Heading into Crypto Policy Summer

Market downturns are typically times when lawmakers and regulators focus their attention on novel or opaque financial instruments. Recent turbulence in crypto markets following a period of spectacular growth is putting digital assets under the spotlight amid renewed calls for tighter regulation. As many insiders warned, an algorithmic stablecoin, one not backed by a fiat currency, was forced to depeg from its dollar equivalent after being subjected to unprecedented speculative pressure.

With digital asset venues working hard to deal with sanctions against Russia, institutional investors are now debating how and when to enter crypto markets in a way that does not expose their core business to disproportionate risk. Allegations of market manipulation during the recent turmoil are fueling expectations the SEC is preparing more enforcement actions in the crypto marketplace.

Meanwhile, the White House, through an Executive Order, has directed government agencies to recommend new rules to guide digital asset innovation and address risk. It’s an important development as some 40 million Americans have invested, traded or use cryptocurrencies.

We went through a so-called “DeFi Summer” and an “NFT Summer.” Now we are heading into “Crypto Policy Summer.” Crypto champions and skeptics both agree that regulation has not kept pace with the explosive growth and underlying risk of some digital assets.

By early September, the White House’s Executive Order’s 180-day deadline for the first batch of reports on digital asset policy changes will be due. Those reports will represent a proliferation of regulatory ideas that, once on paper, will have a stronger likelihood of getting codified. The EU is also working on its own initiative under the Market in Crypto Assets (MiCA) framework that includes safeguards against money laundering and terrorist financing while adding consumer and investor protections.

Other jurisdictions, such as Abu Dhabi and Singapore, are experimenting with new regulatory regimes and debating questions such as the appropriate limits on marketing crypto to the general public. With these varying activities in mind, compliance teams, crypto lawyers and policy associations have this moment to shape regulatory outcomes.

The Need for Regulation

Crypto is not “unregulated”—there are clear guidelines about when anti-money laundering (AML) laws apply, for example. In most jurisdictions, however, the asset class lacks a “framework,” which is often shorthand for saying participants are unclear about what business activity is regulated and by what agency.

Sound crypto regulation should aim to achieve three things: (1) protect investors from fraud, (2) prevent crypto from supporting harmful activities, and (3) encourage innovation through the ownership and trading of digital property. Fraud prevention includes rules about disclosure, clarifying registration requirements, as well as detecting and punishing rug-pulls and price manipulation.

AML and know-your-customer (KYC) rules help stop criminals from exploiting crypto to fund illicit activities. For example, the F.B.I. has warned that state-backed actors from North Korea are targeting crypto exchanges and decentralized finance (DeFi) protocols. An April report by the Washington Post identified North Korea and Iran as among the top hacking nations.

But in addressing calls for wider regulation, there is a need for balance. Being able to enter and exit digital asset markets will encourage entrepreneurs to build new business models online. In stark contrast to extractive technology companies, crypto holds the possibility for customers to become owners and for builders to have the same incentives as those who promote and use their products.

Yet that ownership will require safe and trusted markets where digital assets can be traded freely without, for example, price manipulation that acts as a de facto tax. Structured correctly, flexible regulation and surveillance of crypto markets can be an important driver of the next phase of the internet, sometimes referred to as Web3.

Building from Past Lessons

The good news is that, heading into this crypto policy summer, governments have upped their knowledge on the core issues at play and many digital asset businesses have been proactive in readying themselves for broader regulation. Both are drawing on lessons learned from other asset classes to guide thinking. Though in their early stages, these developments offer valuable knowledge for regulators.

Forward-thinking government innovation has led to deeper insights that can be leveraged to better understand what works and what does not. In comments regarding crypto, U.S. Treasury Secretary Yellen has stressed that the “financial system benefits from responsible innovation.” The U.S. state of Wyoming passed a law in 2021 recognizing digital autonomous organizations (DAOs) giving them the same legal status as limited liability companies.

Miami is planning to offer residents a bitcoin dividend as a reward for staking MiamiCoin, the city’s cryptocurrency. First introduced last year, MiamiCoin generated over $21 million in revenues in just three months. But the project is not without issues and faces the supervisory challenge of distinguishing residents and those that move in and out of the state.

In the U.K., the government has signaled ambitions to become a global cryptocurrency and Fintech hub. In May the Treasury outlined plans to make the U.K. a more attractive venue for crypto assets. Across the English Channel, France became the first major European nation to approve a cryptocurrency exchange when its market regulator AMF listed Binance as a digital assets service provider.

As we have seen in global equity markets, regulation ensures investors can frictionlessly move in and out of investments secure in the knowledge that fraudulent activity can be quickly detected. This degree of comfort has fueled the innovation we see today in capital markets around the world. Lessons garnered from equity markets as well as FX markets, are equally relevant to crypto markets. After all, fraud is fraud, spoofing is spoofing, and wash trading is wash trading.

Be Proactive in Building Compliance

Nevertheless, crypto and digital assets present unique compliance challenges. As an example, it’s difficult to run a KYC check when the customer’s true location may not be clear.

Still, many crypto companies and institutional players are taking the initiative and talking with and educating regulators to ensure they are not only properly licensed but have compliance programs in place to future-proof against an inevitable wave of new regulation. Sharing with regulators what compliance systems already are in place, along with how far surveillance technology has come, could encourage regulators to take a lighter, more experimental approach in setting new rules.

Preparing for the future of digital assets includes investing in regulatory technology tools for disclosure, customer due diligence, transaction monitoring, surveillance and reporting. This investment in tech, plus hiring experienced compliance experts, will become a major business differentiator.