Digital Assets Digest June edition

ECB: Speech by Fabio Panetta, Member of the Executive Board of the ECB: Bringing European payments to the next stage: a public-private endeavour (16 June 2022)

On 16 June 2022, the ECB published a speech by Fabio Panetta, member of the ECB Executive Board, given to the European Payments Council. The speech provides an overview of the payments sector in the EU over the last two decades and outlines steps needed to address fragmentation.

Mr Panetta notes that the Eurosystem is cooperating closely with the EU institutions in relation to the EU retail payments strategy (see our briefing here) and the digital euro project. Mr Panetta argues that pan-European market infrastructures (the back end) has not been accompanied by similar progress with the user-facing systems (the front end). Mr Panetta stresses the importance of cooperation in the face of digitalisation of financial systems.

Treasury Select Committee: Future of financial services regulation (First Report of Session 2022-23)

On 16 June 2022, the Treasury Select Committee issued a report on the future of financial services legislation. The committee's inquiry into the future of financial services, which was launched in November 2020. The report contains a section on payments innovation, summarising developments affecting the cryptoassets sector. The report notes that payments innovation could serve to address weaknesses in international payments systems and to serve consumer needs. The report confirms that the Treasury Select Committee will be carrying out further work to see how challenges associated with innovations in payments can be managed.

The Government is expected to issue its response to the report by August 2022.

European Commission: Speech by Mairead McGuinness, European Commissioner for Financial Stability, Financial Services and the Capital Markets Union: ECON Committee Structured Dialogue

On 14 June 2022, this speech from the EU Commissioner for Financial Stability, Financial Services and the Capital Markets Union, Mairead McGuinness, was published. The speech provided an overview of several projects that are underway at the EU and the current condition of markets. Ms McGuiness alluded to the cryptoassets sector and the EU Regulation on Markets in Cryptoassets, which is currently being negotiated by EU institutions.

Key points

• A political compromise concerning MICA under the French Presidency would be welcome and would be an appropriate tool to address concerns relating to consumer protection, market integrity and financial stability, especially in light of events involving the TerraUSD stablecoin.
• Extreme market conditions are affecting other parts of the cryptoasset sector.

HM Treasury: Joint Statement: UK-Japan Financial Regulatory Forum 2022

On 10 June 2022, HM Treasury anissued a statement concerning the first meeting of the UK-Japan Financial Regulatory Forum.

The purpose of the Forum is to direct financial regulatory co-operation between the UK and Japan. The statement confirms that a working group on innovation will be set up, which will allow for the sharing of expertise on payments, cryptoassets and financial innovation. In the statement, the parties also refer to stablecoins and stress the importance of having an effective and robust regulatory framework for stablecoins based on the principle of “same activity, same risk and same rules” principle outlined by the G7.

FCA: Speech by Jessica Rusu, FCA Chief Data, Information and Intelligence Officer: Innovation & Regulation: Partners in the success of Financial Services

On 10 June 2022, the FCA issued this speech by Jessica Rusu, FCA Chief Data, Information and Intelligence Officer, which looks at the role that technology and data can play in relation to financial services. Themes of the speech included: effective regulation through innovation; technology and external forces driving change; digital revolution; and the FCA CryptoSprint. Ms Rusu's speech also argued that the next few years would see significant innovation and change in financial services.

Notable points

• The FCA welcomes the Government’s recent announcement of a flexible approach to regulation to deal with any risks relating to high-risk assets such as cryptoassets. 
• Research indicates an increasing uptake of cryptoassets. However, regulators are concerned about the potential risks to consumers and these risks appear well founded given the recent turmoil in the stablecoin markets.

Bank of England: Minutes of the CBDC Engagement Forum: Meeting 5 May 2022

On 6 June 2022, the CBDC Engagement Forum published minutes of its meeting held on 5 May 2022. The main item discussed was person-to-business payments using CBDC.

The minutes confirm that there was a presentation on the conditions that would need to be in place for a retail CBDC to be adopted in the UK by consumers and merchants. The minutes state that another presentation was given by a Forum member containing an overview of findings from a survey on merchant and consumer sentiment concerning cryptoassets. The presentation suggested that consumers were increasingly interested in using cryptoassets to invest and also as a means of payment for everyday services.

ESMA: TRV Report: Risk Update

On 9 June 2022, ESMA updated its risk assessment, looking at the impact of recent events on financial markets. The document briefly refers to the cryptoasset sector.

Key points

• Crypto assets have been under severe pressure since the late 2021 peak, with provider business models and financial engineering coming under more scrutiny by markets and authorities.
• Cryptoasset volatility could harm consumers, as detailed in a warning published by the ESAs, which reminded consumers of the highly volatile and speculative nature of crypto markets.
• The collapse in price of Terra USD (UST) and the related strain in the Anchor Protocol (which operates on the Terra blockchain) exposed a failure of the algorithmic arbitrage mechanism.

BIS: Bulletin: Blockchain scalability and the fragmentation of crypto

On 7 June 2022, BIS issued a bulletin on blockchain scalability and the fragmentation of crypto. The bulletin argues that, until recently, there was huge growth in cryptoasset sector. The bulletin states that most DeFi protocols operate on the Ethereum blockchain but that since early 2021 newer rival networks, known as “Ethereum killers” had been gaining market share.

BIS states that in early May 2022, the total value of cryptocurrencies associated with protocols on Ethereum made up just half of the overall assets locked into DeFi and contrasts this fragmentation with the payments network. The bulletin argues that fragmentation arises from inherent limitations of blockchain.

FATF: AML/CFT digital strategy for law enforcement authorities

On 8 June 2022, FATF issued a summary on a AML/CFT digital strategy for law enforcement authorities. FATF states that in recent years, law enforcement agencies have enhanced their digital capabilities to respond to developments in digital finance.

The strategy follows a May 2022 confidential report prepared by FATF looking at how technology can be used by law enforcement agencies in relation to investigating and mitigating the risks of money laundering and terrorist financing, as well as sharing information securely. The document focuses on the key strategic questions to be considered prior to launching digital initiatives.

EU: Regulation on pilot regime for market infrastructures based on DLT published in Official Journal

On 2 June 2022, Regulation (EU) 2022/858 on a pilot regime for market infrastructures based on distributed ledger technology (DLT) was published in the Official Journal of the European Union.

The Regulation seeks to address the limited use to date by trading venues or central securities depositories of DLT.

The European Union considers that EU financial services legislation was not drafted with DLT and digital assets in mind, and contains provisions that may inhibit the use of DLT in the issuance, trading and settlement of digital assets that qualify as financial instruments. The Regulation provides that only certain types of financial instruments can be admitted to trading or recorded on a DLT market infrastructure.

The Regulation will come into force on 22 June 2022 and the majority of the provisions apply in EU member states from March 2023.

For more information, please see our briefing.

ESMA: Speech by Verena Ross: Towards delivering the CMU

On 1 June 2022, ESMA issued a speech by ESMA chair, Verena Ross. In the speech, Ms Ross covered various aspects of the updated EU Capital Markets Union Action Plan. Ms Ross also refers to developments in the cryptoassets sector.

Key points

• The current EU regulatory framework is not capturing most cryptoassets and thus investors are not properly protected. The recent issues with significant falls in the value of some cryptocurrencies worsened the risks associated with the sector and underscore the need for proceeding rapidly with a robust EU-wide legislative regime. The fall of Terra, which saw huge drops in value, should not be viewed lightly.
• ESMA welcomes European Commission’s Digital Finance Package, which includes a Regulation on Markets in Cryptoassets.

Bank of England Speech: Old dogs, new tricks: adapting central bank balance sheets to a world of digital currencies

On 1 June 2022, a speech given by Andrew Hauser at a workshop organised by the Federal Reserve Bank of New York and Columbia SIPA was published. In the speech, Mr Hauser noted that digital currencies were posing challenging policy questions and that public authorities were evaluating the arguments for and against introducing their own CBDCs. He also noted that there was debate in relation to stablecoins and referred to the Bank of England’s Financial Policy Committee recommendation that in the UK, any stablecoin that reaches systemic size should also meet standards equivalent to those of commercial bank money (e.g. the issuer is subject to rigorous central bank regulation and supervision; is insolvency remote; and transparently backs its coins with high quality and liquid assets).

ESAs: Joint report on the withdrawal of authorisation for serious breaches of AML/CFT rules

On 31 May 2022, the European Supervisory Authorities issued a joint report on the withdrawal of authorisations following serious breaches of AML/CTF rules. The report examines action points set out in Objective 5 of the 2018 EU AML Action Plan. Among other things, the report argues that the proposed Regulation on markets in cryptoassets should appropriately integrate AML and CTF issues in the prudential supervision of entities that would come under its remit.

Monetary Authority of Singapore: Project Guardian

On 31 May 2022, the Monetary Authority of Singapore (MAS) announced the launch of Project Guardian, a collaborative initiative with the financial industry that seeks to explore the economic potential and value-adding use cases of asset tokenisation. MAS aims to develop and pilot use cases in four main areas: open, interoperable networks; trust anchors; asset tokenisation; and institutional grade DeFi protocols

HM Treasury: Managing the failure of systemic digital settlement asset (including stablecoin) firms

On 31 May 2022, HM Treasury issued a consultation paper "Managing the failure of systemic digital settlement asset (including stablecoin) firms." The consultation sets out the Government’s proposed approach to managing the failure of a systemic digital settlement asset (including stablecoin) firms, by way of the application to such firms of a modified Financial Market Infrastructure Special Administration Regime (FMI SAR).

For more information, please see our briefing.

ECB: Decrypting financial stability risks in crypto-asset markets

On 24 May 2022, the ECB issued this item on financial stability risk associated with cryptoassets markets. This was published as part of the ECB's May 2022 Financial Stability Review in May 2022. Topics covered include: market developments in recent years; risks stemming from cryptoassets; the role of leverage in cryptoasset markets; and crypto lending in the search for yield. The ECB notes that recent volatility, as well as the rising involvement of institutional investors, show the importance of understanding the potential risks that cryptoassets could pose to financial stability. The ECB argues that systemic risk increases in line with the level of interconnectedness between cryptoassets and the traditional financial sector. The ECB argues that it is important to close regulatory and data gaps in the cryptoasset ecosystem to lessen these systemic risks.

FSB Europe Group: Discussion on regional vulnerabilities

On 24 May 2022, the FSB Europe Group issued a press release on a recent meeting it had to discuss regional vulnerabilities. The FSB Regional Consultative Groups bring together financial authorities from FSB member and non-member countries to exchange views on vulnerabilities affecting financial systems and on initiatives to promote financial stability.

The FSB Europe Group discussed regulatory and supervisory issues related to cryptoassets, and the associated challenges for policymakers. Members were briefed on the FSB’s recently established workstream to examine supervisory and regulatory issues raised by “unbacked” crypto-assets which complements FSB work on issues raised by stablecoins.

BIS CPMI published its paper on DLT-based enhancement of cross-border payment efficiency - a legal and regulatory perspective

On 20 May 2022, BIS CPMI published its paper on DLT-based enhancement of cross-border payment efficiency. The report notes that cross-border payments have, in the past, relied on a "mutually trusted central entity" and argues that distributed ledgers, blockchain and smart contracts could provide an alternative to that approach.

The paper notes that financial law and regulation have assumed that regulated activities and functions are concentrated in a single legal entity responsible and accountable for operations and compliance. It argues that an entity-focused regulatory approach may not be wholly appropriate for DLT-based payment arrangements. It notes that in a cross-border context, multiple regulators will need to decide whether they look at DLT as a whole (ledger perspective) or each individual DLT participant (node perspective). The paper then looks at whether the ledger or the node perspective should prevail, and sets some policy recommendations for regulators.

FCA speech: Listening up to level up – regulating finance for the whole of the UK

On 20 May 2022, the FCA published a speech by Charles Randell, FCA Chair. The speech stressed the importance of collaboration between the Government and regulators in delivering consumer outcomes.

Notable points

• Stablecoins that are strongly regulated and "truly stable" can offer benefits (e.g. reduction of reduction of costs and frictions in certain types of payment transaction).
• Distributed ledger technologies can potentially produce efficiencies in various parts of the financial system.
• Bringing speculative cryptassets into regulation will require a workable operational plan with buy-in from the FCA and other regulators.

OECD: Report on Institutionalisation of crypto-assets and DeFi–TradFi interconnectedness

On 19 May 2022, the OECD published its report on institutionalisation of crypto-assets and decentralised finance and trade finance interconnectedness. The report examines institutional investor participation in markets for digital assets, including cryptoassets and decentralised finance. It looks at the potential drivers of supply and demand for these assets by institutional investors, and also analyses the potential for increasing interconnectedness between traditional finance and decentralised finance. The report then outlines the risks these markets may create, as well as the potential benefits of the decentralisation of financial services. It argues that, given the speed and ease at which cryptoassets and decentralised finance participants move geographic location, it is important to ensure cooperation at the international level so as to prevent regulatory arbitrage.

BIS: Working paper on banking and cryptoassets

On 18 May 2022, BIS published a working paper on banking and cryptoassets. The paper attempts to gauge the presence of traditional intermediaries such as banks and investment funds in crypto markets, and assess factors that motivate these entities to take on cryptocurrency exposures. It also seeks to understand the importance of crypto exchanges.

Findings

• Major banks' exposures currently remain at very modest levels, with the average exposure amounting to less than 0.02 per cent of risk-weighted assets.
• Compared to existing regulated exchanges for “traditional” financial assets, the regulatory and supervisory oversight of crypto exchanges (consumer protection, market integrity, trading, disclosure, prudential and AML/CTF measures) remains patchy at best.
• Substantial activity is concentrated in lightly regulated crypto exchanges and this "shadow crypto financial system" serves both retail and institutional clients, such as dedicated investment funds.
• A proactive, holistic and forward-looking approach to regulating and overseeing cryptocurrency markets is needed in the face of uneven regulatory treatment across banks and crypto exchanges and significant data gaps.

US Congressional Research Service: Report on algorithmic stablecoins and the TerraUSD Crash

On 16 May 2022, US Congressional Research Service published its report "Algorithmic Stablecoins and the TerraUSD Crash". The report provides a background into the workings of stablecoins and, in particular, the workings of Terra USD and its sister coin LUNA. The paper explores the reasons behind the turmoil in the stablecoin markets and also looks at policy issues relating to the risks of a run on stablecoins (where a large number of investors withdraw their investments simultaneously). It then considers policy proposals.

ECB: Paper on central bank digital currency and bank intermediation

On 12 May 2022, the ECB published its paper on central bank digital currency and bank intermediation. This is in response to plans to investigate the feasibility of a digital Euro and uncertainty in relation to the design and demand for the digital euro. The paper contains analytical exercises into the consequences a digital euro could have for bank intermediation in the euro area. The paper looks at the mechanisms through which commercial banks could react to the introduction of a digital euro. The paper finds that effects on bank intermediation vary across credit institutions in normal times.

IMF: Capital Flow Management Measures in the Digital Age: Challenges of Crypto Assets

On 10 May 2022, IMF published its working paper on capital flow management measures and the challenge posed to this by crypto assets.

Key points

•  Crypto assets can be traded via pseudonyms and held without identification of the residency of the asset holder. Many crypto service providers operate across borders, making supervision and enforcement by national authorities more difficult.
• The challenges posed by the attributes of crypto assets are made worse by gaps in the legal and regulatory frameworks, as the legal status of cryptoassets is often not clear and laws and regulations aimed at capital flow management may not cover crypto assets.
• To preserve the effectiveness of capital flow management in an environment of growing cryptoasset use, policymakers need a multifaceted strategy.

House of Commons: Answers to written questions on cryptoassets sector in the UK:

In this exchange Tulip Siddiq, Labour MP, enquired about the number of UK adults with money held on crypto exchanges. John Glen, Economic Secretary to the Treasury cited FCA June 2021 research in which the FCA reported that 4 per cent of UK adults currently hold cryptocurrency, or approximately 2.3 million consumers. The FCA also found that the median value of holdings of crypto owners was £300, and 47 per cent of crypto owners (who chose to declare their holdings) had £260 or less in crypto. In a further exchange, Ms Tulip later asked what estimate had been made of the average value of the money held by UK adults on crypto exchanges who give their reason for buying cryptocurrencies as a gamble that could make or lose money. Mr Glen replied that FCA research points to 38 per cent of crypto users buying cryptocurrencies “as a gamble to make or lose money”. This was down 9 percentage points on 2020, where 47 percent of users bought their cryptocurrencies “as a gamble”.

ECMI: EU’s proposed crypto regulations are flawed

ECMI, a body conducting research on capital markets, published this paper in response to EU proposals for a legislation concerning cryptoassets. The paper has been published in light of the May 2022 turmoil in the cryptoassets sector.

Key points

• The EU is the first international organisation to propose a specific regulatory framework. Certain member states already have special legislation for tokens and crypto, but there is no agreement on this at a multinational level.
• Only crypto coins authorised in the EU can be offered to investors. Crypto assets and exchanges will have a very light supervisory regime (compared to what is in place for financial instruments and other exchanges).
• The EU would have been better off considering crypto under existing laws, rather than creating a new regulatory framework.
• Market and business conduct rules should apply regardless of the packaging.

G7 Finance Ministers: Communiqué

On 20 May 2022, the G7 issued this communique following a recent meeting with world leaders covering a variety of issues, including digital assets.

Key points

• The G20 Roadmap for enhancing cross-border payments is a key policy tool in helping to deliver faster, cheaper, more transparent and more inclusive cross-border payment services.
• The G7 recalls the Public Policy Principles for Retail CBDCs, agreed in October 2021, and calls for any CBDC to be grounded in transparency, the rule of law, sound economic governance, cyber security and data protection.
• In light of the recent turmoil in the cryptoasset market, the G7 encourages the FSB, in collaboration with international standard-setters, to proceed quickly with comprehensive regulation of cryptoasset issuers and service providers, with a view to holding cryptoassets, including stablecoins, to the same standards as the rest of the financial system.
• No global stablecoin project should begin operation until it adequately addresses relevant legal, regulatory and oversight requirements through appropriate design and by adhering to applicable standards.

ISDA: Cryptoasset Risks and Hedging Analysis

On 23 May 2022, ISDA issued this white paper in relation to hedging of cryptoassets. This follows the BCBS consultation for the prudential treatment of banks’ crypto asset exposures.

ISDA notes increased interest in crypto derivatives, arguing that market participants are looking to take synthetic exposure to cryptoassets or to protect their cryptoasset holdings from adverse market risk. The paper argues that hedging the most liquid crypto assets for which there is a two-way market (so-called Group 2a crypto assets such as Bitcoin and Ether) with their respective futures or exchange-traded funds is effective. Thus, the capital treatment should allow for offsetting a given Group 2a crypto asset