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Identifying the missing pieces in crypto’s regulatory puzzle

Is Financial Activity in the Crypto Asset Ecosystem Really That New? That depends on where the focus is, and governments’ regulatory approaches need to respond.

If the focus is squarely on the innovative blockchain technology behind decentralized finance (DeFi), then crypto-related financial activity is clearly new.

But while the blockchain rails that dispense with centralized validation may be new, the fungible and non-fungible tokens that run on them often represent familiar asset types.

Crypto assets bring new technological advantages and challenges, but the types of trading and investing activities often have parallels in the well-regulated financial and trading sectors. And some of the risks they pose are similar to those already covered by existing regulations.

However, a principle of “same risk, same rules” – or even “same risk, same outcome” – can only apply if the risks posed by crypto are truly equal. Efficiency without over-regulation comes from identifying where existing regulations are sufficient to keep changes and new regulations to the minimum necessary. Two issues are particularly telling in this regard: asset ambiguity, and technological and cross-jurisdictional coordination.

Ambiguity around assets

IOSCO’s decentralized finance report notes that stablecoins — cryptocurrencies tied to a stable asset — have become “DeFi’s replacement for fiat currency.” And if stablecoins behave like deposits, then subjecting stablecoin issuers to the same existing deposit rules as banks makes sense.

Payment systems supporting authorization, clearing and settlement of stablecoins should similarly proceed with regulations consistent with today’s positions. The UK Treasury’s stated approach is to “bring activities issuing or facilitating the use of stablecoins used as a means of payment into the UK regulatory framework, primarily by amending existing e-money and payments legislation.”

Minor disagreements stem from decisions about the tax treatment of stablecoin holdings, whether stablecoins should be interest bearing and a role for stablecoins in fractional reserve banking.

Bigger folds come from using stablecoins as investment vehicles. This can refer to when stablecoins hold illiquid reserve assets, when their value is held via algorithms that regulate supply and demand against another cryptocurrency, or when they are used as a type of money market fund to provide liquidity for other investments in volatile crypto assets to provide. The U.S. Treasury Department specifically states that “stablecoins, or certain portions of stablecoin agreements, may be securities, commodities, and/or derivatives.”

Securities and commodities regulations provide precedent, but the challenge is to clearly see whether a stablecoin’s primary goal is deposits and payments or investments. This question brings stablecoins into the broader mix of unpegged cryptocurrencies. The original goal of decentralized cryptocurrencies may have been payments, barring them from treatment as securities, but their predominant use as investments creates regulatory challenges in activities like spot trading.

Further challenges arise from the definition of fungibility. Logically, fungible crypto assets – like cryptocurrencies or crypto securities – should be regulated as a means of payment or exchange, while non-fungible tokens (NFTs) should be exempt from financial regulation. But the line between them is blurred. Fractionalized NFTs, which allow ownership of a unique asset to be divided among multiple individuals, raise questions about what level of fractionation makes the fractional parts of an NFT fungible.

Utility tokens, often associated with raising seed capital as organization-specific currencies, pose problems when they appreciate in value with an organization’s assets and start functioning like stocks. Any voting rights associated with a governance token – a subset of a utility token – may look like those granted to shareholders.

Technological and transnational coordination

Each blockchain is effectively its own community of technological standards. Interoperability is still in its infancy, and the resulting proliferation of cross-chain bridges brings with it a number of security concerns.

The ability of trusted intermediaries to facilitate interoperability depends on regulators laying down bases for consumer protection, security, data protection and privacy. A precedent exists in open banking, where secure open banking connections established via application programming interfaces (APIs) often rely on API aggregators for interoperability. Governments can similarly support security and interoperability via permissionless blockchains.

Removing intermediaries in DeFi transactions is new, but scaling the approach may ultimately require some level of centralization for legitimacy, just as open banking requires some level of closed privacy. And the underlying risks it entails are often analogous to those of traditional finance, as it enables activities such as trade, transfer, settlement or lending.

If existing regulations seem insufficient, e.g. B. anonymous trading via decentralized exchanges (DEX) or from non-hosted wallets, regulations that address similar risks related to issues such as anti-money laundering (AML) and know-your-customer (KYC) compliance may be adjusted as appropriate. At least that’s the theory – especially as new concepts like decentralized IDs emerge.

In reality, ensuring KYC and AML compliance is a challenge. For example, a DEX can circumvent both by automatically creating markets across liquidity pools of invested assets and then executing anonymous trades themselves using “smart contracts”.

Additional challenges arise from international coordination to ensure compliance with the Travel Rule, which requires all financial service providers to share information about originators and beneficiaries, and preventing regulatory arbitrage, where providers seek more favorable jurisdictions. Guidance from international compliance standard setters such as the Financial Action Task Force (FATF) is welcome but requires domestic implementation, which is often lacking.

Inconsistent regulatory treatment across jurisdictions is creating an uncertain business environment for crypto innovation and is particularly stifling the ability of larger organizations to participate.

However, smaller and less risk-averse companies may find little incentive to invest in compliance. Regulations without compliance count for little. A level playing field for all those involved is created through equal enforcement at home and abroad.

Conclusion

Tokenizing assets to record ownership of a blockchain does not alter the assets themselves. This reassuring consistency is as relevant to a bank working with crypto assets as it is to a government providing the regulations around them.

Governments’ duty to mitigate risk while accelerating crypto innovation is aided when many existing regulations require only a considered rewrite, rather than a complex overhaul that can hamper adoption and compliance. Governments’ ability to see how and where to apply these regulations in a clear and consistent manner will not be an easy task. But missing puzzle pieces are much easier to identify once the rest of the puzzle is put together.

Read more about the opportunities related to crypto and blockchain in Mastercard’s report Tokens on a Chain: A Role for Banks in Cryptocurrencies, Crypto Collectibles and everything in between.
Author: Chris Button, Associate Analyst, Marketing, Data and Services, Mastercard

Learn Crypto Trading, Yield Farms, Income strategies and more at CrytoAnswers
https://nov.link/cryptoanswers

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