Crypto-asset regulation

March 2022

As the pace of digitalisation in the financial landscape increases, regulators are racing to turn theory into practice when dealing with different types of crypto assets. While central banks have the benefit of shaping central bank digital currencies (CBDCs) on their own terms, for unbacked crypto regulators are instead reactively expanding their currently limited role as potential harms crystallise.

This article summarises the regulatory developments since our previous updates here and here.

In the UK, the Bank of England (BoE) has continued to hold sessions for its CBDC engagement and technology fora. While the former has focused on the co-existence and interoperability of CBDC with other payment rails (networks or platforms), the latter has predominantly compared alternative structure and design elements. Both groups have stressed the need to establish clear objectives before any prototype or market research can be progressed.

At December's Treasury Select Committee hearing, Governor Andrew Bailey emphasised the BoE's resolve to opt for caution over speed relative to other jurisdictions. He noted that focus would be given to retail rather than wholesale CBDC, and that particular efforts would be taken to minimise any disintermediation of commercial banks. 

However, there has still been some pushback, with a report published by the House of Lords positing that a digital pound would pose “significant risks” to the UK, that the BoE had overstated the potential benefits and that a CBDC could cause a run on the banks during economic downturns.

In Europe, various regulators (notably, Fabio Panetta, ECB Board Member) continue to urge that the development of a CBDC is necessary to provide financial sovereignty in the future — protecting the economy against private sector alternatives as well as international competition. The European Commission has revealed plans to propose a digital euro bill within the first three months of 2023. Although the decision to implement a digital euro (expected after 2025) ultimately lies with the ECB, this legislation would contribute to the necessary legal foundation.

The BIS recently announced the next series of projects to be undertaken by its Innovation Hub — with CBDCs and payments now accounting for 13 out of 17 projects that were active in 2021 or are being launched in 2022. In particular, the Swiss Centre will be compiling lessons learned from two of its recent successful projects — Helvetia II and Jura. Jura explored settling foreign exchange transactions in euro and Swiss franc wholesale CBDCs as well as issuing, transferring and redeeming a tokenised euro-denominated commercial paper between French and Swiss financial institutions. Helvetia II looked at how the Swiss National Bank and five commercial banks could integrate wholesale CBDC in their core banking systems and run end to end transactions.

The BIS has also published a report highlighting the specific impacts of CBDCs on Latin American and Caribbean (LAC) economies. The report reiterated that CBDCs drive competition, promote financial inclusion, reduce payment costs (which are especially high in these countries) and diminish the threat to monetary sovereignty from private digital currencies. However, it also noted that tokens could lead to capital outflows and currency volatility if not properly managed. Currently, a particularly high number of LAC central banks — Ecuador, Uruguay, Bahamas, Eastern Caribbean and Jamaica — have developed pilot or more permanent CBDCs.

The FSB recently published a report assessing the risks posed by expanding crypto-asset market capitalisation (which grew by 3.5 times in 2021 to $2.6 trillion). The report highlights associated vulnerabilities including growing interlinkages with the regulated financial system, increasing leverage use in investment strategies and the high concentration risk for trading platforms. It also notes how the rapid evolution and international nature of these markets increases the potential for regulatory gaps, fragmentation or arbitrage.

Consequently, across the board, regulators are pushing to play a more significant role in the regulation of crypto-assets, apart from those jurisdictions — like India or China — which are proposing to ban them altogether.

In the UK, the FCA's December Board minutes reflect approval of a proposed strategy to extend its role, including further regulations that may be needed to support the FCA's limited existing powers. This may come off the back of FCA Chief Executive Nikhil Rathi's announcement that approximately 90% of cryptocurrency firm applications for authorisation under FCA money laundering regulations have (ironically) either been withdrawn or refused because of an observed “link to money laundering and serious organised crime being propagated”.

HM Treasury, together with the FCA, have announced plans to strengthen rules on cryptocurrency adverts — requiring them to be `fair, clear and not misleading'. This comes in the context of research suggesting the ownership of cryptoassets continues to rise, while consumer comprehension continues to fall.

Verena Ross, Chair of ESMA, has called for similar reforms in Europe, calling on the EU to finalise new crypto marketing regulations for the sector “as soon as possible”. However, some nations appear unwilling to wait, with the Spanish National Securities Market Commission publishing guidance around its own national requirements in February. Expanding on the approach taken in the UK, Spain requires all relevant advertisements to carry a blanket warning that `crypto assets are not regulated' and that `the full investment amount may be lost'.

Responding to requests from the European Parliament and Council, the European Central Bank (ECB) has published its opinion on a proposal for a regulation to extend traceability requirements to transfers of crypto-assets. The regulation (originally stemming from Financial Action Task Force guidance) proposes that crypto-asset service providers collect and make accessible full information about parties involved in transfers (as payment service providers currently do for wire transfers). The ECB notes that crypto-asset transfers are subject to similar money laundering and terrorism financing risks as wire funds transfers, and therefore welcomes the proposed 'levelling of the playing field'. More recently, a handful of EU lawmakers lobbied to take this even further by requesting that any crypto exchange refusing to comply be blacklisted and banned from Europe.

And, with the EU's Markets in Crypto Assets (MiCA) legislation now in its final round of parliamentary talks, some Green MEPs have developed draft amendments taking aim at blockchain's energy consumptive Proof of Work methods. The amendments, which propose crypto assets adhere to a series of minimum environmental standards before going to market, have already led to some legislative delays.

Gibraltar appears to be one of the few countries adopting a bullish approach to the crypto-market. Unlike others, Gibraltar has already committed to formally regulate crypto-technology — and has so far approved 15 firms for its DLT licensing scheme. However, ministers are prepared to replace these laws with the EU’s MiCA and traceability requirements, once passed.

Further afield, the IMF has issued various warnings:

• It has called for global action on regulating crypto currencies “before the market destabilises countries' financial health”. In particular, it has urged that crypto companies be required to jump through similar hoops to other financial firms — including the obligation to acquire licences to store data, transfer and settle funds, and hold reserves and assets. 
• It has warned investors against using crypto-currencies to hedge against the stock market, as they found that the price of Bitcoin is now moving “more in lockstep” with stocks. 
• And it has warned El Salvador to reverse its 2021 decision to treat Bitcoin as legal tender, noting that this could make it difficult to grant the country loans.

Finally, ISDA has announced that it is developing legal standards to support the crypto derivatives market. Until now, institutions have largely traded these derivatives using amended versions of existing ISDA templates, or by using their own bespoke documentation. This not only leads to a lack of standardisation but may also mean that certain events are not directly covered.

These developments demonstrate how global regulators are continuing to grapple with the mammoth task of bringing the crypto world within the regulatory perimeter in a safe and effective way. While the approach for CBDCs remains, by definition, more within their control, regulators are playing `catch up' as the market leads the way for private tokens. The specific impacts for financial firms remain to be seen and they should therefore stay abreast of development and debate in this space.