The digitalisation of the financial sector is continuing at pace, with demand for retail crypto assets growing exponentially. The potential benefits of these technologies — to increase payment efficiency, reduce cost and expand financial inclusion — have been widely acknowledged by regulators. However, regulators have also highlighted concerns around the possible risks and are stepping up warnings to consumers and investors. They are also beginning to differentiate their approaches depending on the structure of the asset.

Stablecoins

The global market capitalisation for stablecoins continues to grow — from near zero in 2019 to approximately $123 billion (PDF 577 KB) in September 2021. Use has expanded into wholesale financial market players and large corporates, with additional proposals developing around larger-scale public participation. And yet, a progress report from the FSB reveals that implementation of its recommendations for global stablecoin supervision remains at an early stage, with many jurisdictions considering different approaches. To limit regulatory arbitrage and market fragmentation, the FSB has called on international regulators to co-operate and accelerate efforts. 

In the UK, regulators are concerned that stablecoins' growth not precipitate any lowering of standards. In fact, they are pushing for systemic stablecoins to be treated equivalently to other retail payment methods — via HM Treasury's (HMT) consultation (PDF 444 KB) to bring such stablecoins within the Bank of England's (BoE's) regulatory remit and the BoE's own discussion paper on new forms of digital money. This sentiment is also reflected at the global level, in recent CPMI-IOSCO guidance.

In Europe, October saw the Members of European Parliament (MEPs) conclude their first round of draft amendments to the proposed Market in Crypto-Assets regulation (MiCA). MiCA recommends that 'asset-referenced tokens' (i.e., stablecoins) require regulatory authorisation to be traded within the EU — with this also applying to stablecoins already in circulation. 

In general, concern is also mounting over potential risks related to stablecoin reserves. In theory, stablecoins are backed one to one with fiat currency (i.e. currency guaranteed by the government as legal tender). However, confidence in the stablecoin could be undermined by factors such as reserve assets that fall in price, become illiquid, or are not adequately safeguarded, or where redemption rights of stablecoin holders are not clear. Short sellers have begun to question the underwriting of some of the world’s largest coins. As primary drivers to the crypto-economy, any collapse or regulatory backlash against these coins could lead to a run on crypto assets, with instability leaking out into the mainstream financial sector.

Unbacked crypto

In regard to unbacked cryptoassets (such as Bitcoin or Ethereum), regulators continue to warn (PDF 1.30 MB) that the investments are highly risky and that consumer should be prepared to “lose all their money”.

While the Basel Committee has proposed that stablecoins be eligible for modified Basel treatment, they have recommended that unbacked cryptoassets be subject to a new and more conservative prudential treatment, effectively requiring banks to hold capital equivalent to the full amount of the exposure. This is a mechanism that attempts to reduce the risk of contagion of the regulated business of authorised firms by unregulated activities in digital tokens. 

In the UK, the particular nature of a cryptoasset still determines its level of supervisory scrutiny. Those firms carrying out regulated activity (i.e. security tokens and e-money tokens (PDF 984 KB)) require FCA authorisation. But all other tokens (including those primarily used as a means of exchange) remain regulated only under money laundering regulations. HMT's January consultation (PDF 444 KB) re-iterated the stance that exchange tokens remain outside the regulatory perimeter for prudential and conduct purposes - while becoming subject to more stringent consumer communications regulation via the financial promotions regime (if adopted) and the FCA's response (PDF 660 KB). 

In October, BoE Deputy Governor Jon Cunliffe cautioned that effectively regulating cryptocurrencies is “a matter of urgency”, in order to prevent the growing risks they pose to financial stability. UK holders increasingly see crypto assets less as speculative and more as complementary to mainstream investments. This despite the value of such assets remaining highly volatile and a scenario involving a major price collapse being plausible. FCA Chair Charles Randell has noted a further complexity whereby attempts to regulate purely speculative tokens could inadvertently provide them with a `halo effect' in the eyes of consumers.

And finally, the situation in Europe remains slightly unclear. Under MiCA’s decentralised approach, the regulation would be enforced primarily by national regulatory authorities – and could result in ‘forum shopping’ with crypto projects seeking out the most crypto-friendly member states.

Evolving market

The crypto world is beginning to connect to the traditional financial system, as large fintech and crypto firms, which are generally not subject to comprehensive supervision, offer bank-like products and services and regulated firms build crypto infrastructure (e.g., custody services, exchanges).

Decentralised Finance (DeFi) is generating its own unique set of challenges. Regulators are considering how to address the risks of a broad range of financial services being affected through these platforms, while simultaneously acknowledging that, due to the inherent lack of intermediaries, there may be no individual to ultimately hold accountable. 

In short, regulators have an enormous task ahead as they try to figure out how to bring the quickly-evolving crypto world effectively within the regulatory perimeter without destroying its potential to significantly enhance the financial system. Not only will this safeguard financial stability, but it will allow the benefits of this technology to flourish in a sustainable way.

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