Is financial activity in the crypto asset ecosystem really that new? It depends on where the focus is, and governments’ regulatory approaches will need to respond accordingly.
If the focus is on the innovative blockchain technology at the heart of decentralized finance (DeFi), then crypto-related financial activities are definitely new.
However, while blockchain rails that eschew central verification may be new, the fungible and non-fungible tokens that run on them often represent familiar asset types.
Cryptocurrency assets bring new technological advantages and challenges, but commercial and investment activities often have parallels in the well-regulated financial and commercial sectors. And some of the risks they pose are similar to those already covered by existing regulations.
However, the principle of “same risk, same rules” or even “same risk, same outcome” can only apply if the risks associated with cryptocurrencies are indeed the same. Efficiency without over-regulation is achieved by determining where existing rules are sufficient to keep amendments and new rules to the minimum necessary. Two issues are particularly instructive in this regard: asset uncertainty and technological and inter-jurisdictional coordination.
IOSCO Decentralized Finance Report notes that stablecoins — cryptocurrencies pegged to a stable asset — have become “a replacement for DeFi fiat currency.” And if stablecoins act like deposits, then it makes sense to apply the same existing rules for accepting deposits to stablecoin issuers as to banks.
Payment systems that support authorization, clearing, and settlement with stablecoins should also continue to operate with rules equivalent to today’s positions. The stated approach of the UK Treasury is to “move activities that issue or facilitate the use of stablecoins used as a means of payment into the UK regulatory perimeter, primarily by amending existing legislation on e-money and payments.”
Minor issues arise from decisions regarding the taxation of stablecoin assets, whether stablecoins should earn interest, and the role of stablecoins in fractional reserve banking.
Big wrinkles arise from the use of stablecoins as investment vehicles. This may apply when stablecoins hold illiquid reserve assets, when their value is maintained by algorithms that regulate supply and demand against another cryptocurrency, or when they are used as a kind of money market fund to provide liquidity for other investments in volatile crypto assets. The US Department of the Treasury specifically notes that “stablecoins or certain parts of stablecoin mechanisms may be securities, commodities and/or derivatives.”
The regulation of securities and commodities sets precedents, but the challenge is to clearly define whether the primary purpose of a stablecoin is deposits and payments or investments. This question puts stablecoins in a wider range of untethered cryptocurrencies. The original purpose of decentralized cryptocurrencies could be payments, which excludes them from being considered securities, but their predominant use as investments raises regulatory problems for activities such as spot trading.
Further problems are related to the definition of interchangeability. Logically, fungible crypto assets such as cryptocurrencies or crypto-currency securities should be regulated as a means of payment or exchange, while non-fungible tokens (NFTs) should be exempt from financial regulation. But the line between them is blurred. Fractional NFTs, which allow ownership of a unique asset to be divided among multiple people, raise the question of what degree of granularity makes fractional NFTs fungible.
Utility tokens, which are often associated with raising seed capital as currencies for specific organizations, create problems when they increase in value with the state of the organization and start to work like stocks. Any voting rights associated with a governance token – a subset of a utility token – may look the same as rights granted to shareholders.
Technology and inter-jurisdictional coordination
Each blockchain is in fact its own community of technology standards. Interoperability remains in its infancy, and the resulting proliferation of bridging poses a number of security concerns.
The ability of trusted intermediaries to promote interoperability depends on regulators setting the baseline standards for consumer protection, security, data protection, and privacy. There is a precedent in open banking, where secure open banking connections established through application programming interfaces (APIs) often rely on API aggregators to provide interoperability. Similarly, governments can maintain the security and interoperability of blockchains without permission.
Removing intermediaries in DeFi transactions is new, but scaling this approach may eventually require a certain degree of centralization for legitimacy, just like open banking requires a certain degree of closed privacy. And the main risks it poses are often similar to traditional finance associated with activities such as trading, transmission, settlement or lending.
When existing rules seem insufficient, such as anonymous trading through decentralized exchanges (DEXs) or non-hosted wallets, rules dealing with similar risks related to issues such as anti-money laundering (AML) and know-your-customer (KYC) ) can be adjusted as needed. . At least that’s the theory, especially as new concepts like decentralized identities emerge.
In fact, enforcing KYC and AML requirements is a complex task. For example, a DEX can bypass both by automatically creating markets through liquidity pools of invested assets and then executing anonymous transactions on its own using “smart contracts”.
Additional challenges relate to international coordination regarding enforcement of the “travel rule”, which requires all financial service providers to share originator and beneficiary information and to prevent regulatory arbitrage when providers seek more favorable jurisdictions. Guidance from international compliance standards makers, such as the Financial Action Task Force on Money Laundering (FATF), is welcome, but requires implementation at the national level, which is often lacking.
The inconsistent regulatory regime across jurisdictions leads to an uncertain business environment for crypto-innovation and especially limits the ability of larger entities to participate.
Meanwhile, smaller and less risk-averse organizations may have little incentive to invest in compliance. Rules without enforcement don’t matter much. A level playing field for all participants is achieved through equal enforcement at home and abroad.
Tokenizing assets to record ownership on the blockchain does not change the assets themselves. This reassuring consistency is just as relevant for a bank handling crypto assets as it is for a government enforcing regulations on them.
The duty of governments to mitigate risks while accelerating crypto innovation is lightened when many existing regulations simply need some thoughtful reorganization, rather than a comprehensive overhaul that could reduce acceptability and compliance. The ability of governments to clearly and consistently determine how and where to apply these rules will be a challenge. But the missing pieces of the puzzle are much easier to spot when the rest of the puzzle is put together.
Learn more about the opportunities associated with crypto and blockchain in the Mastercard report. Tokens on the chain: the role of banks in cryptocurrencies, collecting cryptocurrencies and everything in between.
Author: Chris Button, Marketing, Data & Services Associate Analyst, Mastercard