March 2023

Global Crypto Regulation

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The state of crypto regulation is fragmented, which may localize innovation and impact regional investment returns. This month we will investigate these global discrepancies and explore how to take advantage of the evolving regulatory landscape.

In the last month, the US has become increasingly aggressive in its anti-crypto stance, resulting in the shutting down of Kraken’s staking service and the chairman of the SEC suggesting that anything other than Bitcoin is a security. On the other end of the spectrum, the Securities and Futures Commission (SFC) in Hong Kong released a consultation paper detailing a regulatory framework for digital assets in the city, including participation by retail investors. The UK has also revealed its regulatory framework for the space.

Regulating the digital asset industry is challenging. The industry is nascent, innovative and complex. The ideal law maker would understand how blockchain technology works on a foundational level, the difference between proof-of-work and proof-of-stake consensus, the distinctions between leading layer 1 and layer 2 protocols, what makes the NFT token standard different from an ERC-20 token and the historical context behind the creation of Bitcoin in comparison to Ethereum and projects that came afterwards. In addition, the law maker would have a deep understanding of securities laws and would be able to distinguish the differences and similarities between different token types and how they relate to existing asset types. This ideal law maker may not exist. A lack of education coupled with fast paced innovation means that most countries lack clear regulatory frameworks for digital asset companies, despite Bitcoin being over 14 years old. As a result, there is a tapestry of crypto regulation around the world, ranging from complete bans to varying degrees of regulation.

As the largest global economy, the rest of the world tends to watch and follow the lead of the US when it comes to regulation. Sadly, the US has failed to provide clear guidance for digital assets. To give a sense of how confused the US is, take Bitcoin as an example:

  • In 2013, the US Treasury defined BTC as a virtual currency and payment system.
  • In 2014, the CFTC defined BTC as a commodity under the Commodities Exchange Act.
  • In 2014, the IRS defined BTC as property.
  • In 2021, Congress passed an infrastructure bill that treated BTC as physical cash mandating reporting of transactions over USD10,000 in value.

For years, groups of US lawmakers have been trying to craft a regulatory framework for digital assets. So far, they have failed. As a result, the federal government in the US has opted to regulate by enforcement. This makes it challenging for crypto companies to operate in the US as there are no transparent regulatory frameworks to abide by. At this point it seems that US regulators prefer to engage in court rather than in constructive dialogue with the industry.

In the wake of the FTX debacle, the SEC has become more active in its law enforcement against crypto companies. In January 2023, charges were made against Gemini and Genesis relating to the unregistered offer and sale of crypto asset securities through the Gemini Earn platform. Then in February there were two significant actions taken by the SEC. The first was against Kraken and more broadly was a stance against staking in the US. The second was against Paxos and an indirect (but not so subtle) shot against Binance. It is worth digging into these two enforcements and their implications.

On February 9th, the SEC charged Kraken (a leading US cryptocurrency exchange) with “failing to register the offer and sale of their crypto asset staking-as-a-service program.” The outcome of this was that Kraken settled with the SEC for USD30m and immediately shut down its staking service in the US. Interestingly, there was dissent within the SEC when this action was announced. SEC Commissioner Hester Peirce (a known crypto supporter) publicly dissented from the action taken against Kraken, stating that registration was not possible and that “crypto-related offerings are not making it through the SEC’s registration pipeline.” This was echoed by the founder of Kraken, who confirmed that there was no way for the company to register.

The second major US regulatory action took place on 12 February, when the SEC issued a Wells notice to Paxos regarding the regulator’s plan to sue Paxos for violating investor protection laws. Specifically, the letter claims that the stablecoin Binance USD (BUSD), issued by Paxos, is an unregistered security. This resulted in Paxos immediately terminating its relationship with Binance even though it “categorically disagrees with the SEC staff because BUSD is not a security under the federal securities laws”.

There are three conclusions that can be drawn from these enforcement actions in the US:

  • For now, it appears that US regulators would rather regulate through enforcement rather than through regulatory frameworks and guidance.
  • The SEC considers stablecoins to be securities due to similarities with money market accounts and money market mutual funds.
  • Any staking or interest-bearing products in the US may be labelled by the SEC as securities.

While the US regulatory environment is tightening, other parts of the world are becoming more accommodating to digital assets. In February, the SFC in Hong Kong released a consultation paper detailing a regulatory framework for digital assets. The document outlines a range of approaches to regulating digital assets, including proposals for licensing trading platforms, setting standards for disclosure and implementing investor protection measures. This development is hugely positive and has been welcomed by digital asset businesses and the broader crypto community in Hong Kong. It is also highly likely that the Chinese government gave direct or tacit approval for this regulatory framework to move forward. This could point to a softening of China’s stance as it relates to digital assets in the longer term.

Over in Europe, the UK government announced in February that it plans to regulate crypto under its existing financial services regime. Under the proposals, crypto will be subject to the UK Financial Services and Markets Act and will be under the remit of the UK Financial Conduct Authority. The government has stated that it is aiming to strike a balance between managing consumer risk and creating an environment that will allow for innovation and growth. The focus of this regulation appears to be on activities rather than specific assets and brings the UK more in line with the EU in its approach to the space.

Europe itself has two pieces of policy due to go into effect by 2024; Markets in Crypto-Assets (MiCA) and the Transfer Funds Regulation (TFR). These bills are the result of three years of discussion and are broadly positive in bringing clarity to the space. Most of the regulation is focused on centralized entities such as exchanges, which will be required to have a real presence and management in the EU. Exchanges will have to segregate client assets and will be liable for damages or losses caused by hacks or operational failures. Given the fallout of FTX, this all looks sensible. DeFi regulation is being kicked down the road for the time being, although the early discussion around this is encouraging and includes voluntary supervision and on-chain monitoring.

Global crypto regulation is not homogenous and is unlikely to become uniform in the short to medium term. Geopolitical motivations may also play a role in the creation of conflicting crypto regulations. If the US continues to tighten its stance on digital assets, then other countries may loosen to attract the industry to build inside its borders. As Silicon Valley became the heartland of web1 and web2, there could be significant riches for the victors that are able to foster a web3 nirvana.

Regional regulatory discrepancies offer up regional investment opportunities. As a company with offices in North America, Europe and Asia, we are well placed to take advantage of this regulatory arbitrage. RegTech (regulatory technology) companies looking to provide compliance software are likely to become desirable in tightly regulated markets. Conversely, innovative products are likely to be attracted to more open and accommodating markets. We can scour the market globally and we look forward to supporting successful companies that fit their own regulatory environment.

At CMCC Global, we have always been in favour of regulation and clear guidance for our portfolio companies. Being regulated by the SFC in Hong Kong via our subsidiary Fintech Investment Group, we know firsthand how important regulatory clarity is. Whilst we believe strongly in the positive disruption that crypto and blockchain technology will empower, we understand that some governments will choose to stifle innovation to protect citizens and themselves. What is important is that the guidelines are clear; well-defined regulation boosts investor confidence and helps drive innovation. With that in mind, we are encouraged by the recent consultation released by the Hong Kong government and look forward to a well-defined and clearly regulated crypto market evolving and thriving on our home turf.