The past few months have seen several developments in the world of crypto regulation. Financial regulators – particularly in the US – have come down hard on crypto firms they feel have been flouting the rules. In our latest report, we take a look at the current approaches to crypto regulation around the globe and how this may impact where firms choose to do business.
The collapse of FTX and its impact on the crypto market
Cryptocurrencies have been around since January 2009 when Bitcoin, the world’s first ever cryptocurrency, was created by an anonymous programmer (or several programmers) using the pseudonym Satoshi Nakamoto. Nakamoto also built the blockchain technology which is now the basis for every crypto currency ledger in the world. In the 14 years since, Bitcoin has been hailed several times as “the year’s best investment.” But it has also seen dramatic declines in value after major incidents such as the Mt Gox crypto exchange hack in 2014, and more recently, the collapse of FTX and its sister company Alameda Research in 2022.
What happened at FTX?
FTX was launched in 2019 by 30 year-old entrepreneur and investor, Sam Bankman-Fried. The firm described itself as a “cryptocurrency exchange, built by traders, for traders” and said it strived to provide a platform “robust enough for professional trading firms and intuitive enough for first-time users.”
After a meteoric rise, the firm went into meltdown after rumours circulated suggesting that Alameda Research’s reserves were heavily based on FTT, a token created by FTX, its own “centrally controlled and printed out of thin air token,” in the words of Swan Bitcoin CEO, Cory Klippsten. A few days later, Binance announced it was selling its FTT holdings and Bankman-Fried and Binance CEO Changpeng Zhao had a public row via Twitter. Another few days after that, in a major u-turn, Binance offered to bail out FTX when it became unable to pay its customers back as they scrambled to sell their shares. However, the deal was quickly withdrawn when the dire financial situation at FTX was exposed via a corporate due diligence review.
Two days later, FTX filed for Chapter 11 bankruptcy, and Bankman-Fried resigned as its CEO. Alameda Research also filed for bankruptcy and insolvency expert lawyer, John J Ray III, who was also involved with Enron post-bankruptcy, was appointed as CEO of FTX to manage the bankruptcy process.
According to court documents, in the days leading up to the filing, concerns were being raised about Bankman-Fried’s leadership and his handling of the “complex array of assets and businesses” he was responsible for. As the situation became “increasingly dire,” administrators were brought in and the Bahamian regulators froze the assets of FTX’s Bahamas-based operation.
In court documents, Ray claimed FTX “did not keep appropriate books and records, or security controls, with respect to its digital assets.” Unacceptable management practices cited by Ray included “the use of an unsecured group email account as the root user to access confidential private keys and critically sensitive data for the FTX Group companies around the world, the absence of daily reconciliation of positions on the blockchain, the use of software to conceal the misuse of customer funds, the secret exemption of Alameda from certain aspects of FTX.com’s auto-liquidation protocol, and the absence of independent governance.”
Commingling of funds
Details of what happened at FTX are still unfolding. On June 26th 2023, a second report was released by the firm and its debtors, detailing the commingling and misuse of customer deposits by Bankman-Fried’s management team. “The image that the FTX Group sought to portray as the customer-focused leader of the digital age was a mirage,” says Ray in the report. “From the inception of the FTX.com exchange, the FTX Group commingled customer deposits and corporate funds, and misused them with abandon at the direction and by the design of previous senior executives. We will continue to report our analysis and findings as our work progresses, and remain committed to recovering as much value as possible for creditors.”
The regulators strike back
Since the dramatic demise of FTX, US regulators have set about trying to create a regulatory environment that mitigates the risk of such a collapse happening again. Two huge players in the world of crypto: Binance and Coinbase, were both hit with legal action by the US Securities and Exchange Commission (SEC) in June.
Binance SEC action
Binance, the world’s largest crypto exchange, has been a key focus for US regulators in recent years. The SEC has accused the firm, and its founder, Changpeng Zhao, of engaging in an “extensive web of deception, conflicts of interest, lack of disclosure, and calculated evasion of the law.” The agency claims Zhao and Binance “misled investors about their risk controls and corrupted trading volumes while actively concealing who was operating the platform, the manipulative trading of its affiliated market maker, and even where and with whom investor funds and crypto assets were custodied.”
The regulator also accused the firm of attempting to evade the law by “announcing sham controls” which, the regulator claims, were just for show and were not adhered to behind the scenes. “The public should beware of investing any of their hard-earned assets with or on these unlawful platforms,” it added.
Coinbase SEC action
The SEC is also suing Coinbase for operating its crypto asset trading platform as an unregistered national securities exchange, broker, and clearing agency. It has also charged Coinbase for failing to register the offer and sale of its crypto asset staking-as-a-service programme.
Potential legal issues have been looming over Coinbase ever since it started publicly trading shares in the US more than two years ago. At the time, the firm said there was a “high degree of uncertainty” surrounding the legality of its operations and warned that regulators might disagree with how it interpreted US financial regulation.
In March 2023, when Coinbase was first notified by the SEC of the potential legal action, the company published a blog entitled: We asked the SEC for reasonable crypto rules for Americans. We got legal threats instead. In the blog, Coinbase’s chief legal officer, Paul Grewal wrote: “We welcome a legal process to provide the clarity we have been advocating for and to demonstrate that the SEC simply has not been fair or reasonable when it comes to its engagement on digital assets.”
In another blog, published the day before the SEC’s charges were publicly announced, Grewal argued that US crypto regulation threatened to damage the US economy, putting it far behind other economies with more forward-thinking regulatory approaches to crypto. He said: “Distributed ledger and digital asset technology is, as the White House has stated, critical and foundational. Despite being identified as potentially critical to US economic and national security, the US is pushing the technology and the innovators overseas due to lack of clear rules and regulations for crypto.”
United States: predatory regulation?
The US is considered among crypto firms as one of the least crypto-friendly jurisdictions to do business, thanks to an aggressive regulatory focus on this area in recent years. “The administration really has a target on the industry,” Andrew Durgee, managing director of the crypto division for tech firm Republic, told BBC News. “Regulatory uncertainty makes investments in the US higher risk,” he added.
Lack of clarity
While regulators such as the SEC have been cracking down on crypto, it has been from the perspective of classifying crypto assets as securities – therefore giving the SEC jurisdiction. No official new rules specific to cryptocurrency and the crypto markets in general have actually been implemented in the US. There is also the added complexity of state-led versus nationwide regulation, making the US regulatory landscape a bit foggy to say the least.
US Senator (Rep) Cynthia Lummis has publicly criticised the SEC’s recent legal action against Coinbase, claiming the agency has failed to clarify rules and has not created an environment that allows crypto firms to be compliant. “The SEC has failed to provide a path for digital asset exchanges to register, and even worse has failed to provide adequate legal guidance on what differentiates a security from a commodity,” she said. “Real consumer protection requires creating a robust legal framework that exchanges can comply with, not pushing the industry offshore into the shadows.”
In June 2022, US Senator Lummis and Senator Kirsten Gillibrand (Dem) introduced the bipartisan Responsible Financial Innovation Act, which they say is aimed at providing a framework which “encourages responsible financial innovation, flexibility, transparency, and robust consumer protections while integrating digital assets into existing law.” If passed, it would provide the first ever comprehensive regulatory framework for digital assets in the US.
MiCA – Markets in Crypto Assets Regulation
In the EU, more tangible progress has been made towards a standardised regulatory framework for digital assets than in the US. The Markets in Crypto Assets Regulation (MiCa) was officially published on 9th June 2023 and will begin to come into play next year.
“The provisions on e-money tokens and asset-referenced tokens will become applicable 12 months after the [MiCA] regulation enters into force,” says Lexology.com. “This means that the provisions designed to regulate stablecoins will start applying from 30 June 2024. With respect to the other provisions, specifically those regulating crypto-asset service providers, they will start applying 18 months after the Regulation enters into force. This sets the date for these provisions to start applying as 30 December 2024.”
The European Banking Authority (EBA) will be establishing draft regulatory technical standards, forms, templates and procedures to allow communication and cooperation between authorities responsible for regulating the crypto markets. The EBA will also be publishing guidelines “specifying the criteria and elements that crypto-asset service providers should consider when conducting assessments and risk mitigation measures.”
Latin America and the Caribbean
Latin America and the Caribbean are at the forefront in the adoption of crypto currencies. El Salvador was the first country in the world to make Bitcoin legal tender in June 2021 and other countries have made considerable progress in the adoption of CBDCs (central bank digital currencies.) Finding the right balance between mitigating against the risks associated with crypto currency – such as money laundering and fraud – and reaping the benefits, is the main challenge for these countries. “While a few countries have completely banned crypto assets given their risks, this approach may not be effective in the long run” said the IMF in a blog post on the topic in June 2023. “Regulation of crypto assets varies across LAC countries. While El Salvador has made Bitcoin legal tender – declared by law to be a valid payment instrument to settle transactions and financial obligations – other countries like Argentina and the Dominican Republic have prohibited the use of crypto assets due to concerns about their impact on financial stability, currency and asset substitution, tax evasion, corruption, and money laundering.”
Compared with other jurisdictions such as the US, the UK is seen by many as an attractive place for crypto firms to do business. California-based tech investment firm, Andreessen Horowitz, announced in June that it would be opening an office in the UK, attracted by its crypto-friendly approach to regulation. Chris Dixon, who is head of crypto investment at Andreessen Horowitz, wrote a blog post announcing the firm’s plans to expand in the UK. “We have been working with policymakers and regulators across the globe, and during our discussions it has become clear that the UK government sees the promise of web3, with Prime Minister Rishi Sunak suggesting the UK can become a hub of web3 innovation,” said Horowitz. “UK authorities are also willing to work with the industry to create policies that incentivize startups to pursue decentralisation. More specifically, the UK policymakers and regulators are taking an approach that is uniquely tailored to blockchain and digital asset regulation.”
Dixon praised Sunak’s government for: “Working constructively with industry to identify the unique attributes of blockchain technology and how those attributes shape the risk profile of decentralised services vs. centralised services. Laying the foundation for future applications of blockchain technology. Putting forth an innovative sandbox approach to regulation.
Focusing on an outcomes-based approach. All the while continuing to keep consumer protection front-and-centre of any regulation.” He also said that the UK has “deep pools of talent, world-leading academic institutions, and a strong entrepreneurial culture.”
The UK has proposed it will regulate crypto assets under its existing regime for financial services. This means crypto will be subject to the UK Financial Services and Markets Act 2000 and will be regulated by the UK Financial Conduct Authority. A consultation was carried out in February which built on several HM Treasury publications on cryptoassets, including a consultation into the UK’s regulatory approach to cryptoassets, stablecoins, and distributed ledger technology in financial markets last year, and a consultation on crypto asset promotions in April 2022.
One area of focus for regulators across the globe is how crypto firms advertise their products and services to the public. In the UK, the Treasury Committee recently called for crypto trading for retail customers to be regulated in the same way as gambling.
A report published by the Committee in May 2023 largely condemned cryptocurrencies, saying they have “no intrinsic value and serve no useful social purpose, while consuming large amounts of energy and being used by criminals in scams, fraud and money laundering.” The report also claims “cryptocurrencies pose significant risks to consumers, given their price volatility and the risk of losses,” and “retail trading in unbacked crypto more closely resembles gambling than a financial service.”
In the UK, from 8th October 2023, firms that promote crypto will be required to put clear warnings in place and ensure advertisements are clear, fair and not misleading, according to FCA guidelines. First-time investors will also be required to have a cooling off period and refer-a-friend bonuses will be banned.
Regulating crypto globally
In February 2022, the Financial Stability Board (FSB), which monitors and makes recommendations about the global financial system, warned that crypto-asset markets were “fast evolving and could reach a point where they represent a threat to global financial stability due to their scale, structural vulnerabilities and increasing interconnectedness with the traditional financial system.”
The G20 has tasked the FSB with creating an effective and comprehensive global regulatory framework for crypto-assets, which it consulted on last year and is due to be finalised in the coming months. The FSB is also working on a joint paper with the IMF, combining its research on crypto regulation with the IMF’s work into macroeconomic and monetary issues relating to digital assets.
The responsibility for ensuring crypto is used safely and effectively and not abused by malicious actors will come down to the work of individual governments. “Crypto-assets also raise broader policy issues,” says the FSB, “such as the need for consumer and investor protection; strong market integrity protocols; anti-money laundering and combating the financing of terrorism (AML/CFT) regulation and supervision, including implementation of international sanctions; regulatory measures to prevent tax evasion; the need to avoid circumvention of capital controls; and concerns relating to the facilitation of illegal securities offerings. These are the subject of work at national and international levels and are outside the primary focus of the FSB’s work.”
Japan is hoping to capitalise on the exodus of firms from jurisdictions like the US and China (where cryptocurrencies are banned) by building a regulatory framework designed to foster growth in this area of finance. “While many other countries are standing still and shrugging their shoulders in the face of the cold wind, Japan is positioned to play a unique role in the crypto industry,” said the ruling Liberal Democrat party’s Web3 research team in its consultation.
Japan was an early-adopter of crypto, but was scarred by the collapse of Japanese exchange Mt Gox in 2014 after a major hacking incident resulted in the theft of 750,000 Bitcoins. Then in 2018, another Japanese exchange, Coincheck, was also hacked, losing a total of US$500m worth of crypto currency. After these events, Japan’s crypto laws became so stringent, trading in the country all but stopped.
FTX’s impact on Japan
Following the hacks at Mt Gox and Coincheck, Japan introduced a law that required customer assets and exchange assets to be separated, with the majority of exchange assets to be kept in cold wallets. As a result, when FTX collapsed, its Japanese operation was left in a very different position to the rest of the business. “It is likely that FTX Japan’s Japanese customer assets will be returned without a significant impact from the Chapter 11 global bankruptcy filing,” said Ryosuke Ushida, chief fintech officer at Japan’s Financial Services Agency. “The reason why we ask for this kind of segregation of assets is because we learned our lesson from past incidents like the Mt Gox and Coincheck hacks. Fortunately or unfortunately, we got used to this kind of emergency situation in crypto. Compared to other jurisdictions, we are knowledgeable,” he added.