The increase in crypto asset activities have brought with it debates as to whether these activities should be regulated. Indeed, many jurisdictions have been implementing, or are looking to implement, regulatory frameworks for crypto asset activities. 

Regulation generally involves setting rules that define acceptable conduct of operations/activities. 

Crypto sector activities mimic key activities conducted in the traditional financial services sector in several ways: through capital raising, lending, borrowing, speculation etc, and as with the traditional sector, there are risks (such as financial stability, money laundering, cybersecurity, ineffective governance, lack of consumer protection, etc) that emanate from the conduct of these activities. Furthermore, the nature and characteristics of crypto assets arguably amplifies some of these risks [i].

In that regard, there may be some key benefits to implementing regulation for crypto asset activities. Below, three key benefits are considered. 

Mitigating risks of crypto asset use for financial crime

Due to its anonymous/pseudonymous nature and the ease for conducting cross border transactions, crypto assets are attractive to persons in the business of conducting illicit transactions. Statistics gathered by Chainalysis, noted in its 2022 report, indicate that cybercriminals laundered $8.6 billion worth of cryptocurrency in 2021[ii].

It has also been noted that crypto assets are used for the conduct of not only money laundering but also other crimes including terrorist financing, fraud and theft.

Regulation could assist in mitigating the occurrence of such crimes by requiring entities/organisations, offering crypto assets services, to conduct adequate know your customer due diligence, apply appropriate risk ratings for customers as well as identify and monitor suspicious transactions.

Consumer/ Investor Protection and Confidence

While the market cap for crypto assets have reached as high as $2.8T in 2022[iii], there are still a number of potential investors who are sceptical about accessing crypto asset services.

Investor trust and confidence is dependent upon perceptions of exposure to harm, whether as a result of theft, fraud, misrepresentation, uncertainty or other factors.

Indeed, there are various reasons for scepticism with crypto asset activities including:

• the volatility of crypto assets,
• the lack of certainty that entities/organisations have sufficient funding to be able to provide services offered,
• no assurance of appropriate risk controls and adequate governance being implemented by those offering crypto asset services,
• no commitment for accurate and appropriate disclosures to consumers, and
• lack of recompense for losses, among other things.

Regulation covering some of the key areas that matter to investors such as risk controls, disclosures, etc would likely foster investor confidence long term and support the growth of the crypto asset sector.

Regulation is also likely to legitimize the operations of crypto asset service providers in the eyes of investors and consequently boost reputation which could lead to other positive benefits.

Managing financial stability risks

There are notable interconnections between the crypto asset sector and the traditional sector, including services offered to crypto asset providers by financial institutions (which may result in crypto asset exposures). The growth in the issuance or trading of security products based on crypto assets, fund investments in crypto assets and the increased use of stablecoins tied to traditional financial instruments also play a role in the interconnections of the two sectors. 

The Financial Stability Board (FSB), has concluded that the direct connections to SIFIs and core financial markets remain limited at this time [iv], but it is arguable that given the continued growth of this sector and interactions with the traditional market, there is potential for same to grow [v].

The FSB notes the interconnectedness within the crypto asset sector itself, which may present risks of rapid contagion during a stress period, particularly given the high reliance on leverage[vi]. Moreover, the characteristics of crypto assets may arguably acutely amplify instability due to the lack of risk controls to protect against runs and manage excessive leverage [vii].

The volatility of crypto assets means that a sharp decline in values could trigger margin calls or collateral liquidation. This may lead to fire sales amplifying contagion within this interconnected sector. Furthermore, the Financial Stability Oversight Council has noted that “despite the distributed nature of crypto-asset systems, operational risks may arise from the concentration of key services"[viii].These types of vulnerabilities could lead to financial stability threats. 

Regulation of key actors within the crypto asset sector (such as issuers and service providers), could help mitigate potential contagion and financial stability risks by, for example, ensuring appropriate risk management mechanisms are in place that identifies, measures, evaluates and controls such risks; and promotes operational resilience. The implementation of effective governance, providing for clear lines of responsibility and accountability relevant to the functions and activities being conducted may also be necessary to address vulnerabilities within the sector.  

Conclusion

There are many benefits to the regulation of the crypto asset sector. However, one should note that with all things there should be balance.

In that regard, for regulation to be successful and beneficial to all participants in the crypto asset sector, it should not be overly prescriptive resulting in unnecessary costs and stifling growth and innovation.

The objectives of regulation in the crypto asset sector should be to promote market confidence, support innovation, protect consumers, and maintain financial integrity and stability. Regulation should be tailored having regard to the inimitable nature of the crypto asset sector.

I came across a quote which, although made as a general comment on regulation, aptly applies in the current circumstances as well. “When excessive in number and complexity, regulations can impede innovation, create unnecessary barriers to trade, investment and economic efficiency, and even threaten the legitimacy of the rule of law.”[iv]

It is important that regulation for the crypto asset sector be well considered, finding the right balance for mitigating significant risks and protecting consumers and the financial system. Regulation ought not to be an impediment to the potential growth of this nascent sector but rather should provide sound guardrails that will support the evolution of this sector. 

References

[i] See The Financial Stability Oversight Council’s Report on Digital Asset Financial Stability Risks and Regulation (October 2022), where it is noted that the characteristics of crypto assets acutely amplifies instability. 

[ii] Chainalysis Crypto-Crime-Report-2022, February 2022. https://go.chainalysis.com/2022-Crypto-Crime-Report.html

[iii] Total Cryptocurrency Market Capitalization (Excluding Bitcoin) from Coinmarketcap.com https://coinmarketcap.com/charts

[iv] FSB (2022a): Assessment of Risks to Financial Stability from Crypto-assets, February. 

[v] The FSB in its consultative document ‘Regulation, Supervision and Oversight of Crypto-Asset Activities and Markets’ (October 2022) noted that “recent market trends have also highlighted the increasing correlation between crypto-asset markets and traditional financial markets”. 

[vi] See FSB Report ‘Assessment of Risks to Financial Stability from Crypto-assets’, February 2022. 

[vii] See The Financial Stability Oversight Council’s Report on Digital Asset Financial Stability Risks and Regulation (October 2022). 

[viii] Ibid.

[ix] Nick Malyshev, Head of the Regulatory Policy Division, OECD, ‘A Primer on Regulatory Budgets’, OECD Journal on Budgeting, Volume 2010/3, 2010.