6 minute read 22 Jul 2021
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Four key drivers of the global crypto-asset regulatory risk agenda

Authors
Christopher Woolard CBE

Partner, Financial Services Consulting, Ernst & Young LLP; EY UK FinTech Leader; EY Global Financial Services Regulatory Network Chair; EY EMEIA Financial Services Regulation Leader

Experienced senior leader in regulation, strategy and innovation. Building better consumer and market outcomes in financial services.

Marc Saidenberg

EY Americas Financial Services Regulatory Lead, Principal US Financial Services Consulting, Ernst & Young LLP

Financial services advisor. Facilitating active dialogue between industry and the public sector. Public speaker and thought leader. Husband and father.

Eugène Goyne

EY Asia-Pacific Financial Services Regulatory Lead

Regulatory compliance advisor. Public policy advocate. Fitness and arts fanatic.

6 minute read 22 Jul 2021

Banks can venture into the digital space by staying ahead of crypto-asset market developments and building capabilities to mitigate risks.

In brief
  • Crypto-assets are rapidly emerging, but have yet to fulfill the key functions of money.
  • With the explosive nature of crypto-assets, we expect local regulators and supervisors to embrace a risk-based approach that will encourage innovation.
  • Firms entering the market face the ongoing debate over whether crypto-assets are payment systems or securities – and what is appropriate regulatory oversight.

The use of crypto-assets in the financial services industry is increasing at a fast pace, with the COVID-19 pandemic contributing to its rise. To better serve their customers, a growing list of incumbents are building out custody solutions and trading capabilities for crypto-assets. We are seeing cryptocurrency exchanges and other digital firms moving into banking to leverage their user base and digital asset expertise to launch new products.

As the market continues to mature and find its place in the regulatory world, crypto-assets are becoming more of a priority for policymakers, regulators and international standard setters. Global initiatives and varying political approaches by governments and lawmakers have been launched to regulate the crypto-asset ecosystem and harmonize market infrastructure.

In this article, we explore key regulatory concerns about crypto-assets, market developments by jurisdiction, and implications for traditional and incumbent financial services firms. We focus on the key drivers of crypto-asset regulation that present the highest risk to banks from a safety and soundness perspective.

Financial crime

Of all the drivers, financial crime has garnered the most attention. Several of the properties that have led to the meteoric rise in the adoption of crypto-assets have also given rise to increased money laundering and terrorist financing risks. Although public blockchains are transparent and allow customer identification, there is an ever-growing list of obfuscation mechanisms that seek to protect the anonymity of crypto-asset owners.

Where there is no centralized clearing hub or exchange, there is no institution responsible for collecting and verifying know-your-client (KYC) data on customers or monitoring transactions for suspicious activity. A host of financial crime regulations have come into force across the globe aiming to close gaps in countries’ supervisory and regulatory frameworks, and to counter the money laundering (ML) risks.

Some countries have introduced anti-money laundering (AML) regulation and others enacted more stringent controls. Variations in risk appetite present bad actors with opportunities for regulatory arbitrage. This could mean that some will gravitate to less formal regimes to allow for greater agility and the ability to innovate at speed. Others may gravitate to stronger regimes to demonstrate safety, soundness and confidence.

Consumer protection

Regulators are focusing on crypto-assets largely because of the lack of awareness, knowledge and understanding of the market. Crypto-assets are not currently regulated in most jurisdictions, so consumers are not afforded the same protection they would have in savings and other accounts with authorized banks, building societies and credit unions. There is a patchwork of varying disclosure standards globally, and it is questionable whether crypto-assets are suitable and appropriate for certain consumers.

 

Legislators and regulators will be watching for instances where consumers are defrauded or misled and suffer significant financial harm by using crypto-assets.

Building better consumer awareness efforts and adhering to applicable compliance requirements could lead to improvement in this area. Legislators and regulators will be watching for instances where consumers are defrauded or misled and suffer significant financial harm by using crypto-assets. We can expect that certain elements of suitability and appropriateness will become important. 

Investor protection

The issues associated with crypto-assets and investor protection are exacerbated by price volatility in certain currencies. For example, in terms of market manipulation and exchange risk management mechanisms, there is varying maturity in the market and additional risks posed via high leverage offered.

Pricing variations for the same asset on global exchanges are due primarily to differences in liquidity, jurisdictional onboarding restrictions, and bank limits of exchanges on wire transfers and capital controls. These tend to limit arbitrage opportunities to parties actively trading on multiple exchanges.

Asset illiquidity as a business is also an area where scam projects are seen and garner media attention.

Stability of the financial system, sovereignty and monetary policy

The financial system may be subject to risks from crypto-assets to the extent that both are interconnected; spill-over effects may also be transmitted to the real economy. Crypto-assets may have implications for financial stability and interfere with how payments and market infrastructures function, as well as implications for monetary policy.

The concept of a global digital currency can have both political and economic implications, and be a risk to national sovereignty. There are concerns about virtual dollarization of developing economies, as well as the loss of monetary policy tools in developed nations if there was widespread adoption of digital assets as payment tokens.

Globally, the tax policy and tax evasion implications have been largely unexplored in relation to crypto-assets, although they form an important aspect of the overall regulatory framework. Jurisdictional differences create a tension where regulatory arbitrage may take place – highlighting the need to develop tax guidance.

Other regulatory implications

In a world where financial services and products can be customized and finely targeted to fit the specific needs of customers, money could be facing its unbundling moment with the emergence of crypto-assets.

Money could be facing its unbundling moment with the emergence of crypto-assets.

Money serves three key functions: as a medium of exchange (for example, a currency), a store of value in the form of a security or asset, and as a unit of account, such as credits and debits. Supporters of crypto-assets argue that they can fulfill these functions in time, as they become more popular and are more widely used. But a number of economic, usage and regulatory challenges could stand in the way of crypto-assets becoming realistic alternatives or complements to a viable currency or a method of payment to purchase goods or services.

Concerns voiced by many in using crypto-assets as payment tokens are their volatility in value, intrinsic value, limited supply and accessibility, slower payment processing infrastructure, current high transaction fees, and lack of regulation in most jurisdictions. Solutions to some of these problems have been found by businesses, such as PayPal, which now offer crypto-asset payment products to merchants and retail businesses.

For traditional financial services firms, the emergence of crypto-assets as a medium of exchange could also have important implications. A number of large traditional banks and payment institutions have sought to provide solutions to their customers by offering products and services, such as their own crypto-assets, instant payments using crypto-assets, custody services and debit or credit card solutions to pay for goods and services using crypto balances.

Many regulators recognize that crypto-assets may be here to stay and that they can have uses to support financial inclusion, provide secure payments or improve controls and efficiencies. The rapid growth scale of potential benefits of crypto-assets has driven regulators to consider how best to mitigate the risks and enable meaningful innovation to thrive. As the Basel Committee on Banking Supervision recently stated: the need for adequate regulation, for authorities to have the tools, skills and technology to identify the evolution or creation of crypto-assets and to build appropriate regulatory and supervisory frameworks is key.

Summary

Banks need to demonstrate that they can identify, measure, monitor, control and report on crypto-asset activities and associated risks. Economic, usage and regulatory challenges could stand in the way of crypto-assets becoming realistic alternatives or complements to fiat money. For now, the market is relevant and presents an opportunity to harness the benefits of new technology.

About this article

Authors
Christopher Woolard CBE

Partner, Financial Services Consulting, Ernst & Young LLP; EY UK FinTech Leader; EY Global Financial Services Regulatory Network Chair; EY EMEIA Financial Services Regulation Leader

Experienced senior leader in regulation, strategy and innovation. Building better consumer and market outcomes in financial services.

Marc Saidenberg

EY Americas Financial Services Regulatory Lead, Principal US Financial Services Consulting, Ernst & Young LLP

Financial services advisor. Facilitating active dialogue between industry and the public sector. Public speaker and thought leader. Husband and father.

Eugène Goyne

EY Asia-Pacific Financial Services Regulatory Lead

Regulatory compliance advisor. Public policy advocate. Fitness and arts fanatic.