Insights

The State of Crypto Regulation - June 2021

Bitcoin enduring the birthing pains of regulatory acceptance

By   James Butterfill and Nick du Cros 15th June 2021

Executive Summary:

  • The 2021 G7 G7 Summit is consistent on the topics of Central Bank Digital Currencies (CBDC) and stablecoins by largely copying the text from the last G7 Summit (October 2020).
  • While the US Reserve and the Bank of England continue to release discussion papers on CBDC; the Banque de France and the Swiss National Bank are moving forward with Euro/Franc wholesale CBDC experiments.
  • Europe is currently assessing comments received on its proposed Market in Crypto-Assets; while the US and UK do not yet propose to offer regulation designed for digital assets.
  • Our insights on the interplay of regulation and bitcoin volatility highlight that, ironically, regulatory uncertainty is a significant cause of volatility.

Over the last year it has become evident that Bitcoin and other digital asset prices are hugely sensitive to regulatory announcements and news of governmental policies designed to control mining and force digital assets into fitting within incumbent financial frameworks. We believe that assessing the future potential impact of regulation involves monitoring the narrative around both international standards and local regulation.

International Developments Last Week - G7 Summit and BIS paper

The 2021 G7 Summit, held over the weekend in Cornwall, United Kingdom did not bring any new material proposals for the regulating of digital assets to the fore. The emphasis was on regulatory consistency by largely copying the text from the previous Summit in October 2020 with a hint as to future papers to be released in the second half of 2021. The Communique from the Finance Ministers and Central Bank Governors touched upon:

  • Central Bank Digital Currencies (“CBDC”) - “Innovation in digital money and payments has the potential to bring significant benefits but also raise public policy and regulatory issues.” With a timeline of later in the year to publish further common principles and conclusions.
  • Stablecoins - “We reiterate that no global stablecoin project should begin operation until it adequately addresses relevant legal, regulatory, and oversight requirements through appropriate design and by adhering to applicable standards.” Common standards would be maintained through international cooperation, as well as, standards from the Financial Standards Board.
  • Providing additional expertise and funding to support the assessment programmes of the FATF-Style Regional Bodies.

Thankfully, the Summit did not accept the “cryptocurrency challenge” of John Sulllivan, the US National Security Advisor, who before the Summit outlined his belief that cryptocurrency lay at the core of how ransom transactions occur. Thankfully this FUD (fear, uncertainty and doubt) did not contribute to proposals for tougher regulation of digital assets. The G7 solution, we believe, may be more along the lines of that proposed by Alex Younger (former head of MI6) which would prohibit the payment of terrorist ransom ware requests altogether.

Also released last week, was a consultation paper from the Basel Committee on Banking Supervision on prudential treatment of cryptoasset exposures. While the paper notes that bank exposure is currently limited, “the continued growth and innovation in cryptoassets and related services, coupled with the heightened interest of some banks, could increase global financial stability concerns and risks to the banking system in the absence of a specified prudential treatment.”

The excited reaction to the paper probably had more to do with the fact that bitcoin was being recognised akin to other assets and granted a specified (albeit a very punitive) prudential treatment.

Insights on regulation and bitcoin volatility

As Bitcoin and other digital assets grow in market capitalisation, regulatory scrutiny is only likely to escalate. Recent examples of this are China’s recent clamp down on illegal Bitcoin mining in the Mongolian region, and a recent SEC statement implying that a Bitcoin ETF is less likely in the near term.

A recent Google Trends search for the term “cryptocurrency regulation” highlights the peak of interest was during the previous high volatility and crash in prices of 2018. Today we have not seen the same highs in volatility of 170% as we did in 2018, with volatility now being closer to 100%. While the adoption by investors is far greater this time, net new assets in 2021 now total US$5.5bn (vs US$0.5bn in late 2017) for investment products, it is perhaps the main reason why regulatory scrutiny has risen again. In some ways this increased scrutiny is encouraging as it confirms greater adoption and regulators taking notice.



Are regulators a source of price volatility? We can see through price action that Bitcoin and other digital assets are hypersensitive to regulatory and governmental scrutiny, this is understandable given it's an emerging new asset class. Our analysis, looking at the Google Trends phrase “crypto currency regulation” (interest over time) versus volatility highlights that when the interest overtime is above 50 (a proxy for heightened regulatory scrutiny), 30 day volatility averages 86% versus a much lower 64%



This implies that regulatory scrutiny does look to be a source of volatility. Regulators have only recently begun to regulate as the asset class gains broader acceptance, but there remains uncertainty as to how they will regulate, either by proposing a bespoke regime for digital assets, banning it outright or assimilating the asset class into their existing regulatory frameworks.

At present, getting a gauge for sentiment on digital assets from regulators is difficult due to the muddled nature of reporting by the media. Here we clarify what we believe is the current mood amongst the regulators in Europe, the US, the UK.

Gradual European Acceptance

European regulators have shown progressive (if not hesitant) acceptance of digital assets as a novel asset class. Five mainstream European exchanges, SIX Switzerland, NASDAQ Nordic, Xetra and Euronext Amsterdam and Paris, now allow the listing of exchange traded products referencing digital assets. In turn, this has led to an extremely healthy ETP ecosystem in Europe, with 12 different providers, offering over 35 products to a wide variety of digital assets, representing $7bn of AUM.

European regulators are also allowing more traditional fund structures to directly access digital assets. Alternative Investment Funds (AIFs) are increasingly looking at the asset class to offer different forms of active exposure to institutional investors and receiving favourable approval as to their eligibility. The German regulator BAFIN recently announced that its AIFs could directly invest in digital assets. This increasing acceptance of digital assets as an asset class was reflected in the recent Annual Global Crypto Hedge Fund Report 2021 undertaken by PWC, Elwood and AIMA.

Additionally, the proposed EU-wide regulation entitled Markets in Crypto Assets (MiCA) represents a promising development for providing services across the EU under a consistent piece of regulation. Apparently in excess of 1000 comments were received during the consultation period. Our hope is that MiCA can provide a comprehensive and transparent regulatory regime, providing investor protection, to allow the digital asset ecosystem to flourish. We eagerly await the next draft of these proposals to assess it against these objectives.

Finally, there was exciting CBDC news last week of Project Jura. This being the Banque de France, the Swiss National Bank, in conjunction with a private sector consortium, would work on the technical aspects of swapping a euro wholesale CBDC for a Swiss Franc wholesale CBDC.

Status Quo in the US

The United States remains somewhat mired in its status quo. Although the “Eliminate Barriers to Digital Innovation Act”, introduced in March 2021, will hopefully make some progress in clarifying the responsible regulator for various forms of digital assets, it hardly represents a proposal for a comprehensive and transparent new regulatory framework.

Meanwhile, the Securities and Exchange Commission (SEC) remains steadfast in its requirements for approving an ETF, with particular emphasis on the liquidity on regulated digital asset exchanges reaching sufficient levels to allow for appropriate surveillance sharing agreements. This remains the primary condition precedent for an ETF approval. There are now more than 10 Bitcoin and Ethereum ETFs currently being reviewed by the SEC. Frustratingly for these applicants, Canada has recently approved both Bitcoin and Ethereum ETFs.

With the departure of historically crypto-critical chairman Jay Clayton, and his replacement Gary Gensler, who taught a lecture series at MIT on bitcoin and blockchain, there is an optimism that 2021 will bear witness to material progression from US regulators and law makers on understanding digital assets. Lending credence to this belief is the addition of Cynthia Lummis to the Senate, representing Wyoming. A very vocal advocate for digital assets for years, Ms Lummis has proposed a financial innovation caucus in the senate to better understand digital asset technology and clarify the regulatory framework.

To learn more, here is a link to our Chief Strategy Officer, Meltem Demirors, interviewing Ms Lummis recently at Consensus 2021.

UK Doing its Own Thing

The UK seems to be the lone vocal hold out among Western regulators with its insistence that Bitcoin and other digital assets have zero intrinsic value and its continued desire to ban all access to retail investors. The Financial Conduct Authority (FCA) has already, from 6 January 2021, banned all retail access to derivatives and ETPs referencing digital assets.

There are currently three consultations for where industry is awaiting feedback on the direction of travel by the UK. Earlier this year the UK issued a general consultation and a call for evidence on cryptoassets and stablecoins generally. The consultation states that it is “closely monitoring developments in this space, including the European Commission’s Market in Cryptoassets (MiCA) proposed regulation … [but] Other international approaches include outright bans or amendments to existing legislation (e.g. securities legislation) to bring tokens, and the service providers around them (e.g. exchanges, wallets), into scope”. Even if the UK were to follow the MiCA template it is quite a distance behind where the EU is currently.

The two other consultations relate to imposing additional restrictions on the marketing, which will impact all digital assets. One looks to bring digital assets within the scope of the UK’s financial promotions regime (the regulation that governs public distribution and advertising of regulated assets such as securities) and the other consultation looking to impose additional obligations and restrictions on regulated entities that approve financial promotions of sophisticated assets (which, of course, include digital assets). It is not difficult to envision a scenario in which marketing or offering all digital assets to retail investors is difficult, if not next to impossible.

Finally, the FCA’s (admittedly admirable) attempt to regulate digital asset firms from an AML/KYC perspective has been beset by problems. Initially launched in January 2020, with the deadline of registering all eligible firms by January 2021, the regime has seen the approval of only five firms, while a further 167 await authorisation (and a large number have been denied and/or withdrew their applications). Those 167 firms have been allowed to continue operating under a temporary permission, now extended to 31 March 2022. Next steps for those firms remain unclear.

As a result, the regulatory framework for firms operating digital asset businesses and for those who wish to offer financial products referencing digital assets in the UK remains difficult, at best.

Finally, the Bank of England (BoE) continues to research, but has not yet made a decision on whether to introduce a CBDC in the UK. Last week it released a Discussion Paper New forms of digital money, which builds on the BoE’s earlier March 2020 Discussion Paper.

Summary

A regulatory crack-down on Bitcoin and digital assets more broadly continues to be a risk overhang for investors, with a heavy -handed approach likely to be significantly detrimental to prices. Quite ironically, the uncertainty around crypto-asset regulation is likely a key contributor to volatility in crypto-asset prices, as is evidenced in its extreme sensitivity to the subject. Encouragingly we continue to see a progressing trend towards regulatory acceptance, albeit this path is not always a straight one




By James Butterfill (Investment Strategist), Townsend Lansing (Head of Product) and Nick du Cros (Head Compliance & Regulatory Affairs - UK)



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