Monthly Archives: July 2023

These three dimensions – the purpose of the token, public policy risks, and crypto activities – are evinced in emerging regulation. At the international level, global efforts at regulation have come from the industry itself 92 and supranational bodies such as the EU, 93 IMF, 94 Financial Stability Board, 95 International Organization Of Securities Commissions, 96 and Basel Committee on Bank Supervision (BCBS). 97

An overriding consideration is that legal authority must necessarily precede regulation and enforcement. For instance, a 2022 survey of standards setters and regulators, conducted by the FSB, reveals that the will to regulate key crypto activities such as issuance, wallet provision, and exchange is often hampered by the lack of a clear mandate and enforcement tools. 98 Another key impediment for rule-makers is the lack of a coordinated global approach and the resultant risk of regulatory arbitrage, “in which some actors may be incentivized to structure their businesses to circumvent the application of certain jurisdictions’ more stringent regulatory requirements.” 99

Almost all major economic jurisdictions are working on a suite of regulatory measures along the lines of these global efforts, in an effort to balance risk against innovation. Beyond the previously-discussed US case, some important initiatives include:

● the UK’s recently-unveiled phased approach to align regulation with traditional finance. 100 Targeting crypto trading, financial intermediaries, and custody arrangements, starting first with stablecoins, it is purported that this, “robust approach to regulation mitigates the most significant risks, while harnessing the advantages of crypto technologies.“ 101

● the EU parliament’s Markets in Crypto Assets (MiCR) initiative which imposes obligations for Issuers (e.g. environmental impacts, whitepapers), exchanges (activity-based oversight, service providers (capital requirements), custodians, and other businesses tied to the crypto market. 102

Further, a recent PWC review of the state of crypto regulations worldwide shows that at least thirty-five countries are “researching, defining, consulting, negotiating and legislating in order to bring digital assets…under the existing financial services frameworks”. 103

Regulation in the crypto space, as in traditional finance, is migrating towards an “activity-based”
approach and away from entity-based oversight under the rubric of “same activity, same risk, same regulation.” 66 The FSB and others identify key risks in the crypto space by the activity being undertaken. As with all things crypto, categorization can be elusive – and not exclusive – but key activities include:

● Token issuance: As per the IMF, there are, “several ways to create and issue crypto assets, the three most popular being pre-mining, continuous mining, and a hybrid approach. Crypto assets are usually distributed in five main ways: pre-token sale, initial coin offering or token sale, mining, airdrops, and forks.” 67 Each of these approaches entails different types of risk.

The two most common of these approaches to issuance are continuous mining on
algorithmically controlled ledgers, as with Bitcoin; and pre-mining on ledgers controlled by private entities, as in the case of Ripple (XPR). The continuous mining case is difficult to regulate as no issuing entity exists to be overseen in a traditional sense. New token issuance becomes concentrated in mining pools and big stakes players (aka “whales”) 68 with the power to manipulate market volume and time transactions. On the other hand, pre-mined tokens do have identifiable issuers who exchange the tokens for fiat money and have accordingly been subject to regulatory scrutiny – and to charges that the issued tokens are unregulated securities. 69

To the degree that pre-mined tokens are analogous to securities offerings, regulators are
pushing for similar customer protections measures, including the publication of “white papers” clearly laying out issuance, backing and redemption protocols, notification, licensing, and registration requirements, adherence to fair marketing practices, environmental impact assessments, and more. 70

● Wallet providers: Perhaps unintuitively, cryptocurrencies and assets are not actually held as virtual tokens in a wallet or account. Instead, private keys are housed in the wallet as “codes that are stored and accessed electronically.” 71 The private key is used to unlock and reassign a public key associated with blockchain data. These data usually include value and sometimes other information (e.g. smart contracts). So control of the private key is of critical importance, and its loss is often catastrophic. 72 Private keys may be self-custodied, which places a burden on the user to safely store and use the information. Alternatively, keys may be “custodied” by a service provider as a hosted wallet. This arrangement has many benefits but also entails reliance on a centralized structure that may suffer operational failure, hacks and misuse of funds. 73

Hosted wallet providers, often housed at crypto exchanges, are also a primary conduit for establishing identity and authenticating transactions before they morph into pseudonymous tokens. As such, they have been a priority for extending KYC requirements from the trad-fi space into crypto. 74

● Exchanges: Online marketplaces for buying crypto either with other crypto or fiat money
represent a key risk activity in the crypto space, reflecting the operational importance of the exchange function as well as the due diligence to make sure trades are executed as instructed. Accordingly, this role has faced particular scrutiny in calls for activity-based crypto regulation. 75 Exchanges may be either centralized in an entity (CEX) or decentralized (DEX) across multiple nodes. “Many of the largest and most popular crypto asset exchanges are centralized intermediaries that in practice negate the aim of decentralization and disintermediation”, and face “similar issues to those of securities exchanges.” 76

Beyond the problem of centralization, much of the risk in crypto trading results from the concentration of functions within the exchange. These functions may include: wallet provision and key custody, which may be subject to commingling, 77 hacking, 78 or loss of
access to tokens; 79 staking facilities, where users make some of their crypto tokens or balances available as liquidity for automated market making (AMM) functions; as well as
KYC and reporting functions.

Additionally, centralized exchange operators may engage in a broad array of functions that tend to be segregated in TradFi, including: brokering, order management, and traditional market making functions; provision of liquidity; lending, investing or speculative leveraging, and conflict- of-interest proprietary trading.

● Traditional financial institutions: Banks and other TradFi players have been watching
the crypto space closely and veering between disdain and enthusiasm for its potential and that of its underlying technology. 80 As a speculative asset, they may hold crypto on their balance sheets or provide access for retail and institutional clients. 81 They also may engage in investment banking ventures to support emerging players in the crypto space. 82 Because banks are tightly regulated in most jurisdictions through prudential oversight of their balance sheets, and these regulations generally conform to international principles and best practices, treatment of crypto assets has been at the forefront of efforts to control solvency and systemic risk. 83

Banks have also been active in the wholesale space where they have developed stablecoins or used crypto vehicles to effect faster settlement, particularly in the cross-border space. 84 Similarly, they have also been at the forefront of exploring the possibilities of DLT and its various permutations (e.g. public/private, permissioned/less etc.) to implement smart contracts, tokenized assets and liabilities, and atomic settlement. 85

● Miners and validators: Proof-of-work (PoW) and proof-of-stake (PoS) consensus protocols incentivize entities to do the work of validating blocks through fees and newly issued tokens. The decentralized nature of submitting and propagating transactions across the network creates many potential valid blocks vying for consensus at a given time. Miners and validators are thus in a position to see potentially market-swaying transactions and engage in insider trading and market manipulation accordingly. 86 This insider trading advantage results in “miner extractable value” (MEV). 87

The nature of the consensus mechanism itself is also increasingly in the sights of rule makers, particularly as regards its ecological impact. 88 Specifically, the massive carbon footprint of proof-of-work (PoW) protocols 89 is worsened by the enormous amount of electronic waste generated by continuously obsolete mining processors and equipment. 90 Less energy-intensive proof-of-stake (PoS) protocols drastically reduce the energy footprint but trade off against “excessive concentration of decision-making powers on crypto exchanges and wallet services providers, which may increase market integrity risks.” 91

So how do we predict the direction of crypto regulation, given that it is being built on a shaky conceptual foundation of financial assets? 31 Crypto regulation continues to evolve but appears to be developing along three related dimensions that we can explore in turn:

● The nature of the crypto object itself;
● The financial and social risks being addressed by the regulatory effort;
● The activity being undertaken by the player in the crypto space.

It has been observed that “crypto trading isn’t economically similar to any part of the traditional
financial services system and serves none of the productive purposes that define finance.” 1
Indeed, cryptocurrencies don’t act much like money 2: they are rarely used as a medium of exchange; 3 make a poor store of value owing to their volatility 4 and insecurity; 5 and are of not
much use as a unit of account except within their own ecosystems. 6 Further, they don’t carry the legal imprimatur and legal-tender status 7 of fiat currencies that are issued by central banks.

Equally, crypto-assets do not act much like securities: 8 the “investment contract” 9 is generally lacking and – except in the case where digital tokens point to real-world securities 10 – they do not represent claims on a stream of fixed income. Furthermore, they are rarely used as derivatives, except with respect to other cryptocurrencies. 11 Finally, “crypto-assets lack intrinsic economic value” 12 and the scarce tangibility found in commodities like gold, wheat, or oil.

Hence, cryptocurrencies and assets – instead of having their own intrinsic worth, being claims
on intrinsic worth (like money), being claims on future money (e.g. financial securities), or even
being derivatives used to bet on the future price of real-world securities or commodities, are a
different breed. It is more informative to view them as such.

Crypto assets are virtual digital objects that either point to something “out there” in the real world
– such as stocks, bonds, or even real estate or art – or alternatively, they are self-referencing
(“native”) and are largely constrained to their own ecosystem.