Regulating new forms of technology is never easy. If they are being developed within financial services, the ask is even greater.
As with any new development, there will be bumps along the road. Governments, regulators, and markets will make mistakes. Some organisations will scratch out a profit, while others fail. Then there are those that look to use the technology with malicious intent. Typically, only a select few achieve any real success. Ultimately, there are certainly no guarantees that any of it leads to real value creation.
Back and forth
The world of cryptoassets is, arguably, a case in point. The cryptocurrencies that spawned the first widely adopted use case for decentralised ledger technology have two established camps.
On the one side, we have the zealots who see Bitcoin and Ethereum as technological manna from heaven, sent down to replace fiat currencies and nation state sovereignty over money supply, with a truly peer-to-peer, immutable and decentralised alternative.
On the other side are the sceptics. “Interest income? Nope. Dividends? Nope. Value creation? It depends. Where are the cash flows?” they ask.
The retail punter typically sits somewhere in the middle: not interested in the details and enamoured by the herd. Where there is buyer’s regret, it is likely around the timing of their investments, rather than the investments themselves.
Some would say we are currently in a muddle, but I would argue that none of the above constitutes a reason to stop the music. We should accept the risks and also accept that we do not fully appreciate what the returns might be. That is the gamble with any new technology and it is safe to say that to date, for the most part, that gamble has paid off handsomely.
Where our focus should lie is risk mitigation: where there are known risks, what can we do to manage them down to an acceptable level. This is where regulation can act as a rather powerful safety net.
Let us walk through a hypothetical example to illustrate the point.
Stage 1: Market entry
A firm with a background in investment banking and technology wants to enter the market and provide retail investors with the opportunity to trade a wide range of crypto assets. The firm aims to generate revenue from fees on each trade and is backed by private equity.
It applies for trading permissions under the new cryptoasset regulation regime. During the authorisation process, several shortcomings are revealed.
The firm needs to improve its internal controls to manage conflicts of interest with related parties of its financial backers. For example, one of the firm’s private equity backers holds an outside interest in a cryptocurrency that was to be offered by the firm. To manage this risk, the cryptocurrency is removed from the product suite.
Regulators also identify that the firm’s systems for safe custody of customer assets are designed for traditional assets rather than cryptographically secured assets. These systems need to be overhauled to prevent misappropriation or commingling.
The firm’s prospective marketing campaigns are found to be overly optimistic about potential gains and lack sufficient disclosure of volatility and downside risks. To address this, the firm amends its marketing materials to balance risks and opportunities and imposes concentration caps to limit potential losses from individual crypto assets.
While the firm’s onboarding and ‘know your customer’ processes are robust, it does not have strong enough controls for ongoing detection of money laundering and financial crime risks. These are addressed through improved monitoring and data analytics.
Overall, the authorisation process significantly improves the risks associated with this new enterprise. Similar to the concept of a minimum viable product, it ensures that before the firm goes live, it has systems, processes and controls commensurate with its risks.
Stage 2: Scaling up
After 18 months in operation, the firm has experienced significant growth in trade volumes and customer numbers. It is on the verge of completing a second round of fundraising to support its expansion.
Supervisors review the proposed new capital structure, which includes significant debt financing with a short contractual maturity of 12 months and variable interest rates. Concerns arise because the firm has not yet broken even and additional leverage could leave it exposed to disorderly failure.
The firm is asked to complete a prudential assessment of its prospective capital and liquidity adequacy. It tests its business model’s resilience against several severe but plausible scenarios. The exercise confirms the need for better interest rate risk management and less financial leverage.
Stage 3: Market exit
Three years after its launch, the firm loses momentum. The market is now saturated with platforms and intermediaries offering cryptoassets. Unfortunately, the firm has not achieved critical scale in market penetration and trade volumes needed to generate a profit.
Supervisors have been monitoring the situation and have focused the firm’s efforts on designing a credible plan for an orderly wind-down. Fortunately, the firm has sufficient capital and ring-fenced liquidity to continue paying staff, critical third parties and senior creditors during the six-month run-off period. This provides ample time to return customer assets and money in full.
In the end…
Not all examples will have a happy ending, but that is not the point. The real benefit of regulation is that it sets conditions that make orderly transitions more likely than not. It creates an environment where known risks are managed to at the very least a minimal level rather than not being managed at all.
And all of that supports trust and confidence in the firms and the technology they are developing. With trust comes the virtuous cycle of adoption, market growth, investment and ultimately technological development that generates real value. This rule applies irrespective of whether you are a crypto believer or not.
Reuben Wales, Head of Financial Services, ICAEW.
- Read ICAEW’s response to the future financial services regulatory regime for cryptoassets, published by the HM Treasury on 1 February 2023.
This article appeared in the ICAEW Financial Services Faculty bulletin, available to Financial Services Faculty members. To find out more about the faculty and to become a member, visit the faculty’s dedicated hub.
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