Let’s take an inclusive approach to the regulation of crypto assets

Let’s take an inclusive approach to the regulation of crypto assets

India’s finance minister Nirmala Sitharaman highlighted the centrality of international cooperation on crypto-asset regulation in the monsoon session of Parliament. This comes on the back of a tumultuous year for the crypto market, replete with margin calls and defaults. These adverse events have not translated to systemic risks because crypto assets are not yet deeply integrated with financial markets. However, financial regulators would do well to establish a framework for the oversight of crypto assets to prevent any possibility of future crises. The Financial Stability Board (FSB) recently announced that it will provide a roadmap to regulate certain crypto assets to G20 member nations in October, just in time for India’s presidency of the group, which begins later this year.

The FSB includes policymakers, central bankers and regulators of G20 members, along with financial centres such as Hong Kong, Singapore, Spain and Switzerland, and international standard-setting bodies. This makes it a lynchpin for international coordination on governance of financial markets. While, crypto-asset regulation is nascent in many emerging and developing economies (EMDEs) like India, in part because of a lack of state capacity, a risk-based and context-specific understanding of new markets is critical. The FSB breaks crypto markets down into three segments: unbacked crypto assets, stablecoins and decentralized finance. The risks within each of these should be juxtaposed against the local contexts of EMDEs.

First, unbacked crypto assets derive their value from a mix of factors including cost of production, network effects, user sentiment and speculation. Several such assets are listed by centralized service providers that act like intermediaries and are regulated in advanced jurisdictions. For instance, the EU’s proposed Markets in Crypto Assets regulation specifies compliances that such intermediaries have to adhere to, including measures linked to consumer and investor protection. The EU has effectively established a template that may now be replicated widely by other jurisdictions. But it is important that EMDEs weigh in, via the G20 process, to help shape a context-appropriate and responsive global template.

EMDE citizens are more likely to enter financial markets via unbacked crypto assets as first-time investors. Therefore, it is important to preserve their trust in both financial institutions and government oversight. This could translate into more rigorous standards for listing of crypto assets in such markets by intermediaries. The EU prescribes that such intermediaries publish a white paper having some similarities with prospectuses published under existing financial regulation. EMDEs could consider additional criteria for ‘verification’ of crypto assets to protect investors.

Another area where EMDEs may consider exceptional measures is customer due diligence for anti-money laundering (AML). The Financial Action Task Force’s (FATF) guidance on AML norms for crypto markets is the current gold standard. It prescribes measures like the identification of customers using reliable data sources, identification of beneficial owners as well as the purpose of transactions. The international money laundering and terror financing watchdog also prescribes enhanced due diligence for high-risk transactions linked to notified jurisdictions. These measures include obtaining more information on the customer and transaction, as well as increasing the frequency of discretionary oversight on such transactions. EMDEs could consider widening the net for situations requiring enhanced due diligence based on their own security priorities, such as via thresholds for additional relevant information to be obtained by intermediaries.

Second, stablecoins are typically backed by specified assets (typically US dollars) or a basket of assets, and are used extensively to exchange crypto assets with fiat currency. However, EMDEs like India see a potential currency substitution problem with stablecoins, because dollar-backed coins may offer a better store of value than their local currencies. International standard-setting bodies like the Committee on Payments and Market Infrastructures and the International Organisation of Securities Commissions call for the application of set ‘Principles for Financial Market Infrastructures’ to stablecoins. These principles define the international standards for critical infrastructure such as payment systems, and securities depositories and settlement systems. Application to stablecoins would essentially mean applying a ‘same activity, same risk, same regulation’ principle, which India already espouses in fintech regulation.

Third, decentralized finance is used to offer financial services and products, purportedly without centralized intermediaries. This segment is potentially the most high-risk for EMDEs, given that the visibility and verification of identities of counterparties is typically not required to carry out transactions. EMDEs like India are seeing an increase in money laundering across the board, including through traditional banking channels. As per PTI data, the Enforcement Directorate registered a total of 4,637 money laundering cases between July 2005 to November 2021, of which 769 related to money laundering via bank frauds. Decentralized finance is going to further complicate the nature of financial fraud, and the FSB is unlikely to suggest a regulatory perimeter for this new market anytime soon. EMDEs should therefore exercise abundant caution and allow for decentralized finance to operate within sandboxed environments only.

Over the last decade, technology has served as a key vector of financial inclusion, via fintech as we currently know it. Crypto markets may represent the future of fintech, or at least provide glimpses of it. Therefore, the upcoming G20 presidency will serve as a stepping-stone for India to help shape important financial regulation from the vantage point of EMDEs.

These are the authors’ personal views.

Arvind Gupta & Vivan Sharan are, respectively, founder, Digital India Foundation, and secretary, Esya Centre

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