India’s Finance Minister Nirmala Sitharaman stressed the central importance of international cooperation in regulating crypto assets in the monsoon session of Parliament. This follows a tumultuous year for the crypto market, riddled with margin calls and defaults. These adverse events have not translated into systemic risk as crypto assets are not yet deeply integrated into financial markets. However, financial regulators would do well to establish a framework for overseeing crypto assets to prevent any possibility of future crises. The Financial Stability Board (FSB) recently announced that it will provide G20 member nations with a roadmap to regulate certain crypto assets in October, just in time for India’s presidency of the group, which begins later this year.
The FSB includes policymakers, central bankers and supervisors from G20 members, as well as financial centers such as Hong Kong, Singapore, Spain and Switzerland, as well as international standardization bodies. This makes it a lynchpin for the international coordination of financial markets governance. While crypto asset regulation is nascent in many Emerging Markets and Developing Countries (EMDEs) like India, partly due to a lack of government capacity, a risk-based and context-specific understanding of new markets is crucial. The FSB divides the crypto markets into three segments: unsecured crypto assets, stablecoins, and decentralized finance. The risks in each of these areas should be contrasted with the local contexts of EMDEs.
First, unhedged crypto assets derive their value from a mix of factors including production costs, network effects, user sentiment and speculation. Several such assets are listed by centralized service providers that act like intermediaries and are regulated in advanced jurisdictions. For example, the EU’s proposed regulation on markets in crypto assets lays out compliances that such intermediaries must uphold, including measures related to consumer and investor protection. The EU has effectively created a template that can now be widely adopted by other jurisdictions. But it is important that EMDEs engage through the G20 process to help shape a contextual and responsive global template.
EMDE citizens are more likely than first-time investors to enter the financial markets via unsecured crypto assets. It is therefore important to maintain their trust in both financial institutions and government supervision. This could lead to stricter standards for listing crypto assets in such markets by intermediaries. The EU requires such intermediaries to publish a white paper which bears some similarities to prospectuses published under the existing Financial Regulation. EMDEs could consider additional criteria for “verifying” crypto assets to protect investors.
Another area where EMDEs may consider taking exceptional action is in anti-money laundering (AML) customer due diligence. The Financial Action Task Force (FATF) guidance on AML norms for crypto markets is the current gold standard. It prescribes measures such as identifying customers using reliable data sources, identifying beneficial owners and the purpose of transactions. The International Money Laundering and Terrorist Financing Authority also mandates enhanced due diligence for high-risk transactions related to reported jurisdictions. These measures include gathering more information about the customer and the transaction and increasing the frequency of discretionary monitoring of such transactions. EMDEs might consider expanding the grid for situations that require increased due diligence based on their own security priorities, e.g. B. through thresholds for additional relevant information to be obtained from intermediaries.
Second, stablecoins are typically backed by specific assets (usually US dollars) or a basket of assets, and are used extensively to exchange crypto assets for fiat currency. However, EMDEs like India see a potential currency substitution problem with stablecoins, as dollar-backed coins can offer a better store of value than their local currencies. International standard-setting bodies such as the Committee on Payments and Market Infrastructures and the International Organization of Securities Commissions call for the application of established “Principles for Financial Market Infrastructures” to stablecoins. These principles define the international standards for critical infrastructures such as payment systems, securities accounts and settlement systems. Applying it to stablecoins would essentially mean applying the “same activity, same risk, same regulation” principle that India already upholds in fintech regulation.
Third, decentralized finance is used to offer financial services and products, ostensibly without a central intermediary. This segment is potentially the riskiest for EMDEs, as visibility and verification of counterparty identities are not typically required to complete transactions. EMDEs like India are seeing an increase in money laundering across the board, including through traditional banking channels. According to PTI data, between July 2005 and November 2021, the Enforcement Directorate registered a total of 4,637 money laundering cases, 769 of which related to money laundering through bank fraud. Decentralized finance will further complicate the nature of financial fraud and the FSB is unlikely to be proposing a regulatory framework for this new market any time soon. EMDEs should therefore exercise great caution and only allow decentralized funding in sandbox environments.
Over the past decade, technology has served as a key driver of financial inclusion via fintech as we know it today. Crypto markets could represent the future of fintech, or at least offer a glimpse of it. Therefore, India’s forthcoming G20 presidency will serve as a springboard to help shape important financial regulations from the perspective of the EMDEs.
These are the personal views of the authors.
Arvind Gupta & Vivan Sharan are respectively Founders of Digital India Foundation and Secretary of Esya Center
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