Crypto Prepares for a Regulated Future

As crypto goes mainstream, regulatory compliance will require robust and financial institution-grade AML and KYC processes, says David Liu.

Towards the end of 2021, the value of bitcoin – the original cryptocurrency and still the bellwether for the digital asset sector – rose to a record high of USD 64,400, more than three times its peak in 2017 amid the mania for initial coin offerings (ICOs). The price has dropped in recent weeks, and cryptocurrency markets remain volatile. Nevertheless, taken in its entirety, 2021 witnessed a growing adoption of cryptocurrencies by major international brands and saw their incorporation into services provided by mainstream financial institutions.

In March 2021, Tesla CEO Elon Musk said the carmaker would accept bitcoin as payment for vehicles. Musk later recanted in view of bitcoin’s worrying carbon footprint, but other companies have taken to crypto in a more permanent way. Firms in the payment space, such as Visa, Mastercard and Paypal, announced plans to accept and process cryptocurrency payments while other multinationals, such as Square and MicroStrategy, invested in bitcoin as a treasury asset.

In September 2021, El Salvador became the first country to accept bitcoin as legal tender and subsequently announced plans to issue a bitcoin bond to fund infrastructure investment. In October 2021, the US Securities and Exchange Commission (SEC) gave the green light to ETFs in bitcoin futures, providing a way to trade in bitcoin, albeit without owning it, in a regulated investment vehicle.

In Asia, meanwhile, the Monetary Authority of Singapore (MAS) made clear its intention to position the city-state as a regulated, regional crypto hub and in the process attracted service providers, such as Gemini, Huobi and Crypto.com. MAS had received operating licence applications from 170 crypto firms by November 2021. To date, the regulator has granted four such licences.

Blockchain and digital assets as a catalyst for innovation

Amid this ongoing accommodation of crypto assets into global financial systems, the sector received considerable sums in investment. In the first nine months of 2021, crypto and blockchain startups raised USD 15 billion in venture capital, five times the amount they attracted in the whole of 2020, according to The Economist. And five of crypto’s six biggest-ever fundraising rounds occurred during the year.

Beyond these hard figures, there is a growing consensus among technologists that blockchain, cryptocurrencies and other digital assets could be as transformative as the Internet in ushering in a new iteration of online architecture known as Web 3.0. Similarly grandiose claims have been made of blockchain technology previously. The difference now is that we can begin to see the scale of innovation and some evidence that digital assets have the potential to reshape capital markets, core banking and international settlement processes and platforms.

From a consumer perspective, crypto could underpin the development of virtual environments, making up emerging metaverses and driving the commercialisation of non-fungible tokens (NFTs), reshaping relationships between creators and their audiences in the process. Lest these areas should appear trivial in the scheme of things, it is worth noting that a single recent NFT sale from graphic designer Mike Winkelmann fetched more than USD 69 million, making it the fourth most expensive piece of art from a living artist.

Regulatory certainty is coming

While cryptocurrency markets may be prone to volatility—capable of delivering significant falls in value as well as sharp peaks—the trends noted above would indicate that, as an asset class, cryptocurrencies are here to stay. And, with growing acceptance of the place for digital assets in the world’s financial systems and markets, we will also see greater regulatory clarity and certainty through the course of the coming year.

Global money laundering watchdog, the Financial Action Task Force (FATF), has been issuing assessments on the regulation of digital assets since 2018, and in October 2021, it updated its guidance to effectively bring crypto regulation into line with the rules for traditional banking.

The message from the FATF is that countries must implement these standards now, although there is an acknowledgment that individual regulators will need to allow some flexibility for an immature sector. Similarly, Singapore’s welcoming stance towards crypto operators is being accompanied by a tightening of regulations. “We don’t need 160 of them to set up shop here,” said Ravi Menon, managing director of MAS, in a recent Bloomberg report. “Half of them can do so, but with very high standards. That, I think, is a better outcome.”

Elsewhere in the region, Hong Kong has proposed to restrict crypto trading to professional investors, i.e. individuals with a portfolio of at least HKD 8 million (USD 1 million), narrowing the field for crypto trading. Most recently, regulators have opened the door to allowing banks and securities firms to offer crypto-related financial products and dealing services to sophisticated clients.

Blockchain and digital asset businesses are inherently global operations. While to some degree there is an option to choose locations based on regulatory differences, the direction of travel is clear: cryptocurrency and digital asset service providers will need to conform to much the same standards and regulations as apply in traditional finance.

Compliance in a regulated digital asset sector

As a start, this will involve implementing robust, financial institution-grade, AML and KYC processes, as emphasised in a 28 January circular from the Hong Kong Monetary Authority’s (HKMA).

Digital asset service providers need to deploy advanced transaction monitoring systems to uncover potentially anomalous and fraudulent transfers. Effective compliance with the standards governing traditional finance will also require the capability to check for and manage economic sanctions on territories and individuals.

The cryptocurrency sector evolves quickly, however, and faster than the pace of regulation. Service providers continue to run up against the limits of existing regulation or the incompatibility of legislation with emerging services. Decentralised finance (DeFi), for instance, confers the ability to trade and automate contracts and exchanges without involved parties needing to know the identity of, or trust, the other party. Such anonymity contravenes the laws governing international financial transfers.

DeFi also underpins the interest-paying products and services that exist in the crypto sector, where traders “borrow” assets from holders and pay high short-term yields due to the rewards available from arbitrage opportunities across territories and exchanges. In the US, Coinbase stepped back from launching its yield product when it came under scrutiny from the SEC.

Even when regulations are introduced, the pace of innovation will see discussions on appropriate legislation move to address other emerging services and areas of the industry. All of these developments not only affect the cryptocurrency sector. As regulations take shape, traditional service providers have themselves already started to explore how they can capitalise on opportunities.

In a time of rapid change, evolving regulations and technological innovation, both traditional service providers and crypto-native businesses can benefit from detailed assessments of how AML and KYC processes can be managed and which vendors can support them.

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David Liu is Head of Asia Pacific for the Compliance Risk and Diligence practice of Kroll, based in Hong Kong.