryp­to trans­ac­tions and the speed at which they are processed could pro­duce more dam­ag­ing out­comes. Those risks are exac­er­bat­ed by vul­ner­a­bil­i­ties such as low con­sumer under­stand­ing of cryp­to assets, accord­ing to the FSB. Its report came just weeks after the Bank of Eng­land flagged cryp­tocur­ren­cies as a poten­tial sys­temic risk to UK finan­cial sta­bil­i­ty. 

Sim­i­lar­ly, the IMF has warned that many of the enti­ties with­in the cryp­to ecosys­tem lack “strong oper­a­tional, gov­er­nance, and risk prac­tices.” It also referred to con­sumer pro­tec­tion risks aris­ing from inad­e­quate dis­clo­sure and over­sight, and the poten­tial for the anonymi­ty of cryp­to assets to cre­ate data gaps for reg­u­la­tors and “open unwant­ed doors for mon­ey laun­der­ing.”

Virtual reality

Cryp­to assets are climb­ing up the reg­u­la­to­ry agen­da as the rate of adop­tion and their pres­ence in retail and insti­tu­tion­al invest­ment port­fo­lios moves them ever clos­er to oth­er asset types. 

The lev­el of threat to finan­cial sta­bil­i­ty depends on the extent to which the tra­di­tion­al finan­cial sys­tem is exposed to the cryp­to sys­tem, accord­ing to Andrew Hen­der­son, a part­ner in the finan­cial ser­vices reg­u­la­tion team at Mac­far­lanes.

“For exam­ple, if invest­ment and pen­sion funds, insur­ance com­pa­nies, and banks hold cryp­to posi­tions for invest­ment or cap­i­tal man­age­ment pur­pos­es, and there is a crash in the val­ue of those cryp­to assets, they will suf­fer,” he says. “The oth­er fac­tor is volatil­i­ty dri­ven by the high num­ber of spec­u­la­tors, which is a char­ac­ter­is­tic of an imma­ture mar­ket.”

That issue has been ampli­fied by the extent to which media and polit­i­cal focus has been on cryp­to cur­ren­cies that aren’t asset-backed, most notably Bit­coin, which has expe­ri­enced the fastest growth. Demand has been fuelled to a sig­nif­i­cant degree by gam­i­fi­ca­tion and social media influ­encers, who have also shown how volatile val­u­a­tions can be, explains Rachel Wag­gott, head of reg­u­la­to­ry affairs at Inno­vate Finance.

“It is these cryp­tocur­ren­cies which reg­u­la­tors have par­tic­u­lar­ly focused on in terms of sta­bil­i­ty. As val­ues grow so do fears of a cor­rec­tive mar­ket adjust­ment which could cre­ate a wider eco­nom­ic shock.”

The per­ceived threat should, in the­o­ry, reduce as the mar­ket matures and becomes bet­ter under­stood by investors and author­i­ties. It’s not unusu­al for inno­va­tion in new asset class­es and finan­cial instru­ments to cause con­ster­na­tion among reg­u­la­tors, and the dig­i­tal asset evo­lu­tion­ary cycle is still in a rel­a­tive­ly ear­ly stage.

“What nor­mal­ly fol­lows, as gen­er­al under­stand­ing of the instru­ments improves, is that reg­u­la­tors become increas­ing­ly at ease and focus on con­sumer pro­tec­tion and min­imis­ing abuse [of the sys­tem],” says Hei­di Pease, head of invest­ment prod­ucts at Wave Finan­cial, a dig­i­tal asset invest­ment man­ag­er.

Sev­er­al oth­er issues link cryp­to assets direct­ly or indi­rect­ly to finan­cial sta­bil­i­ty. Most recent­ly, the Russ­ian inva­sion of Ukraine has fur­ther high­light­ed the dif­fi­cul­ties in ful­ly under­stand­ing what the rise of cryp­to means for glob­al secu­ri­ty and finance. There were indi­ca­tions in March that cryp­tocur­ren­cies includ­ing bit­coin were used by Rus­sians as an alter­na­tive to tra­di­tion­al finance, poten­tial­ly under­min­ing the impact of eco­nom­ic sanc­tions.

Sim­i­lar­ly, the FSB and oth­ers have not­ed that the pseu­do­ny­mous nature of cryp­to (cryp­to wal­lets can be held in fake names) makes it a pop­u­lar way of laun­der­ing the pro­ceeds of crime. Cryp­to crim­i­nals held $11bn worth of cryp­to assets by the end of 2021, up from $3bn the pre­vi­ous year, accord­ing to research by Chanaly­sis.

Mean­while, the issue of con­sumer pro­tec­tion becomes cru­cial as the growth in pop­u­lar­i­ty of cryp­to assets widens the market’s expo­sure to the real econ­o­my. The FCA esti­mat­ed in 2021 that around 2.3m UK adults owned cryp­to assets and that almost eight in ten adults had heard of cryp­tocur­ren­cies. At the same time, how­ev­er, it found that the lev­el of con­sumer under­stand­ing of the mar­ket was declin­ing, which sug­gest­ed peo­ple were invest­ing in an asset they knew lit­tle about.

Scattergun approach

The task of ensur­ing effec­tive over­sight of cryp­to assets mar­kets is com­pli­cat­ed, not just by a lack of clar­i­ty as to what exact­ly needs reg­u­lat­ing, but also who should be doing it. It’s no sur­prise, giv­en the vast array of assets under the cryp­to umbrel­la, that the task of reg­u­lat­ing them falls to a sim­i­lar­ly dizzy­ing range of reg­u­la­to­ry agen­cies.

Cryp­to isn’t unusu­al in this respect. Fin­tech firms, for instance, deal with a vari­ety of UK reg­u­la­tors and qua­si-reg­u­la­tors, includ­ing the FCA, the Pru­den­tial Reg­u­la­tion Author­i­ty (PRA), the Pay­ment Sys­tems Reg­u­la­tor and var­i­ous gov­ern­ment depart­ments.

“There is a ten­den­cy to lack a coher­ent nation­al strat­e­gy across these bod­ies,” Pease says. “A joined up approach is need­ed: clear direc­tion from HM Trea­sury and a cohe­sive approach by the Bank of Eng­land, PRA, FCA and HMRC.”

The effec­tive­ness of nation­al approach­es is fur­ther under­mined by the flu­id cross-bor­der, cross-sec­tor nature of cryp­to assets, with the con­trast­ing approach­es of dif­fer­ent reg­u­la­to­ry author­i­ties adding to this frag­men­ta­tion.

Rufus Round, CEO of dig­i­tal asset bro­ker Glob­al­Block notes that some juris­dic­tions, includ­ing Gibral­tar and Switzer­land were quick to estab­lish ded­i­cat­ed reg­u­la­to­ry bod­ies. “They have had pro­tec­tions and reg­u­la­tions in place for some time now, allow­ing many cryp­to asset com­pa­nies to com­ply with strin­gent mon­ey laun­der­ing rules.”

Sim­i­lar­ly, the new Dubai Vir­tu­al Assets Reg­u­la­to­ry Author­i­ty will have over­sight of the sale of vir­tu­al assets and vir­tu­al tokens, as well as respon­si­bil­i­ty for reg­u­la­tion and autho­ris­ing vir­tu­al asset ser­vice providers.

Else­where, though, the view is dif­fer­ent, as glob­al author­i­ties are oper­at­ing at vary­ing speeds. In the EU, the pro­posed Mar­kets in Cryp­to Assets (MICA) bill — which aims to tight­en reg­u­la­tion to a more uni­formed approach on the con­ti­nent — is slow­ly but sure­ly pro­ceed­ing, with poten­tial to form the basis of a glob­al approach. 

MICA focus­es main­ly on dif­fer­ent types of sta­ble­coins (dig­i­tal cur­ren­cies linked to sta­ble assets such as the US dol­lar, the euro or gold) and cryp­tocur­ren­cy exchanges. An addi­tion­al pro­pos­al to ban ener­gy inten­sive “proof-of-work” dig­i­tal cur­ren­cies such as bit­coin — due to their envi­ron­men­tal impact — was removed from the bill in mid-March, albeit with poten­tial for it to be restored.

“Both the US and the EU finan­cial reg­u­la­tors have already sig­nalled that leg­is­la­tion to reg­u­late cryp­to in the com­ing years will focus most­ly on exchanges and sta­ble­coins,” observes Mikkel Morch, exec­u­tive direc­tor at ARK36, a cryp­to-dig­i­tal asset hedge fund.

“For exam­ple, by pro­vid­ing strict guide­lines defin­ing the enti­ties that can issue sta­ble­coins, as well as rules on how these cryp­tocur­ren­cies should be pegged to the under­ly­ing assets, reg­u­la­tors will be able to great­ly lim­it the risks men­tioned by the FSB report.”

While the UK’s strat­e­gy large­ly aligns with the EU, the US has sev­er­al agen­cies tak­ing dif­fer­ent approach­es to the cryp­to chal­lenge. The SEC, for instance, is con­cerned with the cryp­to assets that it views as secu­ri­ties that should be robust­ly reg­u­lat­ed, while the US Trea­sury is more inter­est­ed in finan­cial sta­bil­i­ty and crimes includ­ing mon­ey laun­der­ing.

Again, progress here is slow but steady. Pres­i­dent Biden recent­ly signed an Exec­u­tive Order on dig­i­tal assets that requires the rel­e­vant agen­cies to exam­ine the reg­u­la­to­ry land­scape for cryp­to.

“I believe that many major reg­u­la­tors are wait­ing to see what the world’s biggest cap­i­tal mar­ket does to bet­ter con­tex­tu­alise their approach as the US more clear­ly defines its approach. For exam­ple, toward pure cryp­to ETFs, we will see oth­er major mar­kets fol­low,” says Pease.

Else­where, Japan, seen as friend­ly towards cryp­to, recog­nis­es bit­coin and oth­er dig­i­tal cur­ren­cies as legal ten­der. How­ev­er, it has respond­ed to con­cerns over the poten­tial­ly nefar­i­ous use of sta­ble­coins with pro­pos­als to intro­duce a reg­is­tra­tion sys­tem for inter­me­di­aries pro­vid­ing cryp­to asset trad­ing ser­vices.

Chi­na, by con­trast, takes a much stricter approach, with cryp­tocur­ren­cies not con­sid­ered legal ten­der. Last year it banned all vir­tu­al cur­ren­cy trad­ing and spec­u­la­tion, tag­ging cryp­tocur­ren­cy relat­ed busi­ness activ­i­ties as “ille­gal finan­cial activ­i­ties.”

The lack of inter­na­tion­al coor­di­na­tion cre­ates poten­tial for reg­u­la­to­ry arbi­trage, says Round, as cryp­to firms are able to exploit the pros and cons of dif­fer­ent regimes.

“Poor­ly led reg­u­la­to­ry regimes are see­ing incum­bents move oper­a­tions to more proac­tive juris­dic­tions, main­tain­ing their bases wher­ev­er they go should frame­works change or catch up.”

A balanced approach

The con­trast in glob­al approach­es illus­trates the dif­fi­cul­ty in strik­ing a bal­ance between man­ag­ing the risks posed by cryp­to as an asset class, while also pro­mot­ing inno­va­tion. 

“Reg­u­la­to­ry focus has tend­ed to be more on man­ag­ing risks asso­ci­at­ed with spec­u­la­tive cryp­tocur­ren­cies as opposed to enabling inno­va­tion in pay­ments and in cap­i­tal mar­kets,” accord­ing to Wag­gott.

A more bal­anced approach, she believes, would fea­ture bet­ter con­sumer pro­tec­tion in spec­u­la­tive cryp­to mar­kets, a frame­work for sta­ble­coins that pro­vides con­sumer and mar­ket trust, and a Cen­tral Bank Dig­i­tal Cur­ren­cy that com­ple­ments a vibrant sta­ble­coin mar­ket.

An obvi­ous start­ing point from a finan­cial sta­bil­i­ty per­spec­tive is anti-mon­ey laun­der­ing pro­tec­tion. “This means the trac­ing of the source of cap­i­tal and mak­ing sure sanc­tioned cap­i­tal does not get intro­duced back into the finan­cial sys­tem via cryp­to,” says Pease. 

Sim­i­lar­ly, there are calls for min­i­mum tech­nol­o­gy stan­dards to ensure oper­a­tional resilience and reduce the risk of sys­tem fail­ure. 

Ulti­mate­ly, how­ev­er, any threat posed by cryp­to assets to inter­na­tion­al finan­cial sta­bil­i­ty will best be mit­i­gat­ed by greater glob­al coor­di­na­tion. 

“Since the finan­cial cri­sis, inter­na­tion­al coor­di­na­tion for finan­cial sta­bil­i­ty has been cen­tral to bank­ing reg­u­la­tion,” says Hen­der­son. “Finan­cial sta­bil­i­ty cryp­to reg­u­la­tion is a nat­ur­al exten­sion of this and the signs are pos­i­tive, albeit that, as has been the case his­tor­i­cal­ly with the finan­cial crises, a cryp­to finan­cial cri­sis may be dif­fi­cult to spot.”

Reg­u­la­tors aren’t alone in strug­gling to keep up with this inno­v­a­tive rapid­ly evolv­ing space. Although some seek to embrace dig­i­tal inno­va­tion in gen­er­al, oth­ers take a much stricter, reac­tionary line. But as cryp­to and tra­di­tion­al finan­cial sys­tems become increas­ing­ly inter­con­nect­ed, and the impli­ca­tions for finan­cial sta­bil­i­ty become greater, the frag­men­ta­tion of nation­al and glob­al over­sight will become more exposed. 

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