In October 2022, at the height of a crypto summer, Hong Kong announced plans to allow crypto trading and listing; weeks later, winter came early as FTX collapsed. With Singapore tightening its crypto regulation and Hong Kong proposing a new licensing regime for crypto platforms, we ask what 2023 may hold for the sector.
The pandemic year of 2020 provided fertile ground for money making and agile entrepreneurship in the crypto markets, but also set the stage for a perfect disaster.
As more money was printed in Western economies and the US dollar weakened, investors began spotting opportunities and taking risks. Money could be borrowed cheaply enough to make it much easier to produce returns in crypto, leading to some significant market booms and opening the door for speculators.
It was a good time for crypto – a verdant summer – right through 2020 and almost to the end of 2021. But in November that year, things started to look bleak, and the realisation began to dawn that the bubble had perhaps grown too big. As inflation took hold, interest rate hikes began to be the norm to try to tame excessive price growth.
Then the crashes began to happen.
“2022 was what I like to call a beautiful deleveraging,” says Denish KC, Head of GTM at web3 tech company XGo. “Lo and behold people started getting spooked”.
Terra/Luna was once regarded as an innovative yet reliable model of less risky crypto asset investment. The TerraUSD ‘stablecoin’ was designed to maintain a value of USD 1 by using its sister floating rate cryptocurrency, Luna, and a clever algorithm. In May 2022, however, it all came crashing down thanks to the crypto equivalent of a bank run. Investors lost millions of dollars.
“After that, we were living in a deep crypto winter,” says KC. “Activities were low, emotions were low; everyone was wondering if it’s worth it.”
But it wasn’t over. In November, Binance, which was the world’s biggest crypto exchange at the time, announced a sell-off of all of its FTT tokens. FTX was next to be affected by the sequence of events; only the next day it announced a liquidity crisis, and it was filing for Chapter 11 bankruptcy protection four days later.
But, despite this volatility, somehow, 2023 began with a whiff of optimism in the air, and the crypto market has boomed. At the end of January, Forbes reported that the value of Bitcoin had increased by around 45% since the beginning of 2023, and the market as a whole had climbed by approximately 35%. Analysts expect this to continue. It seems crypto-confident investors had tired of being on the sidelines, and were encouraged by hints of more appeasing behaviour from the US Federal Reserve, leading to some fresh momentum in the market.
The resurgence of crypto may have led to damage to more traditional finance houses. On 8th March, Silvergate Capital, a cryptocurrency-focused bank, suffered the effects of a bank run and ceased trading. On the same day, Silicon Valley Bank (SVB) began to send out worrying messages, leading to a classic knock-on effect and more customer withdrawals – it failed two days later. Another US lender, Signature Bank then suffered huge outflows and was seized by regulators.
“ But if our experiences over the past few years have taught us anything, it is that even the traditional or legacy institutions do not necessarily provide particularly secure harbours, and investors will flee to whatever seems to be the safest shelter at the time. In 2023, we have seen Credit Suisse wobble severely, borrowing USD 54 billion from the Swiss National Bank as its shares plunged to a record low, and finally being subsumed by competitor UBS. The contagion is likely to spread further, and this has led many people, including ordinary investors and customers to move away from traditional finance (to “DeFi”) and hold their money outside the old-fashioned fiat system.”
Traditional wisdom may say that bad events like these would cause investors and customers to shy away from putting their money into less traditional digital banks and fintech-driven firms, and look to familiar names for security. Indeed, a jump in deposits at so-called legacy banks has been reported. But there may be another side to the story. According to KC, and somewhat ironically, many who recently took money out of beleaguered institutions such as SVB saw a safe haven in crypto.
“Crypto is truly a good hedge for assets if you’re thinking long term,” he says.
Regulators and other authorities continue to issue warnings around crypto. Most recently, the US Securities & Exchange Commission issued an investor alert on 23 March 2023 which warned that “investments in crypto asset securities can be exceptionally volatile and speculative, and the platforms where investors buy, sell, borrow, or lend these securities may lack important protections for investors.”
But if our experiences over the past few years have taught us anything, it is that even the traditional or legacy institutions do not necessarily provide particularly secure harbours, and investors will flee to whatever seems to be the safest shelter at the time. In 2023, we have seen Credit Suisse wobble severely, borrowing USD 54 billion from the Swiss National Bank as its shares plunged to a record low, and finally being subsumed by competitor UBS. The contagion is likely to spread further, and this has led many people, including ordinary investors and customers to move away from traditional finance (to “DeFi”) and hold their money outside the old-fashioned fiat system.
However, regulatory warnings highlight the very real risks associated with crypto and the often unregulated platforms on which they trade. Some crypto exchanges have undeniably shady pasts, and remain mysterious: for example, the location of Binance, a leading crypto exchange, is not clear and sources say that even its employees know very little about their employer. The crypto sector, while perhaps not being the absolute Wild West that it once was, is significantly under-regulated in comparison with other investment vehicles or sectors; in many jurisdictions, there is little or no regulation of crypto assets at all.
This will inevitably change, and 2023 may be the year when regulation finally catches up with crypto.
Similar to the development in the UK, the European Banking Association has opened a consultation on amending its AML guidelines for crypto-asset providers. But many think that it is the European Markets in Crypto-Assets (MiCA) Regulation which holds a key to the future. According to a briefing by law firm Mayer Brown, “MiCA is intended to close gaps in existing EU financial services legislation by establishing a harmonized set of rules for crypto-assets and related activities and services. Among other things, MiCA imposes restrictions on the issuance and use of stablecoins”, although it does not cover crypto-assets regulated by other EU financial law instruments, such as security tokens or e-money.
As currently drafted, MiCA would require the owners of a crypto wallet to identify themselves; if they are not able to, they would not legally be able to serve any European client. MiCA will also bring the law relating to crypto-assets in line with that applicable to other areas of the financial services, making it illegal to carry out market manipulation or make misleading statements, for example.
This approach may guide other jurisdictions, too.
“MiCA will dictate what the US does,” says KC. “Up till now, the US view on crypto has been, ‘this is a scam, let’s shut it down’. But at the same time there are big lobby groups in the US, and the US is likely to follow Europe [in terms of regulation].”
Meanwhile in Asia, from 1st June 2023 virtual asset trading platforms that trade non-security tokens in Hong Kong, or actively market those services to Hong Kong investors will become subject to a new licensing regime which was brought into law by way of amendments to the territory’s Anti-Money Laundering and Counter-Terrorist Financing Ordinance.
On 20th February, the Hong Kong Securities and Futures Commission (SFC) published a consultation paper setting out its proposals as to how it will regulate operators which fall within the new regime. The paper is revealing in its ambition and focus.
The approach taken by many regimes is to focus on the anti-money laundering aspects of crypto regulation. In the UK, for example, companies will need to register if they intend to operate a crypto asset business, which in turn will bring them within scope of Money Laundering Regulations. At the end of March 2023, the government published its new three-year economic crime plan, which included a proposal to robustly regulate crypto and fight illicit use of digital assets. In Hong Kong, the SFC is arguably going at least one step further.
“The biggest concern seems to be for investor protection,” says one lawyer at an American firm in Hong Kong. “This is reflected in the requirements for keeping client assets safely or restricting access to certain kinds of crypto tokens, for example. This is in place to protect the end consumer.”
Having previously lagged behind its traditional rival Singapore, which was an early mover to licensing crypto platforms, Hong Kong has now proposed a regime which could be seen as more developed. The SFC appears to have bided its time and learnt lessons from high profile events such as the collapse of FTX and Terra/Luna. The SFC’s paper, for example, sets out the kind of requirements for better custody which perhaps could have prevented or slowed the collapse of FTX.
“The Hong Kong regime is very much geared to what we can learn from the lessons of the past so that licensed businesses will realistically and more safely be able to offer services to the person on the street,” says the lawyer.
How will we all cope?
But are traditional financial sector regulators such as the SFC ready to regulate this still-young sector? There is not a straightforward answer to this question – but in reality there may not be much choice. It will always be the case that governments, and their regulatory agencies, will want to maintain control over money supply and fiscal policy. It may be that the eventful year we have experienced has helped enhance regulators’ experience and maturity.
“They have the benefit of hindsight now … it always sharpens your mind when you’ve seen bad times,” one lawyer comments.
We are now much more educated and the same is true of the regulator, which has had time to study the market, understand the global regulatory framework, and fully plan the future of the regime.
“We see the SFC has come a long way compared to a few years ago – both in their interactiveness with market participants and their knowledge,” says Joshua Chu, a Hong Kong-based lawyer and regulatory and compliance consultant. But Chu also warns that the regulator could be facing a heavy workload, with around 80 potential applicants already lining up.
“ The recent failures of the crypto exchanges led to a banking contagion, which at the same time exposed that this is an area where the industry has not got it quite right.” “While no bank will have enough liquidity to out-run investor confidence, good sensible and timely regulations that have been tried and tested may be what is needed,”
Kate Wombell, Chief Compliance Advocate at Reglex
As for the crypto companies themselves, many will find compliance becoming one of their biggest costs, and will struggle with the increased burden, while some simply may not be capable of devoting sufficient resources to compliance. This may act as a kind of natural selection process.
“There will be two sides – it will clean up the mess, but it will also make it harder for companies to run their BAU processes,” says KC. “This could make the less shrewd companies shut down – the ones who just want to make quick money. On the other hand, it may be onerous for smaller companies.”
Whenever there are new regulatory requirements there will always be higher compliance costs, around introducing new systems and controls for example. But this could lead to a kind of natural selection in the market, as smaller or less-committed businesses depart leaving behind more reliable players.
“I’m sure there will be people who’ll decide they’d rather exit than go through the whole cost, but the regulator will not be too bothered about that. Their purpose is to ensure that the ones who do stay will be the good players, with resources, who don’t collapse or disappear,” says a commentator from an US firm.
Chu agrees, saying that although regulations will likely lead to a burden on licensed entities, this burden comes with accountability and trust. “The virtual asset market is still relatively small now – hopefully these regulations can help make it mainstream, and expand the industry.”
Kate Wombell, Chief Compliance Advocate at Reglex, comments, “The recent failures of the crypto exchanges led to a banking contagion, which at the same time exposed that this is an area where the industry has not got it quite right.”
“While no bank will have enough liquidity to out-run investor confidence, good sensible and timely regulations that have been tried and tested may be what is needed,” she continues.
Fiduciary and regulatory responsibilities for directors and C-suite executives who are properly qualified to understand risks and manage finances have been in place from day one in the financial services sector. In Wombell’s opinion, this should remain the basic tenet for licensing so as to provide safe and well functioning financial markets and consumer protection. “These are mandates that can be found in almost every regulator in the world. Regulators will soon stop navel gazing about licensing and regulatory scopes,” she says.
It would therefore seem wise for newcomers to this environment to keep informed of the impending new requirements by taking advantage and benefit from compliance providers in the RegTech industry.
“At Reglex, we believe in empowering compliance professionals so they can steer their parishes onto the right tracks in such innovative and exciting challenges,” says Wombell.
In Chu’s view, there are three key groups of players in the crypto market: the true DeFi Wild West, centralised crypto that will eventually be regulated (crypto exchanges, crypto payment services, etc.), and those who utilise blockchain for asset tokenization, which will be regulated where they are conducting a regulated activity. Other than the first of these, the crypto space is no more of a “Wild West” than that of the dot com domain space, Chu says.
While many strident voices continue to speak out against crypto, even in its more regulated form (a recent Financial Times opinion piece warned against what the writer described as the plague of “sensible crypto”, including political leaders and financial sector executives people who” lend credibility to a high-risk, opaque and ill-understood industry”) what is clear is that there is huge public interest in crypto. No regulators can realistically ignore that.
“Once more and more people understand what the tech is, proper application, adoption and implementation will come about. Just like a domain without actual functioning business will be useless, so too will crypto without any substance beneath the project fade away,” Chu explains.
Governments will need to navigate a careful course as they develop further crypto and fintech regulation, and be proactive to anticipate the needs of potential investors. While crypto platforms will need tighter oversight, and regulations must be clear to provide certainty, this will need to be applied with care, and with an eye on enabling rather than stifling the kind of innovation which led to the birth of crypto assets in the first place.
“Regulate the platforms, but don’t regulate innovation. That would be the end of the movement,” says KC.
This article was written by Phil Taylor, email@example.com
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