The market is looking for consistency and harmony when it comes to regulating digital assets – but as Nicholas Pratt discovers, this goal is still some way off.
The digital assets market is different from mainstream asset management in many ways, but one of the clearest distinctions regards regulation. It is one of those rare instances where market participants, especially on the institutional side, would welcome more rules.
During a recent Funds Europe webinar, Karen O’Sullivan, head of innovation, payments, market infrastructures and governance at the Luxembourg regulator Commission de Surveillance du Secteur Financier (CSSF), outlined its approach to regulating this nascent asset class.
The emphasis is not so much on the asset, but the structure and processes that sit behind the assets – for example, can a crypto custodian meet their anti-money laundering obligations.
The CSSF has introduced a registration process for virtual asset service providers which is designed to give recognition to the various new entrants to the market, and to remind them that to be licensed participants in Luxembourg’s funds market, they must meet the existing rules regardless of the asset class.
Regulators realise that the existing framework will not be enough and that new rules need to be designed specifically for digital assets, something that may be partially addressed by the introduction of the EU’s Markets in Crypto Assets (MiCA) regulation (see box, next page).
But there also needs to be a harmonised regulatory framework throughout Europe, rather than one where cryptoassets are deemed to be Ucits-compliant in one EU jurisdiction but not in another, a point made by O’Sullivan.
When asked what developments could make the crypto market more sustainable, she also referenced the need for a flexible approach that will “give certainty to the market and the players but won’t impede further innovation in the sector”.
O’Sullivan’s call for more harmony has been echoed throughout the market, by service providers, asset managers, investors and also regulators. However, we are still some way off harmony at this point.
Opening the gates
A change in German law will lead to mass adoption of cryptoassets among institutional investors. This is the view of Global Digital Finance (GDF), the industry body for cryptoassets and digital finance, which states that the new rules will ‘open the gates’ for greater adoption of the asset class.
As of August 2, spezialfonds domiciled in Germany, such as pension funds and insurers, can invest up to 20% of their portfolios in cryptocurrencies. Spezialfonds account for more than $2.1 trillion in assets and it has been forecast that the law change could lead to as much as $400 billion of crypto investment.
“The key component of the [German] law is that it sets clear guidelines under which financial institutions will be expected to invest in cryptoassets,” said Lavan Thasarathakumar, director of regulatory affairs EMEA at GDF. “This gives confidence and a mandate for institutions to be able to invest money into crypto.”
According to GDF, it may also lead other regulators around the world to follow suit. The Bank of International Settlements has recently issued a consultation paper setting out a potential framework for investing in crypto.
Meanwhile in the US, the Securities and Exchanges Commission (SEC) has recently ruled that special purpose broker dealers can invest in cryptoassets, a move that GDF welcomes as a “great starting point”. GDF sees greater institutional involvement in crypto as paving the way for “new products and services to be produced and for more innovative solutions that can take the crypto industry on to a new plain and deliver on some of the benefits that it has promised”.
Regulators in the US have so far adopted a conservative approach to digital assets. The SEC has yet to approve any of the many licensing applications made by crypto ETFs, despite the overwhelming investor demand for these vehicles.
While there has been no movement on crypto ETF approvals, there are signs that the SEC is looking to impose rules on the numerous crypto-trading platforms that operate outside the regulatory environment.
The SEC’s chair, Gary Gensler, recently stated that crypto trading market, estimated to be worth around $2 trillion, is now too big to exist outside the public policy framework.
Gensler concedes that there is a challenge in applying rules to a decentralised finance market that is based on the principle of putting market participants in more direct contact with each other, rather than via traditional intermediaries such as broker dealers and asset servicers. He has also said that it is in the best interests of crypto-trading platforms to engage with regulators and register with the SEC if they are to thrive and survive in the long term.
This engagement may not go smoothly, though, judging by a recent case involving crypto exchange Coinbase and its proposed launch of a digital asset lending product that allows customers to earn interest for certain digital assets they hold on the platform. According to Coinbase chief legal officer Paul Grewal, the SEC has threatened to sue Coinbase if its Lend service is launched. The dispute centres on whether the service is an investment contract involving a security. The SEC believes it is, while Coinbase disagrees.
In a bind
In Grewal’s blogpost on the Coinbase site, his major grievance is that while other crypto companies have launched similar services without seeking regulatory approval, Coinbase decided to engage with the SEC first.
“The SEC has repeatedly asked our industry to ‘talk to us, come in.’ We did that here. But today all we know is that we can either keep Lend off the market indefinitely without knowing why or we can be sued,” wrote Grewal.
“A healthy regulatory relationship should never leave the industry in that kind of bind without explanation. Dialogue is at the heart of good regulation.”
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