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Counsel Kate Gee examines whether regulation risks driving the crypto market underground in The FinTech Times.

Kate’s article was published in The FinTech Times on 14 October 2021 and can be accessed here. 

Despite their inherent volatility, the aggregate market value of cryptocurrencies has twice breached the $2 trillion mark this year. Some forecasts of the crypto industry’s value suggest that this figure may increase to $3 trillion by 2026, indicating a compound growth rate approaching 10 per cent. It therefore comes as no surprise that the potential development of further regulation continues to attract attention and engagement from the global financial markets and investors alike.

Globally, politicians have fired assorted warning shots. This year, US Treasury Secretary Janet Yellen has repeatedly spoken of the dangers that cryptocurrencies – in particular, bitcoin – pose both to investors and to the public. She has argued that there are important fundamental questions about their legitimacy and stability. In July, she “underscored the need to act quickly to ensure there is an appropriate US regulatory framework in place.” Meanwhile, China’s government continues to clamp down on what it perceives as a speculative and volatile markets – it has recently declared all cryptocurrency transactions to be illegal, following which the price of Bitcoin fell by more than USD$2000.  This is not the first time that FUD (Fear, Uncertainty and Doubt) from China has impacted market confidence.

Global regulators are taking a more pragmatic approach. Rather than advocating a ban, they have made prudent calls for cryptocurrencies to become subject to the toughest bank capital rules of any assets. They have further suggested that banks which are exposed to the most volatile cryptocurrencies should face stricter capital requirements to reflect the enhanced levels of risk. Much of the focus is on enhancing the existing regulatory regime to meet the fast-changing crypto market and the parallel risks that are developing alongside it – including fraud, hacking, and money laundering and sanctions risks, as well as market and credit risk more generally.

On any realistic view, devising an appropriate regulatory regime that is bespoke to crypto will take considerable time and effort by the global crypto industry.  The task is made more difficult by the inconsistent use of terminology relating to digital assets globally, and the inconsistent rules and regulations that have been introduced – often on a piecemeal basis – in various jurisdictions around the world.  At the same time, some industry experts think that the regulators do not fully understand the market they are seeking to regulate or the technology used in it – and that there is a risk that unnecessary, unclear or overly stringent regulation could do more harm than good.

However, as the crypto market continues to expand and develop, regulatory bodies worldwide call for more regulation. Gibraltar was the first to take a lead, with a largely positive reception.  Since the Financial Services (Distributed Ledger Technology Providers) Regulations 2020 came into force on 1 January 2018, any entity which, by way of business in or from Gibraltar, stores or transmits value belonging to others using distributed ledger technology must first apply to the Gibraltar Financial Services Commission (GFSC) for a license.  During the rigorous application process, which typically takes a number of months, applicants must show, inter alia, that they will comply with the GFSC’s nine regulatory principles (for which helpful guidance notes have been set out by the regulator).  At the time of writing, there are already 14 licensed DLT Providers and one Virtual Asset Arrangement Provider active in Gibraltar.  No doubt, more will join the ranks in the near future.

By contrast, and despite UK financial regulators having issued warnings about cryptocurrencies and digital assets that are not dissimilar in tone to the remarks made by Janet Yellen, the UK is still some way from having a bespoke regulatory regime for the crypto market. Currently, whether or not a particular cryptocurrency activity is subject to financial regulation in the UK depends on whether it falls within the scope of one or more of: FSMA, the AML regime, the Payment Services Regulations 2017, and the Electronic Money Regulations 2011.

As matters stand, the scope and nature of regulation varies across EU member states.  Recently, French regulators have proposed that EU member state governments give responsibility for overseeing cryptocurrencies to the pan-European markets watchdog, the European Securities and Markets Authority (Esma), instead of to the domestic regulatory bodies of each Member State.  Although strengthening the powers of Esma might deliver some consistency across the EU, it remains to be seen whether national regulators will be prepared to relinquish some or all of their control in this area, and enter into a form of centralised supervision operated by Esma – the nature of which is uncertain.

In circumstances where a lot of activity in crypto asset markets falls outside the regulated sector, a strict approach to regulated entities that operate in the crypto market imposes an additional burden on those institutions. Regulated institutions have to grapple with how to balance the increasing appetite for investments in digital assets and cryptocurrencies with their regulatory obligations, in an environment in which unregulated entities have comparative freedom.  They also have their due diligence and KYC obligations, sanctions risks and credit/market risk to consider.  Trade groups including the Global Financial Markets Association, the Institute of International Finance, ISDA and the Chamber of Digital Commerce recently wrote to the Basel Committee on Banking Supervision to say that their proposals are too conservative and simplistic, and may well preclude bank involvement in the crypto asset markets, not least by making it too costly, risky and commercially unviable.

This begs the question: if regulated entities are required to operate within strict regulatory parameters, will the crypto asset industry be driven underground?  If so, it seems likely to increase the opportunities for fraud, money laundering and other misconduct rather than limit them.