How global crypto regulation will develop post-market collapse

Introduction

The last 18 months have no doubt been eventful in the crypto industry, with several high-profile failures causing many to lose faith in centralised players and call for regulators and policymakers to step up their game. This year we have already witnessed many regulatory enforcement actions and developments. We expect the crypto industry to further mature in a number of key areas going forward. These are:

• Global and national policymakers and regulators ramping up on “non-AML” standards.
• A drive to decentralised finance (DeFi).
• Travel rule implementation with an emphasis on counterpart VASP due diligence.
• A continued focus on the regulation of stablecoins.
• The tokenisation of things.

Global regulators ramping up

We expect increased scrutiny on centralised crypto businesses such as exchanges and custodians, particularly with regard to risk management and the safeguarding of customer funds. Although this will raise the bar for consumer protection across the global crypto landscape, it usually results in smaller players struggling to meet the increased burden of compliance.

To date, much of the regulatory developments in the crypto industry stem from Recommendations made by the Financial Action Task Force (FATF) that have required countries to put in place regimes to regulate Virtual Asset Service Providers (VASPs), crypto businesses that provide exchange, custody and other services related to virtual assets. However, many of the recent market failures have highlighted a need to develop standards which go beyond those implemented for Anti-Money Laundering (AML), Combatting Financial Terrorism (CFT) and Combatting Proliferation Financing (CPF) reasons.

The traditional financial services sector has grown to live with standards on the safeguarding of customer funds (both in fiat and crypto), disclosure requirements, management of conflicts of interest, corporate governance, prudential and risk management requirements and more. The events of last year will likely significantly accelerate regulators’ application of these same standards to the cryptoasset sector. The lack of trust regulators have in the current market will also likely lead to further supervisory scrutiny across the board where such standards are already in place.

A drive to DeFi

Increased activity and scrutiny from policymakers and regulators, combined with a growing lack of trust in centralised actors in the cryptoasset space, is likely to lead to an increase in the number and use of DeFi projects. DeFi activity typically involves borrowing, lending, trading, investing or making payments with digital assets without the presence of a centralised intermediary.

Although many policymakers cite the need to take a “same activity, same risk, same outcome” approach to the regulation of DeFi, existing regulatory frameworks (both for traditional finance and cryptoassets) fundamentally rely on the existence of centralised intermediaries to hold accountable. Arguably, these frameworks will be ineffective at regulating this cutting-edge, continuously evolving technology where there is nobody to hold accountable.

Although there has been much discussion in the industry on potential approaches, there is little concrete, clear guidance on the regulatory perimeter around DeFi. While DeFi in its purest form is perhaps unregulatable, many projects that are decentralised in name only (DINOs) should be able to comply with most existing regulatory requirements. Where will policymakers and regulators draw the line between one and the other? We anticipate the industry will begin to address these questions.

The Travel Rule

The infamous Travel Rule was first formally communicated by the Financial Action Task Force (FATF) in October 2021, yet jurisdictions have lagged in their implementation compared to the rest of the FATF Standards specific to Virtual Asset Service Providers (VASPs). Although some jurisdictions have AML/CFT regimes in place, few have legislated for the Travel Rule, and even fewer are actively enforcing it.

This will significantly change in 2023, with key jurisdictions like the UK and the European Union bringing the Travel Rule into force. The sunrise issue, a term that refers to a lack of global adoption and varying stages of implementation, will likely begin to fade.

There are two key requirements in the Travel Rule for VASPs, one, to share originator and beneficiary information when transferring customer funds and two, to perform due diligence on counterpart VASPs. To date, most VASPs perform due diligence on their customers, but there has been little pressure for them to perform due diligence on counterpart VASPs, a requirement that has not seen much attention from the industry or regulators. As the implementation of the Travel Rule progresses globally, regulators will start more adamantly enforcing the requirement for VASPs to conduct due diligence on counterparts.

A focus on stablecoins

Many countries are expected to expand their regulatory regimes this year, including the European Union, which will formally legislate for the Markets in Crypto-Assets (MiCA) Regulation. What’s been largely cited as a response to Facebook’s now shelved stablecoin project Libra/Diem, MiCA includes specific provisions regarding the issuance of stablecoins, including a cap on stablecoins pegged to non-EU currencies. We expect this trend to continue in several jurisdictions, including the UK, where there is also stablecoin-specific regulation on the horizon. Given that some of the larger jurisdictions have adopted this approach, we expect others to follow suit.

The intersection of crypto and TradFi – tokenise it!

Asset tokenisation, including the issuance of tokenised securities, has been generating a great deal of interest from the industry and is positioned to take off this year. There is little doubt that blockchain technology will become a prominent part of how securities and other real-world assets are traded, given the opportunity to increase the efficiency of issuance, transfer and settlement – and major traditional financial institutions have taken notice. An increasing number of innovative service providers have also entered the space providing know-how and infrastructure to facilitate the growth of the industry.

As with most things crypto, there is a lack of clarity (and likely consistency) at the international level regarding how tokenised assets will be treated from a regulatory perspective. Whether they will be subject to traditional securities laws, virtual asset regimes, or a combination of the two will largely depend on varying jurisdictional approaches. This presents an opportunity for policymakers and regulators to tailor regulatory regimes that allow for new technologies to reshape market infrastructure.