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21 Mar 2023

Progress, at last, on digital asset regulation

The UK’s proposed new approach to regulating digital assets should start to unlock their potential to transform the investment industry.

James Green

Head of Portfolio Insights, NatWest Trustee and Depositary Services

3 minute read time  

The best-known digital assets are cryptocurrencies, which provide an alternative store of value to traditional or ‘fiat’ currencies. Bitcoin, the first cryptocurrency, gained widespread popularity and has encouraged a new class of investors to trade and store their wealth in digital form.

Through a process known as ‘tokenisation’, the ownership of any kind of asset, whether real estate, fine art or stocks, can be represented digitally and then traded electronically in order to transfer ‘title’. Blockchain, the technology on which Bitcoin is based, allows the exchange of digital assets to be validated without an intermediary and, if desired, for all transactions to be publicly visible.

If you follow the concept of tokenisation to its natural conclusion, it should be possible to replicate or replace traditional equity, bond and derivatives markets with more efficient digital solutions. 

The introduction of these technologies promises to transform the way financial markets work – all the way through capital raising, investment, trading and settlement processes. The financial marketplace has evolved over the past 200 years at roughly the same pace as technology. As technological progress is constantly accelerating, it should come as little surprise that we have reached another phase of market transformation.  

A well-regulated digital ecosystem promises a much shorter, cheaper value chain, which should lower the cost of capital and investment, resulting in potentially higher returns to investors with no apparent loss of safety or stability. Yet while the technology to support such a system is increasingly accessible, realising its potential relies on robust regulatory frameworks. Proposals recently announced by the UK Treasury are an important step towards making that happen.

 

A new era

Regulating cryptocurrency markets has been the subject of intense debate for several years, and it seems progress is finally being made. In February, the UK Treasury unveiled proposals to strengthen rules for crypto lending and trading platforms, which will impact investors, asset managers and depositaries. Under the plans, crypto assets will be regulated in line with traditional finance regulation in what the government is calling “a robust world-first regime”.

This marks the beginning of a new era for UK crypto infrastructure, markets and businesses. Despite institutional and retail investors piling into the sector in recent years, the digital asset industry is not currently regulated by the FCA to the extent that more traditional markets are, leaving consumers at greater risk.

Even during boom periods, there have been calls for regulatory guardrails around exchanges and improved transparency across the industry as a whole. This pressure has mounted following significant levels of volatility and a number of high-profile scandals, which wiped billions from the crypto landscape and exposed the fragility of some business models. In late 2022 the collapse and bankruptcy filing (and subsequent contagion) of FTX, the cryptocurrency exchange platform, highlighted the need for better governance across parts of the digital asset sector.

The prospect of bringing cryptocurrency under the umbrella of mainstream financial services regulation will be welcome among fund managers who are increasingly trying to understand how to apply digital currencies, tokenised assets and blockchain technology to their portfolios and operations.

While most funds available to retail investors are currently prevented from taking direct exposure to volatile crypto markets, a rising number of Exchange Traded Products (ETFs etc) are enabling indirect access while still being exposed to the same risks. Meanwhile, globally significant financial institutions are investing in a growing number of products and services designed to facilitate institutional-scale access to the full range of digital assets.

The opportunities to reduce costs, improve transparency, and create more secure and efficient investment processes are enormous. A healthier digital asset ecosystem, backed by robust rules and regulation, will facilitate disintermediation and give investment managers a safer, faster, cheaper investment ecosystem with which to work.

In turn, this should enable portfolios that are more customisable, increased transparency and more effective oversight – all of which will, eventually, manifest in better customer outcomes.

 

UK proposals

The UK Treasury says its proposals are aimed at “strengthening rules around the lending of crypto assets, whilst enhancing consumer protection and the operational resilience of firms”.

Instead of creating a new set of rules, the Treasury intends to regulate them using existing financial services legislation, tailoring the terms of the Financial Services and Markets Act 2000 to the needs of the crypto market. In summary, it proposes to introduce rules that would ensure that customers’ assets are returned to them if a crypto business goes bust, and require crypto-asset promotions to be fair, clear and not misleading.

The proposals would introduce enhanced data-reporting requirements, including with regulators, and implement new regulations to prevent so-called ‘pump and dump’, whereby a market participant artificially inflates the value of a crypto asset before selling it. They would also strengthen the rules around financial intermediaries and custodians, which have responsibility for facilitating transactions and safely storing customer assets.

One area of particular significance to readers of this quarterly update are the proposed regulations on crypto asset custody. When it comes to digital assets, custody is managed through a variety of technological mechanisms, including hot (that is, internet-connected) or cold (offline) wallets.

The Treasury points out that the irreversible nature of blockchain transactions means that controlling access to these mechanisms is especially important. Currently, though, there are no specific rules dictating what happens if access is lost or if a custodian were to go bankrupt. The Treasury therefore proposes to extend and modify custody rules for traditional finance to protect investors’ digital assets. It is the Treasury’s intention to require custodians to provide access to assets in the event of their insolvency and to offer redress for lost digital assets.

 

Beyond regulation

Bringing these proposals into UK law will take time. The government has opened a public consultation on its proposals, which will close in April. After that, ministers will lay secondary legislation, and the FCA will then conduct its own consultation before defining rules and regulations. And the UK does not stand alone: regulations in Europe, the US and elsewhere must converge into some form of consensus for a global system to operate effectively. As each country seeks to take the lead, standardisation may be a casualty.

For now, there are still concerns over how to administer these assets and ensure their safety. Funds must have well-defined and focused risk controls in place so they understand, at all times, what the consequences are of something going wrong and can manage the scale at which they operate.

Education will also play a role in bringing the funds industry up to speed on a digital asset ecosystem that is often shrouded in jargon. Many in the financial services sector still struggle to clearly communicate the core principles of digital finance and often cannot distinguish between digital assets such as tokens, cryptocurrency, stablecoins or the various distributed ledger technologies. Once you understand the purpose of a digital asset and how the system hangs together, however, you realise it’s not that complicated at all – different, certainly, but ultimately it is just stripping out the inefficiencies inherent in the current ecosystem.

Given the current rate of progress in technology, regulation and the wider understanding of the potential opportunities, it is inevitable that lines between digital and traditional financial services will begin to blur, as is necessary in any transition. It remains to be seen how digital assets will affect the way funds invest or manage portfolios. However, robust regulation will reduce the risks currently associated with crypto markets and, in all likelihood, make institutional investors more comfortable with experimentation.

Ultimately, a healthy, well-regulated digital asset ecosystem will be a good outcome for consumers and investors alike, so the long-term landscape looks far more certain.

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