The challenges of regulating crypto assets

November 2019 | FEATURE | BANKING & FINANCE

Financier Worldwide Magazine

November 2019 Issue

Crypto assets are an emerging force in the financial services space. Though still largely in their infancy, companies, consumers and regulators must become familiar with them quickly.

Authorities around the globe face challenging questions about the nature of crypto assets and their regulation, as certain aspects of the rapidly ecosystem and its related risks are still largely unknown. Different jurisdictions have adopted varying approaches to regulate and address crypto asset-related issues.

Going forward, the right approach will likely depend on how crypto assets themselves evolve. Projecting this evolution, and drawing conclusions on appropriate regulation, requires analysis of the users and the crypto-economy in which they operate, according to the Financial Stability Board (FSB).

However, most jurisdictions have not benefitted from a specific regulatory regime to cover crypto assets, though this is beginning to change. “The direction of travel is clear – more regulation,” says Ian Mason, a financial services partner at Gowling WLG. “In July, the UK’s Financial Conduct Authority (FCA) finalised guidance on how it will categorise crypto assets. Regulators in other European jurisdictions are developing a similar approach, and have issued guidance on their approach to crypto assets. Some European jurisdictions have introduced specific regimes to encourage FinTech firms to set up in their countries and are promoting a ‘FinTech friendly’ approach.”

In Canada, a standalone regulatory framework has yet to be adopted at the federal or provincial level. “In 2015, the federal Standing Senate Committee on Banking, Trade and Commerce examined the use of cryptocurrencies and recommended a ‘light regulatory touch’,” says Sonia Struthers, a senior partner at McCarthy Tétrault. “However, since then, regulators in Canada have taken a more active approach, issuing guidance and seeking industry feedback. The Canadian Securities Administrators (CSA) launched a regulatory sandbox in 2017 and certain securities regulators have also created FinTech advisory committees.”

Dangers of regulation

As with the introduction of any regulatory regime, there will be advantages and drawbacks. In the US, the fragmentation of the national regulatory system, with multiple regulators at the federal level, will pose challenges. Regulators must find an appropriate balance between protecting investors and consumers with regulation, while curtailing innovation or the creation of more effective financial markets which could otherwise drive growth and opportunity for citizens. “There are many benefits that blockchain and digital technology can provide that will better monitor and protect the financial system from abusive and illegal activities, including money laundering, tax evasion and fraud,” says Martin Bartlam, international group head of finance and FinTech global co-chair at DLA Piper. “Used appropriately, these technologies could significantly improve the operation and security of our systems. It is incumbent on companies to develop and accept standards of best practice and ethical behaviour that will enable these technologies to offer the benefits they are capable of and to bring along regulators, politicians and the general public in that process.”

“Authorities around the globe face challenging questions about the nature of crypto assets and their regulation, as certain aspects of the rapidly ecosystem and its related risks are still largely unknown.”

As Mr Mason points out, the UK’s FCA has set up an Innovation Hub and regulatory sandboxes to encourage innovation. “This has worked well, and has helped to establish the UK as a leading hub for FinTech,” he says. “Companies seeking to promote crypto assets need to establish at an early stage whether their products or activities will be regulated. If they get it wrong, the regulatory sanctions are serious, including criminal liability and fines. The Fifth Money Laundering Directive (5 AMLD) broadens the scope of the European anti-money laundering (AML) regime to include virtual currencies, and firms will need to plan how they will comply with 5 AMLD in 2020.”

In Canada, the CSA has released detailed guidance to market participants of the potential application of Canadian securities laws to derivatives, coin/token offerings, cryptocurrency exchanges and cryptocurrency investment funds. “In addition, tax authorities and AML regulators have also issued guidance relating to crypto assets,” says Ms Struthers. “Some of the main regulatory challenges with respect to crypto assets have been the complexity and fast changing nature of the technology, its global nature and the challenges of decentralisation. In addition, Canada is a federal state with overlapping federal and provincial jurisdiction over crypto assets, which has caused some challenges as well.”

The regulatory sandbox approach developed by the UK FCA has been used as a model for regulators around the world. “This is now being used to link development by regulators and provides an opportunity for regulators to discuss and establish an understanding of the impact of the developing technology,” says Mr Bartlam. “The best approach has been where these active engagements have developed understanding to enable the development of policy positions and official guidance without blocking the inevitable development of more efficient, cheaper and effective means of conducting financial services activities.”

A gap in the regulation of crypto assets has arguably increased the risk of fraud and weakened investor confidence. In the long term, better, more comprehensive regulation of crypto assets will have myriad advantages for investors and financial services in general. It could aid the development of new technologies, restrict the potential uses of crypto assets in fraudulent or illicit transactions, and reduce the risk of cyber attacks.

Richard Summerfield