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Counsel Kate Gee argues that regulators need to work together to undertake a careful balancing act and to create a robust and consistent environment for cryptoassets in The Banker.

Kate’s article was published in The Banker, 24 January 2022, and can be found here.

Crypto regulation: too little, too late?

Cryptocurrencies continue to make headlines. Last year, their aggregate market value topped the $2 trillion mark; so far this year, investor sentiment remains strong.  Looking ahead, the focus is 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 and that an appropriate US regulatory framework should be implemented.  Based on the US regulator’s recent issued ‘Joint Statement on Crypto-Asset Policy Sprint Initiative and Next Steps‘, the sentiment is that regulation is warranted – but scope, severity and timing remain uncertain.

In the UK last October, the Bank of England suggested that crypto finance could pose a systemic risk to the global financial system. Sir Jon Cunliffe, the Bank’s deputy governor for financial stability, compared their destabilising potential to the subprime collapse of 2008, when problems in a relatively small market were amplified through an under-prepared financial system.  Cunliffe summarised his view:

“When something in the financial system is growing very fast, and growing in largely unregulated space, financial stability authorities have to sit up and take notice. They have to think very carefully about what could happen and whether they, or other regulatory authorities, need to act.

At the same time, they need to be careful not to over-react – particularly when faced with the unfamiliar. [… ]

Cryptoassets are growing fast […]. The bulk of these assets have no intrinsic value and are vulnerable to major price corrections. The crypto world is beginning to connect to the traditional financial system and we are seeing the emergence of leveraged players. And, crucially, this is happening in largely unregulated space.

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 – appears focused on enhancing existing regulatory regimes to accommodate the crypto market.  At present, cryptocurrency activity may fall under one or more of FSMA, the AML regime, the Payment Services Regulations 2017, and the Electronic Money Regulations 2011.  At the same time, the FCA has taken other steps, including banning the sale of crypto-derivatives to retail customers, issuing warnings about investments in cryptoassets, and launching InvestSmart – an £11 million campaign targeting young investors to educate them about investment risks, including in relation to digital assets.  Meanwhile, the English courts have demonstrated a willingness to adapt their tools to meet a claimant’s needs in claims involving crypto assets. While this robust approach is welcome, it is not substitute for proper regulation: a court may be able to help investors once investments have gone wrong, but it can offer little protection at the point of investment.

Devising a global regulatory regime suitable for dealing with the needs of the crypto industry will take significant effort, time and co-ordination. 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 cryptoasset.  There is clearly scope for incompatible measures.

Perhaps with this in mind, French regulators recently proposed that the pan-European markets watchdog, the European Securities and Markets Authority (ESMA), should regulate cryptoassets across the EU rather than domestic regulatory bodies. Strengthening ESMA’s powers might deliver consistency, but whether EU member state regulators would willingly relinquish that control remains in doubt.

One of the first regulatory bodies to take steps towards regulation of the crypto industry was the Gibraltar Financial Services Commission (GFSC), with a largely positive reception. The Financial Services (Distributed Ledger Technology) Regulations 2020, which came into force in 2018, provide that any entity which, 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. Under the rigorous process, applicants must demonstrate that they will fully comply with the GFSC’s nine regulatory principles. 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, the Institute of International Finance, ISDA and the Chamber of Digital Commerce, recently issued a joint response to the Basel Committee on Banking Supervision 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 as to AML, KYC and sanctions.

This is the crux of the matter: 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 cryptoassets – 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 on the global financial economy.