Despite obvious uncertainty, clear themes are developing in the regulation of crypto and digital assets. Crypto isn’t specifically regulated, however, with regulators at pains to say that financial regulation is ‘technology neutral’. But regulators do consistently focus on a couple of big points.
First is deciding what is and isn’t regulated – the regulatory perimeter. Utility tokens – giving holders access to a service and exchange tokens allowing them to transfer value without centralised banking (bitcoin is the best example here) – aren’t regulated. Security tokens – backed by an issuer and with recourse to assets – are.
Initial coin offering activity in 2017 presents a good case study of the new world of digital assets regulation. ICOs that took legal advice were generally structured as utility tokens, designed to fund the development of innovative blockchain software projects and give buyers credit to use with the project. These were outside the regulatory perimeter and some people saw funding being raised without the time, trouble and cost of a securities issue involving a prospectus, third parties and professional fees.
Regulations were not well understood, not everyone got advice on them, there were some innocent failures to comply with the rules and there were some miscreants who took advantage of the situation to get their hands on easy money. It also put on show lot of the characteristics of crypto: innovation and artifice; transformational projects and scams; community support for projects with good founders and fear of missing out. And it was also a lesson in Gresham’s law for anyone who needed to rediscover it.
One of the concerns of regulators and practitioners is that the difference between being inside and outside the regulatory perimeter is so significant that the line must be as clear as possible. That is a job for all stakeholders.
Financial crime and the application of anti-money laundering rules are further concerns. As the industry scales, these topics will get more attention. Companies and projects have to be clear and demonstrate that they’ve complied with all appropriate rules. Regulators are concerned not only that businesses have the right policies and practices in place, but also that senior members of the team have experience in regulated markets and know anti-money laundering measures.
This reveals a cultural aspect of crypto. Crypto was celebrated and promoted by various communities, including deep tech folks and libertarians. Deep tech practice is to iterate and improve projects over time. Libertarians distrust centralised regulation. Neither of these philosophies work for a regulator that is tasked with ensuring that sources of funds are transparent. On the other hand, an immutable, public ledger is not a good tool for laundering money. This will resolve itself, albeit compromises will have to come from the crypto side of the table. Crypto does not seek to facilitate financial crime and projects must reflect that.
Other regulations that are relevant to crypto projects are familiar, such as financial regulations relating to e-money and financial promotions, digital economy regulations such as the European Union’s general data protection regulation and other data regulations, consumer protections rules where retail customers can access products or projects, and so on.
DeFi, decentralised finance, tests our analysis of all these points. Decentralisation means there are no intermediaries. No brokers, arrangers or advisers. No parties to transactions other than the participants. No centralised exchanges, no central banks. The DeFi world now includes lending and borrowing, derivatives, asset management, insurance and most other traditional finance products. But it does so on a peer-to-peer basis with all of the functionality encoded in smart contracts.
DeFi is important for a few reasons. From a regulatory perspective, it’s common to hear people involved in the industry say that it operates outside the traditional legal system. This is really shorthand for the fact that if a truly decentralised project has no more substance than the code that it runs on then there is no ‘firm’ to apply for a licence and no ‘person’ to bring enforcement proceedings against. But, in principle, nothing is outside the traditional legal system.
DeFi is also important because it brings true innovation, which will continue to develop and influence the traditional financial system. It can be a force for democratisation and inclusion, reducing costs and increasing access. It is a route to Web 3.0, the internet of value and the sharing economy, a place where the fruits of the digital revolution are available to all. We are witnessing the first ripples of this through new services and approaches, such as non-fungible tokens, the creator economy and ‘play to earn’ gaming.
Crypto regulation needs to respond. Regulation always trails innovation. This extraordinary innovation needs an equally extraordinary response from regulators. But, just as digitalisation enables trading and other financial products in real time 24/7, so transparent market data will be fed to regulators continuously. And regulators will use artificial intelligence to track it, as will users. Regtech has a big job to do to support the aims of fintech.
This is bigger than crypto and fintech. There is a clear trend to financialise daily life. As well as financial innovation and financial product development by the large tech firms, we are going further down the road of monetising time, attention and personhood. There are big social policy questions which we can’t just hand off to financial markets regulators. They require wisdom as well as engagement and insight.
Charles Kerrigan is Partner at CMS Law.