Crypto Asset Regulation: Quo Vadis?

Regulating digital assets following the collapse of crypto exchange FTX

The collapse of crypto exchange FTX has sent shock waves throughout the digital asset industry.¹ Trust has been lost and other exchanges have rushed to reassure customers their crypto assets are safe.² It’s likely it will take some time for trust to be restored. So, why has this happened?

One of the main problems with trust is the belief is that crypto is still highly unregulated. It’s know as the digital “wild west.” When crypto has a meltdown it shows the industry needs more regulation and when things go awry people expect rules to be severely tightened.

While regulations may increase as a result of FTX’s failure, some commentators believe that it’s just a myth the crypto sector isn’t regulated.³ Several countries like Singapore, Switzerland, and Liechtenstein have already put crypto regulations in place.

What’s missing is regulation that spans across jurisdictions. Such regulations pose challenges because digital assets are global in nature and many are decentralised meaning there’s no middle men such as a broker to transfer goods between buyers and sellers. Instead of a central authority, resources are owned by all the users. Everything that is recorded on the network is transparent for all users to see. This makes it particularly difficult for national regulatory bodies to create laws to govern them.

The challenges of regulating digital assets

The real challenge in regulating digital assets boils down to the fact that they strive to be borderless and decentralised. These two characteristics make it rather difficult for traditional regulations to latch on to.

Cryptocurrencies are borderless because they aren’t issued by any government or central authority. Instead, they are issued on a public blockchain with nodes spread across continents. This makes them truly global. They are different from government-issued fiat currencies, which, in most cases, are issued by a central entity and are only used within the borders of a certain jurisdiction.

Furthermore, people only need an internet connection to access cryptocurrencies. A crypto exchange does not have to be in the same jurisdiction as their users. Attempting to regulate crypto in a given country may be difficult when project developers reside in another one and the companies behind these projects are registered elsewhere. In some instances, the developers behind some cryptocurrencies are anonymous, making it even more difficult for regulators to enforce any rules.

As many digital assets are decentralised, the code that governs the rules of the network can’t be changed unless all users agree. Regulating code is difficult. Code is viewed like speech and therefore, many jurisdictions don’t have the legal powers in place to properly regulate it.

For these reasons, regulators target centralised crypto exchanges because they are companies registered within a specific jurisdiction. It is not only easier to get them to comply with know your customer (KYC), anti-money laundering (AML), and combating the financing of terrorism (CFT) requirements, it is their duty to be regulated accordingly. After all, the financial products they offer, such as crypto derivatives and lending are very similar to traditional financial instruments and are thus subject to regulatory compliance.

Since many different national regulators must regulate a technology that’s international in nature, there is a lot of uncertainty regarding how to control crypto on a global scale. Nonetheless, a few global regulatory bodies like the Financial Action Task Force (FATF), G20, and the Basel Committee on Banking Supervision (BCBS) are striving to propose global regulation for topics like anti-money laundering, stablecoins, and banking capital requirements.
 

The importance of proper regulation

The crypto industry can benefit significantly from well-targeted regulations. That’s because proper regulation means legal certainty and reduced risk. A regulatory framework that adopts risk management best practices increases confidence in both retail and institutional investors. On the other hand, fragmented and unclear regulations that aren’t guided by global standards will do little to remove the current regulatory uncertainty in the space. 

Large economies like the U.S. and Europe are keen to regulate crypto properly. This will prevent crypto companies from going offshore where traditional regulators have barely any oversight on them. This is probably what happened with FTX. The lack of regulatory clarity meant the exchange couldn’t do most of the things it wanted to do in the U.S., thereby driving it to the Bahamas where the biggest part of its business was located. Moreover, proper regulation will give these economies some control over the crypto sector.

Proper regulation also means the ability for regulators to distinguish between players that are truly decentralised to those that play “decentralisation theatre.”⁴ These are decentralised protocols with aspects of centralisation, such as one person or a few people holding the “admin key” or the allocation of a large number of governance tokens to a small group of people. These aspects of centralisation become potential points of failure that could have devastating consequences. As a result, such protocols need to be regulated just like traditional centralised players are.

On the flip side, regulators also need to acknowledge protocols that offer true decentralisation. While there might be few in nature indeed, the true ones must be identified to properly address them. In this case, new regulation may be required or direct regulation may even be unnecessary since what happens in these systems is transparent for all members to see. It’s self regulating. At least this maybe the case with truly decentralised finance (DeFi) protocols. In a way, truly decentralised protocols are like Transmission Control Protocol/Internet Protocol (TCP/IP) – a communication framework for protocols used in the Internet - or other native internet protocols. Regulating them doesn’t make any sense.
 

Where is regulation headed?

The regulation of the crypto industry is inevitable. It is coming, and this isn’t a bad thing when done thoughtfully. As mentioned earlier, it can accelerate the adoption of cryptocurrencies by institutional investors and protect retail investors. However, regulators have to ensure that the laws they create will not stifle innovation. 

The large stakeholders within the crypto sector are also calling for regulation themselves, which is a good thing by and large. For instance, during a recent G20 conference in Bali, Binance’s CEO Changpeng Zhao “CZ” said regulations are necessary.⁵ However, he added that this needs to be done properly and stably. His stance indicates that the space is open to sound and fair laws that seek to solve challenges such as consumer risks and protection from criminal activities. Things like proof of reserves⁶ that exchanges like Binance or BitMex⁷ are offering, which show customer funds are safe are a first step in collaborating with auditors and regulators.

One major milestone could come from overseas. Going forward, the U.S. needs to decide what regulatory body will regulate what within the digital asset space. As it stands, the Securities Exchange Commission (SEC) and the Commodities Futures Trading Commission (CFTC) have been in a battle of sorts in an attempt to gain oversight regarding the regulation of crypto transactions in the country.⁸ This battle has to end and clarity needs to ensue.

Furthermore, the SEC would be well advised to come forward with a list of those digital assets it considers securities. It should also need to provide a clear definition of a security with regards to cryptocurrencies to remove any doubt on what a security is and what it’s not. Based on the differing opinions between the SEC and the CFTC on whether Ethereum (ETH) is a security or commodity, it’s obvious that a clearer definition is required beyond using the archaic Howey test (a US Supreme Court case that determined what type of transaction is an investment contract).⁹ President Joe Biden has also called¹⁰ for international regulation of the crypto market. However, the country can only push for it once it has sorted out its crypto matters back home.

Europe is also working on a regulatory framework called Markets in Crypto Assets (MiCA). The comprehensive legislation will guide crypto activities within all 27 EU nations while creating an environment for crypto to thrive with minimal risks. MiCA was proposed¹¹ in 2020 and should be enforced in 2024.

A smaller country, El Salvador, is acting somewhat faster in this respect. In what is probably the most crypto-friendly country, a new Salvadoran law has just been presented. This new legislation is to regulate all public offerings of digital assets that are tradable. Digital assets are defined as any assets stored on a blockchain. For example, stablecoins, governance tokens, Ethereum, other layer 1 tokens, or NFTs. The law also states that digital assets are not securities. From the perspective of the crypto world, it is to be hoped that other nations will follow this example and that uniform global standards that are positive for the crypto world will one day become reality.

Despite the benefits regulation could bring to the crypto sector, people should realise regulation isn’t a panacea. It will prevent some things but not everything. As Filliti from the Lawfare Project¹² says, "There's a lot that the government can do, but the markets run themselves.” The space will continue to grow, and new solutions and challenges will emerge. Proper regulation should, therefore, be flexible enough to keep up with these changes and unbiased enough to foster further innovation.