The successive crises that marred the cryptoassets market last year dealt a blow to trust in the digital assets industry. High-profile shocks, in particular the implosion of cryptoassets exchange FTX, contributed to a further loss of faith, reinvigorating calls for regulators to bring the industry firmly under their watch.
Despite this bruising, OMFIF’s Digital assets 2023 report shows that considerable progress has been made in converging the worlds of digital and traditional finance. This is due in part to the work done by regulators to rebuild this confidence for institutional investors. Although the global landscape continues to take shape, the development of national frameworks and progress towards international alignment mark significant milestones.
For the launch of the report, OMFIF convened a panel of experts from international regulators, academia and industry to take stock of how the regulatory approach to cryptoassets has evolved and identify where more work is needed.
Progress despite setbacks
When compared to the typically glacial pace of regulatory and supervisory action, progress has been considerable. On the international front, global standard-setting bodies are leading efforts in cross-jurisdictional convergence in regulation, based on tested principles applied to traditional finance.
The Financial Action Task Force was one of the first GSSBs to attempt to regulate the industry, extending its anti-money laundering guidance, known as the travel rule, to digital assets service providers in 2019. More recently, important recommendations have been finalised by the International Organization for Securities Commissions, relating to market integrity, and the Financial Stability Board to ensure that contagion of traditional finance is averted. In both cases, transcribing traditional finance principles is key to the process of building trust around digital assets.
Global implementation of the FATF’s guidance has been progressing, although there is some way to go. Currently, around 30% of jurisdictions are at least partially compliant with the travel rule. ‘A lot of jurisdictions are still waiting to regulate and legislate for this. It is not an easy job to stand up a new supervisory authority and pass legislation to deal with a sector such as this,’ Tom Neyland, head of the FATF risk and policy unit, said at the launch of the report. He pointed to the challenges surrounding privacy laws and different sanctions lists in the implementation of international anti-money laundering standards.
At the jurisdiction level, there has been notable progress towards the implementation of tailored regulatory frameworks for digital assets. The European Union’s Markets in Crypto-Assets, passed in May, will begin to be phased in throughout next year. Amendments to the Financial Services and Markets Act in the UK have also been laying the foundation for more comprehensive oversight of digital assets. Japan has implemented a framework targeting stablecoins, and countries such as Singapore are also setting out plans to regulate their issuance.
Navigating implementation challenges
Establishing the rules of engagement, however, is just the start. There are a number of challenges to implementation which will need to be navigated. ‘Having a law or authority is just the first step,’ cautioned Neyland. ‘Building a relationship with the sector in your country, building an understanding of the risks, building a culture of compliance and getting used to day-to-day supervision is a much longer-term issue.’
Regulators face challenges in building capacity to supervise the risks emerging from these new technologies. While this challenge is universal, it is particularly acute in countries with less experience in financial regulation.
Attempts by some jurisdictions to capitalise on a lack of clear regulatory frameworks in countries such as the US, marketing themselves as crypto hubs and promising an easier path to licensing, are likely to amplify these fears. Given the cross-border nature of digital assets, pockets of weak supervision could risk undermining the efforts of GSSBs and spreading financial stability risks. As Neyland warned, ‘failure to regulate isn’t creating a free bubble for developers to prosper – it is exposing their citizens and everyone else’s to risks’.
Solutions and initiatives
Part of the potential solution to this is ensuring that regulators’ tools keep pace with new technology. Daniel Eidan, adviser and solution architect at the Bank for International Settlements Innovation Hub, observed that: ‘As the tools change, how regulators regulate needs to evolve along with them. There’s a lot more data; global markets are a lot more connected and things get more challenging to harmonise and regulate.’
The BIS Innovation Hub is leading a number of initiatives to develop this regulatory technology. Project Rio provides draws on real-time transactions monitoring data from multiple exchanges, enabling central banks and regulators to attain deeper insights into market movements.
According to Eidan, we may ‘potentially even see new use cases come out of regulation and supervision not hindering the development of these tools’. However, these benefits can only be realised once the industry has confronted questions around its governance and transparency. Richard Berner, clinical professor of finance at New York University Stern School of Business, made the distinction that governance in traditional finance has often arisen in response to collective action problems, such as with the creation of the FX Global Code.
Guidelines akin to this are already present in some parts of the ecosystem. Anthony Ralphs, director of CBDC product management at Ripple, alluded to how similar guidelines that govern interactions are already in use within their ecosystem. This includes requiring members to signup to RippleNet’s rulebook and harmonising data reporting rules.
There are a number of factors for which the longevity of traditional finance institutions can be attributed, but trust is usually revered as the most crucial. It remains to be seen whether the same will be said of digital finance, but the Digital assets report shows that things are moving in the right direction. As Neyland concluded: ‘We don’t very often bring a new sector under regulation… we have an opportunity this time to do it better – fewer false steps, fewer irrelevant rules – but in order to do it we need to get all countries on the starting blocks and ready to begin.’
Edward Maling is Research Analyst, OMFIF.