Digital Asset Regulation – Part 2

Introduction

Daiman Baker and Laurence Parish of GDFM recently sat down with Richard de Bruijn and Neil McDonald of Compass Partners.

Our focus in this series is to look at the latest regulations in the crypto space and to discuss the impacts they may have on the digital asset ecosystem. In this post, Daiman, Laurence, Richard and Neil collaborated on highlighting a few benefits of digital assets.

Read Part 1 here.

Transferring Funds

One benefit of digital assets is how they can be used in transferring funds across borders. Up until a few years ago, to transfer money abroad, correspondent banks were taking care of money movements. Anybody that has ever tried to send money from, for instance, the UK to the US, will remember that back in the day it used to take approximately three days. Correspondent banking also relies on “nostro accounts” – accounts held by one bank in another bank (the facilitator bank) in the FB’s home currency. Nostro accounts enable foreign account holders to transact in the FB’s home currency. As you can imagine, nostro accounts incur fees and those fees are passed on to those who transfer money.

Nowadays in the traditional space it is much quicker to transfer money, but we are still talking about a matter of hours. If you send money in the morning, the recipient will probably receive it in the late afternoon. Going back to fees, there is still that hefty fee attached to such a transfer. If you are sending £500 in a traditional setting, you can expect to pay your high street bank something around £25 for that transfer (remember “no fee” can mean a poor exchange rate … they get their money one way or the other). The fee is basically paying for all the correspondent banks that are forming the money transfer chain. With the implementation of blockchain technology and the use of a digital asset, you can send funds abroad in a matter of seconds and at a fraction of the cost. On October 24, I sent €687 to France and it took 6 seconds, costing €5. That is a very tangible benefit for users.

The cost-saving potential is huge for retail and institutional money and payments alike. Institutional money transferors will no longer have to pre-fund Nostro accounts, freeing up valuable capital. These inefficiencies disappear with the use of blockchain technology.

Digital Asset Infrastructure

Another benefit of digital assets is what can be achieved via the new digital asset infrastructure. Many mainstream digital assets exist in “layer 1 blockchains.” Layer 1 is the main blockchain network in charge of on-chain transactions and layer 2 is the connected network in charge of off-chain transactions that may eventually make their way onto layer 1; the Bitcoin network is layer 1 (source). As more and more use cases emerge on Layer 1 blockchains, scalability becomes an issue because more and more transactions sit on them. It is akin to a bank teller/clerk facing more and more customers demanding transactions. Because of this increase in pressure on layer 1 blockchains, regulators are taking notice and looking to implement protective measures.

Other benefits in using blockchains to process transactions are reliability, high efficiency and high speed. The nature of the blockchain is very secure, even as more and more transactions are processed on the layer 1 blockchains.

Transparency

Another benefit of using digital assets and underlying blockchains is the transparency that comes with the usage of the technology. All transactions are available for everybody to see on the ledger, eliminating the need for regulatory reporting (or at least making it far more efficient). Traditional finance has been struggling to achieve an acceptable level of standardisation. Something that blockchain and distributed ledger technology has managed to get right from the get-go.

Potential Issues

A potential issue going forward is the necessity of new infrastructure being of the same standard or allowing interoperability between standards. There are many layer 1 blockchains and this proliferation is something that the market and the blockchain community are looking at in detail. Interoperability between layer 1 and layer 2 blockchains is critical for this market. One way the industry is getting around the lack of interoperability is by “wrapping” coins. A wrapped coin means that it can be transported onto another blockchain yet has the same value of the underlying token that it represents. For example, one wrapped Bitcoin is worth the same as one Bitcoin. Bitcoin reserves are held in “bridges” to ensure that there’s a one-to-one value of the underlying coin and the wrapped coin. Because underlying and wrapped coins exist on different blockchains (either layer 1 or layer 2), interoperability may still be an issue but it is avoided.

Some tier one banks have developed and are already handling some processes on their own internal infrastructure (their own blockchains), so fragmentation is also a potential risk for this industry going forward. However, the major ledgers – the XRP ledger, the Cardano ledger, Solana, Ethereum – they are all beginning to talk to each other.

Hacking

You may have seen various news articles recently around hacking and losses within certain ledgers. Often it is the bridges where the coins are wrapped that seem to be getting attacked. The hacker will hack into the bridge and steal the reserve currency. Some clients that Richard and Neil speak to are very keen for regulation to mitigate such risks.

The Call for Regulation

The digital asset space is a relatively new phenomenon and is therefore largely unregulated. As it has gained adoption and prominence worldwide, and as real risks proliferate and potential risks emerge, governments and other various legislative bodies have introduced new measures to regulate this growing market. There are three main regulatory regions: the US, the EU and the UK (further Information can be found on our first blog post on this topic). These measures are largely seeking to remove volatility and risk from the digital asset ecosystem. What is consistent throughout this legislation is that there is a drive to ensure that consumers, investors and businesses are protected by ensuring that there is sufficient oversight of this market.

By seeking these objectives, legislators are trying to prevent and mitigate any illicit activity and security risks from spilling over from the broader financial services arena. There are attempts from various regulators to issue further guidance, increase resources towards enforcement, and pursue those who seek to gain illicitly from this market. These are worthy goals. Tension arises when the pursuit of such goals impinges on the phenomenal potential for digital assets to transform core banking infrastructure.

Next

We will be looking at the traditional space for KYC and financial crime controls, and then evaluating and discussing how the latest regulations bring treatment of digital assets into line with the more accepted level of control that we have seen within traditional financial services. Part of the discussion will be how we think the benefits listed above may be impacted by the expected digital asset regulations coming from the UK, US and Europe.