Although cryptocurrencies have been around for about a decade, it was no more than three or four years ago that regulators began to feel intense pressure to catch up. Before then, monetary authorities regarded these digital assets as something belonging to a different world that they thought would never collide with theirs. But as cryptocurrencies started to invade the capital markets, regulators all over the world have scrambled and struggled to respond, while not yet being completely comfortable with them.
There are many reasons why regulators should be uneasy. Cryptocurrencies were borne of the idea to break free from government control, and therefore they pose concerns for money laundering, criminal activity, tax evasion and the government’s ability to regulate the economy or conduct monetary policy. When they were adapted to be a means of raising funds, securities regulators had to step in but were not confident about making judgments on the viability of projects or the adequacy of disclosures because they were not familiar with blockchain technology and the underlying business model underpinning its use. Furthermore, not just regulators but also consumers and businesses are discomfited by not knowing whom to hold accountable should something go wrong.
By the middle of 2017, regulatory responses to cryptocurrencies (or crypto assets in general) varied from banning them outright to avoiding and discouraging them to introducing some regulation. Not many countries chose an outright ban, but initially many countries chose to disassociate themselves from these assets and discourage their people and regulated entities from participating in this market. The problem with that approach, however, is that regulated entities would be at a disadvantage to unregulated entities which are not prohibited from participating. Of greater concern is that investors could be driven to deal with unregulated entities and would then not have the level of protection (in terms of fairness and transparency) that they should have. It would be hard for them to tell which players are legitimate and which are not. This stance only works if there is certainty that the market would not grow to any significant size. This is not the case with crypto assets. By the end of 2017, many jurisdictions moved from avoiding having to deal with the issue to trying to regulate.
As time passed, it has become clear that the challenge is not just about cryptocurrency for the sake of cryptocurrency. There are more significant forces at work that are permeating the whole financial system – the expectation and hope that this disruptive technology will transform financial markets and make them more efficient, accessible and inclusive.
The challenges for financial regulators
1. Cryptocurrency and money
Regulators like to deny that cryptocurrency is money, hence they prefer the term crypto assets. Their view is supported by the failure of classic cryptocurrencies to achieve mainstream adoption due to their price volatility. That major roadblock, however, is solved with stablecoin, cyptocurrencies which are fully backed by fiat currency. No matter what they are called, in substance stablecoin are as close to money as you can get, and central bankers will soon have to step up their game and find a way to regulate stablecoin like money or even go on the offense by adopting a strategy using their own version of digital currency.
2. Existing or new regime?
In most jurisdictions the natural tendency is to use an existing regime. It allows regulators to respond quickly and be consistent: activities performing the same function should be treated under the same rule. Therefore, most jurisdictions use rules from existing laws applicable to cryptocurrency payment and to tokens (actual currency) for securities investments. Even some new laws and rules that are specifically written for crypto assets (such as Thailand’s Emergency Decree on Digital Asset Businesses) could be very similar to the existing securities regime in substance and still use the same function designations – exchange, broker, dealer.
This is where regulators might be overlooking something. In the crypto asset space, we see new types of functions and players emerging such as tokenization platforms and key management services. Furthermore, processes in the market for traditional securities will likely change and follow crypto processes. Some markets are already thinking about using crypto technology for processes such as securities issuance, offering and trading. These transformed markets will need players to perform these new functions associated with crypto assets, as well as new rules for these transactions. This is not going to be just about crypto assets. We will also need new rules for traditional assets. In fact, we will need a whole new regime because the processes and functions and the entire landscape are changing. It is not just about the products.
We are in transition from traditional markets to markets of the future, which will be more efficient and inclusive, precisely because they are going to be more decentralized
Take clearing and settlement as an example. In a world where settlement takes place two or three days after a trade is executed, we have to manage the risk that one party may fail to settle on settlement day. We do that by having the clearinghouse step in as a central counterparty to facilitate netting as well as to guarantee the performance of all parties. But in a world where settlement can take place almost immediately, there would be no need for a central counterparty or large clearing funds.
Or take the role of custodians who hold securities and money on behalf of clients. If traditional securities follow the crypto process, there will be a different kind of custodian known as “wallets” that manage client keys, or carry partial keys, or even a decentralized platform where clients manage their own keys. Even the determination of finality (the instant that a payment to another party is completed) could be different in a distributed ledger scenario.
What we are talking about is a significant change in the conceptual framework applicable not only to financial markets. Can our existing laws address these new concepts? We may need more than just tools to regulate activities. Some jurisdictions such as Liechtenstein have openly recognized the need to create legal certainty in the ownership and transactions in a token economy, covering financial instruments and beyond. The Liechtenstein Law on Tokens and Trustworthy Technology Service Providers (known as the “Blockchain Act”) is a collection of new rules and changes to existing laws that allows rights and assets to be tokenized. After the law comes into force in January 2020, nearly any right or asset can be “packaged” into a token according to what is called the Token Container Model (wherein any asset or right can be represented by a token).
3. Can we rely on intermediaries?
Securities markets have traditionally been an intermediated market, and a core component of securities regulation is about regulating the intermediaries. Some regulations exist for investor protection, e.g. safekeeping of client assets, duty of good advice and best execution. Some put the intermediaries in a gatekeeping role at the onboarding process to help prevent criminal activities including money laundering and terrorist financing.
For crypto assets, there could be different possibilities. The trading platform might still be centralized but allow direct access for investors. In such a case, the trading platform itself could be required to perform the gatekeeping function. But what if the platform is distributed, with investors agreeing on trades on their own and using the platform to settle? If investors place their crypto assets with a custody service, we can then regulate the entity providing custodial service. If investors self-custody using their own wallets, how do we regulate that?
4. Can we really restrict investors?
Another tool commonly used by regulators is to classify investors into different buckets based on legal status, wealth, sophistication, deal size or a combination of these. Then where we think the products are too risky for retail investors, we could take the paternalistic stance and restrict the sale of products to certain investors. There could be a limit on how much each person could buy in the deal or even in all deals combined – or even an outright restriction.
The problem is you can only make that restriction at the primary market, but investors can buy in the secondary market from others who are not restricted. They may end up buying anyway at a much higher price, even allowing unrestricted non-retail investors to profit from a retail restriction. We might stipulate that exchanges and intermediaries enforce that restriction, but what about decentralized platforms? I believe this kind of paternalistic restriction will not serve its purpose, and we need to consider other alternative tools more appropriate for this borderless environment, including education and better access to information, advice and investment services.
5. Competition policy
Competition may not be an issue for advanced markets where it is possible to have multiple trading venues, but it could be a big constraint for some emerging markets where licenses or authorizations to operate an exchange or trading venue or other intermediaries are restricted. This might be the hardest problem to solve, given that the idea behind those legal restrictions have probably been so ingrained into the lawmakers beliefs decades ago. The consequence for these restrictive markets might be that new players will set up to operate where the regime is more open to them, or try to follow the decentralized route altogether where they might not need the exchange license.
The regulator’s mindset
We are in transition from traditional markets to markets of the future, which will be more efficient and inclusive, precisely because they are going to be more decentralized, less dependent on traditional intermediaries, and harder to restrict. During this transition we might instead see a different kind of intermediary. We should encourage responsible intermediaries to emerge and work with regulators to perform some sort of a gatekeeping function, rather than making it hard for newcomers to be a regulated player. We do not want our policies to drive everyone to the end of the spectrum and total decentralization.
We also need to keep in mind that timing is everything, and we cannot wait until we are certain of attaining a perfect solution before moving. Especially in markets with a lot of restrictions and anti-competitive legacies, doing nothing means denying new players a fair opportunity to compete and offer value to our society.
Blumenfeld, Matthew; Horn, Michael; Ames, Keaghan; Raina, Nikhil; Munoz, Cesar; and Paulsen, Margaret. (2018) “Carving up crypto: Regulators begin to find their footing”, Regulatory brief, Financial Services Regulatory Practice, PwC.