A Patchwork of Global Regulations
November 2022 Commentary
“Be careful of what you wish for” seems to be the most appropriate warning for crypto investors who rue the rising correlation between digital assets and traditional risk assets. Mr. Market seemed to have delivered on that request in spades over November. Global equity prices rose over 8.3% this past month and the US 10-yearTreasury yield eased from 4.05% to around 3.6%. US consumer price index grew at a slightly lower than expected rate of 7.7% year-over-year. Admittedly, not everything is rosy about this news. The lower longer yield and the persistently higher shorter-term yields meant the 2-year minus 10-year recession indicator grew to over 70 bps. Nonetheless, it was a good relief rebound for bonds and stocks.
It couldn’t be more different for digital assets. Reminiscent of the creeping contagion of the 2008 GFC, Nov witnessed the continuation of the Terra and 3AC saga with the dramatic unwind of FTX, triggered by Coindesk’s November 2 reporting of questionable assets on Alameda Research’s balance sheet. We’ve previously commented on FTX so we’ll simply note that this led digital assets to shed another 15% of its market cap over Nov. We do recognize that the impact on millions of customer accounts and the loss of billions of dollars in funds will bring about a strong global regulatory response as we head into 2023. This is worth a closer look.
Aligned, in Principle
Legislators and regulators have been hard at work to bring digital assets into their fold. At a meta level, the regulators share the same visions to “protect the consumer, prevent illicit financing, protect the integrity of the market and promote innovation.” They are also aligned to promote global financial stability. However, absent a single global regulatory body, each country is left to pursue their own agenda with their respective priorities determined by the different regional understandings of this nascent technology and asset class, desires for control versus willingness to innovate and grow, and politics. Back in March of this year, the World Economic Forum called for a globally coordinated approach to avoid creating “uncertainties and increased compliance burden for businesses operating in the sector.”
US Legislation & Enforcement
In the US, we see two major competing bills circulating among the US Senate committees. The Responsible Financial Innovation Act was introduced by Senators Cynthia Lummis (Republican from Wyoming and member of the Senate Committee on Banking, Housing, and Urban Affairs) and Kirsten Gillibrand (Democrat from New York and member of the Senate Committee on Agriculture, Nutrition, and Forestry) in June of this year. According to the Senators’ press release, the bill appears quite expansive in scope. Among its many provisions, the bill delineates which digital assets are commodities and which are securities thereby providing a groundwork for a CFTC-SEC partnership, requires stablecoins to be reserve backed with issuers needing to fulfill disclosure and reserve requirements, requires a study on digital assets’ energy consumption, and provides for a regulatory sandbox that would allow for fintech innovation.
The competing Digital Commodities Consumer Protection Act (DCCPA) was introduced in August by Senators Debbie Stabenow (Democrat from Michigan) and John Boozman (Republican from Arkansas). Both sit on the Senate Committee on Agriculture, Nutrition and Forestry of which Senator Stabenow is its Chair. The DCCPA appears to be narrower in scope in that it proposes to treat many digital assets as digital commodities and provides more regulatory authority directly to the Commodities & Futures Trading Commission (CFTC). It does not appear to address whether certain digital assets may be securities nor the issue of shared oversight with the Securities & Exchange Commission (SEC). Anecdotally, the DCCPA bill is not well supported by the crypto community and is seen as killing decentralized finance (DeFi) by creating regulatory moats for centralized financial (CeFi).
Aside from the SEC and the CFTC, other US agencies are stepping up to make sure they are not behind the curve in regulating digital assets given their existing remit. We’ve previously discussed how the US Treasury’s OFAC sanctioned Tornado Cash. Around the same time back in August, the Federal Reserve issued a supervision letter requesting that a “supervised banking organization should notify its lead supervisory point of contact at the Federal Reserve prior to engaging in any crypto-asset-related activity.”
EU – MiCA, a Framework in the Making
Across the pond in Europe, the European Union legislators have passed the Market in Crypto-Assets (MiCA) bill and are expected to vote on passing it into legislation in February 2023.
According to the Alternative Investment Management Association’s (AIMA) discussion on MiCA written by lawyers at Dechert LLP, the bill is intended to regulate cryptoassets, with a particular emphasis on stablecoins, and cryptoasset service providers (CASPs). Wording in the bill appears to favor asset-backed over algorithmic stablecoins. Meanwhile CASPs, which covers custodians, exchanges, brokers, and advisors, will need to provide increased disclosures, investor protection, and even publicize environmental impact data.
Once passed into legislation, there is an expected 18-month process before crypto firms are expected to fall into compliance. Regulatory supervision will likely pass to a combination of the European Banking, especially for stablecoins, and the European Securities and Markets Authorities.
Singapore, Once Burned, Twice Shy
The FTX debacle hit close to home for Singapore with its sovereign wealth fund, Temasek, taking a $275 M write-down. Crypto startups and investors are feeling a chill in this equatorial city-state. Existing regulations are being extended to apply to digital assets. The Payment Services Act 2019 (PSA) may require cryptocurrency service providers (payment, transferors, and exchanges) to apply for licenses. The Securities and Futures Act 2001 (SFA) will likely extend to digital tokens with the attributes of capital market products, i.e., securities. To operate in Singapore, crypto hedge funds will need to obtain a Capital Market Services license, a Payment Institution license if the fund also offers crypto-fiat exchange services, and a Financial Advisor's license when offering financial advice on crypto products.
Singapore is also planning to tighten the protection of retail investors in cryptocurrencies. A new consultation paper released by Monetary Authority of Singapore (MAS) in October suggests that retail investors would have to test to show they have sufficient knowledge of the risks of trading cryptocurrencies and be banned from borrowing to buy cryptocurrencies. Crypto service providers would also not be allowed to use incentives to court retail investors nor be allowed to use the capital of retail investors for lending and staking, and be banned from using celebrity endorsements.
Always Darkest Before Dawn
There is no question that increased regulations will come down on the digital assets industry in 2023. What is unclear remains how much the legislators and regulators understand the distinction between CeFi, CeDeFi (centralized DeFi), and DeFi. Perhaps this distinction is best characterized by the well-publicized debate between Sam Bankman-Fried’s perspectives on standards and regulations, and Erik Voorhees’ prompt response back in October. In contrast to SBF’s sprinkling of regulatory teasers across the industry, and understandably so as it would have helped him build a regulatory moat for the benefit of FTX, Voorhees draws a bright line in the sand at which government regulations must not cross into DeFi. In Voorhees words, “this new, special realm of defi does not bow to man, and if we try to make it do so, we will corrupt only ourselves.”
Stablecoin regulations will probably receive the most clarity across the globe. Referring back to the point about distinguishing CeFi, CeDeFi, and DeFi, to the extent that these coins are issued by centralized organizations, this is progress. These stablecoins ought to be held to the same transparency and disclosure standards as money market funds. However, to the extent that these coins are true DeFi constructs issued by depositing a digital asset into a smart contract, additional requirements are nonsensical as there is already radical transparency on the smart contract software code and the value of the assets locked in the smart contract.
The global set of regulations will likely be a patchwork and heavy-handed at best. Financial regulators are keen to protect consumers and ensure national and global financial stability. Financial innovation will likely take a backseat. This may seem overly pessimistic, but it is a realistic expectation based on observations of decades of financial busts and recoveries. Yet, there are rays of hope. In the US, several regulators and legislators remain outspoken proponents of digital assets and DeFi. The Responsible Financial Innovation Act even allows for a regulatory sandbox to allow for financial innovation. The door remains open for the industry, legislators, and regulators to work together to better understand this new financial technology and push back on restrictive regulations. We have our work cut out for us.