The future of crypto
The collapse of numerous crypto businesses in 2022 has led to alarm and calls for increased regulation. Global Insight assesses what’s at stake and what should be done.
The high-profile collapse of FTX – the world’s second largest cryptocurrency exchange – in November has raised further questions about how crypto companies operate and how they’re regulated. The exchange suspended withdrawals in early November and filed for bankruptcy a few days later.
FTX wasn’t the year’s only high-profile collapse. Crypto hedge fund Three Arrows Capital (3AC) filed for bankruptcy in July following the collapse of TerraUSD, a stablecoin (ie, a cryptocurrency whose value is pegged to the price of another asset class) and its sister cryptocurrency Luna. Also in July, crypto lenders Voyager and Celsius Network filed for bankruptcy. And two weeks after FTX’s unravelling, another lender, BlockFi, filed for Chapter 11 bankruptcy in the US. These corporate failures wiped out billions of dollars of investors’ funds – probably for good. As 2022 drew to a close, commentators were left wondering just how the sector has been allowed to conduct business without the same rules or scrutiny faced by traditional financial services companies.
We are likely to see heightened activity by regulators to protect not just consumers and the wider financial community, but their own reputations as well
Partner, Stokoe Partnership Solicitors
Financial regulators worldwide have hinted that their regulatory stance is set to toughen, but to what extent and how effective regulation will be remains uncertain. Richard Cannon, a partner at UK law firm Stokoe Partnership Solicitors, says ‘we are likely to see heightened activity by regulators to protect not just consumers and the wider financial community, but their own reputations as well’.
In the wake of FTX’s collapse, Sir Jon Cunliffe, Deputy Governor for Financial Stability at the Bank of England, said that while digital currencies are still too small to pose a threat, better regulations are needed to protect the financial system as cryptocurrencies continue to gain ground. He added that recent volatility in the value of cryptocurrencies is an issue: the value of Bitcoin, the world’s largest digital currency, has dived by almost 70 per cent in the last year.
Speaking at the UK’s Warwick Business School in late November, Cunliffe told his audience that ‘we should not wait until [the crypto world] is large and connected to develop the regulatory frameworks necessary to prevent a crypto shock that could have a much greater destabilising impact. The experience in other areas of digitalisation has demonstrated the difficulty of retrofitting regulation on new technologies and new business models after they have reached systemic scale.’
Philippe Tardif, Vice-Chair of the IBA Securities Law Committee and a partner at Canadian law firm Borden Ladner Gervais, says ‘the recent high-profile failures of trading platforms, steep declines in values of various cryptocurrencies, the collapse of certain stablecoins and data breaches will almost assuredly prompt regulatory responses’.
There will be ‘global ramifications’ following 2022’s failures, believes Anurag Bana, a senior project lawyer in the IBA Legal Policy & Research Unit, which will raise questions about the governance of crypto companies and their future oversight by regulators. He believes financial regulators must become actively involved in supervision. ‘In future, financial regulators will need to re-examine how crypto companies operate; how they attract customers; and how they should be more closely monitored, held to account and sanctioned’, says Bana. ‘Regulators need to step up and be prepared to step in when they see signs that crypto companies are going to fail.’
Effective regulation will require acceptance that a degree of regulatory oversight is desirable for the [cryptocurrency] ecosystem. This is not a given
Vice-Chair, IBA Securities Law Committee
Bana adds that regulators may also need to consider the appeal of crypto companies and the impact on customers if they’re based in countries where companies don’t have authorisation to operate. ‘An unauthorised company does not mean that it is doing anything illegal, nor does it mean that it cannot operate or try to attract customers from countries where it is not granted authorisation. Perhaps these are issues that financial regulators need to think about in future, because it suggests a limit of their regulatory oversight and powers’, says Bana.
Pedro Eroles, a partner at Brazilian law firm TozziniFreire Advogados, says there needs to be greater regulatory oversight of the crypto sector as investors appear either unconcerned about risks that have an impact on traditional financial services companies, such as liquidity, solvency and capital market risks, or assume that crypto companies have the same compliance requirements as banks and insurers – which is not always the case. Tighter regulation, he says, ‘would better coordinate the soundness and good functioning of the crypto markets’. He adds that better regulation of the sector would also create a ‘level playing field’, whereas, currently, those companies that are doing more to ensure good corporate governance and risk management are at a competitive disadvantage versus those that don’t spend anywhere near the same amount on compliance, thereby keeping their operational costs lower.
Discussions about regulation are already happening at G20 level, as well as within individual national regulatory bodies, says Eroles, and are likely to focus on increased transparency, monitoring the solvency of trading platforms and ‘crypto banks’ and mandatory asset segregation. For example, he says, transparency could focus on enhanced disclosure relating to the methodologies for setting the values of currencies, of risks relating to investments and trading in currencies, of the regulatory oversight – if any – of the relevant client-facing institutions and of their financial position. Examples of solvency monitoring could include periodic financial statement filing requirements, while in respect of the segregation of assets, there could be a requirement for third-party custody of client assets or, alternatively, the clear segregation of client assets.
However, says Tardif, ‘the hurdle facing regulatory agencies is that cryptocurrencies evolved in an environment designed to avoid the need for regulatory oversight, [instead] relying on verification by individual users (via blockchain)’. As a result, he says, ‘effective regulation will require acceptance that a degree of regulatory oversight is desirable for the ecosystem. This is not a given.’
Giorgio Bovenzi, Head of the Global Credit Risk Management practice in the New York office of law firm Haynes and Boone, agrees that tighter regulation is set to emerge, but believes the timeframe is uncertain. ‘While we have seen crypto regulations emerge and be implemented in several “offshore” jurisdictions, the nations that are the largest players in the financial markets have hesitated to regulate this industry’, he says. ‘In particular, the US has been one of the big absentees. I expect that once the US and UK […] finalise joint parameters for such regulation, other nations will follow.’
Regulators start their engines
The UK is planning to give its financial services regulator, the Financial Conduct Authority (FCA), greater powers to oversee crypto companies via its Financial Services and Markets Bill, which is progressing through the country’s parliament. Currently, the FCA oversees crypto companies’ anti-money laundering and countering terrorist financing rules. Meanwhile, the EU’s planned Markets in Crypto-Assets Regulation is pending approval in the European Parliament and, if passed, promises to be a substantial piece of legislation. It’ll be immediately effective in all EU Member States once it comes into effect – likely to be 2024.
In the US, there’s a major question as to whether the primary regulators in the crypto space – namely, the Securities and Exchange Commission (SEC) and the Commodities Futures Trading Commission (CFTC) – have the adequate legislative authority to regulate crypto platforms, says Bovenzi. In 2022, the SEC used rules that apply to the traditional finance sector to identify some digital assets as ‘securities’, allowing them to bring charges against individuals they suspect of wrongdoing.
At a global level, the Basel Committee on Banking Supervision – the primary global standard setter for the prudential regulation of banks – has agreed a standard on the prudential treatment of cryptoasset exposures, which will take effect from 1 January 2025. Under the standard, banks are required to classify cryptoassets on an ongoing basis into two groups. Group One cryptoassets meet, ‘in full’, a set of classification conditions and are subject to capital requirements based on the risk weights of underlying exposures as set out in the existing Basel Framework (ie, the Committee’s full set of standards). Group Two cryptoassets, on the other hand, are those that fail to meet any of the classification conditions, pose ‘additional and higher risks’, and should therefore be subject to more conservative capital treatment and stricter operational and liquidity risk management controls.
Former FTX Chief Executive Sam Bankman-Fried. REUTERS/Eduardo Munoz
Similarly, in October, the Financial Stability Board (FSB), the international body that co-ordinates effective global regulation, published a proposed framework for the international regulation of cryptoassets, making them subject to the same high standards of regulation as any other financial instrument or activity. A public consultation on the FSB’s proposals closed in mid-December.
The US is looking more deeply into regulating crypto companies. In early October the US Financial Stability Oversight Council (FSOC), a regulatory body set up to identify risks to the financial system, published its Report on Digital Asset Financial Stability Risks and Regulation. While the report found that ‘large parts of the crypto-asset ecosystem are covered by the existing regulatory structure’, it identified three gaps in the regulation of cryptoasset activities in the US. First, there is limited direct federal oversight of the spot market for cryptoassets that aren’t securities. Second, there are opportunities for regulatory arbitrage. Finally, there’s a question as to whether vertically integrated market structures – which enable direct access to markets by retail customers – can or should be accommodated under existing laws and regulations.
As a result, the FSOC recommended legislation providing for explicit rulemaking authority for federal financial regulators to address the spot market gap, initiatives to address the regulatory arbitrage issue and the study of vertically integrated structures. It also recommended bolstering the ability of regulators to collect data and the analysis, monitoring, supervision and regulation of cryptoasset activities.
Specifically, a key FSOC recommendation is ‘bringing transparency to opaque areas, including through disclosures and documentation of key issues such as interconnectedness’ and, more specifically, to pass laws that give rulemaking authority to federal financial regulators – such as the SEC and the CFTC – across a range of areas, including conflicts of interest; abusive trading practices; public trade reporting requirements; recordkeeping; governance standards; customer asset segregation; transparency; and investor protection. The FSOC added that ‘legislation should provide for enforcement and examination authority to ensure compliance with these rules’. The body also recommended legislation to create a comprehensive federal prudential framework for stablecoin issuers that also addresses the associated market integrity, investor and consumer protection, and payment system risks.
In early January, the US Federal Reserve, the US Federal Deposit Insurance Corporation and the US Office of the Comptroller of the Currency issued their Joint Statement on Crypto-Asset Risks to Banking Organizations, which highlighted concerns about key risks in the crypto sector, and the governance, identification and mitigation of these risks. Among the risks highlighted by the agencies were uncertainties as to custody practices, redemptions and ownership rights and the contagion risk within the sector that results from participants being interconnected. The agencies concluded that the experience to date indicates that ‘issuing or holding as principal crypto-assets that are issued, stored, or transferred on an open, public, and/or decentralised network, or similar system is highly likely to be inconsistent with safe and sound banking practices’.
Enter the central banks
Alongside better regulation, keener oversight and more effective enforcement, some commentators believe central banks may also have a role to play in bringing about more stability and greater investor protection. For example, one view is that as central banks launch their own digital currencies (CBDCs), crypto companies will gradually disappear because they’re unable to compete with the stability and other attractions that central banks can offer to crypto coins.
Others believe that crypto companies will remain because there will be a willingness to retain competition in the market. ‘Given the creativity of the creators of crypto coins, it is likely that cryptocurrencies with specific features will emerge after the launch of CBDCs to appeal to consumers and investors’, says Alexei Bonamin, Chair of the IBA Capital Markets Forum and Co-Head of the Corporate Group at TozziniFreire Advogados.
Tardif says the introduction of CBDCs could have a positive impact on other digital currencies – at least those subject to government oversight. CBDCs, he says, ‘would mitigate the credit and liquidity risks associated with crypto currencies’ and ‘could lead the way to enabling the broad adoption of digital currencies for payment and within clearing and settlement systems’. He adds that they could also alleviate systemic risks associated with the collapse of other digital currencies.
Bovenzi agrees that CBDCs could engender greater trust and result in less volatility for investors. They can, he believes, provide households and businesses with a safe and liquid form of central bank money. They could also give entrepreneurs the ability to create new financial products and services and support faster and cheaper payments and, more generally, support and expand consumer access to the financial system, promoting financial inclusion. On the downside, however, ‘many players in the market believe government-backed CBDCs are a backdoor to centralised state surveillance and social control and a competitor that might hinder adoption of a leading, regulated private stablecoin’, says Bovenzi.
A question of faith
One of the key barriers to crypto use and adoption is the lack of faith people have in it – and not without reason. To promote greater consumer trust in cryptocurrencies, Tardif says there needs to be more transparency relating to the functionality, solvency and liquidity of a trading platform, stablecoin or crypto bank. He believes trading platforms can improve transparency by adopting clear user agreements and risk acknowledgments that express in plain language whether client assets are segregated – meaning they’re not commingled with non-client assets – or maintained with a third-party custodian.
In relation to third-party assurance, the first step would be for trading platforms to commit to an audit of their financial records, or be mandated to do so, including of their internal controls, says Tardif. He adds that, to the extent that external auditors are mandated to audit internal controls, they’d be expected to exercise the same degree of professional scepticism as they would when working on comparable assignments for financial institutions of similar breadth in other industries.
However, Bovenzi says there’s a certain amount of ‘distrust’ around external audit companies, which those in the crypto sector will need to address to resolve their vulnerabilities. There are concerns that auditors are struggling to apply accounting rules for digital assets because the rules are still only half formed, hence their reluctance to perform audits that may be highly scrutinised. High-risk audits also require more time and resources, but audit companies may face pressure from crypto auditees who want to pay the lowest fee for what some in the sector regard as a ‘tick-box’ exercise.
According to Bovenzi, after the 3AC and FTX collapses, a trend emerged whereby crypto exchanges issued ‘proof of reserves’ – qualified attestations, often created by external auditors – to gain trust, but the major crypto audit companies have recently ceased performing these. This is probably, Bovenzi says, ‘due to fear of liability and a perception that the market was misinterpreting and ignoring their qualifications’.
Despite the problems involved in attaining additional, independent assurance, few seem to believe that, at this stage at least, further collapses in the crypto sector will affect financial markets or the financial services sector in the same way as the 2008 financial crisis, where systemically large banks failed. ‘While the value of digital assets has seen a significant rise in the last decade, they represent only a fraction in value of asset classes maintained by financial institutions’, says Tardif. ‘Moreover, the risk of contagion among institutions as a result of the collapse of certain digital assets is not the same as the risks leading to the 2008 liquidity crisis. But that is not to say that those risks should be ignored.’
Bonamin says that any market crisis caused by the collapse of crypto companies is not in the same league as the 2008 financial crisis, which ‘emerged from the real estate sector/traditional financial sector, which is a much more widespread form of investment than crypto’. He adds that since crypto investments are still relatively niche and appeal to a limited number of investors, there’s little chance of a systemic collapse. However, he says, ‘we need to follow the development of the crypto market in order to check if those impressions will prove to be accurate or not in the future’.
Bovenzi says that any collapse of the crypto market wouldn’t have the same systemic impact as a crisis within traditional financial services companies – at least not yet. ‘The 2008 financial crisis happened within the banking sector and fundamentally was triggered by the fact that the banks misunderstood the credit risk they were incurring and which should have been kept on their balance sheets. The risks generated by the crypto industry are intermediated and held outside the banking sector – so far’, he says.
The risks generated by the crypto industry are intermediated and held outside the banking sector – so far
Head of Global Credit Risk Management Practice, Haynes and Boone
But, even where there are limited interconnections with the traditional financial system, there are some important caveats to consider so long as crypto activities remain unregulated. For example, some stablecoin users report that they hold assets in the traditional financial system, which, in turn, creates a point of interconnection with the stablecoin markets. ‘As such, stablecoin activities of significant scale could trigger dislocations in traditional markets if runs on stablecoins were to lead to fire sales of traditional assets that back the stablecoin’, explains Bovenzi. ‘The risk would increase if the stablecoin issuer’s assets were held at a traditional financial institution.’
For the crypto sector, financial resilience doesn’t depend on bank buffers or the accuracy of a bank’s credit risk assessment and mitigation, but rather the ability of investors to effectively manage market, credit and liquidity risk in times of stress, says Bovenzi. He adds that because of stablecoin issuers’ opacity about the nature of their asset holdings, and, more importantly, because of the lack of standards for disclosing asset composition, auditing, review requirements and asset management strategies, it’s unclear how crypto investors would adjust their portfolios under stressed market conditions. One possible result, Bovenzi says, could be sudden shifts in the demand for, and supply of, liquidity. For instance, many investors may ‘dash for cash’, due to the accelerated need to liquidate positions. This in turn could put stress on the banks’ ability to supply liquidity.
‘The implication is that these factors, combined, could trigger large swings in liquidity needs which, in turn, could affect banks to the extent that they are unable to keep pace with this increase’, adds Bovenzi. ‘Large swings in demand and insufficient supply of liquidity at the system-wide level would amplify the shock. In this respect, although not in the same way as in the 2008 financial crisis, the resilience of the traditional financial sector could be significantly affected by a systemic crisis of the crypto markets.’
Neil Hodge is a freelance journalist and can be contacted at firstname.lastname@example.org