Bringing tokens into the regulatory fold
Amid concerns about potential mis-selling and a lack of proper investor protections, regulators are now looking to bring in new rules to oversee digital assets. Nonetheless, they are conscious that digital assets are a diverse asset class, meaning a one-size-fits-all approach towards their supervision is not appropriate. Many regulators have made clear that there are significant differences between tokens such as cryptocurrencies and so-called stablecoins (tokens pegged to traditional securities, assets or fiat currencies) versus those that behave like securities. In the case of security tokens – digital assets that confer similar rights to the governance, value and income from an underlying enterprise as do an equity or a bond – regulators have generally said that these will be subject to prevailing securities laws. Conversely, cryptocurrencies are generally considered to be unregulated assets thus far.
“The EU’s proposed Markets in Crypto-assets Regulation (MiCA) states that crypto-assets such as security tokens fall outside the regulation’s remit, although it notes that they must comply with existing rules including the Markets in Financial Instruments Directive II (MiFID II). Security tokens are also subject to similar requirements in the US and UK. However, the EU’s proposals go further as they will create a pilot regime for market infrastructures to facilitate the trading and settlement of regulated crypto-assets (i.e. security tokens) using distributed ledger technology. This is an ambitious move, which could help accelerate more institutional inflows into security tokens,” said Hugo Jack of Datm.
Emerging regulation of securities tokens will be the subject of the next article in this series; in this first part, we focus on the more common cryptocurrency and payments use cases of today.
A delicate balancing act for cryptocurrencies
While global regulators look to be adopting a broadly similar – if less well-advanced – approach towards overseeing security tokens, the same does not ring true for currently non-regulated digital assets, particularly cryptocurrencies and stablecoins. The EU’s proposed MiCA rules are perhaps the most developed, as they introduce stringent regulation (including disclosure and transparency requirements) covering the issuance and trading of such crypto-assets. In addition, the proposals also demand that all manner of crypto-asset service providers, issuers of asset-referenced tokens and issuers of electronic money tokens be fully licensed. Accordingly, this will subject providers – including digital asset custodians – to minimum disclosure requirements, new governance arrangements; prudential requirements, market integrity measures such as compliance with the Market Abuse Regulation, and additional rules on safekeeping clients’ funds and complaint handling procedures.
“By imposing regulation on previously lightly supervised crypto-asset providers, safety and confidence in the asset class will improve and institutional investors may become more comfortable trading in digital assets – at least within the EU,” noted Jack.
In the UK and US, digital assets such as cryptocurrencies will remain unregulated for the time being, although this could change in the future if these countries choose to follow the EU’s lead. Global bodies including the Basel Committee for Banking Supervision are already talking about imposing tough risk-weighted capital obligations on financial institutions holding cryptocurrencies, stressing that their volatility could be destabilising for banks. It has suggested that a risk weighting of 1,250% be applied to banks holding bitcoin, meaning a USD 100 investment in bitcoin would correspond to USD 1,250 of risk-weighted capital. This would make it prohibitively expensive for most banks to trade cryptocurrencies.
Elsewhere, the UK government and the US Federal Reserve have made clear that they are taking a closer interest in stablecoins. According to reports, both governments are prioritising regulation of stablecoins over cryptocurrencies, as they believe the former has the potential to play a significant role in cross-border payments as well as retail and wholesale transactions. The rationale is that the pegging of stablecoins’ value to an underlying stable asset, such as the US dollar or euro, makes them less prone to violent price fluctuations and more suited for payment use cases than volatile non-backed cryptocurrencies like bitcoin.
Despite compelling uses cases, some lawmakers are adopting an uncompromising position toward cryptocurrencies. Having already outlawed cryptocurrency exchanges and initial coin offerings (ICOs) in 2019, the Chinese authorities have since banned financial institutions and payment companies from providing services related to cryptocurrency transactions. Reuters notes that banks and payment companies in China cannot provide clients with any services involving cryptocurrencies, including registration, trading, clearing and settlement. This comes amid Chinese concern about the volatility of cryptocurrencies and, likely, a desire to keep hold of the reins of means of payment. Other leading markets – including India – also have a track record of hostility towards cryptocurrencies. A 2018 circular issued by the Reserve Bank of India (RBI) prohibited banks from facilitating cryptocurrency transactions, although this was recently struck down in a Supreme Court ruling, meaning financial firms can now participate in the market. With the lack of joined-up regulation across different countries, crypto-assets may struggle to acquire broader momentum.
Getting the standards in place
In order for digital assets to thrive, there need to be sensible and proportionate regulations that are broadly aligned in terms of their objectives. Hugo Jack comments, “As of now, there is a plethora of different approaches and requirements across markets that risks persisting for years unless consensus can be reached. Although regulations overseeing security tokens – where they exist – may largely replicate pre-existing securities laws, the rules governing other digital assets like stablecoins and cryptocurrencies are highly divergent and frequently contradictory. Investors of all sizes appear keen to explore this new asset class, but they must first have a clear picture of what activities are permitted and to whom. The present playing field is uneven and its boundaries poorly defined. Equally, if trading in digital assets is to increase, regulators clearly need to bring in heightened checks on digital asset service providers. This will be vital in preserving market security, integrity and confidence.”
Datm will next examine the implications that regulations will have for security tokens, and the impact this could have on markets and service providers.