Written by Akber Datoo and Lisa McClory at D2 Legal Technology
The growing adoption of crypto assets and integration with financial services and traditional financial asset classes and markets is now making it imperative for global consensus on cryptoasset regulation. TradFi firms have started to realise that they need crypto to survive and succeed in the future, heralding a convergence of TradFi innovation and DeFi — with many governments and regulators working hard to secure their positions as leading global financial centres. At the same time, attitudes to regulation have differed significantly across the world, from lax to enforcement led — a patchwork approach that has stifled innovation in some jurisdictions and undermined global stability. The legal system has also stepped into the gap, clarifying that cryptoassets can be ‘property’ in the English law case of AA v Persons Unknown who hold Bitcoin (2019), and therefore that theft and loss can give rise to proprietary remedies for victims. Property rights are essential to allow access to interim remedies, such as a worldwide freezing order. Statutory clarification has followed in the wake of case law findings, with a ground-breaking Property (digital assets, etc) Bill currently under consideration by the UK House of Lords, which will allow a further statutory confirmation of rights of property in this new asset class. Other jurisdictions, including Dubai DIFC, have also recently put forward a codification of property rights in digital assets. Yet, despite these important advancements, tokenised capital markets and liquidity are still hampered by liquidity siloes and lack of interoperability. Given the borderless and fast-paced nature of innovation in cryptoasset markets, regulatory clarity and global consistency is becoming paramount if we are to achieve the full potential of these exciting technologies.
Fragmented regulatory approach
The crypto asset landscape and regulatory response has changed significantly in recent years. The Financial Action Task Force’s (FATF) recommendation that virtual asset service providers should be supervised in all FATF-compliant jurisdictions has been widely adopted to tackle the most obviously high-risk areas of the crypto asset ecosystem: exchanges and custodians. While this response is key to avoiding the creation of safe havens for bad projects that could quickly spread through other jurisdictions, it does not help in areas such as consumer protection, market integrity or market governance and, furthermore, still leaves material gaps in redress for victims of crypto crime seeking recovery of assets. Without the right regulatory frameworks in place to help service providers create a responsible business model, the risk of exchange failure continues. At the same time, good and responsible projects are left out in the cold, facing expensive legal barriers and uncertainty which inhibits them from raising investment, building and scaling innovative new products.
Progress in developing new regulatory frameworks
Regulators in some jurisdictions have looked to interpret existing financial securities law and regulate certain crypto assets as types of financial instrument. Sometimes this has been a step closer to clarity, however, there remains significant variance in interpretive approach. Working with crypto assets generally involves much consultation with lawyers over token classification. A consultation paper of the European Securities and Markets Authority earlier in 2024 found that the definitional boundaries of a ‘financial instrument’ for the purposes of MiFID II vary by member state, which illustrates some of the fundamental scoping challenges for regulators in this fast-moving area. Countries are also looking at IOSCO Policy Recommendations for Crypto and Digital Asset Markets (November 2023), however, these high level principles still require regulators to undertake detailed interpretive work to integrate all principles and outcomes within existing and new regulatory frameworks. The IOSCO recommendations are a helpful starting point, but for many countries there remains a great deal of work to do to implement and operationalise the key principles.
In the meantime, inconsistent and patchwork models of crypto asset regulation around the world hamper the potential for innovation, both from traditional and newer market participants and leave consumers open to risks. For countries looking to take the lead in this area, there is a race to put in place the right kind of elegant, principle-led and proportionate framework that can unlock growth-enhancing innovation in capital markets. For countries that achieve this, there is a clear and valuable global economic advantage, (particularly as the US has now started to swim in these waters) with a crypto-friendly US now exploring more ambitious approaches to crypto regulation. Indeed, as reported by CBS news, the new Chairman of the Securities and Exchange Commission will be Paul Atkins, generally viewed as an advocate of the crypto sector, including in recent reviews by the Financial Times.
The opportunity for regtech
Effective use of data could transform the way regulators supervise these areas. Whilst regulators might feel concerned about the lack of centralised order book insights that aid the supervision of traditional markets, with the right tools, regulators can deploy powerful analytics to make their supervision of digital asset activities and consumer adoption far more efficient. Crypto networks generate a lot of data that that regulators can utilise to enhance the speed and efficiency of oversight and enforcement. Invariably this involves using a combination of AI and predictive analytics. This is not a solvable challenge with a one-off silver bullet style solution but rather, as algorithmic trading patterns and the AIxCrypto technology continues to evolve at lightspeed, regulators need to build their own internal capacity and strengthen their data-driven and regtech enforcement capability to gain near-real time insight into the shifting landscape of risk in their jurisdictions. The onus is therefore on regulators to build strong internal expertise to understand the new crypto asset business models being adopted and keep pace with rapid innovation in crypto asset services. Internal staffing expertise, including crucial data analytics skills will be vital to gain visibility across distributed information networks, whether these are novel proprietary TradFi systems or decentralised ecosystems.
Why take action now to regulate crypto markets?
If there were ever a crucial time for crypto asset regulation, it is now. Markets are growing fast, along with consumer awareness and adoption. Global standards-setting bodies such as UNIDROIT and IOSCO, BIS, FATF and the FSB have published solid guidance, alongside the Basel Framework’s new requirements for prudential treatment of cryptoasset exposures. There is now enough certainty around business models to enable regulators to create rules that will shape relevant and appropriate governance. Data analytics and AI are fundamental assets within the crypto asset regulatory toolkit. Effective use of data will be vital to impose regulation across complex and fast-changing systems, including to keep markets stable and to manage potential risks to financial stability as markets grow and mature. This requires regulators to build not only new skills but also different working models and, while it is tempting to rely on third party data service providers, these companies have their own commercial goals that do not dovetail neatly with regulators’ requirements. Regulators must build their own data analytics capabilities and create a core team that understands the impact of crypto assets and AI and the likely implications on markets in the future. A robust internal resource that understands the new systemic and operational risks will allow regulators to future proof, keep pace with innovation and, critically, deliver the global consistency urgently required.
The time is now for jurisdictions to develop a strong crypto asset regulatory framework and position themselves optimally in the future of digital assets and financial markets.
Time to create digital asset regulations was originally published in Coinmonks on Medium, where people are continuing the conversation by highlighting and responding to this story.