As digital currencies continue to dominate the financial headlines, regula­tors around the world are taking a closer look at how this new money is being used, traded, and developed. Bringing more order to an unruly and somewhat frenetic global market ecosystem hasn’t been easy. The absence of legal definitions for any of the myriad of digital currencies, means there is no clear base from which to start writing much-needed regulations.

New rules for digital currencies will fall into three buckets: cryptocurrencies, stablecoins and central bank digital currencies.

Cryptocurrencies: Many people are now familiar with cryptocurrencies such as Bitcoin, Ethereum and Doge coins - three of the largest. They have become almost as popular among young traders as meme stocks¹, despite their huge volatility. Bitcoin, for instance, traded as high as US$67,582 on November 9, 2020, but stood at US$51,519 by December 24, 2021. Cryptocurrencies such as these are primarily a private sector initiative which exists away from the sovereign government issued money frameworks (fiat currencies). They are created on computers by individuals and exist on distributed ledgers, which rely on blockchain technology: their creation is limited to a fixed number.

Stablecoins: These are a form of cryptocurrency generally backed on a 1-to-1 basis by a basket of government-issued fiat currencies such as dollars or euros or other assets. The most popular stable coins include names like Tether and Diem.² Unlike cryptocurrencies, there is no limit on how much can be issued. Because of their connection with fiat currencies, stablecoin issuance has boomed from US$5 billion in January 2020 to around US$166 billion in December 2021.³

Central Bank Digital Currencies (CBDC): Powered by the technology behind cryptocurrencies, CBDCs represents fiat money that is digitized, using a permission-based blockchain. Unlike fiat currency, CBDCs, much like Bitcoin, have a limit on creation, preventing quantitative easing and debasement, each of which certain commentators suggest have had a detrimental effect on the properties of the traditional fiat money supply. In 2021, the European Central Bank launched a digital euro project⁴ and China began a test of a digital yuan.⁵ Governments believe these would have the advantages of Bitcoin but also be under­pinned by a legal and regulatory framework that would comple­ment, rather than compete with or potentially undermine, global fiat currency ecosystems.

Because computer networks are global, any effort to regulate cryptocurrencies really requires a global approach. In a blog post in December 2021⁶, the International Monetary Fund said there exist a variety of risks associated with cryptocurrencies, which it warned “underscore why we now need comprehensive interna­tional standards that more fully address risks to the financial system from crypto assets, their associated ecosystem, and their related transactions, while allowing for an enabling environment for useful crypto asset products and applications.” Some inter­national agencies, such as the Paris-based Financial Action Task Force, have published guidance⁷ to help governments define “virtual assets” and digital currency providers, and proposed rules to prevent money laundering using digital currencies. However, these proposals are not legally binding. They can help shape lawmakers’ opinions but no more than that.

Looking to the U.S.

The biggest push for new regulations is likely to occur in the U.S., the world’s largest capital market and the most important digital currency battleground. This is where regulators are especially keen to start writing regulations about cryptocurrencies to plug holes that allow criminals and terrorists to send money across borders.

A White House paper on preventing corruption⁸ said: “The United States will continue to review the risk posed by digital assets, including the ways in which corruption contributes to those risks, and will continue to refine policies and regulations as needed.”

While some U.S. government agencies, including the Treasury Department and the Fed, have expressed concern about digi­tal currencies, SEC Chairman Gary Gensler has been the most outspoken on the need for regulation. “The crypto asset market, US$2 trillion plus in size around the globe, needs more inves­tor protection,” Gensler told the Wall Street Journal in December 2021.⁹ Because crypto has raised money from the public, he said it broadly fits the SEC’s remit. Crypto exchanges are holding crypto tokens and trading against their customer base, so they should be regulated like exchanges, he said. One area likely to face tougher regulation is stablecoins, which Gensler recently said were “acting almost like poker chips at the casino right now.” Without stronger oversight, he said, “people get hurt.”

Regulators have already sought to punish some stablecoins for lack of transparency about the assets they hold. The Commodities Futures Trading Commission fined Tether US$41 million¹⁰ on Oct. 15, 2021 for “misleading statements and omissions of material fact” about its asset holdings. The New York state attorney gen­eral also fined Tether US$18.5 million¹¹ and banned it from trading in New York, saying: “Tether’s claims that its virtual currency was fully backed by U.S. dollars at all times was a lie.”

Given the controversy around stablecoin asset holdings, regula­tions requiring more transparent disclosure of what the holdings consist of may be in the offing.

Once U.S. government agencies agree on which agency has juris­diction over cryptocurrencies, rules requiring Know-Your-Customer and Anti-Money Laundering measures for Bitcoin accounts at exchanges, much like opening a commercial bank account, also are likely to be presented.

Numerous proposals have been suggested requiring identification of counterparties and the ultimate beneficial owners of crypto-currency accounts. The Biden Administration slipped a measure into the recently passed Infrastructure law that was signed in November requiring tax payments on profits from crypto trading. Many exchanges only require an email address to open a crypto account. That will likely change in time.

Several fund managers have approached the SEC to set up ETFs based on cryptocurrency daily values, according to a Reuters report.¹² So far, the agency has not granted any application, and Gensler is likely to propose dealing with the crypto issue in its entirety rather than a specific decision on ETFs.

Europe Sets High Benchmark

Meanwhile, Europe is considering a different regulatory approach. The European Securities and Monetary Authority said that in 2022 it will focus on several digital initiatives, including a proposed set of regulations termed the Markets in Crypto Assets Regulation (MiCA). This regulation intends to bring these assets within the scope of regulatory protections in Europe. As is the norm with EU policymaking MiCA is comprehensive and demanding. It applies to any crypto-asset which is not already subject to EU regulation and draws in utility tokens, payment tokens, stablecoins and other asset referenced tokens.¹³

The rules are designed to create a true cross border ruleset – despite laws and regulations that may apply at national levels: there is no attempt to harmonize or rationalize these national approaches. The European parliament has stated that the current absence of crypto regulation:

“... leaves consumers and investors exposed to substantial risks.”

In addition, the fact that some Member States have put in place bespoke rules at national level for crypto-assets that fall outside current EU regulation, leads to regulatory fragmentation which distorts competition in the Single Market, makes it more difficult for crypto-asset service providers to scale up their activities cross-border, and gives rise to regulatory arbitrage. Lastly, the crypto asset subset of stablecoins can raise additional challenges if it becomes widely adopted by consumers.

MiCA is perhaps the most all-inclusive regulatory policy attempt globally thus far. It includes a wide range of crypto-asset services and activities which come under its purview, including:

• The custody and administration of crypto-assets on behalf of third parties (wallet providers)
• The operation of trading platforms for crypto-assets
• The exchange of crypto-assets for fiat currency that is legal tender
• The exchange of crypto-assets for other crypto-assets
• The execution of orders for crypto-assets on behalf of third parties
• Placement of crypto-assets (initial coin offerings)
• The reception and transmission of orders for crypto-assets on behalf of third parties (brokerage)

U.S. Sets Out “Policy Sprints” for Future Work

In November 2021, Federal regulatory agencies, Federal Reserve System, Federal Deposit Insurance Corporation (FDIC) and Office of the Comptroller of the Currency issued a joint statement summarizing their interagency “policy sprints” focused on crypto-assets and providing a roadmap of future work related to crypto-assets. Similar to a “tech sprint” model, agency staff with various backgrounds and relevant subject matter expertise conducted preliminary analysis on various issues regarding crypto-assets. The joint statement summarizes the work un­dertaken during the policy sprints and provides a roadmap of future planned work.¹⁴ Many industry participants agree that the size, shape, and timing of their digital asset programs could be dramatically impacted by what come out of this trio in 2022. It could mean that plans ramp up or ramp down considerably. It has made regulatory topics, and not technology or operational topics, among the most important items to watch.

A Crypto Fast-lane, with Speed-Checks

The crypto craze is global, and it doesn’t appear to be a short-term fad. As it continues to grow it has become a broader macro-pru­dential and systemic policy issue that cannot be ignored. Eager to keep pace with the acceleration of digital currencies, regula­tors are in the fast lane, and it appears that those in major financial centers are keen to provide rules to steer growth. Expect various further regulatory actions throughout 2022.