Banking on crypto: How far should regulators go?

Such is the volatile nature of cryptocurrencies that the market can all too easily enter one of its periodic downturns — what’s referred to as a “crypto winter.” This happened at the end of 2021, and as we write this article, when a mixture of adverse macroeconomic conditions and the failure of major crypto projects injected a negative sentiment into the market.

Banking on crypto: How far should regulators go?

The market saw Bitcoin’s price drop 65% from its November 2021 high of $69,000, wiping $2 trillion off the crypto market’s collective worth – according to a recent Arthur D Little report on crypto.

Adding to the volatility were large, high-profile purchases and sales like those of Tesla, which in July 2022 offloaded three-quarters of its $2 billion holding in Bitcoin. Previously, CEO Elon Musk had been one of cryptocurrency’s major cheerleaders, with his social media pronouncements often driving surges in trading.

Regulators! Mount up

Not surprisingly, risk-averse regulators view such volatility with concern, mindful that the crypto market is bigger than the subprime mortgage market was when it triggered the global financial crisis of 2007-2008.

So, when crypto was just an esoteric “topic of interest,” it could be comfortably ignored because traded volumes were light, but that has changed and now it has become a potentially troublesome, heavyweight problem lurking just over the horizon.

In a recent speech, Fabio Panetta of the European Central Bank (ECB) categorized crypto as a “Wild West” investment, describing market activity as a “digital gold rush beyond state control.”

Regulatory authorities like the Basel Committee on Banking Supervision (BCBS) have already signalled their worries that crypto assets might adversely impact banks’ liquidity and risk — market, credit, operational, legal, and reputational — and, consequently, the stability of the entire financial system.

Headlines such as “How $60 Billion in Terra Coins Went Up in Algorithmic Smoke” do little other than create a sense that cryptocurrencies are built on shaky ground. The International Monetary Fund (IMF) has commented that: “Crypto-assets are potentially changing the international monetary and financial system in profound ways.”

US Federal Reserve Vice Chair Lael Brainard is someone who has voiced concerns when she said: “It is important that the foundations for sound regulation of the crypto financial system be established now before the crypto ecosystem becomes so large or interconnected that it might pose risks to the stability of the broader financial system.”

How much is enough?

And this takes us to the centre of the crypto conundrum: regulation. And, most particularly, how much there should be and what form it should take.

Some countries, such as China, Indonesia, and Turkey have banned cryptocurrency transactions outright, citing concerns not just over financial instability but also the use of cryptos for money laundering and terrorist financing. How valid are such concerns? It is difficult to say.

While crypto has long been considered a hotbed of criminal activity, in reality, this could be overstated.

Research by blockchain data platform Chainalysis suggested it accounted for under 1% of total crypto activity between 2017-2020.

Whether or not this figure is accurate, the truth remains that better know-your-customer (KYC) regulations, periodic reporting, and greater penalties for violations will help dampen bad actor events. This, in turn, will increase trust in cryptocurrencies.

Rather than banning crypto, most countries are taking a more pragmatic view by seeking to find ways to better manage its impact.

So, driven by Europe, and especially the MiCA initiative, efforts have begun to develop a globally coordinated regulatory approach to crypto assets, improve levels of transparency, and establish new codes of conduct and standards for disclosure and reporting.

The Financial Stability Board (FSB), the Basel Committee on Banking Supervision (BCBS), the Committee on Payments and Market Infrastructures (CPMI), the Financial Action Task Force (FATF), and Germany’s Federal Financial Supervisory Authority (BaFin) are some of the key authorities working on the effort.

These discussions tend to focus currently on limiting exposure to unbacked cryptocurrencies and setting specific capital requirements for different types of crypto assets.

They also cover areas such as the taxation of crypto assets, strengthening public disclosure and reporting, transparency levels and standards of conduct, as well as anti-money laundering (AML) solutions and combatting the financing of terrorism (CFT).

For the moment, what we are seeing are ad hoc measures being taken by the likes of the Monetary Authority of Singapore, which has said it will broaden its cryptocurrency regulations so more activities are covered. This is in the light of recent failures of various crypto firms with operations in the country.

But there seems to be a growing move toward tighter regulation by governments around the world that are increasingly worried that privately operated, highly volatile digital currencies could undermine their control of financial and monetary systems.

THERE IS NO DOUBT THAT REGULATION IS COMING DOWN THE LINE

Other nations are now starting to take stronger action against what they see as infringements. As an example, the world’s largest crypto exchange, Binance, was fined $3.4 million by the Dutch Central Bank for operating without authorization in the Netherlands.

There is no doubt that regulation is coming down the line. As Securities and Exchange Commission (SEC) Chair Gary Gensler has pointed out, “Few technologies in history, since antiquity, can persist for long periods of time outside of public policy frameworks.”

The debate will surround the level of regulation that is needed, whether existing rules are being applied, and if the best way to actually supervise the activities of coin issuers is to bring them into the banking system, as some argued in testimony to the US Congress’s House Financial Services Committee in December 2021.

Since then, the US Federal Reserve has issued guidance to banks that might be considering any cryptocurrency activity, making clear that they must notify the authorities of their intentions and make sure that what they are doing is legally permitted.

Given the significant fines previously meted out to those considered in contravention of AML, taxation, and consumer protection rules, financial institutions operating in the “gray zone” do so at their peril.

For their part, banks would welcome clear regulations to enable them to move forward with confidence, rather than overstepping the mark or holding back for fear of making a mistake.

Ultimately, there may be no consensus on regulation, with some regions opting to go light on regulation in an attempt to gain economic advantage, or even doing so at a local level. For example, New York City Mayor Eric Adams is intent on transforming the city into a hotspot for cryptocurrency.

So, while strong reservations remain, there is a growing recognition that crypto is here to stay, though as yet only two countries, both small and with no fiat currency of their own, accept crypto as legal tender.

The Central African Republic (CAR) started doing so this year, and El Salvador began accepting Bitcoin in 2021.

While it is too early to assess what is happening in the CAR, El Salvador’s Bitcoin experiment is perhaps not going well.

Plans to build the world’s first cryptocurrency city have stalled, and the use of cryptocurrency has failed to catch on.

One survey shows that just one-fifth of Salvadorans have downloaded the government’s Bitcoin digital wallet (Chivo) and continued to use it after spending the $30 it came loaded with.

And while the government has encouraged Salvadorans abroad to send money home through Chivo, only about 2% of remittances between September 2021 and June 2022 were through the wallet.

Despite such apparent setbacks, the government of President Nayib Bukele says its Bitcoin policy has attracted investment, reduced bank commissions to zero, increased tourism, and promoted financial inclusion.

In contrast, the IMF says El Salvador should revoke Bitcoin’s status as legal tender because of financial, economic, and legal concerns.

MANY CENTRAL BANKS ARE NOW EXPLORING THE IDEA OF ISSUING A DIGITAL CURRENCY THAT THEY WILL REGULATE

While making privately owned cryptocurrencies legal tender is still a step too far for most countries, many central banks are now exploring the idea of issuing a digital currency that they will regulate: centralized bank digital currencies (CBDC).

A survey by the Bank for International Settlements (BIS) found that 81 were developing projects in this area. China is testing a “digital yuan,” while Nigeria has the e-Naira and Jamaica the JamDex.

With over half of the world’s top banks taking a growing interest in cryptos, after years of resistance the tide may be turning.

Even BIS, which has always viewed crypto with some skepticism, is saying that it may allow banks to hold up to 1% of their reserves in Bitcoin and other cryptocurrencies.

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