Adapting regulations to the fast-paced world of crypto assets

In today’s dynamic financial landscape, cryptocurrencies and their underlying technology have taken centre stage, attracting both enthusiasts and skeptics. The volatility and potential of digital assets prompt questions about their evolving positions in the traditional financial market. While the promise of decentralisation sparks innovation, ongoing debates on regulation, security, and stability keep the narrative of cryptocurrencies and digital assets shrouded in mystery, far from reaching its conclusion.

Implications of the integration of distributed ledger technology in financial services

Integration of blockchain technology into the safeguarding, managing, and trading of financial assets has led to a transformative era of innovation and efficiency within financial markets. By its very nature, blockchains are immutable, transparent, and trustless, where trust in a third party or intermediary is not needed when using the protocol. Hence, blockchain technology has the potential to alter traditionally established roles and relationships in financial transacting. For example, traditional reconciliation processes, can be completed by cryptographic consensus algorithms, which result in an almost immediate settlement. This reduces settlement times, enhances data integrity, and improves operational efficiency, thus reshaping asset trading in unprecedented ways.

Furthermore, self-executing smart contacts, which enforce agreements directly through code, automate and secure contractual processes, reducing the need for manual oversight and minimising errors. These contracts not only automate business logic but also streamline operational workflows and permit real-time settlement audits. This automation transforms various financial services, offering more efficient and reliable solutions and thus reforming the industry.

The transformative potential of blockchain technology has significant implications for existing financial institutions, altering their roles and relationships in the industry. Traditionally, institutions like banks and brokerages functioned as intermediaries, overseeing transactions, maintaining records, and fostering trust. However, blockchain introduces a decentralised ledger system that facilitates peer-to-peer transactions without a central authority. This diminishes dependency on traditional intermediaries, potentially lowering costs, boosting transaction speeds, and improving security and transparency. Indeed, Emmanuel Dooseman, Partner, states

“In an industry where innovation has been mainly driven by financial engineering and product development over the past 40 years, blockchain and decentralised ledger are fostering a new wave of innovation prompting the reevaluation of the scope of financial services and its regulation.”

Cryptocurrencies as an asset class

Blockchain technology with all its capabilities, strengths, and drawbacks, is being utilised by native cryptocurrencies and non-native digital assets, which reside on and operate within it. The emergence of these assets has broadened the realm of investment opportunities and financial instruments. Today, cryptocurrencies are recognised as unique asset classes due to their decentralisation, cryptographic security, and potential for high returns. Operating on blockchain technology, they offer transparency, immutability, and reduced reliance on intermediaries, setting them apart from traditional assets like stocks, bonds, and real estate. According to Wiehann Olivier, Partner at Forvis Mazars South Africa, Bitcoin was originally designed to facilitate peer-to-peer payments over the Internet without needing a trusted intermediary; however, due to its decentralised nature, it has evolved into a speculative asset class. However, we see more and more instances where other use cases emerge, such as the tokenisation of real-world assets, utilising all the fundamental characteristics and advantages that the technology offers to create efficiency in traditional financial models.

Apart from the pioneering Bitcoin, the market now contains various digital assets, like utility tokens, security tokens, and stablecoins. Utility tokens, exemplified by Ethereum’s Ether (ETH), are a special kind of virtual currency that resides on its own blockchain and grants access to specific applications or services within the blockchain ecosystems. Security tokens are digital assets that represents ownership or right towards real-world securities, like a company stock, commodity, bond, real estate share, or any other underlying asset subject to an existing traditional regulatory oversight. Stablecoins, like Tether (USDT) and USD Coin (USDC), are digital assets, whose value is pegged to external stable assets such as fiat currencies or commodities, in an effort to mitigate the usual price volatility associated with cryptocurrencies.

Additionally, digital assets also include non-fungible tokens (NFTs), which are distinct and unduplicable stores of value or digital representation of ownership on the blockchain. NFTs have created a new market for digital ownership and provenance, empowering artists, and creators to monetise their work in innovative ways. Tokenisation of physical assets such as real estate, commodities, and fine art forms an emerging asset class, which enables fractional ownership and liquidity in traditionally illiquid markets. These developments show a shift towards various digital assets, each offering unique investment traits and risks, changing traditional asset allocation strategies.

Digital assets and regulation

The emergence of blockchain technology and its native assets into our current financial system, has highlighted the necessity for a regulatory landscape to accommodate these changes.

A pragmatic approach here, is the adaptation of the existing legal frameworks to encompass crypto assets, utilising current regulations to manage the growing digital asset market. This method ensures continuity and stability in legal and regulatory environments by extending existing financial regulations, including anti-money laundering (AML) and know your customer (KYC) protocols, to cover crypto assets. This approach also promotes the integration of crypto assets into mainstream financial systems while effectively addressing issues such as fraud and investor protection and upholding regulatory oversight.

However, the distinct nature of crypto assets and their underlying technology, often calls for the creation of new legal frameworks tailored to the digital economy. These assets operate on decentralised blockchain systems, challenging traditional concepts of jurisdiction and ownership. For example, in September 2020, the European Commission introduced a digital finance package for Europe, which encompasses a digital finance strategy and three new regulations, which have all been ratified by the EU legislative bodies already –

• Markets in Crypto-Assets regulation (MiCA)
• A pilot regime for market infrastructures based on DLT
• Digital Operational Resilience Act (DORA)

The above legislative texts are the first step in addressing the complexities of the new technology and asset classes, as well as the digitalisation of the financial industry in the EU. Other jurisdictions are also working on setting up such new regulatory frameworks for these fast developing and innovative technologies and asset classes.

What’s next?

The need for harmonised innovative legal structures to tackle issues like smart contract enforceability, decentralised autonomous organisations (DAOs), and cross-border digital transactions continues to exist at a global level. Global regulators strive to be responsive, yet the rapid pace of technological advancements frequently renders their efforts sluggish and ineffective. In the face of such rapid developments, only time will tell how the industry evolves and whether regulators can effectively adapt to keep pace globally.