In a recent Funds Europe webinar, our panel debates the need for an appropriately regulated digital assets market and considers what these rules should look like.
The rapid rise of digital asset classes, products and infrastructure is transforming the investment market at an unprecedented rate.
At the same time, attention is turning to how this emerging market should be regulated. While the wheels of regulatory change generally move much slower than those of technology innovation, one event has accelerated the need for suitable rules.
The collapse of crypto exchange FTX back in November raised a number of critical issues around regulation – what rules are there currently in place for digital assets and are they fit for purpose? Do we need to create an entirely new framework for this virtual marketplace? And how do we ensure investor protection without inhibiting innovation?
One of the most noticeable points to emerge from the FTX collapse was how crypto or digital assets seem to be lumped together as one homogenous thing rather than a diverse marketplace with very different instruments, from tokenisation to cryptocurrencies and from stablecoins to central bank digital currencies (CBDCs), all with their own intrinsic value.
“As a custodian we are much more interested in the payment rails and the digital asset tokens and how they enable the market to be more efficient and more transparent and potentially provide more liquidity and deliver wider investment opportunities for our clients,” said Justin Chapman, Global Head of Digital Assets and Financial Markets at Northern Trust.
Changing the narrative:
For Natalie Berkecz, Global Head of Regulatory Product at Northern Trust, the FTX case has clearly strengthened the need for regulation in the digital assets world. “We need to change the narrative of ‘another month, another crypto crisis’. Consumers need confidence that crypto assets have longevity and that the asset class is secure and robust.”
Currently a lot of digital assets fall outside of the current rules so would not be subject to the same protections and safeguards found in other areas. “This prevents the benefits of the asset class from, being realised and exposes consumers to potential harm and it also poses financial stability risks,” said Berkecz.
For example, the EU’s financial stability board has stated that if its Markets in Crypto Assets (MiCA) regulation had been in place, with proper controls and segregation of assets, the outcome for investors would have been very different, stated Berkecz
For Angus Fletcher, CEO of Fnality UK, the blockchain-based wholesale payment system, it is a case of the same risk/same regulation principle
“That is the approach that regulators should take. If something looks like a payment system, it should be treated like a payment system. But while there should be a technology-agnostic approach where possible, the technology does enable things to be done in a different and more efficient way,” said Fletcher
This is where sandboxes could play a vital role, said Fletcher, in that they enable us to look at what those potential benefits are and whether the regulation should change to accommodate the technology.
For example, the Central Securities Depositary Regulation really prescribes how you should run a post-trade process in the securities world. But in a digital world where you have near-instant settlement, prescribing a set of activities based on a two-day settlement cycle doesn’t make sense, says Fletcher. “So any new opportunities have to be borne in mind when new regulation is rolled out.”
There are some challenges here though in applying the same activity/same regulation principle. As Chapman said, two companies may have the same activity but employ two very different operating models. There is also a potential barrier for smaller startups if they face an expensive compliance process, said Fletcher. “A degree of proportionality is important here and a degree of leeway to ensure that new technology does not impact financial stability but that the regulation is imposed in stages otherwise that new technology will die before it ever gets to market,” said Fletcher.
This is where industry consortiums and partnerships between startups and incumbents can be useful, added Fletcher.
The UK is the latest jurisdiction to have issued its plans for a digital assets regulatory framework. As Berkecz said, it is looking to use as much of the existing regulation as possible while being proportional. For example, there is a lot of transaction reporting as part of MiFID II. While data is relatively easy to access in a digital world, due to the size and the structure of digital and crypto asset markets, it would be inappropriate to impose those measures.
Currently the EU will have the most developed and comprehensive regulatory framework proposals under MiCA, according to Berkecz, covering conduct of business requirements for issuing firms, market abuse regimes as well as anti-money laundering controls.
There will be rules around capital reserves for stablecoin developers while crypto asset service providers will have to provide the source and beneficiary of underlying assets and client assets will need to be segregated.
MiCA also aims to bring some harmony to Europe’s currently fragmented regulatory landscape. And it will provide the legal certainty that consumers and investors need. However, it will be late 2024 at the earliest before the regulation will be in effect.
When it comes to rules specific to funds and investing in crypto assets, there is currently a hugely fragmented approach across the EU in terms of investing in crypto assets or using digital ledgers to issue fund structures, something that is allowed in Germany and other member states, noted Berkecz.
So, is there a role for international bodies like the Bank for International Settlements’ Basel Committee or the Financial Stability Board in bringing some sort of cross-jurisdictional alignment to this area? As Fletcher reminded the audience, there is fragmentation in the regulation of traditional assets and there are also different drivers for different domiciles based on their ambitions to be international crypto hubs as well as the different mechanics of countries’ legislative processes.
Interoperability also needs to be borne in mind, said Fletcher. “With new technology that could be rolled out across several jurisdictions, that interoperability will be key to help reduce cross-border friction.”
Another highly topical area is Central Bank Digital Currencies. While the Bank of England recently announced plans for a digital pound, there are currently more than 100 CBDCs in development internationally.
According to Fletcher, CBDCs are hugely important in both a retail and wholesale context. “When you look at other digital assets there is a need for a payment leg in order to be able to support the settlement of that asset – this was the reason Fnality was formed. Having a central bank-backed currency is hugely important for the efficiency and liquidity management of these assets.”
One concern is the current capital requirements associated with digital assets. If banks are given overly punitive capital rules, it will suppress the opportunity and push investors down unregulated avenues.
Any regulations for digital assets have to start with investor protection, said Chapman. But when it comes to the allocation of risk and capital, there is a real challenge.
For example, a US custodian may have to pay a capital charge multiple times for holding digital assets, which is not a fair reflection of the risk profile of the asset class. It also minimises the amount of capital you can apply to servicing these assets. “The investor protection has to be gold-plated and at least as good as it is now. But the other regulations have to reflect the true risk profile of the assets,” said Chapman.
While there are some familiar arguments around the regulation of digital assets such as the need for proportionality and some kind of global harmony, there is one essential difference, concluded Berkecz.
“There is a race to be the first jurisdiction to be appropriately regulated. Sometimes financial markets participants are looking for the most lightly regulated location but I think the opposite is true in digital assets. Firms will move to the most highly regulated jurisdictions because that’s what consumers and investors are looking for.”
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