Emergence of global regulatory framework on Crypto: A long winter ahead

After the frightening market distress triggered from crash of Terra Luna - engulfing prominent players like Three Arrows Capital and Celsius in recent months, the crypto ecosystem is still finding a way. At the same time, the recent turmoil in crypto-asset markets has underlined increased risks from intense volatility and structural vulnerabilities of completely unregulated ecosystem. Meanwhile, the regulators across the globe are heaving a sigh of big relief for their espoused regulatory conservatism, which kept traditional banking and financial sector –both at the domestic and global level, insulated from the alarming crypto-meltdown.

Prevailing regulatory vacuum and missing investor protection norms

With legal and regulatory framework vacuum, lack of clear classification and uncertain legal and taxation status make investment in crypto assets confounding. Thus, it remains unclear – whether crypto-asset to qualify as an instrument of payment, currency or foreign exchange, electronic money token, speculative investment, commodity or any other non-specified asset class. The issue becomes more complex in case of so-called Stablecoins, which can be backed by money (one or more fiat currencies) or other assets or collaterals. The algorithmic Stablecoins can be more vexed as its price stability reference is derived from opaque algorithms and smart contracts. Likewise, Non-fungible tokens (NFTs) - i.e., digital assets representing real objects like art, music and videos, it is hard to determine the basis of value and risks from independent sources.

The pseudonymous nature of cross-border transactions without traceability of true identity and jurisdictional residency makes risk monitoring and regulatory supervision immensely difficult. In absence of basic disclosures enabling reliable view of stock or flow of crypto-assets, the cross-border fund flows almost bypass anti-money laundering (AML) and tax compliance requirements. Establishing the true identity of involved entities becomes quite hard, if mixing and intermingling/interchange of crypto-assets have been applied in the transactions or transactions involving intermediaries / counterparties based in shady jurisdictions.

Low transparency and less standardized market information about crypto-assets issuance and trading on the centralized or decentralized platform operated by non-regulated intermediaries make it less credible for the investors. In one-sided bilateral contracts of crypto-intermediaries, there is hardly any provision for segregation and protection of customer assets or any other safeguards for investor protection on such platforms. It makes extremely difficult to hold the intermediaries liable, in case the intermediaries lose investors’ crypto-assets or commit a willful fraud. Given opacity of such platforms, it remains vulnerable to extreme risks of market manipulation, price rigging and insider dealing, besides loss of assets. In absence of requisite investor protection rights, no rightful recourse is available to the investors for seeking redressal against issues of fraud, abuse and manipulation.

Global regulations on Crypto-assets: A long and meandering work in progress

Opacity and inherent complexities of cross-border transactions demand enhanced international collaboration for a consistent and comprehensive global regulatory framework covering crypto-assets, processing chains and associated intermediaries. At present global regulatory and standard-setting bodies –e.g., Financial Stability Board (FSB), Financial Action Task Force (FATF), Basel Committee on Banking Supervision (BCBS), and International Organization of Securities Commissions (IOSCO) amongst others are closely evaluating ongoing crypto-asset markets developments for focused guidance on diverse risk perspectives – including financial stability and anti-money laundering nuances. 

G20 Finance Ministers and Central Bank Governors meeting of Bali in July 2022 emphatically supported FSB’s position to ensure that crypto-assets - including Stablecoins and related markets to be supervised under effective regulation. Comparing with regulations applicable in traditional financial sector, it endorsed FSB considerations of implementing the principle of ‘same activity, same risk, same regulation’ to strengthen regulatory framework and support a level playing field, while fostering benefits from the innovation. In early July, IOSCO published its Crypto-Asset Roadmap for 2022-2023 highlighting its regulatory agenda. Focusing on Crypto and Digital Assets (CDA) and Decentralized Finance (DeFi), its Fintech Taskforce (FTF) is aiming to come up with policy recommendations by the end of 2023. Around the same time, CPMI and IOSCO published their final guidance on Stablecoin arrangements emphasizing that the Principles for Financial Market Infrastructures (the international standards formulated in 2012 for critical payment, clearing and settlement systems) to be applied for systemically important Stablecoin arrangements.

Earlier, the Basel Committee initiated its second public consultation on the conservative prudential treatment of banks' crypto-asset exposures – particularly unbacked crypto-assets and Stablecoins with ineffective stabilization mechanisms, with a consideration of new limit on gross exposures. The Committee expects to finalize the related standard around the year-end. While regulatory framework and standard setting are underway, the Bank for International Settlements (BIS) Innovation Hub in partnership with the central banks of Australia, Malaysia, Singapore, and South Africa announced the completion of Project Dunbar. The project developed and validated prototypes for a common platform enabling international settlements using multiple central bank digital currencies (mCBDCs) toward cheaper, faster and safer cross-border payments.

Progress of regulatory formulation in different jurisdictions

Largely guided by the regulatory stance outlined by the international standard setting bodies, regulators in different jurisdictions are currently at the different stages of market consultation and formulation of regulatory approach and supervisory oversight mechanism. Till the time global consensus on a coherent regulatory framework is not finalized, country-specific regulation in isolation may have less desired regulatory outcomes.

While national regulators are keeping a watchful stance, EU and HK have progressed on the regulatory proposal under stages of legislative authorization. EU Markets in Crypto-Assets (MiCA) proposal after approval by the Council and the European Parliament is expected to come into force in early 2024. The HKSAR government has introduced comprehensive licensing regime for virtual asset service providers (VASP). After recent authorization from the legislative council, the VASP licensing regime is expected to begin in March 2023. Japan too has revised its existing the payment services law to regulate Stablecoins and cryptocurrencies to be issued by regulated entities, besides reinforcing AML measures. In USA, following President’s Executive Order on Digital Assets, Department of the Treasury has issued a framework for interagency engagement with foreign counterparts and various international standard setting bodies. Meanwhile, the Monetary Authority of Singapore (MAS) has issued guidelines for cryptocurrency service providers to not promote their cryptocurrency related services to the general public.

Outlook for the global regulatory framework and key imperatives

Importantly, a broad-level agreement is emerging amongst the global regulators about the significant financial, legal and security risks as well as larger threats to financial stability posed by unregulated crypto ecosystem. G20 Finance Ministers and Central Bank Governors have realized the urgency for the development of a comprehensive global regulatory framework. Given unwieldly and long-winded rule-making and stakeholders consultations, global consensus is easier said than done. As witnessed in context of international tax reform agreement, global minimal tax rules and fair share of taxation, global consensus and coordination on crypto regulatory framework is expected to be a long-drawn process.

While waiting for global regulatory framework and underlying approaches to be finalized, formulation of crypto-assets focused regulation in each jurisdiction is also going to be slow and onerous exercise. At the same time, maintaining at-par treatment with mainstream financial assets and services intermediaries, to-be regulatory architecture for crypto-assets ecosystem must reckon following critical considerations:

• Measures to ensure Financial stability and mitigation of systemic risks from cryptocurrency, electronic money token and Stablecoins 
• Anti-money laundering and mitigation of illicit financing and national security risks
• Authorization and supervision of intermediaries: crypto-assets issuers (including asset-referenced tokens and electronic money tokens), centralized or decentralized form of trading platforms, custodians, fund administrators, market data and index providers.
• Capital, networth, operational capabilities, conduct, disclosure and governance rules for the intermediaries 
• Market integrity, transparency and protection against market abuse and manipulation by the intermediaries
• Investor awareness, education and sound protection measures

Given the complex nature of crypto-assets and tokens overlapping the regulatory boundaries of the Central Bank or monetary authority, investment and securities markets regulator as well as tax and AML authorities, a multi-regulatory supervisory oversight becomes a basic requisite. Keeping a more graded approach, regulators can suitably devise regulatory mechanism beyond two extremes of non-interventionism (laissez faire) and the complete ban. Maintaining a balance between supervisory costs and innovation advantages to the financial system, a more calibrated risk-based approach with diverse stance – e.g., opt-in, exploratory piloting, extensive all-or-nothing can be considered for different crypto-product types. While investing regulatory efforts toward enabling of crypto- markets and ecosystem, it must answer the most fundamental question as to what extent innovation advantages overweighs the supervisory costs and unaddressed risks to financial system and investor communities.

Image courtesy: source - outliookindia.com (copyright of the owner acknowledged)