Global regulatory authorities don’t usually make stern warnings that certain assets may pose a threat to the global financial system. Wary of the unintended consequences of their caution, they might avoid statements. But when it comes to crypto assets, those warnings have become increasingly familiar.
Many global regulators and Central Banks are increasingly uncomfortable with developments in the crypto universe and the rate at which crypto assets are growing.
The Financial Stability Board (FSB) in February, added its voice to the chorus of international bodies worried about the direction in which the crypto market might go. It claimed that unless regulators take action, crypto assets could cause significant disturbance to the global economy.
The Bank of England, the UK’s Financial Conduct Authority (FCA), the Bank for International Settlements and the US Federal Reserve are among others to have expressed similar concerns in recent months. But what exactly is the threat and why are policymakers so worried?
Playing catch up
The crypto assets ecosystem is expanding rapidly, housing a vast range of assets with different and often complex underlying technologies and governance characteristics.
The FCA defines crypto assets as “a cryptographically secured digital representation of value or contractual rights that is powered by forms of distributed ledger technology and can be stored, transferred or traded electronically.”
At its most basic, a cryptocurrency (such as Bitcoin, which launched in 2009) becomes an asset once it can be traded by investors. There are thousands of different types of crypto assets, including exchange tokens, utility tokens, security tokens, and non-fungible tokens (NFTs). NFTs have risen in popularity and made headlines over the past 12 months.
The rate at which the crypto assets ecosystem is evolving is, for many, a source of fascination and promise. Whereas, for those responsible for global financial oversight and regulation it’s also a source of headaches.
What exactly constitutes a crypto asset? Which crypto assets should be defined as securities? Who can create or issue one? Do investors understand how they work, let alone the risks? Where should the regulatory focus be? These are just some of the many questions occupying authorities responsible for financial regulation.
Threat modelling
In purely financial terms, the market is not particularly big for crypto assets. Market capitalisation grew 3.5 times in 2021 to $2.6tn (£1.9tn), according to the FSB.
But in its February paper, it said crypto assets markets could grow to represent a threat to global financial stability due to their “scale, structural vulnerabilities and increasing interconnectedness with the traditional financial system.” The nature of crypto assets markets creates potential for regulatory gaps, fragmentation or arbitrage, said the FSB, adding that any stability risks could escalate quickly.
Although there have been bouts of severe price volatility in crypto assets markets, these haven’t so far impacted on traditional financial markets, not least because they aren’t widely used in real world financial services (such as payments). And they operate largely outside financial regulatory perimetres. But the knock-on effect could soon change given the speed at which crypto assets are evolving.
Crypto assets are in many ways digital versions of traditional financial assets and are vulnerable to similar risks and scams, but the anonymity of crypto transactions and the speed at which they are processed could produce more damaging outcomes. Those risks are exacerbated by vulnerabilities such as low consumer understanding of crypto assets, according to the FSB. Its report came just weeks after the Bank of England flagged cryptocurrencies as a potential systemic risk to UK financial stability.
Similarly, the IMF has warned that many of the entities within the crypto ecosystem lack “strong operational, governance, and risk practices.” It also referred to consumer protection risks arising from inadequate disclosure and oversight, and the potential for the anonymity of crypto assets to create data gaps for regulators and “open unwanted doors for money laundering.”
Virtual reality
Crypto assets are climbing up the regulatory agenda as the rate of adoption and their presence in retail and institutional investment portfolios moves them ever closer to other asset types.
The level of threat to financial stability depends on the extent to which the traditional financial system is exposed to the crypto system, according to Andrew Henderson, a partner in the financial services regulation team at Macfarlanes.
“For example, if investment and pension funds, insurance companies, and banks hold crypto positions for investment or capital management purposes, and there is a crash in the value of those crypto assets, they will suffer,” he says. “The other factor is volatility driven by the high number of speculators, which is a characteristic of an immature market.”
That issue has been amplified by the extent to which media and political focus has been on crypto currencies that aren’t asset-backed, most notably Bitcoin, which has experienced the fastest growth. Demand has been fuelled to a significant degree by gamification and social media influencers, who have also shown how volatile valuations can be, explains Rachel Waggott, head of regulatory affairs at Innovate Finance.
“It is these cryptocurrencies which regulators have particularly focused on in terms of stability. As values grow so do fears of a corrective market adjustment which could create a wider economic shock.”
The perceived threat should, in theory, reduce as the market matures and becomes better understood by investors and authorities. It’s not unusual for innovation in new asset classes and financial instruments to cause consternation among regulators, and the digital asset evolutionary cycle is still in a relatively early stage.
“What normally follows, as general understanding of the instruments improves, is that regulators become increasingly at ease and focus on consumer protection and minimising abuse [of the system],” says Heidi Pease, head of investment products at Wave Financial, a digital asset investment manager.
Several other issues link crypto assets directly or indirectly to financial stability. Most recently, the Russian invasion of Ukraine has further highlighted the difficulties in fully understanding what the rise of crypto means for global security and finance. There were indications in March that cryptocurrencies including bitcoin were used by Russians as an alternative to traditional finance, potentially undermining the impact of economic sanctions.
Similarly, the FSB and others have noted that the pseudonymous nature of crypto (crypto wallets can be held in fake names) makes it a popular way of laundering the proceeds of crime. Crypto criminals held $11bn worth of crypto assets by the end of 2021, up from $3bn the previous year, according to research by Chanalysis.
Meanwhile, the issue of consumer protection becomes crucial as the growth in popularity of crypto assets widens the market’s exposure to the real economy. The FCA estimated in 2021 that around 2.3m UK adults owned crypto assets and that almost eight in ten adults had heard of cryptocurrencies. At the same time, however, it found that the level of consumer understanding of the market was declining, which suggested people were investing in an asset they knew little about.
Scattergun approach
The task of ensuring effective oversight of crypto assets markets is complicated, not just by a lack of clarity as to what exactly needs regulating, but also who should be doing it. It’s no surprise, given the vast array of assets under the crypto umbrella, that the task of regulating them falls to a similarly dizzying range of regulatory agencies.
Crypto isn’t unusual in this respect. Fintech firms, for instance, deal with a variety of UK regulators and quasi-regulators, including the FCA, the Prudential Regulation Authority (PRA), the Payment Systems Regulator and various government departments.
“There is a tendency to lack a coherent national strategy across these bodies,” Pease says. “A joined up approach is needed: clear direction from HM Treasury and a cohesive approach by the Bank of England, PRA, FCA and HMRC.”
The effectiveness of national approaches is further undermined by the fluid cross-border, cross-sector nature of crypto assets, with the contrasting approaches of different regulatory authorities adding to this fragmentation.
Rufus Round, CEO of digital asset broker GlobalBlock notes that some jurisdictions, including Gibraltar and Switzerland were quick to establish dedicated regulatory bodies. “They have had protections and regulations in place for some time now, allowing many crypto asset companies to comply with stringent money laundering rules.”
Similarly, the new Dubai Virtual Assets Regulatory Authority will have oversight of the sale of virtual assets and virtual tokens, as well as responsibility for regulation and authorising virtual asset service providers.
Elsewhere, though, the view is different, as global authorities are operating at varying speeds. In the EU, the proposed Markets in Crypto Assets (MICA) bill - which aims to tighten regulation to a more uniformed approach on the continent - is slowly but surely proceeding, with potential to form the basis of a global approach.
MICA focuses mainly on different types of stablecoins (digital currencies linked to stable assets such as the US dollar, the euro or gold) and cryptocurrency exchanges. An additional proposal to ban energy intensive “proof-of-work” digital currencies such as bitcoin - due to their environmental impact - was removed from the bill in mid-March, albeit with potential for it to be restored.
“Both the US and the EU financial regulators have already signalled that legislation to regulate crypto in the coming years will focus mostly on exchanges and stablecoins,” observes Mikkel Morch, executive director at ARK36, a crypto-digital asset hedge fund.
“For example, by providing strict guidelines defining the entities that can issue stablecoins, as well as rules on how these cryptocurrencies should be pegged to the underlying assets, regulators will be able to greatly limit the risks mentioned by the FSB report.”
While the UK’s strategy largely aligns with the EU, the US has several agencies taking different approaches to the crypto challenge. The SEC, for instance, is concerned with the crypto assets that it views as securities that should be robustly regulated, while the US Treasury is more interested in financial stability and crimes including money laundering.
Again, progress here is slow but steady. President Biden recently signed an Executive Order on digital assets that requires the relevant agencies to examine the regulatory landscape for crypto.
“I believe that many major regulators are waiting to see what the world’s biggest capital market does to better contextualise their approach as the US more clearly defines its approach. For example, toward pure crypto ETFs, we will see other major markets follow,” says Pease.
Elsewhere, Japan, seen as friendly towards crypto, recognises bitcoin and other digital currencies as legal tender. However, it has responded to concerns over the potentially nefarious use of stablecoins with proposals to introduce a registration system for intermediaries providing crypto asset trading services.
China, by contrast, takes a much stricter approach, with cryptocurrencies not considered legal tender. Last year it banned all virtual currency trading and speculation, tagging cryptocurrency related business activities as “illegal financial activities.”
The lack of international coordination creates potential for regulatory arbitrage, says Round, as crypto firms are able to exploit the pros and cons of different regimes.
“Poorly led regulatory regimes are seeing incumbents move operations to more proactive jurisdictions, maintaining their bases wherever they go should frameworks change or catch up.”
A balanced approach
The contrast in global approaches illustrates the difficulty in striking a balance between managing the risks posed by crypto as an asset class, while also promoting innovation.
“Regulatory focus has tended to be more on managing risks associated with speculative cryptocurrencies as opposed to enabling innovation in payments and in capital markets,” according to Waggott.
A more balanced approach, she believes, would feature better consumer protection in speculative crypto markets, a framework for stablecoins that provides consumer and market trust, and a Central Bank Digital Currency that complements a vibrant stablecoin market.
An obvious starting point from a financial stability perspective is anti-money laundering protection. “This means the tracing of the source of capital and making sure sanctioned capital does not get introduced back into the financial system via crypto,” says Pease.
Similarly, there are calls for minimum technology standards to ensure operational resilience and reduce the risk of system failure.
Ultimately, however, any threat posed by crypto assets to international financial stability will best be mitigated by greater global coordination.
“Since the financial crisis, international coordination for financial stability has been central to banking regulation,” says Henderson. “Financial stability crypto regulation is a natural extension of this and the signs are positive, albeit that, as has been the case historically with the financial crises, a crypto financial crisis may be difficult to spot.”
Regulators aren’t alone in struggling to keep up with this innovative rapidly evolving space. Although some seek to embrace digital innovation in general, others take a much stricter, reactionary line. But as crypto and traditional financial systems become increasingly interconnected, and the implications for financial stability become greater, the fragmentation of national and global oversight will become more exposed.
