June 07, 2021 - 6 min read
The fact that cryptocurrencies have been around for a little over a decade means their regulation presents a unique set of issues. We examine where the industry started from, its current state, and where it is headed in terms of regulatory progress to see how it will affect its institutionalization.
Years of market history have taught us that innovation predates regulation. Usually, the regulatory response is post-factum, following a crisis (i.e., the Emergency Bank Act of 1933 as a response to the Great Depression and the Dodd-Frank Act following the Financial Crisis of 2008).
Today, while regulators’ reaction was once again outpaced by the digital asset innovation, it is no longer taking the shape of damage control measures.
The explosion of consumer and institutional interest in digital assets made regulators more proactive in designing new or tailoring frameworks that already exist within the conventional financial system to better fit the crypto industry’s intricacies.
Governing bodies have the challenging task of drafting flexible but not loose frameworks to efficiently fulfill their role of market stabilizer without becoming a barrier to cryptocurrency adoption. They are aware that too much regulation can suppress growth, while being too lenient in their approach may destabilize the system and allow criminals to exploit regulatory holes.
However, following constructive dialogue with the industry and avoiding one-sided authoritative decisions, regulators are now starting to find the right balance.
Currently, according to the International Securities Services Association (ISSA), the regulations governing digital assets lack consistency across jurisdictions. Discrepancies also remain within separate corners of the market and among governing bodies.
For example, in the US, all bodies involved in the regulatory discussion treat cryptocurrencies differently and have varying views on the regulation application. The Financial Crimes Enforcement Network (FinCEN) doesn’t consider cryptocurrencies legal tender. At the same time, it treats exchanges as money service businesses (MSB), subject to their jurisdiction and existing banking regulations like the Anti-Money Laundering (AML), know your customer (KYC), and various financial reporting requirements.
The Internal Revenue Service (IRS), on the other hand, considers digital assets a property, meaning crypto businesses have to consider tax implications. The Commodity Futures Trading Commission (CFTC) treats cryptocurrencies as commodities, while the Securities and Exchange Commission (SEC) views them as securities.
Cryptocurrency categorization proves challenging also because of the underlying assets’ specifics or the varying use-cases. Stablecoins, for example, maybe backed by fiat currency, commodities, and even algorithms, making them subject to different classification standards.
Despite the lack of harmony between these agencies, the federal government hasn’t intervened to regulate blockchain in the same way as the conventional financial industry. This has left individual states free to introduce their own rules and regulations. Currently, thirty-one states have pending crypto legislation in the 2021 legislative session.
However, all these challenges are a typical part of the regulatory process surrounding new assets. Regulations are complicated, and follow-up guidance might take several iterations to nail down, especially in fast-paced areas as cryptocurrency and digital assets.
After an extended debate among governments over the last couple of years, today, the progress is evident. Based on the way of approaching cryptocurrency regulation, countries worldwide are generally divided into three categories:
In the EU, despite the overall positive approach towards digital assets, it only introduced official legislation in January 2020. The 5th Anti-Money Laundering Directive (5AMLD) brings exchanges and custodian wallets within the scope of EU money laundering legislation, meaning they now fall under the same regulatory requirements as banks and other financial institutions and must register with financial authorities. The framework also proposes Financial Intelligence Units (FIUs) to access a unified central database, shared among member states and comprised of crypto users’ identities and custodian wallet addresses.
The 6AMLD, which came into effect at the start of this month, has further tightened the compliance requirements for obligated entities. The directive’s scope was expanded by introducing 22 predicate offenses, an extension of liability to include legal persons and individuals, stricter penalties for money laundering, and more.
Furthermore, at the end of 2020, the EU imposed a cyber sanctions regime against Russian, North Korean, and Chinese actors found responsible for cyber-attacks against member states. The United States is following a similar path.
The Financial Action Task Force (FATF), the inter-governmental watchdog in charge of AML and KYC requirements, is one of the most vocal advocates for harmonizing the regulations within the digital assets niche. Earlier this year, it released a draft for an updated version of its 2019 guidance to further clarify risk mitigation for peer-to-peer transactions, licensing and registration of Virtual Asset Service Providers (VASPs), and streamlining cooperation and information sharing between regulators. Before officially adopting it, the FATF is seeking comments from the public, including academics, service providers, and regulated entities such as banks.
Regulation is poised to continue developing. In the US, for example, appointing the longtime crypto expert Gary Gensler as the new head of the SEC is considered a sign that it will soon be granted broader jurisdiction to regulate crypto businesses. Teams at different governing bodies are continuously complemented with professionals with experience in the field, meaning that the regulators are adopting a hands-on approach and remain open to an industry dialogue.
What started as a retail boom is now a trend on an institutional and even national scale, considering that over 140 countries conduct different sorts of crypto-related activities. Governments and central banks are seriously considering or even finalizing the digitization process of currencies like the US dollar, the Euro, and the Yuan.
Oversight authorities are increasingly looking to erase the image of a Wild West associated with the niche and further boost this transition through strict yet reasonable and detailed regulatory frameworks.
While the regulatory landscape remains blurry, the efforts are already coming to fruition. In the US, Democrats and Republicans alike have made cryptocurrency regulation a top priority in 2021. The EU announced plans to issue comprehensive rules for cryptocurrencies by 2024. Officials worldwide are taking steps to create regulatory ecosystems that can empower crypto businesses to operate safely and efficiently in what is already a mature industry. The question that remains is who is joining the revolution?