History repeats itself – first as banking, then as crypto  

15 Nov, 2022

The collapse of FTX came about because of poor practice that has been outlawed in other parts of the financial system, including the mismanagement of client assets, which resulted in significant investor harm. Its failure is redolent of aspects of the 2008 financial crisis and has given crypto-sceptics their highest-profile example of why crypto should be tightly regulated. But care must be taken – crypto has the potential to provide new and innovative solutions to old financial services challenges; overly stringent regulation could strangle nascent innovation and simply displace criminal activity rather than reduce it. 

Developments in recent weeks relating to FTX, the world’s third-largest crypto exchange, mean that cryptoasset regulation has never been a hotter topic. But it had already grown increasingly high-profile in recent months following the failure of major actors in this space, including Celsius, Voyager, Three Arrows Capital and Terra.  

The EU is leading the field in global regulation, with its Markets in Crypto-Assets Regulation (MiCA) currently in the process of being finalised. MiCA represents one of the most extensive regulatory frameworks for cryptoassets agreed to date – and is now more relevant than ever. The UK and US have taken initial steps towards new crypto regulation themselves, and have been watching the EU’s experience with great interest. 

New technology, old failures 

The collapse of FTX stems from a number of failings in its business practices and model, which are well-known in traditional finance and covered by existing financial regulation, particularly after the post-2008 financial crisis reforms. FTX and a related party, Alameda Research, reportedly engaged in inappropriate transactions with client assets, failed to implement adequate client asset custody policies, and had significant flaws in their internal risk monitoring and management processes (particularly with regard to client leverage). 

We expect the FTX crisis to catalyse a shift in the regulation of crypto towards an entity-based approach which focuses upon the activities carried out by those entities, rather than an asset-based approach. At present, many jurisdictions regulate only a small fraction of cryptoassets, and the activities associated with those assets, rather than the wider crypto universe. As such, entities like FTX whose activities lie primarily or entirely in the unregulated universe can fly below the radar. 

A more holistic regulatory approach would enable regulators to better understand and supervise the activities of service providers whose current business model blurs the lines between acting as an exchange and, essentially, a digital current account (given divergent treatments and safeguarding of client assets). 

MiCA: A timely regulatory framework 

At its core, the regulatory framework introduced by MiCA is a digital analogue of the EU’s approach to regulating traditional financial markets, drawing heavily upon the approach taken for traditional financial instruments in MiFID (the scope of MiCA covers “traditional” cryptoassets and stablecoins, but not NFTs or DeFi). 

MEP Stefan Berger, who was the rapporteur for MiCA in the European Parliament’s Committee on Economic and Monetary Affairs, has argued that the FTX crash would not have happened with a “global MiCA” in place. While this point can be debated, it is clear that the final MiCA text does address many of the regulatory gaps which contributed to the FTX crisis. For example, Article 67 (Custody and administration of crypto-assets on behalf of third parties) provides clear requirements for cryptoasset service providers who offer custody services, including both legal and operational segregation of client assets from own assets.  

More extensive regulation in major jurisdictions is inevitable 

Other major jurisdictions which do not currently have comprehensive regulatory frameworks for cryptoassets, such as the UK, the US and Australia, are exploring how to properly regulate the cryptoasset sector. To date, these countries have regulated individual assets or specific risks related to cryptoassets (e.g. AML) rather than introducing holistic regulatory regimes. More holistic regimes would, in addition to better safeguarding against an FTX-style crisis, enable regulators to manage other crypto-related issues, such as conflict-of-interest risks and energy consumption. 

FTX’s failure, and the scale of client losses, will put pressure on politicians and regulators to accelerate the process of introducing more comprehensive regimes for cryptoassets. The White House has said that the FTX crisis “highlights why prudent regulation of cryptocurrencies is indeed needed”. In the UK, HM Treasury has committed to releasing a consultation paper on cryptoasset regulation by the end of 2022. Many within the EU hope that its relative speed in introducing and finalising MiCA will mean that other jurisdictions follow a similar approach to regulating cryptoassets.  

With workstreams underway across major jurisdictions, as well as at a global level (e.g. by the Financial Stability Board), greater regulatory scrutiny of and more extensive regulatory requirements for cryptoasset service providers is inevitable. The Financial Stability Board’s recent consultation papers are closely aligned with the approach taken in MiCA and were presented to G20 finance ministers last month. This latest global incident will encourage jurisdictions to take action to implement their recommendations. 

The core concept of MiCA, drawing upon established principles for financial regulation but tailoring for the nature of crypto, is a good basis for other jurisdictions. However, there is a risk that instead, bank-like regulation could be called for, especially given the shared dynamics of the FTX crisis and 2008 – a digital “bank run”, liquidity mismatch when lending out client assets, and lack of internal limits and transparency.  

An increasing range of businesses have an interest in crypto regulation. They should closely follow global developments to inform their commercial strategy and seek to influence the process of policy formation, at both a political and official level, in order to ensure that future regulatory frameworks support innovation and new technologies whilst addressing concerns about consumer protection and market integrity.  

How Flint can help you 

Flint’s Crypto team has exceptional people in London, Brussels, and across Europe, able to help clients navigate the increasingly complex and fragmented global regulatory environment for cryptoasset services, steer government policy, and achieve their commercial objectives.    

Sam Juthani is a manager based in London. He is an economist and primarily advises financial service and investor clients on policy and political issues. Conor Sewell is a consultant based in London and provides advice to clients across a range of sectors, including financial services and crypto, on political, policy and regulatory issues. Sam and Conor previously worked at the Bank of England and HM Treasury.

To find out more about how Flint can help you navigate the risks and opportunities from changing regulation and increasing political focus on cryptoassets and digital finance, get in touch.   

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