1656622808 Traditional Finance and the Need for Crypto Regulation Part

Traditional Finance and the Need for Crypto Regulation ~ Part 3

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Crypto is now facing its “Lehman Brothers’ moment”, and a sober, forward-thinking response is needed to ensure the future of DeFi.

Time for Crypto to Face the Music

About a year ago, US officials began laying out an aggressive approach to regulating cryptocurrency, starting with stablecoins. The market turmoil of recent weeks has accelerated these efforts, which is mainly a good thing for the industry.

As detailed in two recent posts (Part 1 and Part 2), the collapses of Luna and Celsius and the broader subsequent market trouble echo the bank runs and financial disasters of previous decades — and would, similarly, be best addressed via increased oversight and regulation. Once revealed, the problematic investments of Bank of United States and Continental Illinois made investors skittish and desperate to recoup their investments asap. Decades later, Lehman Brothers relied too heavily on subprime mortgages and its house of cards collapsed along with the housing market. In all three cases, regulatory responses added increased oversight, significantly reducing risk and increasing stability.

Crypto is now facing its “Lehman Brothers’ moment”, and a sober, forward-thinking response is needed to ensure the future of DeFi. In late June, after crypto markets had slumped more than $2 trillion, the head of the Bank for International Settlements argued that any form of money not backed by reserves funded by taxes lacked credibility. “You just cannot defy gravity,” said Agustin Carstens. “At some point, you really have to face the music.”

Regulators Prepare

What might facing the music look like for stablecoins? The best way to begin to answer that is to examine regulatory thinking and actions thus far. The first major signal appeared in October 2021, when the Financial Action Task Force (FATF), which combats money laundering (AML) and terrorist financing, issued new regulatory guidelines, amending its statements from the previous April after considerable pushback. The FATF did not introduce new regulatory changes for virtual assets, but rather made the industry and markets aware of the risks and future expectations. Virtual asset service providers (VASPs), such as crypto exchanges, were made aware that they would be accountable for conducting compliance steps, such as Know Your Customer (KYC). The FATF also made clear that DeFi companies are not VASPs, but their operators and creators — any entity with “control or sufficient influence” over the protocol — can be seen as such under certain conditions, which would require them to comply with all existing FATF requirements, including the KYC compliance DeFi has avoided with its user anonymity.

The FATF hinted that it might soon move to crack down on problematic exploits, which would be good news for the industry. “With decentralized exchanges and protocols suffering record hacks and scams (‘rug pulls’) worth hundreds of millions of dollars and being largely unregulated,” its guidelines explained, “this is creating fertile ground for bad actors to acquire significant funds to perpetrate ML/TF transgressions, which in turn places extra pressure on the FATF and other regulators like FinCEN to take action.”

In November, the US President’s Working Group on Financial Markets published a report on stablecoins that highlighted risks to market integrity and investor protection, including possible fraud, terrorist financing and money laundering, and trading misconduct such as market manipulation, insider trading and front running, as well as risks to the broader financial system. “If stablecoin issuers do not honor a request to redeem a stablecoin, or if users lose confidence in a stablecoin issuer’s ability to honor such a request, runs on the arrangement could occur that may result in harm to users and the broader financial system,” argued the report, peering successfully into the near future. The Working Group, the FDIC, and the Office of the Comptroller of the Currency (OCC) went on to jointly “recommend that Congress act promptly to enact legislation to ensure that payment stablecoins and payment stablecoin arrangements are subject to a federal prudential framework on a consistent and comprehensive basis.”

The report also encouraged legislation to be flexible yet comprehensive and complement existing authorities while aiming to minimize stablecoin user risk by requiring stablecoin issuers and any holding company or parent to: be insured depository institutions subject to supervision and regulation; require wallet providers to be subject to federal oversight; and enable the federal supervisor of stablecoins to require that any entities critical to the functioning of a stablecoin to meet certain risk management standards.

In March, President Joe Biden issued an executive order on ensuring the responsible development of digital assets. The order highlighted the remarkable growth of digital asset markets (from $14B to $3T in five years ending Nov 2021) and the implications for consumers, investors and businesses and risks to financial stability. “We must take strong steps to reduce the risks that digital assets could pose to consumers, investors, and business protections; financial stability and financial system integrity…US should ensure that safeguards are in place and promote the responsible development of digital assets to protect consumers, investors, and businesses.”

Biden also went into illicit finance and crime, including fraud, money laundering, terror financing, as well as the underbanked and privacy. The issue of money laundering has become more urgent for policymakers in the wake of Russia’s invasion of Ukraine, with officials fearing that Russia could use stablecoin and crypto tools to evade sanctions. This is an important concern, yet it’s largely beyond the scope of this post, which is focused on stablecoins and regulations that might limit the risks they pose to users, investors, businesses and the financial system. On that last issue, Biden smartly added that “We must reinforce United States leadership in the global financial system and in technological and economic competitiveness, including through the responsible development of payment innovations and digital assets.” Thus, smart, effective regulation for crypto will not only stabilize the industry but also help keep the US at the forefront of digital innovation.

Biden went on to outline his stance on a Central Bank digital currency. “My Administration places the highest urgency on research and development efforts into the potential design and deployment options of a United States CBDC.” Such a currency could strengthen the dollar and solidify its international position, which would in turn strengthen stablecoins linked to the dollar. As part of a “whole of government” approach to crypto, Biden’s Executive Order urged the Federal Reserve to outline a plan and required most government bodies — Treasury, State, Attorney General, Commerce, Homeland Security, Office of Management and Budget, National Intelligence and “other relevant agencies” — to submit, by September, a report on money and payment systems, digital assets, likely impact of a CBDC, the implications for the US financial system, and more.

The order also required these bodies to establish a framework for international adoption of global principles and standards for the trade and use of digital assets. This suggests that legislation momentum is likely going to build significantly in the fall. Senator Pat Toomey of Pennsylvania has already taken the lead, introducing in April the stablecoin TRUST act, which would establish a new federal license for stablecoin issuers — as of now it would be the world’s first — that would make stablecoins act like most other banks. Under this proposed regulatory framework, they would have to maintain reserves, disclose their holdings and submit to regular audits.

The US is far from alone in its plan to regulate. In June, Japan passed a new law allowing banks, money transfer agents and trust companies to issue stablecoins — the world’s first such regulation. The government will soon introduce a registration system to monitor the circulation of stablecoins and enforce anti-money laundering and terrorist financing measures. Essentially, the law bars tech firms and startups — which have spearheaded growth of this DeFi segment, and likely sparked its decline — from issuing stablecoins. Also in June, the Bank of England’s executive director for markets, Andrew Hauser, said that digital currencies did not represent any “red line” risks for central banks, but that a combination of stablecoins and CBDCs could significantly alter central banks’ control of monetary policy. Governments need to be prepared, he argued, to adjust to the changing markets.

Meanwhile, the European Commission is finalizing its landmark Markets in Crypto Assets Regulation (MiCA) law, and an internal paper leaked in May revealed that the commission appears to be in favor of a hard curb that would allow regulators to order issuers of larger stablecoins (exceeding 200M euros in value and 1M daily transactions) to halt issuances until those totals drop beneath the threshold. The European Parliament, on the other hand, favors a gentler approach under which stablecoins would be reclassified and subject to oversight by the European Banking Authority — a move that to some extent would echo US regulatory plans.

Finally, Singapore’s monetary authority in late June granted in-principle approval to leading exchange crypto.com as a payments platform. This has little to do with stablecoins, but it does suggest that some forward-thinking governments are beginning to view cryptocurrencies as clearing the regulatory bar for payments systems — a key step on the road to a broader embrace.

As authorities accelerate the pace of regulatory efforts, how should crypto players respond and prepare for the upcoming changes? In our next blog post, we’ll discuss what actions crypto firms are taking to find a balance between innovation and regulation. Stay tuned!

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📰 Traditional Finance and the Need for Crypto Regulation ~ Part 1

📰 Traditional Finance and the Need for Crypto Regulation ~ Part 2


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