A version of this article was originally published in Global Government Forum on November 25, 2022.
Is the financial activity in the crypto asset ecosystem really all that new? That depends on where the focus lies, and governments’ approaches to crypto regulation will need to respond accordingly.
If the focus is squarely on the innovative blockchain technology behind decentralized finance (DeFi), then crypto-related financial activity is unequivocally novel.
Yet while the blockchain rails that eschew centralized validation might be new, the fungible and non-fungible tokens that run on them often represent familiar asset types. That observation is one of the key insights for banks in our recent Tokens on a chain report, but it is just as significant for regulators.
Crypto assets bring new technological advantages and challenges, but the types of commercial and investment activities often have parallels in the well-regulated financial and commercial sectors. And some of the risks they present are similar to those already covered by existing regulations.
Yet a “same risk, same rules”—or even “same risk, same outcome”—principle can only apply if the risks posed by crypto are truly the same.
Efficiency without over-regulation comes from identifying where existing regulations suffice so as to keep amendments and new regulations to the minimum necessary.
Two issues are particularly instructive in this regard: ambiguity around assets, and technological and cross-jurisdictional coordination.
Ambiguity around assets
The IOSCO decentralized finance report notes that stablecoins—cryptocurrencies pegged to a stable asset—have become “DeFi’s substitute for fiat currency.” And if stablecoins act like deposits, then it makes sense to subject stablecoin issuers to the same existing deposit-taking regulations as banks.
Payment systems that support the authorization, clearing and settlement of stablecoins should similarly continue with regulations equivalent to today’s stances. The UK Treasury‘s stated approach is to “bring activities that issue or facilitate the use of stablecoins used as a means of payment into the UK regulatory perimeter, primarily by amending existing electronic money and payments legislation.”
Small wrinkles come from decisions around the tax treatment of stablecoin holdings, whether stablecoins should be interest bearing, and a role for stablecoins in fractional reserve banking.
Bigger wrinkles come from the use of stablecoins as investment instruments. That may pertain to when stablecoins hold illiquid reserve assets, when their value is maintained via algorithms that regulate supply and demand against another cryptocurrency, or when they are used as a kind of money market fund to provide liquidity for other investments in volatile crypto assets. The US Treasury specifically notes that “stablecoins, or certain parts of stablecoin arrangements, may be securities, commodities and/or derivatives.”
Securities and commodities regulations provide precedents, but the challenge is to clearly identify whether the primary objective of a stablecoin is for deposits and payments or for investments. That question brings stablecoins into the broader mix of unpegged cryptocurrencies. The original aim for decentralized cryptocurrencies might have been for payments, which excludes them from being treated as securities, but their predominant use as investments causes regulatory challenges around activities like spot trading.
Further challenges come from defining fungibility. Logically, fungible crypto assets—such as cryptocurrencies or crypto securities—should be regulated as a means of payment or exchange, while non-fungible tokens (NFTs) should be exempt from financial regulation. But the line between them is blurry.
Fractionalized NFTs, which allow ownership of a unique asset to be divided among multiple people, raise questions over what degree of fractionalization makes the fractionalized parts of an NFT fungible.
Utility tokens, which are often associated with raising startup capital as organization-specific currencies, pose problems when they increase in value with an organization’s fortunes and start to operate like shares. Any voting rights associated with a governance token—a subset of a utility token—can look like those accorded to shareholders.
Technological and cross-jurisdictional coordination
Each blockchain is effectively its own technological standards community. Interoperability remains nascent, and the resulting proliferation of cross-chain bridges introduces a range of security concerns.
The ability of trusted intermediaries to facilitate interoperability relies on regulators to establish baselines for consumer protection, security, data protection and privacy. A precedent exists in open banking, where secure open banking connections made via application programming interfaces (APIs) often rely on API aggregators for interoperability. Governments can support security and interoperability across permissionless blockchains in a similar manner.
The removal of intermediaries in DeFi transactions is novel, but scaling the approach may ultimately require a degree of centralization for legitimacy in the same way open banking requires a degree of closed privacy. And the underlying risks it poses are often analogous to those of traditional finance in enabling activities like trading, transmission, settlement or lending.
When existing regulations appear insufficient, such as anonymous trading via decentralized exchanges (DEX) or from unhosted wallets, regulations addressing similar risks around issues like anti–money laundering (AML) and know-your-customer (KYC) compliance may be adjusted as appropriate. That is the theory at least—particularly as new concepts, such as decentralized IDs, emerge.
In reality, ensuring KYC and AML compliance is challenging. For example, a DEX can circumvent both by making markets automatically through liquidity pools of invested assets and then self-execute anonymous transactions using "smart contracts.”
Further challenges come from international coordination around ensuring “travel rule” compliance, which requires all financial service providers to share originator and beneficiary information, and preventing regulatory arbitrage, where providers seek out more favorable jurisdictions. Guidance from international compliance standard setters, such as the Financial Action Task Force (FATF), is welcome but requires domestic implementation, which is often lacking.
Inconsistent regulatory treatment across jurisdictions leads to an uncertain business environment for crypto innovation and particularly stifles the ability of larger organizations to participate.
Meanwhile, smaller and less risk averse organizations may find themselves with few incentives to invest in compliance. Regulations without compliance count for little. A level playing field for all participants comes from equal enforcement at home and abroad.
The tokenization of assets to record ownership on a blockchain does not alter the assets themselves. That reassuring consistency is as relevant to a bank working with crypto assets as to a government providing the regulations around them.
The onus on governments to mitigate risk while accelerating crypto innovation is alleviated when many existing regulations just need some considered rearrangement rather than a complex overhaul that may reduce acceptance and compliance. The ability of governments to identify how and where to apply those regulations in a clear and consistent manner will be no easy feat. But missing puzzle pieces are far easier to identify once the rest of the puzzle is assembled.