Regulating Digital Assets: Fitting a Square Peg in a Round Hole

This explainer is a collaboration between the Tony Blair Institute for Global Change (TBI) and FS Vector (FSV), an advisory firm at the forefront of financial innovation and the novel legal, regulatory, technical, and business issues that ensue. 

The growth of the digital assets industry and the proliferation of uses for the underlying blockchain technology brings important benefits, such as efficiency gains, increased transparency, and potentially more equitable access to a new asset class. However, digital assets and the technological innovations that enable them also pose risks to consumers, investors, and issuers. How should regulators approach the variety of digital assets being developed at a startling pace? 

Before we address this question, we’re reminded of the childhood game in which you fit a certain shape into the right hole, and the frustration when the shape wouldn’t fit.  We are now playing this game in the financial services industry - regulators are attempting to create or use the existing shapes while innovators are quickly developing new shapes.

This is not the first time we’ve seen a significant shift in the financial industry.  With each evolution, however, the industry encounters a regulatory environment not necessarily built nor prepared for change.  Regulators don’t test and hope to fail only to test again - rather, regulators develop regulations slowly and deliberately. But within the time it takes to develop new regulations, innovators continue to innovate. And in the context of digital assets, innovations are occurring at breakneck speed. The result is often an unbalanced system - a box where shapes do not fit.  

The term “digital assets'' is very broad. Many will instantly recognise Bitcoin, but this is just one of many cryptocurrencies.  Today, there are over 12,000 different cryptocurrencies with a total market cap of $2.6 trillion - enough to be the 8th largest economy worldwide by gross domestic product. The number of cryptocurrencies is only growing as more players enter the industry. Further, cryptocurrencies are just one of multiple different types of digital assets.

Figure 1

Fig. 1: A Taxonomy of Digital Assets

A blockchain represents a transparent and decentralized way of recording transactions, both financial and non-financial. Technically, a blockchain is a distributed database of records or public ledger of all transactions or digital events executed and shared among participants. One of the key characteristics of blockchain is this decentralized nature, which can be attributed to the peer-to-peer networks that support it.  Each transaction is verified by a community - miners work either together or individually to verify the transactions and create a record of those transactions, obviating the need for an institution (such as a bank) to perform this function.

Blockchain is not new - and it’s not only associated with digital assets.  The financial services industry also uses blockchain for authentication purposes or for digital identification.  Blockchain can be successfully applied to non-financial applications too. Recently, we’ve seen the use of blockchain during the pandemic, particularly in the area of distribution and management of the COVID-19 vaccine. In the US, the State of Illinois has its own Blockchain Initiative to use blockchain to enhance storage and security around birth or death certificates, social security numbers, or voter registration cards. The underlying technology of blockchain allows for its many applications because it doesn’t require a third party, making it easier for people to secure data and reduce fees of traditional services such as notarization fees and cloud storage costs.

Blockchain essentially cuts out the middleman, which in traditional financial services are institutions that verified or otherwise brokered transactions. “Cutting out the middleman” is not something the traditional financial services industry is comfortable with - or more importantly, that regulators fully understand.  Regulatory mindsets focus on how to protect the market and the underlying consumer or investor.  If there’s no middleman, there’s no stopgap, no single company to go to fix the problem or stop the problem when the market needs intervention. Now, policymakers must determine how best to protect markets and people in a system without traditional intermediaries. 

We are now at a tipping point.  Innovation continues to grow in this industry - yet, regulation has stagnated. In the US, the latest and largest financial services overhaul was in 2010 with the Dodd-Frank Act.  To put it in perspective, Bitcoin was proposed in 2009.  Crypto exchanges were created in 2012.  Today, there are over 221 million crypto users worldwide, up from about 5 million in 2017 - a 4,320% increase. In that time, the global crypto market cap has increased by 17,552%, from $16.429 billion to $2.9 trillion. The most recent financial services regulatory update was only 11 years ago - but within two years of its enactment, it was already out of date with the latest innovations in the marketplace.   This highlights the importance of creating a regulatory environment that can evolve along with technological innovation - namely, principles-based regulation. 

Principles-based regulation is just that - establishing principles within the regulation that protect consumers or investors and provide clear regulatory guardrails. Principles-based regulations are drafted at a high level of generality to maximize flexibility; focus on objectives or outcomes rather than specific conduct; include qualitative rather than quantitative terms; and can be supplemented with other forms of rules and guidance. When contrasted with traditional rules-based regulation, they can be simpler, more flexible, and facilitate better supervision and cooperation. While rules-based regulations are more appropriate in some contexts, like investor or consumer protection, principles-based regulations have proved particularly useful in financial regulation of rapidly innovating areas, such as the regulation of derivatives by the CFTC.

Some principles that a cohesive digital assets regulatory regime should include are:  classification of digital assets - focusing on their underlying functions in order to determine who can best regulate the asset; consumer and investor protections; and transparency - ensuring that a consumer or investor of a digital asset knows what they are buying or investing.  

How are regulators approaching this rapidly changing and expanding market? The answer is, unfortunately, different depending on your geography.

For example, the UK, Switzerland, and Gibraltar have “one-stop shop” financial regulators to supervise crypto markets. This type of regulation is seen as a “friendly” approach to regulating crypto because it provides structure and clarity for those in the industry. The Swiss Financial Market Supervisory Authority (FINMA) and the UK Financial Conduct Authority (FCA) both provide a regulatory framework for certain aspects of crypto markets, which are overseen by the sole regulator. 

In other countries, various regulatory bodies have teamed up. For example, the Japanese Financial Services Authority is working with the Japan Virtual Currency Exchange Association to oversee digital asset-related activities. Japan’s developed regulatory regimes for cryptocurrencies cover everything from traditional AML/CFT compliance requirements to categorizing and defining different types of crypto assets for tax reporting purposes. 

As many countries develop regulatory frameworks for crypto, some have employed more extreme, sweeping measures for the fast-growing industry. China recently outlawed crypto mining and declared all cryptocurrency transactions illegal. This decision by the Chinese government was not shocking to the industry given China’s vision for a state-dominated economy and the distributed nature of crypto, which is successful because of its decentralized, borderless backbone. Other countries have taken a much more welcoming approach to crypto, including El Salvador, which became the first country to adopt Bitcoin as legal tender. 

Many regulatory frameworks for crypto fall somewhere in between total acceptance and official forbiddance, including the US, which relies on over ten regulatory agencies to oversee crypto-related activities. 

Two specific types of digital assets have been top of mind for US policymakers:  stablecoins and CBDCs. Recently, the President’s Working Group on Financial Markets (PWG), comprised of financial regulators, acknowledged the rapid growth of stablecoins and published a report detailing the risks and opportunities of their adoption. The report identifies the need for Congressional action to help the financial regulators govern those that issue and/or hold stablecoins. CBDCs have also been in the forefront of discussions. The Federal Reserve is expected to launch a detailed review of the risks and benefits of issuing a US CBDC, as central banks around the world experiment with CBDCs.  

Invest in education.  Communicate with innovators and fellow regulators.  Advance principles-based regulation.

First, education is key.  Regulators and policymakers must learn about blockchain and digital assets through in-depth reviews of the technology itself.  They should learn from the innovators themselves, who can answer the questions of why now and what role this technology plays in the industry.  

There must also be a constant dialogue between innovators and regulators.  By hearing from innovators directly, especially those working with crypto products, regulators and policymakers can better understand the benefits of integrating these products into traditional financial arrangements. Many financial regulators around the world have created innovation offices to be a nexus for innovators and regulators to have these discussions. The Global Financial Innovation Network is an organisation of these offices that share their knowledge and expertise to fellow regulators, fostering innovation and education. 

Prescriptive regulations in the financial services industry will not work for this dynamic asset class. Rather, regulators should embrace a principles-based approach that sets out parameters and guardrails. In doing so, regulators will be able to easily adjust to the ever-changing and evolving industry and innovators will be able to build their products in a way that continues to address regulators’ concerns of market integrity and consumer/investor protection.

With this fresh outlook, regulators and policymakers will be able to identify how best to fit today’s shapes into yesterday’s puzzle box - by creating the new puzzle, regulators will create a fluid boundary in which innovation can thrive and people and markets are protected, regardless of the ever-changing nature of the technology itself.