CHAPTER SEVEN

Regulation

In the wake of recent events, we have seen calls for more stringent regulation of the crypto industry ranging from user access to ecosystem activities. However, many of the failures and insolvencies of the crypto entities in 2022 share certain commonalities like undue leverage, insufficient risk controls, and in some cases, unethical business practices. These charactenstics are seen (too often) in traditional finance as well and should not be interpreted as an indictment of blockchain technology or its potential to improve the future of financial markets and services. In fact, the fundamental intent of decentralized protocols is to minimize the need for trust, remove frictions posed by centralized intermediaries, and foster transparency.

Appropriately tailored regulatory standards are needed to build a workable framework for the cryptoeconomy that appropriately mitigates risk, while enabling the development and adoption of digital innovation for the broader benefit of society.

While regulatory clarity is certainly needed for this market to mature, the risk is that heavyhanded regulation drives crypto participants offshore, which can put customers at even greater risk. Appropriately tailored regulatory standards are needed to build a workable framework for the cryptoeconomy that appropriately mitigates risk, while enabling the development and adoption of digital innovation for the broader benefit of society. The first step is putting clear guidelines in place that developers and users alike can follow. Our experiences in 2022 show that crypto is a globally important asset class with widespread commercial and investor appeal, and it needs thoughtful legislation to encourage innovation and protect consumers.

Awaiting clarity in the US

We believe crypto policy in the US is at an inflection point.

In March 2022, President Joe Biden issued an executive order focused on laying out organizational principles and regulatory objectives for the crypto space, asking government agencies to research various topics related to digital assets. Some of the resulting reports included helpful proposals, like the Treasury's report on payments, for example. It recommends the establishment of a federal framework for payments regulation to replace the patchwork of state laws governing money transmission. Others were Light on specific recommendations and reinforced the status quo: continuing to assess risks across the digital asset space, pursuing enforcement actions where they see fit, and (slowly) advancing discussions around a potential US central bank digital currency, or CBDC.

One of the most important outstanding regulatory issues today is the critical question of how to classify a digital asset. In August 2022, bipartisan senators introduced the Digital Commodities Consumer Protection Act (DCCPA) that would establish the Commodities Futures Trading Commission (CFTC) as the primary regulator of digital asset commodities and thus close one of the biggest gaps in the existing crypto regulatory system. While there are unresolved issues with this legislation, such as its treatment of DeFi, it represents a major potential step forward on crypto policy.

That said, the failure of FTX has stalled legislative progress on the DCCPA for now, primarily because of its association with the former CEO of FTX, Sam Bankman-Fried, who was a major proponent of the bill, and because of concerns that the DCCPA on its own would not have prevented FTX’s collapse. The current CFTC Chairman, Rostin Behnam, suggested in December 2022 that lawmakers pause the advance of legislation such as the DCCPA and work to fill any remaining gaps. In a late 2022 hearing, senators suggested they anticipate taking up revised legislation in 2023.

Securities and Exchange Commission (SEC) chair Gary Gensler has also been vocal about his views on what jurisdiction he believes his agency should have over digital assets. In September, the SEC filed a lawsuit against a crypto influencer for allegedly having undisclosed incentives linked to an initial coin offering in 2018. The case references ETH transactions that the SEC states "were validated by a network of nodes on the Ethereum blockchain, which are clustered more densely in the United States than in any other country/ and that "as a result, those transactions took place in the United States."

This line of reasoning suggests that the SEC believes it can assert junsdiction over the entirety of the Ethereum network due to the number of US-located nodes. A plurality of ETH nodes, around 47%, are currently located in the US, which is more than any other country. But Ethereum nodes can be permissionlessly spun up by anyone, anywhere in the world, and it is unclear if the SEC is willing to follow its own logic and relinquish their jurisdictional claims if or when the majority of Ethereum nodes reside in a different country.

We expect government agencies to continue discussions over the short term to expand their jurisdiction over the digital asset space. Over the intermediate to long term, we expect that clearer lines will be drawn, which we hope will lead to deference among federal agencies regarding matters within their respective areas of authority.

Progress in EMEA

Meanwhile, leading economies including the European Union, the United Kingdom, Switzerland, and the United Arab Emirates, are taking substantial regulatory steps to secure their role as leaders in crypto. Indeed, we believe the EMEA region is leading the way in creating a safe and secure regulatory environment for the asset class. The significant progress that has been made here is an example of what can be achieved when the political will is there.

In Europe, there has been greater regulatory progress relative to the US, with the EU having reached agreement on the finalized text for MiCA (Markets in Crypto Assets regulation). Once implemented, MiCA will deliver a single rule book across the EU, as national regimes fall away and firms that receive a MiCA license gain access to the EU single market. While supervision of stablecoin issuers falls to the European Banking Authority (EBA), supervision of all Crypto Asset Service Providers (CASPs) remains at the national level. But the European Securities and Markets Authority (ESMA) is granted additional powers to take direct action against non-compliant CASPs. This is particularly important in the context of FTX's failings.

In the UK, Prime Minister Rishi Sunak's government has reasserted its commitment to position the country as a global crypto hub. A consultation on a comprehensive regulatory framework for crypto is expected by year-end 2022 or early 2023. The Financial Services and Markets Bill (FSMB), which is making its way through Parliament, gives the UK government and regulators the powers to develop more detailed rules for crypto. This follows important work by HM Revenue and Customs (HMRC) on the tax treatment for DeFi and by the Law Commission, which is an important step towards providing legal certainty on the treatment of crypto assets.

In Switzerland, the regulations governing cryptocurrencies are fairly accommodative, as one might expect given that it is the home to Europe's Crypto Valley. The country enacted the “Federal Act on the Adaptation of Federal Law to Developments in Distributed Ledger Technology” (otherwise known colloquially as the Blockchain Act) in August 2021. This provided a secure legal basis for the trading of cryptocurrency rights. The main regulatory body tasked with matters related to digital assets is the Swiss Financial Market Supervisory Authority (FlNMA), which classifies crypto as a distinct asset class, most similar to property or hard metals, as opposed to securities.

In the UAE, policymakers have created the Virtual Assets Regulatory Authority (VARA), an independent regulator for virtual assets, which aims to foster a supportive environment for digital asset innovation in Dubai. VARA's goal is to develop regulatory frameworks for investors and businesses operating in the digital asset space. In August 2022, VARA announced guidelines pertaining to the marketing, promotion, and advertising of digital assets in the region, and established penalties for failure to comply.

Africa represents one of the fastest growing markets in the world for digital assets, but the regulatory environment remains highly diverse. According to the IMF, around 25% of countries in sub-Saharan Africa regulate crypto with some restrictions, while six countries (representing 20%) - Cameroon, Ethiopia, Lesotho, Sierra Leone, Tanzania, and the Republic of Congo - have explicitly banned digital assets. Zimbabwe and Liberia meanwhile have implicit bans. Conversely, the Central African Republic joined EL Salvador in designating bitcoin as legal tender, becoming the second country in the world to do so.

Full Spectrum of Regulatory Approaches in Asia

Unlike Europe, there isn't a central representative group uniting regulations across Asia, and as a result, when considering the region as a whole, there is some fragmentation. That means countries are approaching regulatory clarity with respect to crypto on their own timelines and in a manner which suits their respective contexts.

In Australia, crypto firms currently register with AUSTRAC's AML/KYC regime and may also obtain an 'Australia Financial Services License" from the Australian Securities & Investments Commission (ASIC). Those requirements are not unique to crypto - in fact, any fintech firm would be required to do the same. However, there is mounting political and regulatory interest in establishing a clear regulatory approach to CASPs. This pressure reached a crescendo when the previous-Liberal Government set forth a framework for regulation through the Treasury. However, the new Labour Government has taken a step-by-step approach to its consideration of digital asset regulation.

As such, the Treasury will imminently lay out a token mapping framework for consideration by the industry. It is expected that in short order following this release, the Treasury will author an additional consultation paper addressing custody. Over time, these exercises might constitute a comprehensive regulatory framework for digital assets in Australia. In parallel, the Reserve Bank of Australia is working on a CBDC framework and contemplating the role of stablecoins.

China has historically implemented one of the strictest approaches to crypto regulation in the world. The country has enforced a widespread ban on all activities related to digital assets, including mining, trading, issuing tokens, and providing crypto-services. There are, however, Chinese investors in other commercial hubs who do engage digital assets activity.

Conversely, in an effort to reassert itself as a global financial hub, Hong Kong has announced plans to permit retail trading of digital assets and establish a regulatory framework for crypto service providers. It remains unclear what that regime will entail (and what, if any limitations would remain) when in force. Additionally, a key consideration will be the pace by which entities might register within Hong Kong under its new regime. As a proxy, many fintechs have been in the proverbial "queue" awaiting their "Stored Value Facility” (SVF) License for several years due to a combination of market saturation and regulatory bandwidth.

Further, financial agencies in Hong Kong will begin piloting two different versions of stablecoins towards the end of 2022, the first of which will be an intermediated digital currency, while the second will be a CBDC-backed stablecoin circulated in the interbank system. The Hong Kong Monetary Authority has already worked on many innovative pilot programmes for CBDCs - including multi-CBDC pilots with other jurisdictions such as Singapore, Thailand, and others.

In India, lawmakers have shifted their view of digital assets multiple times in the past, but most recently, they have announced intentions to regulate the space via the forthcoming Cryptocurrency and Regulation of Official Digital Currency Bill. This legislation plans to distinguish between various digital assets and establish frameworks which will dictate how citizens will be allowed to interact with digital assets and crypto companies going forward. There is still some hesitation on timing of the pending legislation, particularly as the government is inclined to take a ‘wait-and- see’ approach in view of the ongoing work at the Financial Stability Board (FSB). India is hosting the G20 in 2023 where digital assets regulation is on the agenda and a key focus of the FSB’s work. Separately, in November 2022, the Reserve Bank of India (RBI) announced its pilot programme for the retail CBDC. The RBI will continue to pilot the CBDC in select parts of India and with select banks (not unlike the approach taken in China with the eCNY).

In Japan, the digital asset space is governed by the Financial Services Agency (FSA), which characterizes digital assets alongside other forms of money and deems them legal property. Additionally, the Japanese Payment Services Act was enacted to create a holistic regulatory framework for payment providers and services that utilize digital assets as potential payment methods. Japan was among the first markets globally to enact broad regulatory requirements, including a licensing regime around digital assets. It places some restrictions on the number of tokens that exchanges are able to list, as well as other localization requirements.

Singapore has been an organic hub to digital asset innovation much in the way the country has attracted other financial and technology sector investments in recent years. The primary regulatory entity - the Monetary Authority of Singapore (MAS) - had previously regulated crypto within the broader Payment Services Act. The license therein was focused primarily on AML/KYC with requirements comparable to other fintech services. Currently, MAS is evaluating additional guardrails for consumer and investor protection within retail crypto trading, as well as codifying a formal regulatory regime for stablecoins. Earlier this year, MAS issued guidance preventing the advertisements of crypto-related assets or activity to the general population in Singapore. MAS has assumed a receptive posture toward stablecoins (especially those denominated in Singapore Dollar or G10 currencies).

In Thailand, lawmakers have historically been relatively averse to the adoption of crypto and are preparing to establish regulatory frameworks for the industry. Thailand had previously imposed significant capital gains taxes on crypto investments, but relaxed its regime in March 2022 in order to incentivize growth of the sector domestically. Finance Minister Arkhom Termpittayapaisith announced that traders would be allowed to offset annual losses against gains and would not be subject to a 7% VAT (previously contemplated). The exemption, which is set to continue until December 2023, also exempts taxation on the retail CBDC. Thailand does not permit the use of crypto for payments.

https://coinbase.bynder.com/m/4888c95272561d10/original/2023-Crypto-Market-Outlook.pdf