Crypto assets represent a rapidly growing category of assets, but they generally fall outside the regulatory perimeter – despite being beset with numerous and potentially detrimental issues. However, regulatory interest is gathering pace.
Last month, the Financial Stability Board published its global regulatory framework for crypto assets and just this week a group of American central banks published a summary of the financial stability risks, with some proposals for regulation in emerging markets.
Crypto asset market
Less than 15 years since the Bitcoin – possibly the most well-known crypto asset – launched, there are today around 20,000 crypto assets, including exchange tokens, stablecoins, utility tokens and non-fungible tokens. In 2021, the Financial Conduct Authority (FCA) estimated 2.3 million UK adults held crypto assets. Bitcoin dominates the market with an estimated 50% market share, followed by Ethereum and Tether, which have 19% and 7% of the market respectively.
Bitcoin is famously volatile: its price hit a high of almost $70,000 in November 2021, yet a year later was down at around $17,000. Today, the market capitalisation of assets excluding Bitcoin is around $0.6trn, down around two thirds from a high of almost $1.6trn in November 2021.
Accusations of facilitating money laundering are not new. However, a number of significant failures in the past year have highlighted poor controls, market abuse and fraud, prompting the US Securities and Exchange Commission (SEC) to take action against some high-profile players.
In December last year, Samuel Bankman-Fried was charged with orchestrating a scheme to defraud equity investors in FTX Trading. More recently, in June crypto asset trading platform Binance was charged with a series of securities violations. In the same month, Coinbase was charged with not registering its activities, thus depriving consumers of usual protections.
Risks with crypto assets: reasons to regulate
For individuals, crypto assets are innovative, exciting and complex products, which seemingly offer better rewards than more traditional investment products. However, they also present several risks, many of which have crystallised, causing significant losses to individuals and prompting the UK Treasury Committee to describe the industry as the “wild west” and to call for greater regulation to protect consumers.
Many crypto assets are by nature highly speculative products with no intrinsic value. Price moves can be caused by significant shifts in demand that are driven by price expectations. High potential returns can blind individuals to the risks, or the complexity of the product can obscure the risks, making them difficult to understand.
As the crypto space currently stands, there is significant potential for conduct issues such as market abuse and mis-selling, as the unwary may be induced into investing in products that are not suited to their needs or do not match their risk appetite.
The unregulated nature of the market also makes it a strong magnet for scams, fraud and financial crime. Crypto currencies have already facilitated money laundering through the anonymity of holdings, their global reach, the potential for complexity to obscure transactions and because they are out of sight of traditional anti-money laundering approaches not designed for the emerging digital age.
At the same time, risk management and governance processes at crypto firms may be weak (or non-existent). This is a typical feature of immature companies or markets, as developments outstrip the resources needed to manage and control the risks. But the crypto-asset space seems plagued with strong antipathy to conventional controls and norms, to the extent that significant conflicts of interest seem deliberately inbuilt in certain crypto-asset business.
The nascent nature of the market also means existing legal frameworks and practices may not provide an adequate framework to deal with the risks, in particular new risks around legal ownership. The speed of development of products and the market may also create challenges in keeping regulations updated.
The risk is currently perceived as low, but the flow of funds into crypto assets may also have a significant effect on the flow of funds within the financial system and the real economy. If the volatility in crypto-asset prices or values gives rise to significant losses, these may bleed back into the financial system and real economy, causing disruption to financial stability. The nature of many crypto products and immature or poor risk-management practices exacerbate the risks.
The cost of regulating crypto assets
The case for regulation may be strong, but it is not without its cost, not only in monetary terms but also the time to comply with rules. Regulation may also act as an impediment to market growth or development, as it may stifle innovation or impede competition. It is fair to say that the development of many crypto assets is in part due to the unregulated environment that allows them the freedom to grow and evolve.
For example, regulatory standards may prevent or delay the launch of new and potentially better products or services, or deter new entrants from entering the market and therefore relieve the competitive pressures on incumbents.
It has also been argued that regulation provides an undeserved veneer of approval or respectability to assets that remain unduly risky, that might not meet the requisite standards and instead pose a significant threat to individuals and possibly the economy. This is not an argument against crypto-asset regulation. Rather, it is a call for effective regulation that is appropriate to the risks created.
If regulation is done well, the rules and standards should be clear and proportionate; they should allow products and services the appropriate flexibility to develop, while also providing consumer protections and promoting market integrity. Effective regulation should also facilitate competition, as it provides a safe and ordered environment in which participants can confidently make decisions and take risks.
The UK government is consulting on regulating crypto activities, such as issuing, payment, managing an exchange, custody arrangements, investment and risk management, and promotions. This is consistent with existing UK financial services regulation and we believe this is right approach. The FCA will be the responsible regulator.
The UK Treasury Committee raised particular concern that regulating retail trading and investment activity in unbacked crypto assets as a financial service will create a ‘halo’ effect that leads consumers to believe that this activity is safer than it actually is. The Committee suggested regulating this type of crypto asset as a gambling activity, rather than a financial services activity, arguing that this is consistent with the generally accepted principle of ‘same risk, same regulatory outcome’.
Regulating unbacked crypto-asset activities in a similar way to gambling might not, however, be the best way forward. This runs the risk of a fragmented regulatory framework across the crypto landscape, which might facilitate arbitrage. Given the emerging technology and practises, it may be better to develop and concentrate the regulatory expertise in a single regulator with a broader remit, to better manage the risks.
There have been calls to ban outright certain crypto assets. For assets that really have no intrinsic value and where there is the potential for significant loss to individuals, this seems attractive. But the genie is out of the bottle and, as attempts to ban certain drugs have shown us, the act of prohibition is no guarantee that something will go away.
With the recent spate of failed firms, strong evidence of criminality and unethical behaviour and the legislative responses of authorities such as the SEC, effective regulation may also be what the market requires to restore trust and confidence. But regulation must also be proportionate and focused on the risks to enable innovation to flourish and allow the benefits of technological advances to be realised.
- This article was authored by ICAEW’s Financial Services Faculty. To find out more about the faculty and to become a member, visit the faculty’s dedicated hub.
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