On October 11, the Financial Stability Board (FSB) – a multilateral body that monitors and seeks to address systemic financial risks – published a consultative report on “Regulation, supervision and monitoring of the cryptoasset market”.
This is the latest in a series of crypto-asset-related initiatives by the FSB, as regulators and central banks increasingly focus on the potential for the crypto-asset sector to pose a risk to the wider financial sector.
The FSB report is critical reading for governance, risk and compliance professionals in the crypto space, as it offers insight into the regulator’s thinking on the macro picture surrounding cryptocurrencies.
It provides an overview of the state of crypto markets, their interrelationship with the broader financial system, and the potential implications of these growing intersections. It also highlights existing regulatory gaps that could exacerbate the potential for risks in crypto markets to affect the banking sector and other components of the financial system.
Furthermore, the report outlines nine high-level recommendations that describe how policymakers can begin to address the problems posed by cryptoassets. These include ensuring that supervisors have adequate resources to oversee cryptoasset markets, the importance of international cooperation among regulators, and the importance of ensuring that cryptoasset service providers have an effective risk mitigation framework. The FSB has invited the public to comment on the issues raised in the report – with a consultation period open until 15 December.
We asked three leading legal experts for their views on the implications of the FSB’s latest report.
Information gathering
The report identifies the difficulties that anonymity and decentralization pose for regulatory oversight and enforcement. Cross-border cooperation is one way the FSB proposes to address this. But this appears to be only a partial solution, and regulators will need to think creatively about how they can use existing and new powers to advance their policy goals without direct supervisory involvement in all cases.
The recommendations in the report require a lot of information gathering by regulators and may involve the use of monitoring channels that they have not traditionally adopted. In practice, regulators will seek market data from regulated entities and certain third parties – perhaps such as Elliptic. We can expect that setting clear mandates and information collection obligations will be a key priority for regulators building their supervisory regimes for virtual assets.
The report notes the different regulatory approaches to custodial and non-custodial wallets and highlights some of the risks inherent in the use of non-custodial wallets. This background, however, is not reflected in the recommendations that apply only to custodial wallets. This is not surprising, given the similar approach adopted in some jurisdictions when implementing crypto-asset travel rules. However, we can expect continued policy debate on the oversight of non-custodial wallets – especially those offered alongside custodial wallets by regulated providers.
Rory Copeland, Allen & Overy.
Legal perspective
Individual lawyers are licensed in one or two countries, so there is an immediate challenge with international legal frameworks. In practice, these frameworks require lawyers to have a good understanding of the rules outside their home jurisdiction. The international nature of crypto and digital assets creates a new class of advisors who understand the rules in major jurisdictions. A token that is useful in the UK will almost certainly be a security in the US and this has implications for most new token issuances.
Harmonized regulation has obvious advantages in improving efficiency and transparency. But the EU’s attempts to harmonize, for example, capital market rules show that this is difficult in practice. Additionally, one of the recent trends in cryptoasset regulation is the attempt by different jurisdictions to compete to be crypto-friendly and attract business. So there is a tension between harmonization and competitiveness.
In terms of integrated rules, financial stability is key, but only one of a number of issues that cryptoassets must contend with. Previous studies have found that the cryptoasset market is not a source of contagion risk. Ironically, the closer we get to global rules related to cryptoassets in general, the easier it is for projects to scale and, ultimately, the greater the risk of contagion.
Charles Kerrigan, CMS.
Focus on stable coins
There are several interesting points arising from the FSB’s plans. First, there’s the focus on “same activity, same risk, same regulation,” which sounds uncontroversial, but it’s unclear what that means in practice.
Implicit assumptions are that blockchain and crypto-based solutions simply mirror traditional finance (TradFi), which may not be the case, and that it is up to blockchain solutions to embrace the solutions used in the TradFi environment. The problem with this assumption is that there is only one correct answer, and usually that one answer involves an intermediary.
For a decentralized finance (DeFi) platform that has the role of TradFi, the focus is on removing the middleman, and it’s really clear that the role of the middleman is redundant in certain scenarios. To give an example, AML frameworks generally assume a face-to-face interaction between a service provider and a client, during which the latter provides certain information such as a passport to the service provider.
There are real problems with that approach. For example, if there is a hack, sensitive personal data is lost, and providing all this information is a crude tool for answering a relatively simple question, namely whether there is an AML risk in dealing with a client. Presuming that a regulatory solution based on a centralized model is the way to tackle this type of risk may therefore be a missed opportunity when different techniques can deliver better results.
Another interesting aspect will be the focus on stablecoins. Given recent events, compliance requirements for such cryptoassets – especially in the context of payments – will become more stringent internationally. This in itself is not a bad thing as it restores consumer confidence, however a particular concern will be what providers of such cryptoassets will have to do in practice, for example in terms of meeting potential transparency and liquidity requirements.
While it is currently unclear what exact approach the FSB will want to take here, the current perception is that algorithmic stablecoins will have particularly rigorous regulatory hurdles to climb, especially given the reference in the consultation that Terra is a cryptoasset that would not meet the FSB’s recommendations at a high level. Balancing the advantages of stablecoins, for example in terms of settlement speed and lower fees, with the real and perceived risks will therefore be a fine balancing act.
James Burnie, Gunner Cooke.
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