Crypto-assets are at the top of many a regulator's agenda, whether for anti-money laundering purposes, investor protection or the promotion of fair and efficient markets, as illustrated by the UK Crypto-asset Task Force's report on this emerging asset class published in December 2018. Although the G-20, in their March 2018 Communiqué, said that crypto-assets were not a material risk to financial stability, they did “raise issues with respect to consumer and investor protection, market integrity, tax evasion, money laundering and terrorist financing.” Quite a list! Accordingly, it called upon international standard setting bodies “to continue their monitoring of crypto-assets and their risks . . . and assess [the] multilateral responses as needed.” Consequently, in March 2019, the work programme of the International Organisation of Securities Commissions (IOSCO) identified crypto-assets as a priority, specifically citing concerns over trading, custody and settlement, valuation and intermediation, as well as the exposure of investment funds to such assets.
A Regulator's Tool Kit
As part of this work programme, IOSCO published a consultation in May 2019 focusing on how platforms which trade crypto-assets are regulated. The global standards setting body considers that promoting innovation must be balanced with appropriate regulatory oversight. Besides discussing the issues and risks with trading crypto-assets, IOSCO flags up issues which regulators and the market should be aware of, setting out the relevant IOSCO Principles and Methodology that provide a framework to support regulation, together with a "tool kit" of measures or indicators to identify and address failings. Given that the market is rapidly changing IOSCO says it does not intend to prescribe any specific approach, but rather market authorities should pay regard to its framework and tool kit. The tool kit draws on the experiences of the IOSCO's ICO Network - through which member regulators can share their experiences and concerns with each other.
Different Regulatory Approaches
IOSCO considers that if crypto-asset trading platforms (or CTPs) trade a crypto-asset that is a security and it falls within a regulator’s jurisdiction, then standard regulatory principles should apply (i.e. in terms of investor protection, fair, efficient and transparent markets and investor confidence). The approach to CTP regulation differs between jurisdictions. The majority apply their existing regulatory frameworks when crypto-assets qualify as securities or other financial instruments. In the US existing regulation for derivatives traded on exchanges has been applied to the trading of crypto-asset derivatives. This approach can leave crypto-assets outside regulation in those jurisdictions whose regimes do not capture this asset class. On the other hand, a number of jurisdictions favour a specific framework for CTPs that trade crypto-assets falling within their regulatory remit. Yet again, other jurisdictions are adapting their existing regimes by tailoring requirements and exemptions while some jurisdictions apply their payment services framework. A final group of jurisdictions have banned the trading of crypto-assets.
Which Crypto-Assets Are Regulated?
For the purposes of the consultation, IOSCO has defined crypto-assets broadly as "a type of private asset that depends primarily on cryptography and DLT or similar technology as part of its perceived or inherent value, and can represent an asset such as a currency, commodity or security, or be a derivative on a commodity." Crucially though, IOSCO does not analyse which crypto-assets constitutes a security, understandably deferring to regulators in their own jurisdictions. Helpfully, in this regard, Annex A to the IOSCO consultation contains a list of resources country by country. Among these are the UK Financial Conduct Authority's proposed guidance on crypto-assets and, while overall the FCA publication is of limited assistance, the worked examples are helpful to industry players in understanding the FCA's approach to determining whether an asset falls within regulation.
Risks and Issues of Trading
A CTP is "a facility or system that brings together multiple buyers and sellers of crypto-assets for the purpose of completing transactions or trades." IOSCO explains that although they are like traditional trading venues, they can also perform roles more usually undertaken by intermediaries, custodians, transfer agents and clearing houses - and this fact can increase the potential risks as discussed below. An analysis of CTP operational models by regulators is therefore important.
IOSCO identifies the specific risks and issues of trading on a CTP as including:
- Access - where investors, particularly retail investors, have non-intermediated access to a CTP, an important consideration for regulatory authorities centres on who performs the customer on-boarding process. Intermediaries usually carry out such steps and without on-boarding there will be concerns over conduct of business (KYC) and AML due diligence.
- Safeguarding participant assets - customers' crypto-assets can be held in wallets where the CTP controls the private key giving it sole control over them. At the very least, this can give rise to the sort of governance issues experience by investors in Quadriga, whose founder apparently died, taking with him the encrypted access keys to US $143 million of cryptocurrencies held by the exchange in offline storage.
- Conflicts of interest - CTPs that offer end-to-end services usually performed by independent parties on traditional venues, for example, the admittance and trading of the crypto-asset, settlement, custody, market making and advisory services may have additional conflicts.
- Operations - the use of DLT may limit the ability to cancel or modify trades once verified on the ledger. It is therefore very important how CTPs deal with error trades and cancellations as well as modifications.
- Market integrity - according to IOSCO effective monitoring of trading may be challenging. This is because beneficial ownership is transferred differently from traditional trading venues making it harder to monitor market manipulation or insider trading. IOSCO suggests new rules could be needed to catch new forms of manipulation.
- Price discovery - additional challenges in looking to ensure efficient price formation may arise where a crypto-asset trades on various CTPs or jurisdictions making price discovery complex and fragmented.
- Technology - as CTPs often hold participant assets and funds, unlike tradition trading venues, this means that the infrastructure and/or processes for their safeguarding are critical because weaknesses could increase the risk of loss to participants e.g., through cyber-attack.
The paper also discusses the cross-border sharing of information between regulators. As CTPs operate across multiple jurisdictions, IOSCO considers it vital that its members cooperate in implementing consistent standards of regulation e.g. on enhancing investor protection and exchanging information. As happens for traditional trading venues, market participants may seek to engage in regulatory arbitrage over CTPs. While different approaches by regulators are to be expected, IOSCO considers that effective information sharing and cooperation is important to manage these risks. In this respect, many of the tools are already in place including the IOSCO Multilateral Memorandum of Understanding.
IOSCO intends to monitor the market, reviewing and updating this report as necessary. Feedback may be provided until 29 July.