Why does regulation matter for Crypto?

Crypto being regulated will be a strong indicator that it has been accepted by governments as an asset class that can be considered alongside assets such as fiat, gold, derivatives or emissions. It’s still unclear how crypto will or should be considered, clarity will bring confidence, confidence should bring greater adoption.

As a firm building in the crypto space we face lots of hurdles; primarily the historic associations with illicit activity, hacks and scams. Despite many reports on how crypto is changing and how illicit activity is different for different token types, for many that general perception persists. Which makes them cautious about entering or being seen to support the space more generally.

Market education and clarity on the regulatory obligations will help speed cryptos journey to an accepted asset class, unfortunately this takes time. If you’re reading this, then you are on the cutting edge, the world still needs to catch up to you. I’m sure you remember where and when you went down the crypto rabbit hole, for many these early exposures are yet to come, and there is much to cover before we even discuss the complexities of decentralised assets and the importance of private keys. Regulation will smooth the path of what is important to help protect people and society. It’s coming, albeit slowly for now.

But why regulate? We’re happy with the way things are.

Laws and regulations have been put in place to protect society. They are reflections of societies norms, the rules that we all agree to live by, either implicitly or explicitly. Consider how many lives have been saved by mandating not only the inclusion of seatbelts in cars but that passengers must wear them. Within financial services, how many firms or individuals have been protected from front running or price manipulation, investing in pyramid schemes or being mis-sold products.

It’s always hard to quantify benefits once controls are in place and we have to keep reminding ourselves that we are on the cutting edge and the world behind us doesn’t have the same “appetite for the new” that we have, things take time to flow into all parts of society. Regulations change, they are not set in stone, they are written by people, they bend and flex as confidence changes. If we, as society, don’t like a set of regulations we can use our right to vote and look to have these changed. The issue with this is that it can lead to narratives and rules that often lags innovation.

Who are the regulators?

Each body has a different mandate but one can think of the organisations involved broadly at a global or regional level. Global bodies such as the G20, BIS and FATF set high level standards, commitments, guidance or recommendations, then the regional or local bodies interpret that output and implement local laws. Regional and local bodies however ultimately are autonomous and have final authority, so it is rare that globally uniform frameworks are agreed and there is often regulatory arbitrage.

What activity is regulated?

Regulatory coverage consists of three main areas.

Financial crime regulations, where rules are put in place to make it more difficult for bad actors to fund their activity, through controls and sanctions, these regulations are broad in their reach and cover many types of firms, and despite coordinated guidance from FATF global implementation remains variable. Conduct and behaviour regulations, where rules are set out for firms to establish boundaries of behaviour and transparency of information. The aim here is to protect less informed individuals from being manipulated, being subject to scams and mis selling activities. Financial stability, where markets are observed and sometimes influenced in an attempt to prevent runaway growth, collapses and failures. Regulations though, do not solve everything as the collapse of the financial markets demonstrated in 2008.

Q1 2018 — “The FSB agreed that crypto-assets do not pose a material risk to global financial stability at this time, but supported vigilant monitoring in light of the speed of developments and data gaps.”

How can regulations influence activity?

A regulator can only regulate within their remit. This remit is given to them by government or state and usually allows the regulation of a states assets, it’s companies, organisations and its citizens. Historically regulations were bound within the jurisdictions that drafted them, but following US FATCA and EU GDPR, regulations are expanding their regulatory reach extraterritorially.

Regulations are complex and intertwined, they can be argued and interpretation can vary. We have seen a shift from principles based regulations to rules based because of the failure of interpretation but both systems have merits and weaknesses.

What does this mean for us at TokenCard?

It means we recognise the importance of regulations and are looking ahead, building to the rules we not only know will impact us, but also incorporating tools to help derisk our platform further. We want to build a strong platform that the bad guys can’t take advantage of.

To be clear we believe very strongly in decentralisation, but to bridge to fiat i.e. “the real world” we have to have partners that have confidence in our systems and demonstrate we meet the real world obligations.

The first step in determining our regulatory obligations was to develop clarity on the activities we undertake. We settled with the FCA that firstly we provide an app which is the tool to allow users to manage their own decentralised wallet, and secondly, we operate simple exchange to allow crypto to be easily converted to fiat. As part of the sandbox approach, partnering with an established and respected card issuer was an exceptionally important step for us, and we’re working directly with our card association to break new ground. We are able to focus on the crypto business without blurring the lines between crypto and electronic money. In fact recital 10 of the AMLD5 states that virtual currencies (read crypto) should not be confused with electronic money or funds.

“Virtual currencies should not to be confused with electronic money as defined in point (2) of Article 2 of Directive 2009/110/EC of the European Parliament and of the Council (1), with the larger concept of ‘funds’ as defined in point (25) of Article 4 of Directive (EU) 2015/2366 of the European Parliament and of the Council (2), nor with monetary value stored on instruments exempted as specified in points (k) and (l) of Article 3 of Directive (EU) 2015/2366, nor with in-games currencies, that can be used exclusively within a specific game environment.”

So where do the regulations touch the TokenCard model?

You’re probably all familiar with the crypto conversations on KYC. Compliance geeks don’t talk about KYC per se, we talk about anti money laundering (AML), combating terrorist financing (CTF), identity verification (ID&V) and three forms of due diligence (simple, client and enhanced). AMLD5 when it comes into force in Jan 2020 will require crypto exchanges that interact with fiat and custodian crypto wallets to undertake ID&V, in addition AMLD5 includes further obligations on an organisations governance, operations, monitoring and reporting. We, for our simple crypto to fiat exchange are building to these guidelines today.

Regarding reporting, you may or may not have heard of Suspicious Activity Reports or SARs, these are the reports that obliged firms must make to their Financial Intelligence Units if they have suspicion (find your countries FIU here )

AMLD5 also obligises traditional financial service platforms to freeze the assets of suspicious accounts, we can’t freeze your decentralised assets, so we have developed a framework that allows our partners to be comfortable. By utilising blockchain analysis tools to evidence that the assets we exchange have sound provenance, we can do something that has never been done before and cannot be done with cash or banking as it stands today.

With respect to the broader regulatory landscape, discussing AML is just scratching the surface, there are obligations relating to sanctions, bribery, corruption, GDPR and we expect conduct rules to follow on topics such as market abuse, insider trading and some sort of client appropriateness checks to become mandatory in future. We will continue to address these topics as they develop and adopt them for our decentralised model where we feel it’s right to.

Where does this leave the crypto industry in terms of regulatory next steps?

Regulators today have stated that they want to understand the new space, and that they don’t want to crush and restrict innovation. So they are asking questions, watching, listening and waiting, so as to introduce the right level of control at the right time. This has led to frustration within the industry who are seeking clarity.

Papers continue to be published by regulators that provide greater certainty , some jurisdictions are lurching ahead in an attempt to make land grabs for the new frontier.

Europe are in no rush — https://www.bloomberg.com/news/articles/2018-09-08/europe-is-in-no-rush-to-regulate-crypto-market-officials-say

And the US Congress are also engaged in dialogue —

What is clear is that financial crime controls will be first. Europe’s AMLD5 sets out clear obligations for exchanges that deal with fiat currencies and custodian wallet providers. KYC will be enforced on the fiat gateways to crypto.

Old Paper vs New Crypto

What comes next is much more complex, because crypto can represent everything we see today and tomorrow’s future intangible assets. The industry is asking for jurisdictions to set out their token taxonomies to provide certainty in how issues are dealt with from tax to operational requirements.

Some of the forms Crypto can take;

Digital fungible (bitcoin),

Representative fungible (gold, fiat, shares or bonds),

Utility fungible (eth, filecoin),

Non fungible (cryptokitties, art and asset ownership),

Collections or Baskets (Gaming hoddle or collection).

Today, we use legal contracts, written on paper to document our rights and ownership. Tomorrow, we will document our rights and ownership in code and crypto assets.

We don’t have the same rules for everything written in paper, we develop rules that map to the shape and features of the underlying asset or the service, which means, if we apply the same logic to crypto, the number of regulatory agencies that will need to comprehend what crypto will do to their market is huge.

We’ve got lots to do to get there. As we say, we’re starting with money.

Ben Whitby —Risk & Compliance Director @ TokenCard