Digital Asset Regulation – Part 3
Against the backdrop of Chainalysis’ announcement on 12 January 2023 of its upcoming report in February on trends in illicit crypto-related transactions and the dust settling on phase one of the FTX debacle (at least one alleged perpetrator having recently been arraigned), more and more efforts at regulating the industry are afoot at pace in the space. It seems a good time to summarize what we at GDFM would like to see from the regulatory community in 2023 regarding the regulation of digital assets (DAs) and digital asset service providers (DASPs). We run a vibrant anti-financial crime practice and the digital asset space interests us as it continues to evolve. Please reach out to the expert team at GDFM if you are interested in crypto or our AML services more broadly.
By way of background on just five relatively recent achievements related specifically to oversight of DAs and DASPs (with many more to come):
- EU’s MiCA is expected to be voted on by the European Parliament in April (reported by CoinDesk). There is also passage of the Transfer of Funds Regulation (TOFR) which is included in a European Council communication in December 2022.
- UK’s Financial Services and Markets Bill (working its way through Parliament…currently in Committee stage) and The Money Laundering and Terrorist Financing (Amendment) (No. 2) Regulations 2022 (already in force and incorporating TOFR’s travel rule).
- The Biden Administration’s “First-Ever Comprehensive Framework for Responsible Development of Digital Assets” announced in September 2022.
- Dubai’s Virtual Assets Regulatory Authority (VARA) announced its new CEO (Henson Orser) in January 2023.
- In Brazil, approval of the bill (PL) 4401/2021 regulating the country’s cryptocurrency sector which was published in November 2022.
The traditional finance space, by comparison, has well-established AML, CFT and KYC standards promulgated by FATCA, the EU’s legislative triumvirate, the UK’s legislative bodies, myriad central banks … the list continues ad nauseum. As a result of these recent developments in the DA space, market participants and observers are rightfully concerned/interested in rules that are fit-for-purpose and which are somewhat consistent with each other.
What we would like to see as upcoming digital asset regulatory initiatives take shape
Regulation (not ex poste enforcement…more on that in a later article) that takes into account at least some of the idiosyncrasies existent in the digital asset space:
- A recognition that digital assets are an asset class different and distinct from others such as equities, bonds, commodities, even FX. For example, there is an inherent volatility that many digital assets display; it would be overkill to try to minimize volatility in digital asset prices. There should not be a comparison of volatility with traditional asset classes because digital assets are sui generis, i.e., in a class by itself. It really should be enough to take an observational approach and not a controlling approach to regulation: simply observe volatility and mandate disclosure of risks; do not mandate vol targets or similar controls on how these asset prices oscillate. We do not advocate a more stringent and a more relaxed approach to regulating digital assets; just a more nuanced approach.
- A focus on protecting recipients of services (consumers) and on regulating the providers of such services (exchanges, wallet providers, custodians, value transfer services like e-money providers). This way the obligations will fall on a clearly defined set of actors and would mirror (and hopefully be consistent with) the GDPR and UK Data Protection Act 2018. Moreover, clarity on who can sue whom and where they can sue them is important.
- An attempt at parity of digital asset KYC/AML obligations applied to DASPs and TradFi service providers; not direct inclusion in an existing regulatory regime by expanding certain definitions. What Dubai’s VARA is attempting is especially interesting because they have set up the “world’s first independent regulator for virtual assets.” It is a laudable goal to establish a sound virtual asset legal framework and a virtual asset regulatory authority to develop and enforce it. All of this in the hopes of sustaining a vibrant, virtual asset economy.
Finally, mandatory insurance. While insurance is not germane to the digital asset space, the underwriting process would de-risk any venture as a prerequisite to insurability. Underwriting asks tough questions around:
- Segregation of client funds;
- Segregation of functions. This is a feature clearly lacking in this space, where one company like FTX provided a trading platform, acted as counterparty, offered leverage and was entrusted with the safekeeping of client assets. There was very little oversight and too much power placed in one entity;
- Adequate and demonstrable capital requirements and capital management;
- Heightened cyber security;
- Improved corporate governance; and
- Background checks on key personnel.
We definitely appreciate there are, always have been and always will be myriad interests to serve with the drafting, passing and enforcing of financial services legislation. Due to the borderless nature of the global digital asset economy, those looking to control actors and actions within it should take into account digital asset nuances, as well as a wider set of interests and inputs when looking to develop, execute and even amend their respective mandates.
Read Part 1 here.
Read Part 2 here.
 I include in these terms virtual assets and virtual asset service providers.
[…] Read Part 1 here. Read Part 2 here. Read Part 3 here. […]
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