Digital assets markets – which include cryptocurrencies, stablecoins, and other assets – have undergone a rapid expansion in the post-2020 landscape, marking a valuation trajectory from under $17 billion in 2017 to an astonishing $3 trillion by 2021. This spectacular growth, however, was followed by a sharp decline, resulting in very high volatility in the market ever since. Among the factors that explain these abrupt changes are regulatory shifts such as China’s ban on cryptocurrencies in May 2021, a perceptible change in market sentiment, and the onset of global inflation starting in the first quarter of 2022. These combined factors all led to a sharp market downturn of more than $1 trillion by the middle of 2022, a phenomenon known as crypto winter, and from which markets have only partially recovered their value.
In terms of the adoption of digital assets, the user and investor base has expanded significantly from only 0.5% of the global population back in 2017 to 3.4% by 2022, and, according to some market estimates, it is projected to incorporate more than 300 million new users in the next two years to reach over 4% of the global population by 2025.
The number and variety of digital assets have also multiplied in less than a decade. There were no more than 100 in 2013 and the number now exceeds 16,000. Furthermore, despite the high attrition rate of these assets, new ones continue to enter the market, around ten new assets each day according to the European Central Bank. It is relevant to note, however, that market concentration is markedly skewed, with the top 10 assets accounting for nearly 80% of the entire market capitalization.
Against this backdrop, there is growing consensus about the need to regulate the digital assets ecosystem. When Facebook (now Meta) announced the Libra project in 2019 and its potential base of more than two billion users, policymakers took note. It became clear that digital assets had the capacity to not only make a systemic impact on the market but to do so at speed. There have since been additional episodes that have enhanced the urgency of regulation, for example the first major crash of an algorithm stablecoin, Terra, and the high-profile collapse of one of the biggest exchanges, FTX. Indeed, the industry has raised concerns about the lack of transparency – in regard to the information provided, for example – and the need for regulation to provide stability and market certainty.
While obviously necessary such regulation is also challenging, thanks to the digital assets’ use of decentralized technologies rather than the traditional centralized context. Additionally, the use of open-source platforms, combined with the borderless nature of their application and the fast and constantly-evolving landscape, further compounds the complexity of regulatory efforts. One of the first challenges that any global approach to regulating digital assets faces is the lack of homogeneous definitions and classifications. There are significant variations in their typology across constituencies, regulatory bodies, market participants, and analysts.
A second challenge to regulation is the absence of complete and coherent data. As the International Monetary Fund has raised on several occasions, the lack of homogeneous data disclosure standards by the different digital asset exchange platforms makes it extremely difficult to analyze aggregate data, which could give a comprehensive perspective and guide the direction of regulation. This is further complicated by the fact that a significant part of transactions is processed in “off-chain mode,” i.e., outside the blockchain.
A related challenge to the lack of comprehensive data is the difficulty of analyzing the systemic impact of digital assets and the contagion across different asset classes. Early analyses point out that the increase in digital asset adoption, especially since 2020, and the growing participation of institutional investors have led to instances of consistent positive correlations with stock indexes. This suggests the potential for contagion effects beyond the realm of digital asset classes.
A fourth challenge stems from the borderless nature of digital assets, which allows for regulatory arbitrage and significantly reduces the individual oversight capacity of countries, thus making the case for a global regulatory approach. However, the fact that monitoring, supervision, and enforcement are mostly fragmented across jurisdictions means that a coordinated global approach is particularly complex.
As the number of investors in the crypto space has increased, other important questions have come up on how to maintain consumer and investor protection.
When embarking on the regulation of digital assets, national authorities aim to achieve key regulatory objectives such as maintaining financial stability, ensuring investors protection – especially retail investors – and preventing money laundering and financial crime. Additionally, regulatory efforts focus on ensuring a legal certainty that encourages responsible innovation, facilitates effective risk monitoring, and promotes the adoption of international best practices and cross-border cooperation.
Despite these commonalities, however, the approaches taken to reach these regulatory objectives differ across jurisdictions. In some cases, regulators and policymakers have opted for principle-based regulation, concentrating on the results and expected outcomes, rather than prescribing detailed rules. This is the approach taken by the UK to determine the requirements for asset custodians. Another followed by many regulators is the risk-based approach, which establishes a level of intervention in accordance with the level of risk. We can find one example of a risk-based approach in the higher compliance requirements for service providers in Singapore, while the less sophisticated is the retail client. In other cases, when the regulator would like to encourage innovation, an agile approach is the most appropriate, and this often includes the issuance of guidelines, the acceptance of no-objection letters, or the establishment of regulatory sandboxes.
Various jurisdictions typically regulate the following: the establishment of licensing and registration regimes for exchanges, custodians, and other intermediaries; the extension of AML/CFT requirements for crypto activities; the development of regulation or guidance for marketing and promotion of digital assets; the issuance of regulation for stablecoins, including particular requirements for the definition of reserves or redemption rights; the inclusion of particular provisions to ensure consumer and investor protection; and clarifications to the tax treatment of digital assets. Generally, regulations pertaining to decentralized finance (DeFi) are still in the consultation phase in select countries and have not yet been regulated.
In terms of the competent authorities in charge of digital assets regulation and the oversight and surveillance of crypto assets service providers, most countries have incorporated this authority in established regulators, although in some cases there is still internal discussion on the assignment of responsibilities. The United Arab Emirates was the first country to set a dedicated authority in charge of virtual assets regulation, with the Virtual Assets Law in March 2022 that granted extensive powers in the matter to the newly created Virtual Assets Regulatory Authority (VARA).
Notably, in 2023, Europe approved the first cross-jurisdictional regulatory and supervisory framework for digital assets – the Markets in Crypto-Assets Regulation (MiCA). This comprehensive regulation covers both issuers and service providers, with the aim of protecting consumers and investors while ensuring financial stability and fostering innovation. This regulation is expected to take effect between mid-2024 and early 2025 and will provide legal clarity in Europe, establishing an attractive framework for crypto activities.
International financial institutions such as the IMF have very clearly justified, on several occasions, that we need a global and coordinated approach to the regulation of digital assets. The growing size and adoption of digital assets, coupled with their increased interconnection with traditional financial systems, has pushed global regulatory standard-setters to expedite the release of guidelines and recommendations that can help preserve financial stability and encourage a global coordinated regulatory response.
Highlights among the main global regulatory efforts include the Financial Stability Board framework and recommendations for global regulation of crypto-asset and stablecoins, first drafted in 2022 and finalized in July 2023. Banking supervisors are also coordinating their efforts through the Basel Committee on Banking Supervision (BCBS), which published its final rules in the prudential treatment of banks’ crypto assets disclosures in 2022. Concerning AML/CFT recommendations, the Financial Action Task Force (FATF) updated its guidelines in 2021 for a risk-based approach to virtual assets and virtual assets providers. And finally, in 2022, the global standard-setter for securities market regulation, IOSCO, issued both a report clarifying the application of the Principles for Financial Market Infrastructures to stablecoin arrangements and a Crypto-Asset Roadmap, including workstreams in crypto and digital assets and DeFi.
Distributed Ledger Technologies have enabled an unprecedented wave of innovation in the financial sector, giving rise to a new set of assets that are grouped under the general concept of digital assets. Most of these innovations have started occupying spaces outside the boundaries traditionally regulated. However, the speed of growth of these kinds of assets and the increased adoption have raised concerns over their potential interconnectedness and the implications for financial stability. Additionally, as the number of investors in the crypto space has increased, other important questions have come up on how to maintain consumer and investor protection.
The winds of regulation moving around digital assets are strong and in the last few years more and more countries have chosen to issue regulation. Yet, still, the debate around the regulation of digital assets is far from closed. Regulators and policymakers need to keep moving forward in this regard, and quickly, because the technology continues to evolve and the use cases to multiply. It’s time for regulation to catch up.
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