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Print articleCryptos want regulation on their own terms
December, 2022 - Shoosmiths LLP
Cryptocurrency firms and lobbyists have reacted to the collapse and bankruptcy of FTX by calling for regulation. When unpacked, however, their pleas to be regulated reveal an industry wanting regulation on its own terms while unwilling to face home truths about its faults and efficacy. Regulation would confer legitimacy on crypto that it does not deserve and would further harm investors and endanger the wider financial system, critics said.
"The overriding goal of policymakers should be to keep crypto systemically irrelevant. The best way to do this is to let it implode under the pressure of its unsafe and unsound business practices. Meanwhile, authorities should constantly point to the record that crypto is rife with failures and fraud. Rather than creating a new legal and regulatory framework that legitimises crypto, we should simply let it burn," Stephen Cecchetti, the Rosen Family chair in international finance at Brandeis International Business School, and Kim Schoenholtz, clinical professor emeritus at NYU's Stern School of Business, wrote in the Financial Times last week.
Making the argument
Crypto-asset industry representatives had a chance last week to set out arguments for regulation, to rebuild trust and to explain benefits to consumers in front of the UK House of Commons' Treasury Select Committee. The blame for industry failures could be laid partly at regulators' feet, said Ian Taylor, head of crypto-assets at KPMG UK and board adviser to trade body CryptoUK. Industry's poor practices and excesses should have been reined in sooner, he said.
"Perhaps if we had had some regulation, some of these recent events may not have taken place, where we have seen some pretty poor business practices," Taylor said.
The UK's approach to crypto is "piecemeal", Taylor said. CryptoUK wanted the government to appoint a "crypto tsar" to "move across different departments" who "understands the complex nature of some of the technology" to drive cross-department collaboration. That would deliver on the UK's goal to become a crypto technology hub.
The Financial Services and Markets Bill will seek to regulate stablecoins —cryptocurrencies with values tied to fiat currencies or other assets — in a similar way to e-money firms, but the crypto industry would need to make sure the rules were fit-for-purpose, he said.
"The final point is that, while we do not know what it is going to look like, we need to make sure that the secondary legislation [tothe Financial Services and Markets Bill] is practical in its nature, because, at this time, it is unclear. We need to make sure that the government engages with the industry to ensure that these practical measures and the secondary legislation are fit-for-purpose for stablecoin issuers," Taylor told MPs.
Crypto experts' track record for understanding what might be a viable and safe stablecoin is mixed at best, however. Members of parliament (MPs) asked Tim Grant, Galaxy Digital's head of EMEA in London, to explain his company's large stake in Terra Luna's stablecoin TerraUSD, which imploded in May. Galaxy, despite Grant describing its approach to investment as "very buttoned up and institutionally focused", lost $77 million on the TerraUSD stablecoin.
"[TerraUSD] had an approach to building a blockchain technology and an ecosystem that looked like it had a lot of promise. With time, what happened was that it created an algorithmic stablecoin, so it created a means of stable payment within its ecosystem, with a particular design. There are multiple ways of designing these coins. The algorithmic stablecoin design has certain flaws in certain states of the world and, when they get under stress, they can rapidly unravel," Grant told MPs.
Crypto firms tend to invest in each other — for example, Binance, an early venture capital investor in FTX, had a huge stake in its FTT coin, only to lose money along with everyone else. Similarly, institutional investors have been badly burned investing in crypto, and therefore presumably have lacked a full understanding of the risks involved or awareness that the business was flawed or a fraud. Sequoia Capital, Tiger Global Management, Temasek and the Ontario Teachers' Pension Plan, among others, were all FTX series C investors in January.
Transparency
Until two weeks ago FTX was one of the more respected crypto businesses worldwide, but it imploded within a few days. One of the problems with FTX — in addition to governance, risk management and customer asset failings as well as fraud — was, essentially, that it printed its own money and its solvency relied on that money: its own FTT coin. When the coin collapsed, the business went with it.
"It highlights the fact that we need to put in place clear guardrails for these types of centralised actors. This is what our founding members of CryptoUK came to this select committee in 2018 to ask for. We need to make sure that we put some clarity around how these operations, which are now worth billions of dollars and use billions of dollars of their clients' funds, behave and perform. We need more clarity. We need auditing. We need to make sure that customer assets are not used in the way that they were used here," Taylor told MPs.
FTX had two auditors looking at its business, and its founder Sam Bankman-Fried spent millions lobbying U.S. lawmakers seeking to influence rulemaking. That activity now looks as if it was part of the fraud, some commentators have said. Private crypto businesses, such as FTX, which was based in the Bahamas, and Binance, will not be required to share their balance sheets and auditor reports.
To gain regulatory approval, these firms would have to show they can manage prudential risk for a start. That would be a bridge too far for many.
"It is [a bridge too far], but that's what they're asking for. If that's what they're saying the good actors in this business should be doing, the tools for them to be so are there already: they could voluntarily submit to a number of QA marks, ISO standards and accounting principles. It is a valid question to ask why they choose not to do that," said Sam Tyfield, a financial services partner at Shoosmiths in London.
Binance and the FCA
Crypto firm Binance's fraught relationship with the UK Financial Conduct Authority (FCA) illustrates how some crypto companies seek market access via regulation but are unwilling to provide the transparency and governance standards required. The FCA refused to register Binance in the UK under the Money Laundering Regulations ( MLR 2017) and in 2021 issued a first supervisory notice on Binance Markets Ltd prohibiting it from conducting any regulated activities in the UK without regulatory consent.
The FCA had issued Binance with two formal information requirements in 2021 — both under the Money Laundering Regulations — but Binance failed to provide basic information about how the business and group were organised or the routes UK customers might use to buy products, or to identify the legal entity behind Binance.com.
"Based upon the firm's engagement to date, the FCA considers that the firm is not capable of being effectively supervised. This is of particular concern in the context of the Firm's membership of a global Group which offers complex and high-risk financial products, which pose a significant risk to consumers," the FCA said.
The FCA issued a consumer warning on Binance Markets Ltd and the Binance Group in June last year saying it was not permitted to undertake any regulated activity in the UK.
"No other entity in the Binance Group holds any form of UK authorisation, registration or licence to conduct regulated activity in the UK.
The Binance Group appear to be offering UK customers a range of products and services via a website, Binance.com," the FCA said.
On its own terms
Since the FCA's 2021 rebuke, Binance has sought to access the UK market through alternative routes. In February, Binance announced a deal with Paysafe to allow its users to deposit sterling using the Faster Payments Service. The FCA said its concerns about Binance remained and it had communicated those concerns to Paysafe. In March, the FCA again publicised concerns about Binance.
This time it said the crypto exchange could be the beneficial owner of UK-registered and -based Digivault Ltd after a transaction announced with its parent company, Singapore-based Eqonex. The FCA reserved the right to suspend or cancel Digivault's registration if its ultimate beneficial owner was found not to be fit and proper.
Members of parliament asked Daniel Trinder, Binance's vice-president, government affairs, Europe and MENA in London, whether the Paysafe deal was an attempt to circumvent UK regulation. In a follow-up letter Trinder told MPs the firm advised the FCA about its partnership with Paysafe and Skrill, a UK company authorised by the FCA under the Electronic Money Regulations 2011 to provide card payment processing services and fiat wallet services, respectively, to Binance in respect of its UK users. Neither would be providing crypto-asset services, therefore it was "by no means an attempt to circumvent UK regulation".
"Binance also remains fully committed to obtaining a registration with the FCA under the MLRs to provide crypto-asset services in the UK and has been engaging in dialogue to this end with the FCA for more than a year. Binance is also fully supportive of the development of a comprehensive legal framework for crypto-assets in the UK, above and beyond the existing AML-focused registration regime under the MLRs," the Binance letter to the Treasury committee said.
This activity has not endeared Binance to the UK regulator.
"Our concerns about Binance remain. We received a notification of the Binance/Paysafe business partnership but have limited powers to object to arrangements of this kind. Paysafe is aware of our concerns and is subject to close ongoing supervision consistent with our approach for firms of its size. We cannot comment further," an FCA spokeperson said.
Binance has had better luck with regulators in Dubai. There it has been instrumental — according to Twitter brags from Changpeng
Zhao, Binance's chief executive — in establishing the Virtual Assets Regulatory Authority (VARA). The Dubai regulator has yet to release a comprehensive regulatory framework, but that did not stop Binance securing a minimal viable product licence from VARA in September. It is a process some are calling " pre-regulation". VARA has established a presence in the metaverse to reach a "borderless audience".
Myths…
Last week's Treasury committee crypto-asset hearing was an opportunity, too, for the industry to calibrate its claims about the benefits the sector can provide consumers and where its value sits. Witnesses instead repeated myths about and aspirations for the technology.
Bitcoin was a hedge against inflation, except in 2022, Grant said told Harriett Baldwin MP (Con), the committee chair.
"Over time, it certainly has been [an inflation hedge]. 2022 is just a small measure of time. You would not measure inflation in a matter of days and months anyway. I would hope that you would look at it as a long-term investment over years," Grant said.
Bitcoin started in 2013 and in 2022, the first period of serious inflation during its existence, it dropped in value by roughly 55%.
Grant likened crypto-assets to technology stocks, another common way crypto providers seek to describe value in their assets.
"It is important to consider what crypto-assets represent. Ultimately, they are, in some way, like technology stocks. They represent some sort of claim or some sort of representation of something going on underneath. There is no question that, if you look across the entire gamut, there are many thousands of coins that, like many technology stocks in the early part of the internet boom back in the late 1990s and early 2000s, ended up not being worth much, but it would be wrong to throw the baby out with the bathwater and say that all crypto-assets are purely speculative, do not have some economic value and do not have some element of value creation built into them," Grant said.
That characterisation, promulgated widely by crypto executives, is confusing, Tyfield said.
"It is confusing for them to say that when they are also saying that the asset has a utility in itself. No one can say that a share or an equity has an innate use. It represents a stake in in something else. Maybe it does have a utility as far as a store of value or a source of income is concerned, but that's not what they mean: they mean it's useful in and of itself," he said.
Faster, cheaper payments and inclusion
Faster, cheaper payments were a benefit that crypto brought consumers, said Taylor and Susan Friedman, Ripple's head of policy in Washington, D.C.
"Credit card fees are over 2% now. A stablecoin issuer can get that down to 1%. In a lot of cases, these public blockchains settle transactions in seconds, so the merchant can receive the receipt for their sale of goods and services in real time and then go on and use it to pay for other goods and services that they may need to run their business," Taylor said, declining to elaborate.
"I am not aware of a traditional finance option that is as quick or offers the same benefits as blockchain in the cross-border space.
That is a place that industry seems to universally agree where blockchain and crypto can add real value that does not exist today, just because of the traditional players involved, their entrenchment, the fees that are associated, and the opacity of the system, which blockchain solves for," Friedman said.
Ripple does not market to consumers directly. A diagram on its website purporting to show how its cross-border payment solution works illustrates a financial institution using Ripple to change U.S. dollars into its XRP token, then into Mexican pesos into a wallet at another bank, then to be distributed to beneficiaries. There is no description of fees for the sending institution and its customer, the two foreign exchange transactions, and any fees incurred by the receiving institution and its customer.
Inclusion was cited by both Taylor and Friedman as another crypto benefit.
"The ability to have a digital wallet on a phone opens up opportunities for financial inclusion that perhaps did not exist when the only way to access services is through a brick and mortar facility," Friedman said.
Alison Thewliss MP (SNP) pushed back on this claim, saying customers still need a bank account and pointing out that one the main drivers for digital exclusion and being unbanked was age. Some 28% of those aged 75 to 84 were digitally excluded, alongside 74% of those over 85, she said, citing FCA data.
"You are really not going to be able reach many of those people that you claim to be able to reach with this. Digital exclusion is a significant issue in the east end of Glasgow, for example. They are not going to benefit from this whatsoever. I am just curious as to how you are going to help these excluded people," Thewliss said.
"It was a matter of more education", Friedman said.
"Non-fungible tokens (NFTs) are a form of social inclusion", Taylor said.
"In terms of social inclusion, we saw last year a really big increase in new users of the technology coming in, because of non-fungible tokens. $4.5 billion of NFTs was traded in November 2021. They serve as cryptographically secured certificates of authenticity for a variety of digital goods, from fine art to music, collectibles and video game assets," he said.
Non-fungible tokens are largely deemed to be collectibles, and even before the FTX collapse trading volumes were down 98%.
…Reality
Many regulators see value in crypto, but not necessarily cryptocurrencies and assets as they are today. Regulators such as the European Commission, the European Securities and Markets Authority and the Monetary Authority of Singapore are all running pilots exploring blockchain technology and central bank digital currencies.
Following FTX's collapse, cryptos should be regulated for financial stability and consumer protection reasons. Cryptos' potential benefits for financial markets infrastructure was a reason not to drop the technology, said Jon Cunliffe, the Bank of England's deputy governor for financial stability.
"The technologies that have been pioneered and refined in the crypto world, such as tokenisation, encryption, distribution, atomic settlement and smart contracts, not only seem unlikely to go away as our everyday lives become more 'digital', but may well have the potential to improve efficiency, functionality and reduce risk in the financial system," Cunliffe said.
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