Digital Assets: The Incoming Regulatory Landscape!
What will regulation look like across the world
The regulation of digital assets is a big topic not just amongst the crypto community but also amongst the world’s largest financial institutions - who are seeking to start taking some positions in the asset space. This is even more the case in light of some of the recent high profile collapses in the sector.
A number of commentators focus on the potential negative effects excessive regulation might have on the tremendous growth in digital asset investments over the last decade, and especially the last few years. The Chinese government’s ban on cryptocurrencies is often cited in this regard. Others see regulatory clarity as the green light institutional investors are waiting for before beginning minor forays into this sector. ‘Minor’ meaning billions of dollars! Without doubt, regulatory clarity will spur increased institutional investment in digital assets. It is also not in doubt that regulations are coming!
Individual countries are at various stages of progress in developing legal and regulatory frameworks for digital assets. Some, (like Gibraltar, Estonia, Hong Kong, Singapore and Malaysia) have made rapid progress - quickly developing new laws and regulations to attract founders and companies that issue or provide services related to digital assets to their jurisdictions.
This notwithstanding, countries have already been coordinating in terms of their research, initial policy positions, and guidelines. The Financial Action Taskforce (FATF) is the intergovernmental body tasked with developing the overarching framework that all countries will eventually be encouraged to harmonise and adopt.
In the meantime, the governments of some of the key developed economies are beginning to take their own steps towards regulating digital assets.
United States
The US government has arguably been quite slow out of the blocks in taking a firm position on digital assets.
In trying to classify digital assets within the US’ existing (90 year old) regulatory framework, current classifications (crudely) distinguish between: assets that are akin to commodities; those that are akin to securities; and other types of digital assets that do not fall in the former two categories.
Commodity-like tokens will be regulated by the Commodities and Futures Trading Commission (CFTC), and tokens akin to securities will be regulated by the Securities Exchange Commission (SEC). Tokens that do not fall into either category will be unregulated (subject to any new legislation).
As a result, the CFTC and SEC have been the only US government agencies attempting to engage/regulate this sector. Both agencies (but especially the latter) have filed law suits against digital asset issuers and service where there activities have been deemed to fall within regulations.
However, due to a lack of resources these agencies have been extremely selective in who they target with law suits. Given that their primary tactic seems to be achieving settlements by way of fines (rather than actual court judgments), it’s safe to assume that a platform or token’s success plays a part in their target selection process. A high profile example of these law suits is the SEC’s action against Ripple Inc. (Ripple), issuers of the XRP token. It will be interesting to see if it will result in any definitive pronouncements being made on the types of token that fall under US securities laws. Note that Ripple has demonstrated that it has no intentions of settlement, which means a court judgment/pronouncement is highly probable in this case.
US regulators seem to focus on the structure and use case of a token, more than the technologies involved. The primary test being applied by SEC (to determine if a token is a security) is called the Howie Test. Using this test, the SEC will view a digital asset as a security if it’s an “investment contract”. This requires four elements: an investment of money; in a common enterprise; with an expectation of profit; and from the efforts of an identifiable third party. This is the primary legal framework currently being used by digital asset issuers and service providers to determine if their offerings can be accessed by US citizens without first having to be registered with the SEC.
But there now seems to be greater momentum from the top of the country’s executive branch. The US Federal Government recently published a report stating its position on this digital assets. The report is the result of a prior Executive Order issued by the President of the United States to all federal government agencies to undertake and coordinate their research, and prepare a joint report, on this asset class.
In the US Government’s legislative branch, there is currently a ‘Crypto Bill’ (sponsored by Senator Cynthia Loomis) before the US Congress. The main aim of the Bill is to adopt a legal framework so that ‘cryptocurrencies and traditional assets fall under the same regulatory categories’. State Governments are also beginning to take policy positions, issue guidelines, and in some cases even considering Bills related to digital assets.
In all, despite a slow and confusing start, it seems the US Government is now kicking into gear regarding a more definitive position on digital assets.
United Kingdom
The UK government, which has made more progress than its US equivalent, has concluded a number of consultations and issued guidance documents on the classification of various digital assets and whether they fall within the current ‘regulatory perimeter’ (ie existing legislation). The UK’s financial regulator, the Financial Conduct Authority (FCA), is the body appointed to spearhead this exercise and it has gone some way in providing guidance on these issues.
For example, in 2019 the FCA conducted its first public consultation and issued a guidance document on the different classifications of crypto assets, and which of them fall within existing regulations. There have been subsequent consultations and revisions to the initial guidance since then, with the most recent being last year. Based on the FCA’s guidance, cryptocurrencies and other digital assets can be classified as: exchange tokens, electronic money tokens, security tokens. The first type are unregulated, whilst the latter two are regulated. Though unregulated, if an exchange token is used for any regulated activities such as remittances then they would become subject to regulation. Specifically, the UK’s Payment Service Regulations (PSR).
Digital assets that are commonly referred to as ‘stable coins’ (ie assets that are designed to maintain their value relative to another asset - usually the US Dollar) are classified as electronic money tokens. As such, they must comply with the UK’s ‘E-Money Regulations’. Tokens that are like securities (ie that give the holder rights and obligations similar to a security) are subject to the Markets in Financial Instruments Directive (MiFID) and possibly other existing regulations.
It must be noted that the UK government has indicated many times that it intends to work with the industry to support digital asset adoption but in a regulated manner to protect the public. The initial guidance documents issued by the FCA have been useful, with said guidance being further refined with each subsequent consultation with additional stakeholders.
Notwithstanding the UK Government’s commendable proactive response (through its guidance notes) to the growth of the digital sector, continuous efforts are still required for the regulatory framework to keep pace with the rapid development occurring in this industry.
European Union
A few of the smaller European countries have quickly put in place laws and regulations to govern digital assets, primarily to attract targeted investment (eg Malta, Cyprus, Estonia). However, there has barely been any movement at the EU level, til now.
The EU Commission recently issued the draft regulation for Markets in Crypto Assets (MiCA). MiCA seeks to harmonise the classifications and regulation of digital assets across all EU member countries. As a side note, it’s important that MiCA is eventually passed as regulation rather than a directive. It’s a small nuance in EU law, but a directive allows for each EU member state to pass a national law to make the directive binding; and this can lead to different interpretations of the directive in each country which would cause a regulatory quagmire for digital asset issuers and service providers. A regulation, on the other hand, becomes binding on every member state once passed at EU level, which at least means one framework governing every European country - providing more legal stability for the industry across the EU.
MiCA categorises digital asset’s in a similar manner to the UK framework albeit with less specificity. Within the MiCA framework, digital assets can be classified as utility tokens or security tokens. Security tokens can be further classified into asset-referenced tokens and e-money tokens.
ANALYSIS
One thing is clear from the various pieces of legislation, guidances, that make up the current mosaic of global regulatory framework for digital assets. The main areas of focus for regulation can be categorised under the headings of anti-money laundering/terrorism financing prevention; consumer protection; competition matters.
Any business (whether or not related to digital assets) that involves the potential exchange of large sums of money will almost certainly have to maintain some form of KYC documentation on its customers. And in the digital world especially, this is now part and parcel of doing business. Consumer protection covers both securities laws (which are effectively small investor protection laws) and actual consumer protection laws. Competition matters relates to abuse of dominant market positions by participants in this sector, again to ensure competitive products and services for consumers.
Ultimately, the regulation of digital assets will not be determined along the lines of the names/classifications of such assets, but on their features and their use cases.
This means that even if an asset can be initially classified in one category of the regulatory framework, if it adds use cases that bring it within additional regulatory perimeters then issuers and/or service providers of the asset will become subject to those additional regulations.
In the UK/EU for example, these use cases (and their corresponding regulations) could include:
use for payment of goods and services with third parties (Electronic Money Regulations, UK)
payments and cross-border remittances (Payment Service Regulations, UK)
investment/asset speculation (MiFID 1&2, UK/EU)
So if you’re an issuer or a service provider (eg exchange platform) for an otherwise unregulated digital asset but then a feature is added that enables the asset to be used for payment (or entitles holders to a portion of profits/revenues from the issuer or a vote in how the issuer operates), then these transactions would very likely need to meet regulatory compliance.
CONCLUSION
Effectively, it may end up that digital asset firms are structured in a way that different entities are setup to run an issuer’s regulated and unregulated activities. For regulatory and liability risk management reasons, this may increasingly make sense as the smoke clears on the regulatory landscape.
So if you’re a digital asset issuer or service provider the key questions to ask yourself regarding whether your platform/token would fall under regulatory oversight depends on: how the asset works, how it’s structured, and what users can do with it.
Once these questions have been addressed considerations can then begin to made as to how best to structure your organisation and operations to ensure compliance without affecting commercial efficiencies.