Where Is Crypto Regulation Headed – And How Will That Affect Trading and Prices…
The topic of regulating the crypto world is highly controversial, as it concerns finding a suitable balance between the original concept of decentralized money/distributed ledger technologies and addressing the risks of such an alternative system. Countries and economic blocs around the world have taken various approaches to such regulations, ranging from securities laws, licensing of intermediaries, and transaction supervision, to full-on bans on the mining, trading and usage of crypto. The scope and nature of these regulations are constantly evolving and they can therefore still have significant implications for the price dynamics of crypto, especially in the biggest asset markets such as Bitcoin and Ethereum. What should we expect going forward?
The content of this post does not constitute financial or investment advice. It is intended for information and education purposes only. The author is not affiliated with any institution and does not earn income from any company or financial product that might be mentioned. References to names of institutions are not recommendations.
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Where are we now?
As of May 2024, most countries around the world where crypto trading is (still) legal have either established or made steps toward introducing some form of regulation. Generally, cryptocurrencies and crypto assets are not treated as legal tender, but in some countries (e.g., Germany), there are provisions in the local laws that hint at potential usage as a method of taxation and settlement of payments. There are usually several elements of crypto regulations, implemented to a different degree across various countries (some of these are in the chart below for the EU, US and UK):
– Requirements for intermediaries involved in transactions with crypto assets, including licensing and investor protection;
– Laws, standards, and regulations regarding anti-money laundering and terrorism financing;
– Taxation and related requirements;
– Frameworks and standards for classification and legal status;
– Rules and requirements concerning the interaction with the traditional financial system (e.g., standards for treatment and risk assessment in bank portfolios);
– Laws regarding market integrity and market manipulation.
International organizations such as the Financial Stability Board (FSB), the International Monetary Fund (IMF), the European Central Bank, etc., have made statements about the intent of these regulations. It generally goes like this: we want the innovation, cost advantages and new technology that come with this new system, but we want to make sure risks are minimized and people are protected. However, it goes much further beyond that. The more an alternative system grows and becomes integrated into the existing system, the more unpredictable and potentially disastrous the consequences could be for both systems and the macroeconomy should one of them falter or lose people’s confidence. Also, the more the alternative system becomes a viable replacement candidate, the more powerful interests (such as established financial institutions and monetary authorities) will attempt to take over or subordinate this new system in order to retain their influence and power.
This is not a statement rooted in conspiracy beliefs, it is purely about how political and market power works in this world. So a regulatory framework is an attempt to apply known instruments of moderation and control over something of (yet) unknown prospects and properties. It is one of the key reasons why regulating the crypto world is so controversial, but perhaps also why, at least to some extent, it is indeed necessary.
What do regulators have in store for us?
Whatever we have seen so far in terms of regulation, authorities will not stop there. There has been a widespread realization in recent years that as the crypto world grows and draws in more interest and people’s savings, regulators must be just as dynamic and evolve their responses to catch up.
Based on official statements and public proposals and opinions, we have some idea as to where the most powerful monetary and supervisory bodies want to bring their regulatory efforts:
1. European Central Bank (ECB) & European Securities and Markets Authority (ESMA)
According to the ECB, the promise of bitcoin and crypto assets to offer a viable alternative has not really been realized. In the words of ECB Director General Bindsail, responsible for Market Infrastructure and Payments, the Markets in Crypto Assets Regulation (MiCA) introduced in 2023, might create a false impression that Bitcoin is now regulated and safe but in fact it remains “a cursed tool for anonymity, facilitating illicit activities and leading to legal action against offenders by the tracing of transactions”. Therefore, the preferred action going forward would be tighter regulation of the crypto space, with a focus on protecting society from money laundering, cyber and other crimes, financial losses for the financially less educated, and extensive environmental damage.
At the end of last year, Chair Enria of the ECB Supervisory Board expressed his concern that groups of undertakings offering both financial and commercial services operating on a cross-border basis and reaching millions of clients may raise level-playing-field concerns and pose a threat to overall financial stability. His view was that crypto-asset service providers should be included in the scope of prudential consolidation of banking groups to properly capture crypto exposures for the purpose of the consolidated capital requirements.
There are a number of ongoing consultations, led by ESMA, regarding the issuing or trading of cryptocurrency. Going forward, a license will probably be a requirement for these activities and all service providers will have to obtain the names of senders and beneficiaries, no matter the amount being transferred. This is contrary to one of the main benefits of such cryptos like Bitcoin, where anonymity is one of the key features. Additionally, self-hosted wallets holding over €1,000 will need to run a wallet ownership verification process before they can execute transactions.
2. Federal Reserve (Fed), Securities and Exchange Commission (SEC) and US Government
In August 2023, the Fed released guidance in addition to the existing regulations, related to the issuance of and engagement with digital assets by state member banks. It clarified the process for gaining a supervisory non-objection to get involved in stablecoin activities and a program for ‘novel activities’ complementing existing supervisory processes. This guidance is most likely a placeholder unless and until stablecoin legislation is passed. It will probably be followed by some similar form of guidance regarding other crypto-asset-related activities, such as crypto-asset custody and facilitating crypto-asset trading.
However, the Federal Reserve Board signaled, that banks should not expect such guidance for engaging with crypto-assets as principal. A footnote in the statement says that issuing or holding as principal crypto-assets that are issued, stored, or transferred on an open, public, and/or decentralized network, or similar system is highly likely to be inconsistent with safe and sound banking practices.
Furthermore, the SEC has been trying to determine how exactly to draw the line between which crypto offerings constitute securities and which do not. In that sense, such scrutiny is only more likely to intensify. For instance, recently, the popular trading platform Robinhood received a legal notice that it may be in violation of federal securities broker laws, related to whether the crypto assets listed on the platform are indeed securities. This is just one example of how the SEC intends to step up its enforcement approach to the industry. Some legal experts point to the fact that this is even more important now that the Bitcoin ETFs received a green light. Some high-profile legal cases in the US are ongoing and we can probably expect a bigger legislative impulse from the government after they are decided by the courts. SEC Commissioner Hester Peirce has referred to the MiCA in the EU as a good starting point that could be used as an example by the US to set up a more sound regulatory regime.
3. International Monetary Fund (IMF) and Financial Stability Board (FSB)
At the end of 2023, both institutions came out with a joint paper of policy recommendations on crypto assets. One of its recommendations is that simply banning crypto will not eliminate risks so instead, there should be policy coordination, especially when it comes to global stablecoins which can pose risks to financial stability across jurisdictions. It advocates for ‘appropriate’ powers and authorities in the hands of regulators, so they can properly supervise and oversee the space, as well as more comprehensive and effective regulatory frameworks. Essentially, the requirements that the paper refers to (for crypto asset issuers and/or service providers) are moving in a direction similar to what is already applied to other intermediaries and banks: risk management processes, data collection and storing, reporting and disclosures, addressing interdependency and financial stability risks.
4. Bank for International Settlements (BIS)
In its overview of the regulatory landscape, the BIS did emphasize that there are segments of the crypto space where regulation is lacking — and that is where they recommend that authorities put more effort going forward. For instance, specific regulatory initiatives for issuers of utility tokens, governance tokens or non-fungible tokens. One example is the use of utility tokens as investments, where there could be restrictions to the issuers’ ability to buy back such tokens or prohibit exchanges from listing such tokens or provide credit to trade such tokens.
The BIS also highlights that other areas of regulation may need to be further developed, such as:
– expanding the regulatory scope to capture new actors involved in services provided through DeFi protocols;
– introducing legal frameworks to enforce agreements coded in smart contracts;
– defining which authorities will regulate and supervise various entities and activities involved in offering financial services with crypto assets, especially in jurisdictions where multiple authorities regulate and supervise these entities and/or activities;
– addressing technical aspects of public permissionless distributed ledger technologies in the regulatory frameworks, as they could differ and affect the risk level of applications built thereon.
What impact on prices and trading activity can we expect?
Multiple research papers have examined the impact of regulation on the crypto markets, most of which use event studies (listed in the references below). The most comprehensive of those studies, encompassing a large number of regulatory events (2015–2019), shows that investors generally reacted negatively to the possible adoption of new regulations of the cryptocurrency market in the short run and considered such events “bad” news. The magnitude of such reactions was not uniform across various crypto assets due to their differences in market size/liquidity and information asymmetries.
The authors suggest that investors may have been motivated to enter the crypto market mainly because it is a non-regulated market and due to the absence of additional transaction costs. This is the reason why such a reaction makes sense. It is also likely explained by the distrust toward financial regulators, related to their insufficient technical understanding of the markets. The reaction was even more negative and significant when there was a regulatory decision to treat cryptocurrencies under securities laws. When measuring the long-term effects, the authors find that there was positive and significant performance in the pre-event period, but non-significant performance in the post-event period. This means that risks related to illiquidity and information asymmetry were likely remunerated in advance of the event but not thereafter.
Several studies confirm that large bans or major regulation news cause Bitcoin volatility to surge and prices to drop more significantly. This is usually combined with a deterioration of market liquidity and while the volatility jump could be relatively short-lived, the price decrease and liquidity effects persist.
conclusion
Regulatory efforts will likely intensify in this and the coming years as supervisory authorities and governments attempt to constrain the crypto space from growing further out of their control. How much that will contain existing and future risks, including the possibility of spillovers into the traditional financial system, is not yet certain. However, given the trajectory set by recent legislation in the EU and the UK, as well as in other countries, and the increased scrutiny by the US supervisors, we will likely see higher volatility in the crypto markets in the future as a result of new regulations and more stringent requirements. This may be the cause of new market crashes and drops in market liquidity, as we have observed in the past. Tighten your seat belts – the ride in crypto-land is not over yet.
References
1. Chokor, Alfieri, Long and short-term impacts of regulation in the cryptocurrency market, The Quarterly Review of Economics and Finance, 2021
2. Griffith, Shang, Cryptocurrency regulation and market quality, Journal of International Financial Markets, Institutions and Money, 2023
3. Lyócsa, et.al., Impact of macroeconomic news, regulation and hacking exchange markets on the volatility of bitcoin, Journal of Economic Dynamics and Control, 2020
Author: Nikolay
Founder of MoneyCraft
