Managing cryptocurrency regulation
October 2021 | TALKINGPOINT | FINANCE & INVESTMENT
Financier Worldwide Magazine
October 2021 Issue
FW discusses cryptocurrency regulation with Paul Brody and Joe McCarney at EY.
FW: Could you explain the difference between a digital asset and a cryptocurrency?
Brody: Digital assets can be any asset – real or virtual – that is represented in a digital format. It can be a dollar or a share of stock or a piece of art. It can be entirely virtual, like a digital art token, or it can be a representation of something that exists in the real world, like the title to a car. Cryptocurrencies are a form of digital asset that are intended to be used as currencies – a replacement for dollars or euros or yen. They are not tied to any underlying asset, like a dollar or some amount of gold, but they are intended to function as a medium of exchange. Bitcoin, Litecoin and Ether are examples of cryptocurrencies, where a US Dollar Coin (USDC) or a CryptoPunk art token would be considered digital assets. However, there is no perfect or agreed-upon definition to allow one to differentiate between the two.
FW: How would you characterise the rise of cryptoassets in recent years? What are the implications for the financial services (FS) industry?
Brody: There are three big things that have happened in this space in the last decade or so. The first is the rise of cryptocurrencies and the proof that you can create reliable and secure payment systems that are decentralised. This is by far a big milestone technologically, but it has occurred at a time when many stakeholders are demanding increased trust and transparency, including from established public and private institutions. This combination has fuelled interest in cryptocurrencies, like Bitcoin, which some consider to be indicative of a worldview where fallible, political humans are replaced with predictable, trustworthy algorithms. However, it is worth noting that cryptocurrencies have their own challenges around trust. The second big thing has been the creation of Ethereum, which took the foundational principles of Bitcoin and expanded from the concept of a cryptocurrency to the vision of a decentralised world-spanning computer. Ethereum is, by design, programmable and what came out of that was an entirely new way to create, define and manage large-scale investments and digital assets. The Ethereum ecosystem is now home to tens of thousands of non-profits, start-ups and digital asset networks. If you can define it, you can make it transactable on the Ethereum ecosystem, from industrial assets to art. The third and final big impact has been the rise of decentralised financial (DeFi) services, which also took place on the Ethereum blockchain. In this case, developers have used the programmability enabled by Ethereum not just to define new assets, but to build a whole new ecosystem of interconnected banking and financial services. These look and feel a bit like traditional banking services but they are entirely natively digital, and they can be stood up and integrated in a fraction of the time and the cost associated with the existing banking system. They can also be fully automated thanks to the programmability of Ethereum. Simple things like finding the best deposit yield are already standard features in the ecosystem but ever more sophisticated solutions from liquidity pools to derivatives are emerging as well.
McCarney: The sum total of these changes has had an intense competitive impact on the world of financial services. Cryptocurrencies are competition for government-issued currencies. Digital asset markets are alternatives to traditional markets, auctions and venture capital funds. And DeFi is a lean, fast digital-native banking system with an extraordinarily fast innovation engine. Right now, blockchain-based financial services are where online retail was 20 years ago – a fast growing but relatively small slice of the total picture. Blockchain and crypto or digital assets altogether are worth about $2 trillion. A lot of money in absolute terms but rather small compared to the $70 trillion in global stocks or more than $100 trillion in global bank deposits. They may also be perceived by many to be crude, high-risk and with a potential to be hacked, but the growth trajectory is clear and so is the competitive challenge they are laying down for financial institutions and governments.
“With the pace of change in the digital asset space, and the broader DeFi space, there is a strong emphasis on the need for a formalised agenda to support regulatory oversight.”
FW: To what extent has the coronavirus (COVID-19) pandemic increased the appetite for cryptoassets, including cryptocurrencies?
Brody: The coronavirus (COVID-19) pandemic is having a similar impact in the world of blockchain as it did in digital retail: it has already packed a decade’s worth of acceleration into a single year. All the trends that fuelled blockchain originally are still there – including intense politicisation of every financial decision being made by regulators and central bankers. Quantitative easing (QE) has produced both an avalanche of investible capital seeking returns and stoked fears that central bankers are much too easily pressured into this strategy by politicians who will do anything in the short term to avoid a recession. While the impact of QE and fears of inflation are likely to recede, and with it some of the flood of money into digital assets, the longer-term impact of this highly innovative ecosystem is likely to be the biggest takeaway. DeFi may one day be larger in total value than the stock or bond markets, and it will be where people put their assets to work in a highly efficient and global marketplace.
FW: From a regulatory point of view, could you outline some of the key concerns surrounding cryptocurrencies? How challenging is it for regulators to keep pace with market developments?
McCarney: With the pace of change in the digital asset space, and the broader DeFi space, there is a strong emphasis on the need for a formalised agenda to support regulatory oversight. Know your customer (KYC) and anti-money laundering (AML) is and should be the focus of any regulatory agenda given that trust is a key concern. Some of this will ultimately fall to the financial institutions that are facilitating the trading and custody of digital assets. Tax regulation will continue to evolve, both on a geographic-specific and global basis. As the use cases and options for digital assets continue to expand, we will likely see further development in how each country treats digital assets. With the discussion of stablecoins and other types of digital assets, such as central bank digital currencies, we may see new tax policies and differentiated treatment by type of digital assets. Given the growth of this space, we anticipate that there will be maturation of the tax and regulatory policies. How quickly that evolution occurs remains to be seen. One other area of focus, from a regulatory standpoint, will be investor protection.
FW: In what ways is regulation and enforcement needed to address international anti-money laundering (AML) activities associated with cryptocurrencies? What pressures are being placed on FS firms?
McCarney: Regulation and enforcement will be needed for the digital asset space to continue to grow and expand. Large financial institutions entering the digital asset ecosystem will act as a significant catalyst for the expansion of regulatory frameworks. Financial services organisations will be expected to focus on AML requirements for digital assets. Until there is a broad-based set of international standards or operating procedures, companies need to follow their traditional procedures for AML activities. The current discussion on the regulatory front could change that soon and could help to instil further confidence in this space.
FW: How would you characterise the challenge of harmonising regulations across jurisdictions? In your opinion, how effective are AML initiatives proposed by standard setters such as the G20, FSB, IOSCO, BCBS and FATF, for example?
McCarney: Like any emerging area, developing and implementing a global framework will remain challenging; however, a broad-based set of regulations could prove to be beneficial to the industry as a whole. Globally, given the varying political environments, it is likely to take time to have a widely adopted set of standards. The discussion around global regulation for digital assets, and specifically AML, has been on the agenda at various stages for around five years now. Given the continued expansion of digital assets, standard setters are more willing to establish regulations to help address concerns around AML. While the AML efforts proposed by standard setters are intended to provide an overall level of effectiveness, current regulations should allow for the continued country-specific customisation that we are currently seeing take shape.
“DeFi may one day be larger in total value than the stock or bond markets, and it will be where people put their assets to work in a highly efficient and global marketplace.”
FW: What advice would you offer to FS firms on establishing internal processes and controls to manage the risks and compliance challenges associated with cryptocurrencies?
McCarney: It starts with an entity developing a baseline understanding of the digital asset environment, such as types of digital assets, the underlying differences in each of the protocols and technologies, the intention for digital assets, and the regulatory and taxation considerations. The digital asset arena is expanding rapidly, and new opportunities are coming to market very quickly. Currently, there are many different types of digital assets, such as native cryptocurrencies, utility tokens, governance tokens, hybrid tokens, stablecoins, tokenised assets and non-fungible tokens (NFTs), among others, and each of these types of digital assets can have different risks. Companies must understand what their intention and ability to utilise digital assets is going to be. Once their internal strategy is developed and understood, companies should look to develop specific internal compliance policies, designed to prevent unintended consequences by utilising digital assets that are not properly understood.
Brody: As companies begin to move into this space, one of the key internal control considerations will be around the custody function. We are currently seeing advancements in the digital asset custodial space, with new participants that are developing new custody solutions. Companies will want to identify and leverage a custodian that can best suit their digital asset strategy – types of digital assets that can be custodied, access to digital assets, security, and so on. In addition to custody, the operational and regulatory complexities must also be considered. Finally, as the digital asset space continues to expand and mature, we fully expect there to be an evolving suite of regulatory and compliance requirements. Companies can work closely with regulators or preclear certain offerings or services that may mitigate the risks of subsequent regulation leading to fines or business risks.
FW: With cryptocurrencies presenting complex, volatile and unpredictable issues, what do you believe is the future of regulation in this market over the years ahead? What developments would you expect or hope to see?
Brody: The regulation will depend on the kind of digital asset. Cryptocurrencies in their purest form should probably be treated like currencies or perhaps commodities. What is much more pressing is the enormous range of digital assets that have sprung up recently. These go by many different names – utility tokens, payment coupons, governance tokens – and have become incredibly important in the ecosystem and have not yet been clearly regulated. We see a couple of key issues. The first is that tokens that are sold and marketed in a manner that looks like securities are likely to be regulated as such. Public agencies such as the US Securities and Exchange Commission (SEC) are increasingly developing new policy on this agenda, and we will likely have a lot of enforcement in this space. The other big issue is around stablecoins, particularly those that are denominated in, and aligned to, fiat currencies. These are not cryptocurrencies and they may not be securities, but they have an enormously important role to play in the DeFi ecosystem. We expect to see some specific regulations around how to manage those and what does and does not qualify as a stablecoin in the future.
Paul Brody drives EY initiatives and investments in blockchain technology across consulting, assurance and tax business lines. He has 20 years of consulting and strategy experience in mobile and electronics. Prior to joining EY, he served as vice president and global industry leader of electronics at a multinational technology company. He earned a bachelor’s degree in economics and a certificate in African studies, both from Princeton University. He can be contacted by email: paul.brody@ey.com.
Joe McCarney is responsible for driving EY assurance service line response to blockchain, together with EY’s assurance clients service teams and the global blockchain network to implement and deliver a service line-specific strategy. He has 20 years of assurance experience in the financial services industry, with a focus on asset management and digital assets. He earned a Bachelor of Arts degree in accounting from the University of St. Thomas. He can be contacted by email: joseph.mccarney@ey.com.
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