A crypto regulatory storm is coming in 2023. Are we ready?

Please fol­low and like us:
Pin Share

After the spec­tac­u­lar crash of Sam Bankman-Fried’s FTX and its asso­ci­at­ed orga­ni­za­tions, finan­cial reg­u­la­tors world­wide have to keep their atten­tion on two places at once. As one eye stays firm­ly on pre­clud­ing ter­ror­ism fund­ing, the oth­er is glued on the fall­out among FTX retail investors and its knock-on effects through­out the greater finan­cial landscape.

There will cer­tain­ly be moments of crossed eyes as lit­i­ga­tors intro­duce new and evolv­ing legal frame­works, and even more when fin­tech com­pa­nies have to com­ply. Regard­less of whether it’s still a speck on the hori­zon or loom­ing large, this leg­is­la­tion is inevitable, but what shape will it take?

Rising temperatures

Long before US$8 bil­lion in FTX deposits seem­ing­ly dis­ap­peared, some regions had leg­is­la­tors draw­ing up plans to turn up the heat on retail cryp­to oper­a­tors. Indeed, one of the major regions whose leg­is­la­tion won’t be affect­ed by the Alame­da Research/FTX fall­out is the Euro­pean Union, where the Mar­ket in Cryp­to-Assets (MiCA) reg­u­la­tion, designed to pro­tect con­sumers in such an inci­dent, was already writ­ten and signed. It’s not yet imple­ment­ed, though. More on MiCA later. 

Of course, major exchanges like Binance US and Coin­base were already under intense scruti­ny to adhere to know-your-cus­tomer (KYC) and anti-mon­ey laun­der­ing (AML) reg­u­la­tions, so they were used to a lit­tle heat. Com­pli­ance teams were accus­tomed to legal lan­guage that under­stands both the need for a low-fric­tion user expe­ri­ence, as well as the chal­lenges involved with some aspects of AML enforce­ment. That lan­guage has lured some com­pa­nies towards the lax­er side of due dili­gence. As Coin­base was recent­ly fined US$100 mil­lion by New York reg­u­la­tors for AML non­com­pli­ance, at least when MiCA-like reg­u­la­tions come down, that com­pa­ny will prob­a­bly be bet­ter pre­pared — half of that US$100 mil­lion should be invest­ed in bol­ster­ing inter­nal com­pli­ance routines.

For decen­tral­ized finance (DeFi) com­pa­nies that aren’t being forced into fix­ing the leaks in their ship, an obvi­ous chal­lenge is being pre­sent­ed: pro­tect your cus­tomers or get used to more inclement legal weath­er, even if you’re still get­ting used to the AML climate.

Initial drizzle

As of the end of a tur­bu­lent 2022, the reg­u­la­to­ry frame­works of most major mar­kets were still coa­lesc­ing. Like a bit of rain that promis­es high winds and tor­ren­tial down­pours, we can look to these to get an idea of what might come lat­er this year. 

A few regions, like Sin­ga­pore, had already imple­ment­ed mod­er­ate con­trol mech­a­nisms, large­ly con­cerned with adher­ing to Finan­cial Action Task Force’s AML guide­lines, and avoid­ing sanc­tions. Mean­while, India rat­i­fied a 30% tax on all vir­tu­al asset gains in April of 2022.

How­ev­er, for retail cus­tomer pro­tec­tion against pre­da­tion, fraud and embez­zle­ment, almost noth­ing is cur­rent­ly being enforced with cryp­to-spe­cif­ic language. 

MiCA will be one of the first major imple­men­ta­tions and was ini­tial­ly pro­posed in Novem­ber 2020 in the Euro­pean Union Par­lia­ment, to pro­vide legal con­fi­dence in a noto­ri­ous­ly volatile space. Though it was signed into law in Octo­ber 2022, it like­ly will not require busi­ness­es to be ful­ly com­pli­ant until mid-2024.

At a glance, MiCA will:

  • Estab­lish one def­i­n­i­tion for a “cryp­to-asset” in the Euro­pean Union.
  • Define what blockchain ver­ti­cals fall out­side this juris­dic­tion — such as insur­ance and pen­sion providers.
  • Cre­ate four cat­e­gories for assets to fall under: asset ref­er­ence tokens, e‑money tokens, util­i­ty tokens and every­thing else.
  • Estab­lish enforce­able man­dates for how sta­ble­coins and non-sta­ble­coins are brought to mar­kets and then the pub­lic, includ­ing dis­clo­sure laws mod­eled on the E.U. Prospec­tus Regulation.
  • Reg­u­late how cryp­to-asset ser­vices are autho­rized to car­ry out busi­ness as usu­al, mod­eled on MiFiD (Mar­kets in Finan­cial Instru­ments Directive).

Sim­i­lar­ly, the afore­men­tioned Sin­ga­pore­an reg­u­la­tion was being care­ful about which dig­i­tal pay­ment token ser­vice providers (DPT­SPs) they could trust with licens­es to oper­ate in the coun­try. Only recent­ly, the Mon­e­tary Author­i­ty of Sin­ga­pore made pro­pos­als to enforce cus­tomer safe­ty and anti-cor­rup­tion pro­to­cols among the licensees.

The pro­posed Sin­ga­pore­an regimes include par­tic­u­lars that are more suit­able for their size and cul­ture, but estab­lish good bench­marks for oth­er regions to poten­tial­ly follow:

  • DPT­SPs should con­duct risk aware­ness assess­ments for customers.
  • DPT­SPs should not offer incen­tives to retail investors (like an online casi­no might).
  • Retail cus­tomers should be pre­vent­ed from bor­row­ing mon­ey to invest in DeFi assets.
  • DPT­SPs should guar­an­tee that investor funds are kept sep­a­rate from com­pa­ny funds.
  • Self-detec­tion and report­ing of any inter­nal con­flicts of interest.
  • Trans­paren­cy for cryp­to firms when it comes to how they invest in new assets.
  • Ade­quate cus­tomer ser­vice infrastructure.
  • Man­dat­ed emer­gency back­ups for vital oper­at­ing systems.

As oth­er regions scram­ble to sew con­sumer safe­ty into their secu­ri­ty blan­kets, it seems like­ly that these will serve as the mod­els for many. 

Ominous clouds and risk of lightning

As the steps of 300 new hires can be heard stomp­ing through the crim­i­nal divi­sion of the U.S. Inter­nal Rev­enue Ser­vice, one won­ders if their boots are weath­er­proofed against the com­ing storms. Along­side the appar­ent­ly “hun­dreds” of cas­es being built by the IRS against cryp­to tax evaders, prece­dent-set­ting legal cas­es are wait­ing to drop the gav­el on the cryp­to space. Depend­ing on how they set­tle, many in the indus­try con­sid­er them to be piv­otal when it comes to form­ing the shape of DeFi’s future. 

Until now, invest­ing in decen­tral­ized cur­ren­cies of any kind was an invest­ment into an envi­ron­ment of less scruti­ny, by def­i­n­i­tion. A pri­va­cy mind­set — name­ly keep­ing “off the grid” — is par for the course when it comes to much of the DeFi com­mu­ni­ty. As FTX asset hold­ers know, though, this pri­va­cy comes at the cost of your deposits being unsecured.

While writ­ing for Forkast, Michael Shing notes that this cre­ates a knife’s‑edge sit­u­a­tion in terms of cul­pa­bil­i­ty. When near­ly all your cus­tomers are con­nect­ing pseu­do­ny­mous­ly, but some of them are crim­i­nals, where does the legal pun­ish­ment go? In the cur­rent legal frame­work, there’s nowhere to pass the buck but up, to the exchange oper­a­tors and owners.

A hail of precedents

Cur­rent­ly roil­ing are three legal cas­es where this fric­tion has result­ed in elec­tri­cal buildup, and then light­ning strikes: FTX, Coin­base and Ripple.

In the cas­es where the lack of com­pli­ance con­trols allows oper­a­tors to obfus­cate their own deal­ings, which is like­ly the case in Sam Bankman-Fried’s FTX and Alame­da Research, reg­u­la­tion to cre­ate a safe and more account­able space for every­day busi­ness deal­ings makes sense. SBF has made that obvious. 

In terms of how the cus­tomer will be affect­ed by this, New York leg­is­la­tors have stat­ed that Coin­base did only the bare min­i­mum in terms of mak­ing their cus­tomers adhere to KYC man­dates — a bare min­i­mum that they deter­mined was actu­al­ly below accept­able. While some com­pa­nies that are required to be KYC com­pli­ant use alter­na­tive data sourc­ing, such as social media cred­it scor­ing, with min­i­mal fric­tion for trust­wor­thy users, Coin­base opt­ed to only have the most low-fric­tion onboard­ing process­es in place, rather than the improved secu­ri­ty of step-up or dynam­ic fric­tion at reg­is­tra­tion. This US$100 mil­lion mis­take will sure­ly force Coin­base to reassess its risk appetite and onboard­ing process­es, and prob­a­bly pull some of the main­stream cryp­to mar­ket with it. Expect to see what­ev­er cus­tomer due dili­gence (CDD) prac­tices Coin­base imple­ments now to be echoed around the world. 

Final­ly, many cryp­to experts are pin­ning the impend­ing rul­ing of the U.S. Secu­ri­ties and Exchange Com­mis­sion v. Rip­ple (XRP) law­suit to the future of the entire cryp­to land­scape. That case will decide if cryp­to assets are cur­ren­cies or secu­ri­ties, with the lat­ter falling inside a legal frame­work with much more reg­u­la­tion already on the books.

A perfect storm of legal complications

The com­ing cal­en­dar year may be the most tumul­tuous yet in terms of com­ing storms and how cryp­to busi­ness­es will keep them­selves dry — and solvent. 

Leg­is­la­tors have a churn­ing, boil­ing ocean to nav­i­gate, and their ships have been look­ing less-than-sea­wor­thy of late, with many of their sailors not quite sure where they’re going or even what the water is, exact­ly. After all, these kinds of vir­tu­al finan­cial prod­ucts are com­pli­cat­ed to under­stand, and the con­text around them includes:

  • The greed of SBF that (alleged­ly) tanked the greater DeFi ecosystem.
  • A sanc­tioned, aggres­sive Rus­sia has invest­ed heav­i­ly in cryp­to after the ruble tum­bled in wartime, and has announced plans for a nation­al­ized cryp­to exchange.
  • Busi­ness­es are increas­ing­ly pushed towards juris­dic­tions with low­er, or at least solid­i­fied, scruti­ny, mak­ing some nations lose out in tax­es and eco­nom­ic boosts.
  • Many world gov­ern­ments plan­ning to release their own cen­tral bank dig­i­tal cur­ren­cies (CBD­Cs).

Know­ing this con­text makes some hes­i­tan­cy on the part of the SEC and oth­er rul­ing bod­ies under­stand­able. Before hard lines can be drawn to shape the future of the cryp­to space, bal­ances must be checked and cal­cu­la­tions must be final­ized. For cryp­to oper­a­tors, how­ev­er, it remains to be seen whether reg­u­la­tors will allow them to keep their heads above water with lighter reg­u­la­tions, or else sink every­one and wor­ry about enforce­ment when they’ve all sunk to the bottom.

Conclusion

Cre­at­ing a block of leg­is­la­tion that sets a perime­ter around such a chop­py ocean seems a mon­u­men­tal task. Bod­ies of gov­er­nance are still dis­cov­er­ing where they need to put their foot down, and how hard.

As the con­ver­sa­tion rages around cryp­to reg­u­la­tion, and the most las­civ­i­ous instances of cryp­to cul­ture are put on media dis­play, it is hard to say what side of the argu­ment is mak­ing head­way. Though it seems obvi­ous that high cus­tomer-due-dili­gence scruti­ny will lead to down­turns in prof­it mar­gins for exchanges, human greed is get­ting a lot more press these days, as are the calls for reg­u­la­to­ry safety.

As finan­cial leg­is­la­tors world­wide bal­ance eco­nom­ic pros­per­i­ty with not financ­ing war and pro­tect­ing their cit­i­zens, it seems like­ly that what­ev­er con­clu­sion they come to will require a step up in terms of due dili­gence. DeFi traders would be smart to either bring them­selves into com­pli­ance or try to lob­by for reg­u­la­to­ry mod­er­a­tion. Oth­er­wise, they may find them­selves feel­ing rud­der­less in a sea of legal bat­tles and sails slack, with oars­men decid­ing to aban­don ship and get oth­er pro­gram­ming jobs.

Source link

Please fol­low and like us:
Pin Share

Leave a Reply

Your email address will not be published.