Over the past decade, cryptocurrencies have multiplied, the surrounding industry has ballooned and the conversation around digital assets has scampered up the mainstream agenda. But one thing that has grown very little is clarity on the sector’s legal standing.
Around the world, different regimes have taken vastly different approaches to crypto, from China’s total ban to El Salvador’s enthusiastic embrace. Between those two poles, most countries are trying to figure out how to shoehorn this brand new asset class into regulatory frameworks that evolved slowly over decades or centuries, trying to weigh up the risks of financial destabilization against the rewards of innovation. International coordination is woefully lacking, and market participants have little hope of understanding what rules apply to any given entity when even within the US, competing legislation attempts get stuck in political gridlock and separate agencies argue over how to define and oversee digital assets.
Against this background, the fall of FTX was seen as a wake-up call. India had already made crypto regulation one of the eight priorities for its presidency of the G20 next year. After the G20 leaders met on November 15th & 16th, US president Joe Biden published a collective statement that it was “critical… to strengthen regulatory outcomes and to support a level playing field” in the sector.
The crypto industry has from inception seen itself as an alternative to the financial establishment. Many of its biggest entities have deliberately evaded regulation, setting themselves up in countries with a lighter regulatory touch (such as the Bahamas), either following this anti-authoritarian spirit, or for less principled reasons. This makes the challenge of formulating better oversight and protections all the harder, but it is essential.
Despite resistance from the core crypto community, especially decentralized exchanges, in the wider market, investors are eager to see stronger regulation. After multiple bankruptcies caused market havoc this year, there is a sense that it’s time to grow up – greater oversight will only make the sector more attractive. The investment industry wishlist emphasizes common-sense measures such as audited accounts, separation of activities and segregation of client assets. Protecting naive investors from their own naivety, should they bet on a token without underlying value, is not a priority.
The International Financial Stability Board has proposed recommendations (now reiterated by the G20) that broadly follow the principle of “same activity, same risk, same regulation”. That is, crypto should fall under similar rules to entities that perform similar functions – with higher standards for stablecoins, owing to their structural importance.
In the US, the Securities and Exchange Commission has been pushing to have cryptocurrencies treated as securities, attempting to establish regulatory oversight by simply applying existing laws to the new crypto institutions. That has meant suing Ripple for offering unregistered securities, and charging a Coinbase employee with insider trading, for example. But this “regulation by enforcement” approach leaves a lot of uncertainty, and is not proactive enough in protecting investors.
The same can be said for licensing regimes in those countries that are eager to establish themselves as crypto hubs, such as the UAE or Singapore. Licensing may seem to provide a framework for oversight, but without clear international standards, how can consumers know what (if any) protections they actually have? Since Singapore suffered its own FTX moment, with the collapse of Three Arrows Capital, it has taken a more restrictive tone, proposing measures such as prohibiting the purchase of tokens with credit cards. But this brings new risks if it pushes investors toward unregulated instruments.
Inevitably, the shockwaves caused by FTX’s dramatic failure drew all the wrong kinds of attention, and renewed pressure from crypto skeptics such as Elizabeth Warren, who took to the Wall Street Journal to warn that if left unchecked, crypto could take down the economy. Despite complaints from within the sector that such headlines show lack of understanding, authorities around the world will surely be scrambling to accelerate their existing efforts to regulate, and examine existing frameworks for weaknesses.
As major economies and global financial bodies set their sights firmly on establishing a framework for international collaboration (and thus reducing the risks of destabilization), it is likely that policy will settle along the lines now emerging in the US, Europe and Australia, all of which are focusing largely on secondary providers. Setting liquidity provisions and other requirements for exchanges could go a long way to improving consumer protection, though it would come at a cost of privacy.
The EU’s upcoming rules for Markets in Crypto Assets – due for a final vote in February – would also make exchanges responsible for protecting consumer assets, establish a need for reserves to back stablecoins, and introduce a requirement for crypto issuers to register. Legislators are said to be monitoring the FTX situation closely as the vote approaches, but are not likely to make any adjustments at this stage.
Opinions are divided on how effective the MiCA rules might have been in preventing the FTX disaster, even among the legislators involved. One MEP has already stated that MiCA would have been effective in protecting EU-based crypto users of the exchange, while another has said he believes the regulation would only have mitigated the worst of the damage.
But even if legislation would have limited effect, given the complexities of crypto markets and jurisdictions, authorities are impatient to act. As a deputy governor at the Bank of England warns, delaying action will allow even more interconnections to develop with the wider financial system, meaning greater risks to the economy. And Switzerland – which already regulates crypto service providers via its comprehensive blockchain law – may provide a case study for regulation as a protective mechanism. Many in the country are hoping that its existing safeguards may attract more platforms and entrench its “safe haven” reputation.
While authorities wrestle with these problems, a voluntary solution within the industry has been proposed. Multiple exchanges have followed Binance’s pledge to publish Merkle tree proof of reserves, and Coinmarketcap is now showing these holdings (constantly updated) where available.
However, while this transparency is welcome, assets are at best half the picture; it is impossible to judge an entity’s financial health without being able to assess liabilities as well. Furthermore, just one company is currently providing almost all independent proof of reserves attestations – as it did for FTX. The fact that FTX received a clean audit on this basis should bring some perspective to the notion that this is an adequate measure of financial health.
Meanwhile, the market is still anxiously watching and waiting for more dominoes to fall; BlockFi announced bankruptcy proceedings and the Digital Currency Group is urgently fundraising. In the ongoing market turmoil, we can expect even crypto-friendly regimes to look for ways to improve consumer protections and reduce vulnerability.
The details are murky, but looking at the latest developments around the world, the general direction of travel seems fairly clear: a push for greater coordination between authorities, building on existing efforts, and an emphasis on transparent accounting, stricter licensing and requirements for reserves as well as segregation of customer assets.
Not only authorities, but also investors, are looking for reassurance along these lines. Which makes for some good news. If regulators succeed in creating some clarity, this year’s crises should ultimately drive sustainable growth in the sector, in a stronger, healthier ecosystem. In the long run, that might even mean crypto’s worst week turns out to deliver its best news.
