Cryptocurrency and ESG: the contradictions and complexities

In an age where society celebrates not only transparency but greener choices from financial institutions, cryptocurrency – an asset which sometimes contradicts both these concepts – has become mainstream. More individuals are becoming clued up on the benefits of long-term investment through the fast circulation of internet-based information. This presents a new challenge for regulators who must keep up with technological advancement whilst also protecting our economy and the masses.

Cryptocurrency was once untouched by regulators and government hands. Fast growth in technology – social apps, in particular, have aided in the popularity of cryptocurrency – unowned and uncontrolled by any government and dubbed as a glitch in the ‘matrix.’

More than one billion people in the world use cryptocurrency, and the more it is used, the greater the risks for customers, investors and asset managers – it has become a legitimate asset, but regulation is needed for it to function as such.

The noise around Environmental, Social and Governance (ESG) has increased simultaneously with cryptocurrency’s popularity, and it seems as though we are now at a crossroads – or perhaps more of a clash of two titans rather than a friendly meeting.

If society fully immerses in the realm of cryptocurrency, will it unleash Pandora’s box for regulators or can it be regulated in a way that benefits both parties – the cryptocurrency provider and the user.

For a greener, socially friendly and fairly governed financial system, regulators need to look at regulations that incorporate the three pillars of ESG. By doing so, financial systems can benefit from reduced regulatory repercussions and growth.  

Will cryptocurrency work hand-in-hand with ESG to become a supreme investment opportunity?

Investors are looking for opportunities that are environmentally and socially friendly – as well as well governed. They are much more mindful when it comes to longevity and reputation and will assess how the investment will impact their own ESG reporting requirements e.g., climate metrics. Strictly speaking, investors are leaning more toward sustainable investments rather than putting funds towards something that produces excess energy, waste or damages the environment.

Regulators have started to think of the bigger picture for crypto, although this is happening at a slower rate in regard to ESG. North America has published 7,456 crypto-related issuances such as references to Bank Secrecy Act (BSA) and Anti-Money Laundering (AML) – this has already led to some crypto providers being held accountable in the US. Governments, banks and regulators across the world are paving the way for a regulated crypto industry, however, less than 0.1% of those regulations discussed sustainability.

With ESG in the limelight, we won’t have to wait too long before regulators look at the complete ESG performance of cryptocurrency. Whilst crypto’s lack of regulation could mean it doesn’t consider ESG, with effective regulation it will need to overcome this hurdle over time.

E – Environmental

Climate change and sustainability are predominant in society – at the United Nations Climate Change Conference (COP26). 196 countries agreed to reach net zero by 2050 and a global warming target of 1.5C.

Many believe crypto to be harmless, however, there are downsides of crypto mining to the environment.

Popular forms of cryptocurrency such as Bitcoin and Ether accelerate global warming through the process of creating new coins through ‘mining.’ ‘Mining’ is the act of solving highly complex problems using supercomputers through ‘Proof of Work’ (PoW). This method is used to verify transactions without the need for a financial organisation such as a bank. As the more bitcoin is mined, the harder the problem becomes, and even more, energy is used. The electricity used by these supercomputers comes from fossil fuels, as such, it releases large amounts of carbon emissions.

The University of Cambridge found that the pride and joy of crypto, Bitcoin, was responsible for 0.4% of the world’s total energy consumption – consuming more electricity in a year than Sweden, Norway or the United Arab Emirates.

However, it’s not all doom and gloom, the shift from non-renewable energy sources to renewal sources can drastically reduce the crypto mining carbon footprint. The industry is starting to take steps in the right direction – in 2021, the Bitcoin Mining Council (BMC) was formed to reduce the global warming effects of mining. China banned all Bitcoin mining in May 2021 and seemingly 57% of all Bitcoin is now mined using renewable energy sources. Proof of Stake (PoS) is a method that verifies transactions, doesn’t require mining and also consumes a lot less energy.

More recent developments include Ethereum (decentralised blockchain platform) merging with proof-of-stake blockchain, Beacon Chain. The merge has changed how transactions are validated and are believed to cut energy use by over 99%.

The Task Force on Climate-Related Financial Disclosures (TCFD) has devised adoptable and applicable recommendations on climate-related disclosures to educate investors about the climate risks of an investment. This is voluntary but can be adopted by organisations across all financial sectors including cryptocurrency – to get ahead of the game before regulatory obligations are in place. In the EU, there are different requirements implemented that cover both the ‘E’ and ‘G’ of ESG reporting for financial institutions – the social side being less well defined. The European Commission’s Regulation of Markets in Crypto assets (MICA) did raise sustainability issues of crypto, but these were quickly scrubbed from the proposed rules.

Other examples of developments include optional carbon calculators for crypto providers to estimate their carbon footprint; if they have low emissions, investors looking to sustainably invest will be more inclined to.

However, given the current rate of carbon emissions, the effects of global warming are causing floods, extreme heat waves and unpredictable weather – it seems that regulation for firms with large carbon footprints couldn’t come soon enough.

With proper regulatory oversight, the conflict between cryptocurrencies and environmental risk can be solved, global regulators will need to drive forward sufficient regulation to ensure both can thrive. Our recent report found that while regulators have issued over 15,000 pieces of regulatory content around crypto, less than 0.1% of those discussed sustainability issues.

Appropriate measures that take into account cryptocurrencies’ impact on climate change and repercussions for providers that don’t follow the rules should ensure crypto operates in an environmentally safe way whilst deterring non-renewable energy usage.

S – Social

‘Social’ refers to respecting human rights, having proper data security in place, fair labour, diversity and inclusion. For many, crypto is a vehicle for financial crime – a space for cybercriminals to operate, pay for illegal activities such as terrorism and hit men, evade sanctions and hide wealth.

Because of crypto’s decentralised nature, those who commit crimes are very rarely convicted and don’t protect those who lost their funds.

According to CipherTrace’s Cryptocurrency Crime and Anti-Money Laundering Report, in 2020, crypto thefts, hacks and fraud equalled US$1.9 billion. This just portrays how easily customers can be targeted and become victims of fraud, loss or theft in this broadly unregulated industry.

Regulatory bodies are beginning to crack down on the social implications of crypto. For example, the EU is proposing changes to the law to decrease the financing of terrorism, money laundering and cybercrime. The changes would require firms that work with cryptocurrency to collect details of the recipient and sender – with greater transparency comes greater consumer safety and respect for their rights.

The US Digital Commodities Consumer Protection Act of 2022 will close regulatory gaps, protect customers and keep financial systems safe – this enforces greater accountability, reporting of suspicious transactions, protection of customer assets and being more upfront about the risks of investing in crypto. The UK’s money laundering obligations also require crypto firms to register with the FCA; these firms will need appropriate Know Your Customer (KYC) measures in place and proof of any required checks.  

Global regulators are certainly taking steps in the right direction but as with most changes to legislation, it can take years to come into effect. There’s a lot of work to be done around crypto regulation, partly as it is so new to governments, but as education and resources increase it may become easier to regulate. Regulations can also enable greater financial inclusion and responsible investments, ensuring a thriving cryptocurrency industry.

G – Governance

Governance refers to accountability, having a diverse and inclusive board of members, tax transparency, fair executive pay, no bribery and corruption risk.

Already, cryptocurrency clashes with the above. It is a decentralised method of investing where no one can be held responsible, and anyone can create a new cryptocurrency. There is also no single entity that enforces regulations which makes it difficult to regulate and ensure that there are fair, crimeless systems in place – current financial laws are unable to cover all aspects of cryptocurrencies. To this day, we still don’t know the true identity of the Bitcoin creator.

Many regulators have started discussions around crypto and financial crime and the need for regulation. Recently, the U.S. charged nine defendants for cryptocurrency-related fraud including multiple global Ponzi schemes involving the sale of unregistered crypto securities.

Cryptocurrency is vast and intricate meaning it will be difficult to enable transparency throughout, the likes of corruption and bribery exist already. To fully govern crypto, it will take time but with a proper evaluation, governing bodies can come together and enforce rules, deter bad actors and ensure stability.

CUBE Comment

To truly reap the benefits of cryptocurrency, the three pillars of ESG need to be considered. Can ESG and cryptocurrency go hand in hand or is it a battle between the two?

There are quite a few red flags when it comes to cryptocurrency and its ESG reputation but that doesn’t mean it has to stay this way. Crypto may have a bad name, especially from environmentalists due to its carbon-emitting mining methods but all is not lost.

What we need to see is a comprehensive evaluation of cryptocurrency methods and regulations to ensure it operates safely, sustainably and socially. Through proper governance, individuals and firms can be held accountable for their mistakes as we’ve seen recently with Robinhood. This should, in turn, persuade other crypto providers to not follow suit and behave within the laws.

Crypto operated in a world where it was free from total censorship, thus, there will be a few mistakes along the way. Regulators may face difficulty in asking for total transparency as it is an industry that operates globally on a 24/7/365 basis with numerous transactions every minute – perhaps it calls for advanced systems that can track these payments.

Investors wish to invest in something that won’t have ESG or reputational risks and will ask crypto providers for the ins and outs to make more informed risks. Global regulators will definitely develop more regulations, even if this will be at a slower pace, there will be a greater deal of insight into the crypto market. For example, ESG legislation such as the Economic Crime Bill and the UK Sustainable Disclosure Requirement is expected to come to fruition in 2022-2023.

Once crypto becomes regulated, it could promote greater global financial inclusion and we can truly open our arms to crypto. 

The main issue for many providers will be following different requirements in different jurisdictions as well as having various regulations to follow. To avoid missing a single regulation, automating your regulatory change management process is the best solution. With regulatory technology, firms can stay on top of regulations in different areas all over the world, ensuring compliance throughout.