In the wake of several prominent scandals and bankruptcies, global regulators are ramping up efforts to finalise regulatory frameworks for the crypto sector. 2022 has already seen the completion of Europe's Markets in Cryptoassets (MiCA) rulebook and the Basel Committee's prudential proposals. Looking towards 2023, we expect increased focus around the development of central bank digital currencies (CBDCs), Distributed Ledger Technology (DLT) sandbox initiatives and Decentralised Finance (DeFi). As a result, the expected impact on firms' business models is becoming clearer.
In June, European regulators reached provisional agreement on MiCA — which aims to clarify the application of existing EU rules to cryptoassets and introduces a new legal framework for any asset falling outside the remit of these rules. The regulation was initially proposed in September 2020 as part of the Digital Finance package and has now worked its way through several rounds of drafting and trilogues. Due to the `borderless' nature of the crypto sector and the consequent need for frameworks to operate globally, European representatives are touting MiCA as a potential blue-print for other jurisdictions. It's worth noting however, that MiCA in its current form does not substantially address DeFi or Non Fungible Token (NFT) regulation.
As MiCA will not begin applying to in-scope firms until Q1 2024, the European Central Bank (ECB) has announced it will develop crypto supervision standards aimed at functioning as a `stop gap' until then. These standards will focus specifically on harmonising the licensing of crypto activities across the block — with a horizontal analysis expected before the end of 2022.
In December, after two rounds of consultation, the Basel Committee for Banking Supervision's (BCBS) oversight body finalised proposals for the prudential treatment of cryptoassets and stablecoins. Despite push-back from industry, the BCBS doubled down on its conservative approach, requiring “unbacked cryptoassets and stablecoins with ineffective stabilisation mechanisms” to be subject to the highest possible one-for-one capital charges. This would make it highly unappealing for financial institutions to hold these assets on their balance sheets.
The Committee noted that, while the banking system's direct exposures to cryptoassets remains relatively low, recent developments have emphasised the importance of having a strong prudential framework. Nonetheless, it did grant some concessions to industry, including softening the overall limit on banks' exposures from 1% of Tier 1 capital to 2% and increasing flexibility in the capital add-on to cover the uncertainties of the novel infrastructure.
The Financial Stability Board (FSB) also recently published a consultation examining the regulatory and supervisory issues raised by cryptoasset activities. The consultation shows a growing understanding of the nascent ecosystem and clearly sets out expectations that these assets should be regulated in a similar way to traditional finance — “same activity, same risk, same regulation”. However, for now, the FSB does not offer practical proposals to address key challenges including the sector's cross-border nature and DeFi applications.
Financial Services and Markets Bill (FSMB)
In the UK, the FSMB was introduced in July 2022 — formally proposing to bring “digital settlement assets” used for payments (i.e. stablecoins) within existing e-money regulations. The Payment Services Regulations (PSRs) and e-Money Regulations (EMRs) impose capital, safeguarding, outsourcing, accounting and audit requirements on intermediaries and require firms to be authorised by the FCA.
The FSMB is set to be finalised in spring 2023 and, once stablecoins have been addressed, HM Treasury (HMT) will look to consult on wider cryptoassets.
It's worth noting that, following discussions in the House of Commons, the FSMB was pre-emptively amended to introduce an (intentionally broad) definition of cryptoassets that will bring them within the scope of the regulatory perimeter in the Financial Services and Markets Act 2000. This will account for the evolving nature of the ecosystem and will allow HMT to apply different parts of the regulatory framework (e.g., the financial promotions regime) based on responses to their consultations without the need for further primary legislation.
Central Bank Digital Currencies (CBDCs)
Both the ECB and the Bank of England (BoE), along with at least 50 other central banks, are in the process of researching and / or developing their own CBDC.
The ECB's 24-month investigation phase into a digital euro is set to conclude in October 2023, with the development of a prototype. As part of this phase, the ECB has been collaborating with private sector companies and intermediaries on potential user interfaces. Once the prototype is complete, the decision will be made on whether to go ahead with actually developing a digital euro.
The UK has followed a slightly more cautious timeline in the hope of gaining a second-mover advantage. As part of the recent Edinburgh Reforms, HMT and the BoE re-confirmed the launch of their first consultation into a CBDC “in the coming weeks”.
The two jurisdictions are also diverging on design. The EU is looking into both a wholesale and retail CBDC, whereas the UK has made it clear that, at least in the short term, it will focus exclusively on a potential retail CBDC. This is because most of the benefits of a wholesale option are already being provided by the BoE's Real-Time Gross Settlement (RTGS) omnibus account, which facilitates wholesale payments settlement in central bank money.
More specifically, the EU is looking to use an intermediated model for its retail CBDC — where the ECB creates its own digital currency that is distributed via private sector companies and commercial banks. The UK, on the other hand, is looking to use a synthetic model — which is essentially a private sector stablecoin backed by central bank reserves in their standard form.
Both the UK and EU are in the process of establishing regulatory sandboxes to experiment with the use of DLT in financial market infrastructures.
In June, Europe reached agreement on final regulation for the pilot regime for market infrastructures based on DLT (which ESMA has now dubbed DLTR) — which sets out a legal framework for the trading and settlement of transactions in crypto-assets that qualify as financial instruments (under MiFID II). Similar to a sandbox approach, the pilot allows for `safe experimentation' and will provide evidence for a potential subsequent permanent regime. The pilot is set to go live in March 2023 with a formal review scheduled for 2026. In the meantime, ESMA continues to consult on draft guidelines to establish standard formats and templates for application to the DLTR and has started to issue Q&As to assist with implementation.
In the UK, July's FSMB gave HMT the power to establish FMI regulatory sandboxes. These are set to launch by the end of 2023 (following formal assent of the Bill) — but still need to go through several legislative layers, where each sandbox is created by a specific statutory instrument. Within the sandboxes, HMT will be able to temporarily disapply or modify relevant legislation, to allow participating FMIs to “test and adopt new technologies and practices”. This aligns with the EU's DLTR and is a step away from the FCA's original regulatory sandbox (launched in 2016). However, unlike the EU equivalent, the scope of the UK sandboxes is intentionally not limited to DLT, in order to maintain technology neutrality.
The ongoing market chaos has reignited criticism of `centralised' crypto platforms — with some crypto advocates seeing this as proof of the need to move towards DeFi applications where self-executing smart contracts allow everything to be handled amongst peers.
However, regulators are more wary and emphasise the need for significantly more analysis and assurance before these applications can be deployed at scale. Jon Cunliffe (Deputy Governor of the BoE) recently stressed that neither the robustness nor the actual degree of decentralisation of these solutions is proven.
A recent BIS staff paper also noted that DeFi provides “the opportunity for market participants to circumvent controls in the financial system and create externalities for the rest of society” — e.g., “through facilitating tax evasion or skirting AML laws”.
What does this mean for clients?
Increasing calls for cryptoassets to be brought within the regulatory perimeter have led supervisory bodies to focus on finalising their frameworks. Moreover, the recent failures of several prominent crypto platforms have led supervisors to err, even further, on the side of caution.
Now, these frameworks (especially for `centralised' firms), are looking increasingly likely to include `traditional' pillars of existing financial regulation such as separation of client assets, financial and operational resilience requirements and audit/assurance requirements. Firms should continue to monitor developments closely and consider the implications for their business model.
In the interim, the UK Financial Policy Committee has warned that “financial institutions and investors should take an especially cautious and prudent approach to any adoption of (cryptoassets) until the necessary regulatory regimes are in place”.
For further details on US-specific developments, see the latest update here.