The past year has seen a flurry of cryptocurrency regulation-related activity, particularly from banking regulators. On March 9, U.S. President Joe Biden signed the executive order called “Ensuring Responsible Development of Digital Assets” amid the explosive growth in blockchain technologies and cryptocurrency adoption. Just three weeks ago, U.S. Treasury Secretary Janet Yellen made her first-ever public speech addressing digital assets.
The beginning of a regulatory framework for digital assets now seems to be coalescing. But what would such a framework entail? What aspects of the digital asset ecosystem will the regulation affect?
Michael Shing is the director of risk management of XREX, a blockchain and fintech company. He is focused on emerging cryptocurrency regulation and risk assessments of crypto firms.
The executive order has set the gears in motion for building a comprehensive and far-reaching crypto regulatory framework. This article highlights the key developments leading up to and following the order that help us anticipate the approach and areas of focus for emerging crypto regulation.
Nearly all participants in the crypto ecosystem will be affected by regulation in some manner, large or small. Anticipating possible next steps in the near future and developing a game plan on how to prepare will be especially crucial for companies and builders in crypto.
Road to regulation
Consider some of the significant regulatory events from recent months. In November, the Federal Reserve, Federal Deposit Insurance Corp. (FDIC) and the Office of the Comptroller of the Currency (OCC) jointly announced the completion of “policy sprint” initiatives on crypto assets. Those “sprints” identified and assessed key risks surrounding crypto assets and provided a gap assessment of existing banking regulations and guidance that needed additional clarification.
This is crucial because the web of regulatory agencies tasked with maintaining the health of the financial system is a complicated one. With different bodies governing different financial entities and activities, it is critical for regulators to have a unified view of what a new digital asset landscape looks like and identify the areas subjected to governance.
Digital dollars in the form of stablecoins and a central bank digital currency (CBDC) have also garnered significant attention from regulators and legislators. Also in November, the President’s Working Group on Financial Markets issued a report on stablecoins that demonstrated a firm understanding of the current stablecoin market, highlighted the inherent risks and gaps within current regulation and, most importantly, recommended legislative action to ensure a comprehensive regulatory framework. The report also spurred constructive discussion at both Senate Banking Committee and House Financial Services Committee hearings.
Read more: The Downside of Programmable Money
The executive order signed by Biden outlines a whole-of-government approach by calling on numerous government agencies to collaborate on research, regulatory and legislative recommendations in order to achieve several policy objectives related to digital assets.
The order marks both a historic moment on the path to broader adoption and enhanced regulation of cryptocurrency. It is also largely symbolic in its purpose of tying together regulatory work that has been ongoing. The many government agencies are not starting from scratch and have been hard at work. The executive order, however, may be just the adrenaline shot regulators needed to get to the finish line.
Regulators watching closely
The recent timeline for crypto regulation shows substantive progress and demonstrates that regulatory knowledge of crypto is deeper than what the public may perceive. Regulators have consistently signaled both their understanding and interest in decentralized finance (DeFi), which is at the leading edge of crypto financial innovation. Under the policy objective of mitigating illicit finance, the executive order states that “growth in decentralized financial ecosystems, peer-to-peer payment activity and obscured blockchain ledgers without controls to mitigate illicit finance could also present additional market and national security risks in the future.”
Further, in remarks to the Blockchain Association in September, Acting Comptroller of the OCC Michael Hsu likened crypto and DeFi to credit default swaps (CDS) in the early 2000s. Hsu warned, “We saw innovations that brought genuine improvements to clients and risk managers, but we also saw innovations that would imperil the firms that promoted them and amplify the 2008 crisis. I see similarities with emerging risks in the crypto and DeFi space today.”
The principal policy objectives of the executive order are providing consumer and investor protection, ensuring financial stability, mitigating illicit activities, reinforcing U.S. leadership in the global financial system, fostering responsible development of digital assets and exploring a CBDC.
The order prescribes several deadlines ranging from 90 to 210 days and beyond for the completion of several reports on digital assets. The law firm of Davis Polk has published a helpful graphic outlining the list of action items as well as the associated agencies that play a role.
Apart from deadlines for reports, the executive order doesn't actually preclude legislative or regulatory actions from taking place much sooner than the timeline prescribed. In fact, cryptocurrency already has the full attention of lawmakers. According to Forbes, Congress has introduced 35 bills related to blockchain technology and cryptocurrency.
Legislative action is a prerequisite for a comprehensive, effective framework to regulate digital assets and cryptocurrency. Once laws are enacted, however, government agencies may need time to translate those laws into coherent regulations. To put into perspective the enormity of financial regulatory reform, in the six years following the passing of the Dodd-Frank Act in 2010, regulatory agencies completed only 70% of the total rulemaking requirements set forth by Dodd-Frank, as reported by Davis Polk.
There is still great uncertainty regarding the timing and scope of impending crypto regulations with a wide range of possible outcomes. Will oversight be distributed among existing regulatory agencies? Will there be a new agency under the Treasury Department to encompass comprehensive and consolidated supervision? (Recall that the Consumer Financial Protection Bureau that was founded after Dodd-Frank was enacted to consolidate the responsibilities of many regulators.)
One thing is certain: U.S. regulators will build on existing knowledge and expertise to both leverage existing regulatory frameworks and to design new ones for the most innovative corners of the digital asset space. As a global leader in financial services innovations and regulations, the U.S. must take a clear and reasonable approach so that the crypto industry has both the necessary guardrails to protect its users and the open road to build financial services the future requires.
As Yellen said in her speech, “Regulation should be based on risks and activities, not specific technologies” and “regulation should be tech neutral.” I believe Yellen is emphasizing that whether it is distributed ledgers or another emerging technology, customers and investors should receive the benefit of prudent regulation no matter where the financial activity resides. Furthermore, illicit activity should always be prevented no matter where it occurs.
The best-in-class crypto companies should have existing risk and compliance programs to handle illicit finance and cybersecurity risks. Staffing experienced professionals in customer due diligence and anti-money laundering is considered table stakes. Crypto firms will need to enhance their risk and compliance chops to address emerging regulations commensurate with their evolving slate of product offerings. For example, qualified stablecoin issuers may need in-house expertise in financial risks common to the banking sector to meet potential regulatory capital and liquidity requirements. DeFi protocols may need to meet greater scrutiny in their disclosure of risks and financial terms to meet investor protection requirements.
Regulations will increase the table stakes for all players in the crypto ecosystem, increase consequences for mismanagement and set an appropriate barrier to entry. The net result will be less customer harm, less illicit and fraudulent activity and greater trust in the crypto ecosystem, which we, as responsible players share the same value, would be glad to see happen.
UPDATE (April 28, 2022): Corrects date of Yellen's speech.
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