Will the crypto asset industry be driven underground? Regulatory regimes and risks – Kate Gee and Johnny Shearman

Cryptocurrencies continue to dominate the attention of finance reporters. Despite their much-publicised volatility, investor sentiment remains strong. In September, their aggregate market value topped USD 2 trillion for the second time this year. According to some forecasts, this figure may increase to USD 3 trillion by 2026. Equally, the potential development of further regulation continues to gather pace, provoking the attention of global financial markets and investors.

Across the growing industry, warning shots have been fired by key global regulators. Most recently, the Financial Conduct Authority (FCA) launched an GBP 11 million campaign targeting inexperienced, and in particular young, investors to help them understand the risks associated with cryptocurrencies.  Those risks include fraud, hacking, money laundering, sanctions risks, as well as general market and credit risks.  The US Treasury Secretary Janet Yellen has also repeatedly warned of the inherent risks that cryptocurrencies – notably, Bitcoin – pose to investors. She argues that fundamental questions exist 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.

China has gone much further. In its drive to clamp down on what the Chinese government perceives as speculative and volatile, it recently declared all cryptocurrency transactions illegal. Following the announcement, Bitcoin’s price fell by more than USD 2000 before recovering.

Elsewhere, some global regulators seem to be adopting a slightly more pragmatic approach. Rather than an outright ban, they are calling for cryptocurrencies to become subject to the toughest bank capital rules of any assets. To reflect the perceived enhanced levels of risk, they have also recommended that banks exposed to the most volatile cryptocurrencies should face stricter capital requirements. However, currently, most regulators are focused on enhancing existing regulatory regimes in order to accommodate the fast-changing crypto market and the risks that are developing in parallel, rather than launching new, tailored measures.

Given the enormous complexities, determining a new regulatory regime that is bespoke to their assorted needs will take significant time and effort by the myriad participants in the global crypto industry.  This task is even more challenging because of the variable terminology used in relation to digital assets, and the inconsistent and often piecemeal regulations that have been introduced around the world.  Simultaneously, a number of industry experts believe that regulators do not fully comprehend either the market or the activities they are seeking to regulate, or indeed the technology that is used. As a consequence, there is a risk that unclear, unnecessary, or overly draconian regulation could potentially do more harm than good.

Against this backdrop, the momentum of the crypto market as it continues to expand and develop is driving regulatory bodies worldwide to call for more regulation. The first to take a lead was Gibraltar, with a largely positive reception.  Under the Financial Services (Distributed Ledger Technology) Regulations 2020, which came into force in 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 licence.  As part of the rigorous application process, applicants must demonstrate that they will fully comply with the GFSC’s nine regulatory principles (for which the regulator has outlined helpful guidance notes).  At present, 14 licensed DLT providers and one virtual asset arrangement provider are already active in Gibraltar. No doubt, more will soon join their ranks.

In October this year, the Bank of England issued a statement saying that cryptocurrency assets could pose a systematic risk to the global financial system. Jon Cunliffe, the Bank’s deputy governor of financial stability, compared the destabilizing power of cryptocurrency to the subprime collapse of 2008. In that instance, the knock-on effects of a price collapse in a relatively small market were amplified and reverberated through an un-resilient financial system. The result was dramatic and persistent economic damage.  Care must be taken to limit the risk of a parallel situation occurring in the crypto market.

Despite further warnings from its financial regulators about cryptocurrencies and digital assets that match the tone of Yellen’s remarks, the UK is still some way from having a regulatory regime that is tailored for the crypto market. At present, the issue of whether or not a particular cryptocurrency activity is subject to UK financial regulation 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.

Across the EU, the scope and nature of regulation varies across the 27 member states. French regulators recently proposed that member state governments should give responsibility for overseeing cryptocurrencies to the pan-European markets watchdog, the European Securities and Markets Authority (ESMA), instead of the domestic regulatory bodies in each member state.  Strengthening ESMA’s powers might deliver a degree of consistency across the EU, but it remains to be seen whether national regulators will willingly relinquish some or all of their control over crypto, and enter into some form of centralised, and as yet uncertain, supervision by ESMA.

Where much of the activity in crypto asset markets falls outside the regulated sector, a strict approach to regulated entities that operate in that market imposes an additional burden. In trying to balance the growing appetite for investments in digital assets and cryptocurrencies with their regulatory obligations, it is an environment in which unregulated entities have a degree of freedom as compared to their regulated counterparts. Regulated firms also have to consider their AML and KYC obligations, as well as sanctions, credit and market risk.  A number of trade groups, including the Global Financial Markets Association, the Institute of International Finance, ISDA and the Chamber of Digital Commerce, recently wrote a letter to the Basel Committee on Banking Supervision. It stated that the Committee’s proposals are too conservative and simplistic, and may well preclude bank involvement in the crypto asset markets, making it too costly, risky and commercially unviable.

Going forward, a careful balancing act will be required by regulators. The risk is that if the crypto asset industry has to operate within overly strict regulatory parameters, or at the other extreme without any regulation at all, then it may be driven underground. Should that happen, the opportunities for fraud, money laundering and other misconduct seem likely to increase rather than decrease.