The rise of global crypto regulation: A long winter ahead

After the terrifying market distress triggered by the crash of Terra Luna – which has engulfed prominent players such as 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 underscored increased risk from intense volatility and structural vulnerabilities in a completely unregulated ecosystem. Meanwhile, regulators around the world are heaving a sigh of relief for their espoused regulatory conservatism, which kept traditional banking and finance sectors – both nationally and globally, insulated from the alarming crypto meltdown.

Prevailing regulatory vacuum and lack of investor protection norms

With a vacuum in the legal and regulatory framework, lack of clear classification and uncertain legal and tax status, investments in cryptoassets are confusing. Therefore, it is still unclear – whether crypto-assets should qualify as a payment instrument, currency or currency, electronic money token, speculative investment, commodity or other unspecified asset class. The issue becomes more complex in the case of so-called Stablecoins, which can be backed by money (one or more fiat currencies) or other assets or securities. The algorithmic Stablecoins may be more vexed since the price stability benchmark is derived from opaque algorithms and smart contracts. Likewise, Non-fungible tokens (NFTs) – i.e. digital assets that represent real objects such as art, music and videos, it is difficult to determine the basis of value and risk from independent sources.

The pseudonymous nature of cross-border transactions without traceability of true identity and jurisdictional residence makes risk monitoring and regulatory oversight enormously difficult. In the absence of basic disclosures that enable a reliable record of shares or flows of cryptoassets, cross-border fund flows virtually bypass anti-money laundering (AML) and tax compliance requirements. Establishing the true identity of entities involved becomes quite difficult if commingling and commingling/exchange of cryptoassets has been used in transactions or transactions involving intermediaries/counterparties based in shady jurisdictions.

Low transparency and less standardized market information about the issuance and trading of cryptoassets on the centralized or decentralized platform operated by unregulated intermediaries makes it less credible for investors. In unilateral bilateral contracts with crypto-intermediaries, there is hardly any provision for segregation and protection of customer funds or other safeguards for investor protection on such platforms. That makes it extremely difficult to hold the middlemen accountable in case the middlemen lose the investors’ crypto assets or commit an intentional fraud. Given the opacity of such platforms, it remains vulnerable to extreme risks of market manipulation, price rigging and insider trading, in addition to loss of assets. In the absence of necessary investor protection rights, no legal recourse is available to investors to seek redress against issues of fraud, abuse and manipulation.

Global regulations on cryptoassets: A long and winding work in progress

The opacity and inherent complexity of cross-border transactions require improved international cooperation for a consistent and comprehensive global regulatory framework covering crypto-assets, processing chains and associated intermediaries. Currently, 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) carefully. ongoing development of crypto-asset markets for focused guidance on various risk perspectives – including financial stability and anti-money laundering nuances.

The G20 Finance Ministers and Central Bank Governors meeting in Bali in July 2022 strongly endorsed the FSB’s position to ensure that crypto-assets – including Stablecoins and related markets are monitored under effective regulation. Compared to regulations applicable in the traditional financial sector, it supported FSB considerations to implement the principle of “same activity, same risk, same regulation” to strengthen the regulatory framework and support a level playing field, while promoting the benefits of innovation. In early July, IOSCO published its Crypto-Asset Roadmap for 2022-2023 and highlighted its regulatory agenda. Focusing on crypto and digital assets (CDA) and decentralized finance (DeFi), the Fintech Taskforce (FTF) aims to make policy recommendations by the end of 2023. Around the same time, CPMI and IOSCO published their final guidance on Stablecoin schemes which emphasizes that the principles for financial market infrastructures (the international standards formulated in 2012 for critical payment, settlement and settlement systems) shall be applied to systemically important Stablecoin arrangements.

Earlier, the Basel Committee initiated its second public consultation on the conservative prudential treatment of banks’ exposures to cryptoassets – especially unsecured cryptoassets and Stablecoins with ineffective stabilization mechanisms, with an assessment of new limits on gross exposures. The committee expects to finalize the related standard around the turn of the year. While the regulatory and standard-setting process is 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 that enables international settlements using several central banks’ digital currencies (mCBDCs) for cheaper, faster and more secure cross-border payments.

Progress of regulatory formulation in different jurisdictions

Largely guided by the regulatory stance outlined by the international standards bodies, regulators in different jurisdictions are currently at different stages of market consultation and formulation of regulatory approach and oversight mechanism. Until the global consensus on a coherent set of regulations is finalised, country-specific regulation in isolation may have less desirable regulatory outcomes.

While national regulators are maintaining a vigilant stance, the EU and HK have moved forward with the regulatory proposal under stages of legislative authorisation. The EU Markets in Crypto-Assets (MiCA) proposal after approval by the Council and the European Parliament is expected to enter into force in early 2024. The HKSAR government has introduced a comprehensive licensing regime for Virtual Asset Service Providers (VASP). Following recent approval from the Legislative Council, the VASP licensing regime is expected to begin in March 2023. Japan has also revised its existing Payment Services Law to regulate Stablecoins and cryptocurrencies to be issued by regulated entities, in addition to strengthening AML measures. In the United States, following the President’s Executive Order on Digital Assets, the Department of Treasury has issued a framework for the agency’s engagement with foreign counterparts and various international standardization bodies. Meanwhile, the Monetary Authority of Singapore (MAS) has issued guidelines for cryptocurrency service providers not to market their cryptocurrency-related services to the general public.

Outlook for the global regulatory framework and key imperatives

It is important that a broad-level consensus emerges among global regulators on the significant economic, legal and security risks, as well as greater threats to financial stability, that the unregulated crypto ecosystem poses. G20 finance ministers and central bank governors have realized that the development of a comprehensive global regulatory framework is urgent. Given unwieldy and lengthy rulemaking and stakeholder consultations, global consensus is easier said than done. As witnessed in the context of international tax reform agreement, global minimum tax rules and fair share of taxation, global consensus and coordination of cryptoregulatory framework is expected to be a long-term process.

While waiting for the global regulatory framework and underlying approaches to be finalised, the formulation of crypto-asset-focused regulation in each jurisdiction will also be slow and demanding. At the same time, maintaining equal treatment with ordinary financial assets and service intermediaries, the upcoming regulatory architecture of the crypto-asset ecosystem must consider the following critical considerations:

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

Given the complex nature of cryptoassets and tokens that overlap the regulatory boundaries of the central bank or monetary authorities, investment and securities market regulators as well as tax and AML authorities, a multi-regulatory supervisory control becomes a fundamental prerequisite. By keeping a more graduated approach, regulators can appropriately develop regulatory mechanisms beyond two extremes of non-interventionism (laissez faire) and outright prohibition. Maintaining a balance between regulatory costs and innovation benefits for the financial system, a more calibrated risk-based approach with different stances – for example, opt-in, exploratory piloting, comprehensive all-or-nothing can be considered for different crypto product types. While investing regulatory efforts to enable crypto markets and ecosystems, it must answer the most fundamental question of the extent to which innovation benefits outweigh the regulatory costs and unaddressed risks to the financial system and investor communities.

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