Regulators need to work together to create a robust and consistent environment for crypto assets.
Kate Gee, Signature Litigation
Cryptocurrencies continue to make headlines. Their aggregate market value topped $2tn last year and investor sentiment remains strong into 2022. The focus is now on how global regulators are reacting and responding to the associated risks.
US treasury secretary Janet Yellen has repeatedly argued that fundamental questions exist about cryptocurrency’s legitimacy and stability; she believes that an appropriate US regulatory framework should be implemented. Based on the US regulator’s recent ‘Joint statement on crypto-asset policy sprint initiative and next steps’, the sentiment is that regulation is warranted, but the scope, severity and timing remain uncertain.
In the UK, the Bank of England (BoE) recently suggested that crypto finance could pose a systemic risk to the global financial system. In a October 2021 speech, Jon Cunliffe, the BoE’s deputy governor for financial stability, compared the destabilising potential of these assets to the subprime collapse of 2008, when problems in a relatively small market were amplified through an under-prepared financial system.
He said: “Crypto assets are growing fast … Financial stability risks currently are relatively limited, but they could grow very rapidly if, as I expect, this area continues to develop and expand at pace. How large those risks could grow will depend in no small part on the nature and on the speed of the response by regulatory and supervisory authorities.”
Nevertheless, the UK remains some way from having a bespoke regulatory regime for the crypto market and, like many other regulators, it appears focused on adapting existing regulatory regimes. At present, cryptocurrency activity may fall under one or more of Financial Services and Markets Acts, the anti-money laundering (AML) regime, the Payment Services Regulations 2017 and the Electronic Money Regulations 2011.
At the same time, the UK Financial Conduct Authority has taken other steps, including banning the sale of crypto derivatives to retail customers, issuing warnings about investments in crypto assets and launching InvestSmart — an £11m campaign targeting young investors to educate them about investment risks, including in relation to digital assets.
Harmonised approach
Clearly, devising a global regulatory regime suitable for dealing with the needs of the crypto industry will take significant effort, time and coordination. The task is made more challenging by the inconsistent use of terminology and the lack of a common methodology for distinguishing between different types of crypto assets.
Regulators need to work together to undertake a careful balancing act and to create a robust and consistent environment for crypto assets
Perhaps with this in mind, French regulators recently proposed that the pan-EU markets watchdog, the European Securities and Markets Authority (ESMA), should regulate crypto assets across the EU. Strengthening ESMA’s powers might deliver consistency, but whether EU member state regulators would willingly relinquish that control remains to be seen.
One of the first regulatory bodies to take steps towards regulation of the crypto industry was the Gibraltar Financial Services Commission (GFSC). The Financial Services (Distributed Ledger Technology [DLT]) Regulations 2020, which came into force in 2018, provide that any entity that, by way of business in or from Gibraltar, stores or transmits value belonging to others using DLT must first apply to the GFSC for a licence. Applicants must demonstrate that they will fully comply with the GFSC’s nine regulatory principles in order to be licensed. At present, 15 licensed DLT providers and one virtual asset arrangement provider are active in Gibraltar, and more applications are understood to be pending.
At the other extreme, in a drive to clamp down on what it perceives as speculative and volatile, China recently declared all cryptocurrency transactions illegal. Other global regulators are calling for tougher bank capital rules for crypto, in particular where there is exposure to more volatile assets.
Several key trade groups, including the Global Financial Markets Association, Institute of International Finance, International Swaps and Derivatives Association and the Chamber of Digital Commerce, recently issued a joint response to the Basel Committee on Banking Supervision’s proposals for the prudential treatment of crypto asset exposures. They stated that these proposals are too conservative and simplistic, and “would create material impediments to regulated bank participation in crypto-asset markets”. Since most crypto asset activity falls outside the regulated sector, unregulated entities enjoy a degree of freedom compared to their regulated counterparts operating in the same market. The regulated entities must still comply with their regulatory obligations, including AML, know-your-customer and sanctions.
The crux of the matter is that if the crypto asset industry has to operate within overly strict regulatory parameters or, at the other extreme, without any effective regulation, then the opportunities for fraud, money laundering and other misconduct seem likely to increase rather than decrease. Regulators need to work together to undertake a careful balancing act and to create a robust and consistent environment for crypto assets; the question is whether they will do so before a seismic market event exposes the gaps and generates financial instability in the crypto industry, with corresponding implications for the global economy.
Kate Gee is counsel at specialist law firm Signature Litigation.
