How Regulation Affects Crypto
*This article was written prior to the week of Nov. 7, when crypto currency exchange FTX collapsed and filed for bankruptcy.
Regulation and cryptocurrencies are a never-ending story. While common perception still thinks crypto to be widely unregulated, this is not true, especially when it comes to centralized counterparties dealing with digital assets. If anything, it is crypto’s decentralized technologies like DeFi protocols or blockchain networks that are yet to be incorporated into regulatory frameworks.
In the pursuit of this, several countries have made efforts towards regulating cryptocurrencies, but this has been difficult because global standards do not yet exist. Standard Setting Bodies (SSBs) have tried to develop regulatory standards, but they concentrate on specific products (global stablecoins), sectors (securities and banking), entities, and issues like financial integrity.
Another problem that’s inhibiting crypto regulations is that digital assets are cross-border and cross-sector, limiting the effectiveness of regulations created by single countries. Also, cryptocurrencies are often issued, exchanged, and transferred by non-bank entities. These entities offer products and services that aren’t legally recognized as financial products or services and thus require a new regulatory approach.
While it may take some time before the existing regulatory gaps are filled, many consider regulations based on global standards a factor that will have a positive impact on the crypto space. Some of these effects may include improved market stability, better investor protection and increased confidence, and an overall safer crypto ecosystem.
The challenge of regulating crypto
The new world of digital assets is complex, unconventional, and fast-moving. That means regulators have their work cut out for them because they not only need to understand this space but also keep up with its speedy growth. Here are some of the reasons that make crypto regulation an arduous task.
Diverging Domestic Views
Crypto assets and decentralized finance (DeFi) are polarizing topics in any domestic political context because they’re hard to classify. For instance, regulators are struggling to figure out which digital assets are securities and which are commodities. The recent differing positions between the CFTC (Commodity Futures Trading Commission) and SEC (Securities and Exchange Commission) in the U.S. are clear examples of this struggle.
Further issues develop when deciding which bodies should supervise the various products in the crypto market because politicians, regulatory entities, and central banks typically hold opposing views, and it seems like everybody wants to take responsibility.
Different Global Views
Existing geo-political differences will inhibit the likelihood of nations working together as a single unit to develop global standards for crypto assets. This could compromise the future of nation-state money and the state of the global financial sector. Views on significant matters such as privacy vary across countries, and the level of institutional trust and access to financial products and services is different across jurisdictions.
Regulating a decentralized sector is complicated and somewhat ironic because decentralization was created to mostly eliminate authorities that control money on behalf of the masses. That means regulators have the massive task of figuring out what should be regulated and what cannot. So far, regulators have been going after entities like crypto exchanges that allow users to exchange crypto assets. This is more straightforward than attempting to regulate protocols that are simply made up of code.
Developing comprehensive policies and regulations for crypto assets is an opportunity for jurisdictions to position themselves as leaders in this vibrant space. A few countries have been competing to be the first in issuing comprehensive crypto regulations. Unfortunately, this competition can inhibit the progress of taking a unified approach to establishing global standards.
Digital assets don’t recognize borders or jurisdictions because users only need an internet connection to access them. That means project developers can build protocols from anywhere in the world and make them instantly available. As such, relevant parties might not even reside in a country that looks to regulate them, which makes it a lot harder to actually enact robust regulations.
What to regulate in crypto
In order to craft out proper regulation, governmental watchdog entities have to be aware of what to regulate in the first place. To date, the following objectives have been identified, whose proper regulation is believed to mitigate the risks that are common in the sector.
Crypto regulations can focus on mitigating the risks posed for global financial stability. Because of increasing interconnectedness with the traditional financial system, cryptocurrencies’ volatility can potentially threaten bank balance sheets and that of other financial intermediaries. Such risks are especially imminent in the case of stablecoins, which some have identified as the world’s new shadow banks.
It is no secret that consumers have lost a lot of money through investments in shady crypto assets. More generally, market risks may also be brought about by the volatility of crypto assets, which could result in losses for investors. On the other hand, users that store their crypto with custodial platforms expose themselves to third-party risks because they could lose their assets if the platform suspends withdrawals or ceases operations. Therefore, crypto regulations seek to protect users from such losses. To illustrate, rules can be put in place to guide virtual asset service providers (VASPs) in the response and recovery process following cyberattacks.
Crypto regulations should demand transparency from VASPs to ensure they don’t engage in harmful practices like market manipulation and opaque price formation. This can offer further protection to consumers.
As mentioned earlier, regulators have differing views on how to classify crypto assets, which creates regulatory uncertainty. Some also lack the expertise and knowledge concerning digital assets. Therefore, these issues need to be addressed before legal certainty can be achieved. Having legal certainty will make life easier for crypto-asset companies.
Crypto regulation: Who to regulate
Once regulators are aware of what areas to regulate and why, it is important to carve out what regulators in the crypto space need to regulate. These are:
Banks and Crypto
Prudent requirements are needed for bank exposures to the crypto market, and active monitoring is necessary for indirect exposures. For example, banks that want to add digital assets to their balance sheets should meet a set of strict requirements created by the Basel Committee on Banking Supervision (BCBS). In order to protect banks, the Committee’s binding suggestion makes it expensive for banks to hold crypto assets because of their high-risk profile. So, for every $1 in Bitcoin, banks need $1 of capital. Additionally, the risk weighting is very high at 1,250% for most crypto assets held on a bank’s balance sheets.
Within the crypto space, stablecoins are used as a hedge against high market volatility or during crypto bear markets. That means they need to be very reliable because they are somewhat regarded as a “last line of defense” by many actors from within the crypto sector. This reliability can be more thoroughly guaranteed by ensuring fiat assets actually exist and back every single token in circulation. Hence orders to redeem a token can be fulfilled if a lot of holders decide to cash out at the same time.
Adequate stablecoin regulation may involve requiring projects to provide transparent proof through proper audits indicating that they are actually backing the circulating tokens. This is crucial because stablecoins are, in reality, money market funds that affect global financial stability. Regulation could also address algorithmic stablecoins, which remain risky given UST’s collapse.
Regulating Crypto Exchanges
Centralized crypto exchanges are generally regulated by the existing national authorities (NCAs) in the jurisdictions where they operate. However, more can be done beyond simply demanding that they observe Know Your Customer (KYC) and Anti-Money Laundering (AML) requirements. For example, exchanges may be asked to maintain transparency to prove they are not manipulating the market or engaging in opaque price formation. They may also be required to follow Combating the Financing of Terrorism (CFT) requirements.
A look at the most important jurisdictions
Globally impactful economic areas such as Europe, China, and the U.S. are taking diverse approaches to crypto regulation. Here’s what’s happening in each of these jurisdictions.
China is probably one of the most crypto-unfriendly environments in the world because it banned all crypto activity in 2021. The People’s Bank of China declared all crypto-related activities illegal, leading to the great mining migration. Most Bitcoin miners previously relied on the country’s cheap electricity to power their mining operations. China’s share of the global mining capacity officially dropped to zero in July and August 2021 following the ban. Nonetheless, reports indicate that underground mining operations exist as miners try to work a way around the restriction. Also, mainland China ranked tenth in the Chainalysis 2022 global crypto adoption index despite the crypto crackdown.
China has offered its citizens a CBDC as an alternative to risky crypto assets. The central bank digital currency (CBDC), e-CNY, recorded $13.9 billion worth of transactions on October 22. It has been introduced on a trial basis in 23 cities.
Unlike China, which has banned cryptocurrencies outright, Europe is working on a regulatory framework called the Markets in Crypto Assets (MiCA). The legislation seeks to boost the potential for crypto assets while mitigating its threats. The European Council and the European Parliament Committee on Economic and Monetary Affairs (ECON) have approved the MiCA bill, which will come into effect in 2024.
MiCA was first proposed in September 2020 and will provide a uniform crypto regulatory framework for the 27 E.U. states. VASPs operating in the E.U. will be regulated under this legislation.
The United States
The United States is rushing to catch up with Europe and Asia on the crypto regulation front. The country signed into law its first digital assets regulation on November 15, 2021, introduced in the Infrastructure and Investment Jobs Act. On September 16, 2022, the U.S. released the first comprehensive framework for the responsible development of digital assets following President Joe Biden’s executive order in March 2022. This framework will act as a guide “for further action at home and abroad.”
The U.S. remains in the discovery phase of this process as it contemplates which regulatory bodies will oversee various crypto assets. Therefore, there’s likely to be a lot of debate regarding crypto legislation in the U.S. Congress in the coming months. Currently, the Commodity Futures Trading Commission (CFTC) is seeking authority over digital assets categorized as commodities.
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A few notable countries are quite advanced when it comes to crypto regulation. They include:
In September 2020, the Swiss parliament passed the DLT Act (Federal Act on the Adaptation of Federal Law to Developments in Distributed Ledger Technology). The legislation improves conditions for DLT and blockchain companies in the country.
Switzerland also proved to be quite progressive when it approved the stock exchange SDX to launch a digital asset exchange in 2021. This move could attract more crypto-asset investments in the country. Already in early 2018, Switzerland’s regulator Finma provided one of the first guidelines in classifying different digital assets.
Singapore offers a friendly regulatory crypto environment thanks to its favorable capital gains taxes and its approach to regulating crypto activities based on purpose instead of technology. As a result, the country is very attractive to crypto companies. Nonetheless, the country has recently announced plans to tighten crypto trading regulations to protect retail investors from the associated risks.
El Salvador made global headlines in 2021 for being the first country to make Bitcoin legal tender. This made it one of the most crypto-friendly countries in the world. The country’s president, Nayib Bukele, announced plans to build a smart city based on the use of BTC in May 2022. The city will attract crypto investment and maintain the country’s status as a crypto hub. Through its planned Bitcoin-backed bond, the country will exhibit how the issuance of compliant Bitcoin-based assets could look like in the future.