Does regulating cryptocurrency make it like every other fiat currency?

As the latest storm in the crypto winter blew in via the FTX collapse in November 2022, the financial sector and policymakers are again asking how does the US regulate a virtual asset that only exists on a blockchain ledger which is inherently borderless?

Further, how should central agencies regulate a technological innovation designed specifically to be decentralized? As with all emerging technologies and new financial instruments, we remain snared in the eternal balancing act between enabling innovation and protecting the public.

Cryptocurrency, stablecoin, and NFTs went swiftly from being a fringe novelty to widespread adoption intertwined with mainstream financial markets, presenting lawmakers with a problem they don’t fully understand.

The dramatic fall of the Terra stablecoin earlier this year, and FTX’s disintegration, sounded the clarion call for oversight. Rival interests are seeking to answer questions about what we want the fundamental nature of digital assets to be. Are they securities or commodities? Should cryptocurrencies, which have no physical token, behave like the US dollar and other fiat currencies? Will regulations curtail crypto’s potential for unprecedented financial inclusion?

State of crypto regulations by the end of 2022

The European Union has set out to take the lead in designing the most comprehensive crypto regulations to date, known as Markets in Crypto Assets (MiCA), which will likely take effect in 2024.

In October 2022, the House of Commons voted to recognize all cryptocurrencies as regulated financial instruments, introduced via an amendment to the Financial Services and Markets Bill — which still must pass the House of Lords.

Meanwhile, the US has opted to incorporate digital assets into existing financial regulatory frameworks and allow the states to regulate themselves. Comprehensive federal legislation will take years of deliberations, as bipartisan proposals to set up crypto standards at the federal level have been exercises in futility – like the certain-to-fail Responsible Financial Innovation Act.

The White House did release the inaugural Comprehensive Framework for Responsible Development of Digital Assets in 2022, which serves as part of a much-needed awareness campaign to educate US lawmakers about the opportunities and threats of digital assets.

Micro: ramifications of unregulated markets

The collapse of one of the world’s largest crypto exchanges, FTX, demonstrates a major issue within the unregulated market. Lacking the protections that stock markets investors enjoy from intermediaries like brokers and exchanges, a million FTX investors saw billions of dollars vaporized.

A European Commission’s financial stability unit official commented that an in-force MiCA would have prevented such egregious corporate mismanagement.

In regulated crypto markets, consumers would be protected from an exchange’s unwarranted risk-taking, outside manipulation, misuse of their assets, and outright fraud; and exchanges would be required to have controls and accurate disclosures and reporting standards. Customers’ assets need to be segregated from the financial institution’s assets to prevent exchanges like FTX from wheeling and dealing with their money.

Macro: Consequences for our entire economy

But the consequences of an unregulated financial market go well beyond crypto exchange bankruptcies and victimized customers. Digital asset markets have grown so fast (it is estimated that 46 million Americans own crypto), and legacy investment banks like JPMorgan Chase, payments apps like PayPal, and credit card giants like Mastercard have incorporated cryptocurrency into their offerings.

Cryptocurrencies have become somewhat normalized and inextricably interconnected with other components of the financial sector. A poorly regulated subprime mortgage market hammered the entire economy in 2008.

An unregulated digital asset market collapse could someday have destabilizing effects on the entire economy.

A fragmented regulatory hodgepodge

So, the financial industry leaders, politicians, and policymakers have been summoned to the crypto sidelines to install guardrails that must both protect consumers and encourage innovation.

The global and the US regulatory landscapes are badly fragmented with a lack of cohesion and collaboration, causing a nightmare for compliance teams and a waterbed effect where people move around from country to country depending on the regulations.

While some jurisdictions have taken pro-innovation stances by imposing commercially attractive regulatory standards, others have pursued a more critical approach. At least 37 US states currently have varying levels of crypto regulatory standards on the books.

Federal regulators like the SEC and the Commodity Futures Trading Commission are executing their own oversight against crypto-market participants, based on assumptions that certain digital assets fall under their jurisdictions.

Calling all crypto compliance officers

All these inscrutable regulatory deliberations spell enormous complexity for corporate counsels and compliance leaders working in exchanges or other virtual asset service providers (VASPs).

With the taming of the crypto wild west an inevitability, compliance should never be an afterthought and always be covered within a company’s policies.

VASPs must also find precise, real-time methods to manage and mitigate regulatory risk, which is a decidedly moving target. Compliance officers should prioritize leveraging the best available regulatory technology for establishing processes for identifying new and changing regulations, communications to all impacted parties, assessing the new or changed regulation against business processes, risk rating, the appropriate documentation and reporting, and mapping to business, products, and processes. To that end, regulatory technology would also enable compliance officers to automate upcoming crypto regulations.

Compliance pros relying on paper-based, manual processes will likely expose their companies to penalties. The smartest crypto exchanges will proactively work with regulatory agencies to craft a holistic framework for crypto’s future success.

Is a regulated crypto simply another fiat currency?

A regulated industry will not render cryptocurrencies on par with other fiat currencies – aka regular money. Many applications of tokenized assets on the blockchain have emerged, from speculative investing, NFTs, play-to-earn gaming, overseas money transfers, gold trading, fully pegged stablecoins (which act more like fiat currencies than most crypto), and merchant payments, among other things.

Cryptocurrencies have brought millions of previously unbanked or underbanked people into the financial and economic system, especially in Latin America.

Furthermore, many believe crypto will be the common method of exchange in web3 and the metaverse. Perhaps the more important question is: Will a regulated cryptocurrency industry dilute the essential decentralized, democratic dream for crypto?

Aside from the boon to inclusivity, the real fiat differentiator for crypto is the instantaneousness and ease of transactions, as well as the increased liquidity it offers for certain investors. The digital assets industry should open its arms to sensible regulations.

The arrival of federal oversight is an official rite of passage meaning crypto has arrived and is mainstream. Further, volatility and instability do not benefit the industry’s long-term viability, it benefits only the criminals and fraudsters.

Keep ahead of emerging crypto regulations by speaking to CUBE.