News & Insights

Cryptocurrencies

“Cryptocurrencies have given rise to an entire new criminal industry, comprising unregulated offshore exchanges, paid propagandists, and an army of scammers looking to fleece retail investors. Yet, despite the overwhelming evidence of rampant fraud and abuse, financial regulators and law-enforcement agencies remain asleep at the wheel[1].” 

12/07/2022

Introduction

In one form or another, Cryptocurrencies and related assets feature constantly in the news.

These sorts of assets have occupied financial regulators for some time now in relation to the form and function of regulation. The very nature of these assets, and indeed the genesis of their design was to evade regulation.

From a regulator’s perspective, the history of cryptocurrency has proven to be a constant concern given the incredible increases in value, with many concerned that a bubble was being created.

These concerns crystalised in the crypto crash, or “crypto winter”.

The collapse in the value of crypto currencies began with “Terra” and “Luna”.[1]

What happened?

The crash began with Terra and Luna.

Terra is its own blockchain, very similar to Bitcoin or Ethereum. Its foremost product is the ‘stablecoin’, TerraUSD [“UST”].  The value of UST purported to be pegged to or fixed against the U.S. dollar, which provided a notion of security.

Keeping funds as stablecoins rather than converting them into cash is seen as desirable as conversion can trigger expensive tax liabilities.

The two forms of stablecoin are those backed by reserves and those that rely on algorithms.

Algorithmic stablecoins normally are not backed by reserves but use an algorithm or smart contract to manage the supply of tokens and guide their value to match some reference asset.

UST was supposed to maintain its 1:1 parity with dollar via an algorithmic relationship with Terra’s native cryptocurrency, Luna.

When the UST supply is too small and demand for it is too high, the price of UST goes above a dollar.

To bring UST back down, Terra lets users trade one dollar of Luna for one UST.

Users are permitted to convert UST as needed from burned Luna until the value of UST goes back down to a dollar. As the supply increases, the price eventually comes down. This protocol works in the opposite way as well, allowing purchases of UST when the price falls below a dollar, increasing value.

Because Luna can be created any time UST is below a dollar, its value can plummet in the face of increasing token supply.

This clearly exposes such a commodity to intense vulnerabilities if there was a sudden run on or lack of confidence in the commodity.

This is precisely what happened in May 2022. There are a large number of theories about what happened to Terra and Luna’s value, concerning co-ordinated attacks on the medium, short-selling and so on.

The value plummeted and the unfortunate consequence was that the perceived value of other crypto currencies, even those backed by funds dropped too.

The crash has uncomfortable similarities to the South Sea Bubble and a whole host of similar financial crashes throughout history, even drawing comparisons to a Ponzi scheme.

Every financial crash has led to new regulation.

What is interesting in this instance will be the move from a completely unregulated state to that of regulation, whatever form that may take.

Why the need for regulation?

Despite the crash, the regulators remain deeply concerned.

Charles Randall, the Chair of the Financial Conduct Authority [“FCA”] spoke at the Centre for Commercial Law Studies, Queen Mary University of London on 20 May 2022[2].

Notably, he said:

Last month I met a group of year eight and nine students at one of the academies in Newham near our Stratford office. They acknowledged that crypto was like gambling, but some of them had also been convinced by the internet that they could predict price movements and make money from them. They were very able students, but the hope of getting rich was stronger than any facts or rational arguments I could give them.

With celebrities as varied as Kim Kardashian and Larry David willing to take money to promote speculative crypto, how do we curb people’s enthusiasm to do something that may seriously harm their financial lives?”

Questionable punning aside, this comment raises a serious concern; despite volatility and huge risk, young people are still seeing crypto as a get-rich-quick scheme.

The similarities to gambling are extremely troubling as are the comments made by the students in Newham about how they were convinced by the internet about the viability of crypto. Anecdotally, we are all bombarded on the internet by adverts for crypto schemes to make money quickly.

Hence the need for regulation.

What is coming?

On 10 May 2022, the Queen referred in her speech to Parliament to the Financial Services and Markets Bill[3].

One of the main benefits of the Bill is suggested to be:

Harnessing the opportunities of innovative technologies in financial services, including supporting the safe adoption of cryptocurrencies and resilient outsourcing to technology providers.”

HM Treasury has said that it will consult later in the year on regulating other types of cryptocurrencies, such as Bitcoin.

On 4 April 2022, the UK government published a response to its initial consultation and called for evidence on the regulation in relation to cryptoassets and stablecoins[4].

Stablecoins are very clearly at the heart of the proposed regulation being promoted and sought by the Government, primarily through amendments to the Electronic Money Regulations 2011 and the Payment Services Regulations 2017 which will regulate the issue of stablecoins that are within the scope envisaged, wallets and related custody services.

The proposed amendment is that stablecoins that stabilise algorithmically would be excluded from the regulation; such stablecoins like this may already fall within the current regulatory regime as specified instruments.

Part 5 of the Banking Act 2009 will be extended to include arrangements around the control or facilitation of the transfer of ‘digital settlement assets”.

This is important as it means the FCA and the Bank of England will have the power and authority to supervise in certain stablecoin systems deemed to pose systemic risk.

Issuers of stablecoins referring to fiat currencies will also be required to seek authorisation from the FCA, as will providers of custodial wallet services.

There is unfortunately no mention in the consultation about the territoriality of the proposed regulation.

Given the amount of press that has been devoted to crypto currencies recently, along with the clear appetite that the Government and FCA has for increasing the regulatory regime for such assets, any business and/or individual should review the current facilities that they have in relation to crypto and any licensing requirements, any new products that touch upon any crypto currency with a constant eye on the ever-changing and evolving regulatory environment.


[1] https://www.ft.com/content/c10bc6f7-abbe-45dc-9367-042186c3336f

[2] https://www.fca.org.uk/news/speeches/listening-up-level-up-regulating-finance-uk

[3]https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/1074113/Lobby_Pack_10_May_2022.pdf

[4] https://www.gov.uk/government/consultations/uk-regulatory-approach-to-cryptoassets-and-stablecoins-consultation-and-call-for-evidence

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