By Kate Gee, Counsel at Signature Litigation

Notwithstanding its inherent volatility, the sustained growth of the crypto market continues to attract an army of global investors.  Having twice breached the $2 trillion (£1.48tn) mark this year, some forecasters suggest that the aggregate value of the crypto industry may reach $3 trillion in the next five years. In response, the discussion about its potential regulation continues to attract attention from the global financial markets and investors alike.

Among politicians to fire warning shots, US Treasury Secretary Janet Yellen has repeatedly talked about the potential dangers presented by cryptocurrencies, arguing that critical questions about their legitimacy and stability need to be addressed.

In July, she emphasised “the need to act quickly to ensure there is an appropriate US regulatory framework in place”. Across the globe, China continues to crackdown on what it considers a volatile and speculative market and has recently declared that all cryptocurrency transactions are illegal – following which the price of Bitcoin fell by more than £1460.  This is not the first time that FUD (Fear, Uncertainty and Doubt) from China has impacted market confidence.

Global regulators are exercising caution, calling for cryptocurrencies to become subject to the toughest bank capital rules of any assets. It has been suggested that banks exposed to the most volatile cryptocurrencies should face stricter capital requirements to reflect the greater risk involved.

Regulators are also turning attention to boosting existing regulatory regimes to suit the fast-changing crypto market and the parallel risks that are developing alongside it: for example, fraud, hacking, money laundering involving cryptocurrencies or other digital assets.

Realistically, devising an appropriate regulatory regime for the crypto market – whether on a domestic or global scale - will take time and collaboration.

The market is truly global, and there are competing views and priorities, not to mention inconsistent use of terminology.  At the same time, some industry experts think that unnecessary or overly stringent regulation could do more harm than good – in particular if the market and the technology is not fully understood.

However, we are starting to see regulatory bodies in some jurisdictions advocating regulation with some success. Gibraltar has been the frontrunner, which has – in the main – been positively received.

Since the Financial Services (Distributed Ledger Technology Providers) Regulations 2020 came into force on 1 January 2018, any entity which, by way of business in or from Gibraltar, stores or transmits value belonging to others using distributed ledger technology must first apply to the Gibraltar Financial Services Commission (GFSC) for a license.

During the rigorous application process, which typically takes a number of months, applicants must show, inter alia, that they will comply with the GFSC’s nine regulatory principles (for which helpful guidance notes have been set out by the regulator).  At the time of writing, there are already 14 licensed DLT Providers and one Virtual Asset Arrangement Provider active in Gibraltar.  We anticipate that more will join the ranks in the near future.

By contrast, and despite warnings from UK financial regulators about the risks of crypto investments, the UK is still some way off having a regulatory regime specifically for cryptocurrencies and digital assets.  At the moment, whether and how dealings in digital finance are regulated in the UK depends on whether the activity falls within the scope of one or more of: FSMA, the AML regime, the Payment Services Regulations 2017, and the Electronic Money Regulations 2011.  There is therefore minimal regulation when dealing in digital finance in the UK now.

At present, the scope and nature of regulation varies across EU member states.  However, French regulators have proposed that EU member states give responsibility for overseeing cryptocurrencies to the pan-European markets watchdog, the European Securities and Markets Authority (Esma). There has been a mixed response to this proposal. While strengthening Esma’s powers in this area might deliver consistency, it is a bold move to ask national regulators to relinquish some or all of their control in this rapidly developing market and to agree to some form of centralised supervision (as yet unknown) by Esma.

Given that most activity in crypto assets falls outside the regulated sector, a strict approach to regulated entities that operate in the crypto market imposes an additional burden on those institutions. Regulated institutions have to grapple with how to balance the increasing appetite for investments in digital assets and cryptocurrencies with their regulatory obligations, in an environment in which unregulated entities have comparative freedom.

They also have their due diligence and KYC obligations, sanctions risks and credit/market risk to consider.  Trade groups including the Global Financial Markets Association, the Institute of International Finance, ISDA and the Chamber of Digital Commerce recently wrote to the Basel Committee on Banking Supervision to say that their proposals are too conservative and simplistic, and may well preclude bank involvement in the crypto asset markets, not least by making it too costly, risky and commercially unviable.