Let’s Take an Inclusive Approach to Crypto Asset Regulation

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Indian Finance Minister Nirmala Sitharaman highlighted the centrality of international cooperation in crypto-asset regulation during the parliamentary monsoon session. This follows a tumultuous year for the crypto market, filled with margin calls and defaults. These adverse events have not translated into systemic risks because crypto assets are not yet deeply integrated into financial markets. However, financial regulators would do well to establish a framework for monitoring crypto assets to avoid any possibility of future crises. The Financial Stability Board (FSB) recently announced that it will provide a roadmap to regulate certain crypto assets to G20 member countries in October, just in time for the group’s Indian chairmanship, which begins later this year.

The FSB includes policymakers, central bankers and regulators from G20 members, as well as financial centers such as Hong Kong, Singapore, Spain and Switzerland, and international standards bodies. This makes it a centerpiece of international coordination in the governance of financial markets. While crypto-asset regulation is nascent in many emerging and developing economies (EMDEs) like India, partly due to a lack of state capacity, a risk-based understanding of new markets and context-specific is essential. The FSB divides the crypto markets into three segments: unsecured crypto assets, stablecoins, and decentralized finance. The risks within each must be juxtaposed against local EMDE contexts.

First, unbacked crypto assets derive their value from a combination of factors, including production cost, network effects, user sentiment, and speculation. Many of these assets are listed by centralized service providers who act as intermediaries and are regulated in advanced jurisdictions. For example, the proposed EU Regulation on Crypto Asset Markets specifies the compliances these intermediaries must comply with, including measures related to consumer and investor protection. The EU has effectively established a model that can now be widely replicated by other jurisdictions. But it is important that EMDEs step in, through the G20 process, to help shape a context-specific and responsive global model.

EMDE citizens are more likely to enter financial markets via unbacked crypto assets as new investors. Therefore, it is important to maintain their trust in both financial institutions and government oversight. This could result in more rigorous standards for the listing of crypto assets on these markets by intermediaries. The EU requires these intermediaries to publish a white paper with certain similarities to the prospectuses published within the framework of the financial regulations in force. EMDEs could consider additional criteria for “verification” of crypto assets to protect investors.

Another area where EMDEs may consider exceptional measures is anti-money laundering (AML) customer due diligence. The Financial Action Task Force (FATF) guidelines on AML standards for crypto markets are the current gold standard. It prescribes measures such as the identification of customers using reliable data sources, the identification of beneficial owners and the purpose of transactions. The international money laundering and terrorist financing watchdog also prescribes enhanced due diligence for high-risk transactions related to notified jurisdictions. These measures include obtaining more information about the customer and the transaction, as well as increasing the frequency of discretionary monitoring of these transactions. EMDEs could consider widening the net for situations requiring enhanced due diligence based on their own security priorities, for example through thresholds for additional relevant information to be obtained through intermediaries.

Second, stablecoins are usually backed by specific assets (usually US dollars) or a basket of assets, and are widely used to exchange crypto assets with fiat currency. However, EMDEs like India see a potential currency substitution issue with stablecoins, as dollar-backed coins can offer a better store of value than their local currencies. International standards bodies such as the Committee on Payments and Market Infrastructures and the International Organization of Securities Commissions call for the application of a set of “principles for financial market infrastructures” to stablecoins. These principles define international standards for critical infrastructures such as payment systems, securities depositories and settlement systems. Application to stablecoins would essentially mean applying a “same business, same risk, same regulation” principle, which India has already adopted in fintech regulation.

Third, decentralized finance is used to offer financial services and products, allegedly without centralized intermediaries. This segment is potentially the riskiest for EMDEs, since visibility and verification of counterparty identities are generally not required to transact. EMDEs like India are seeing an increase in money laundering across the board, including through traditional banking channels. According to PTI data, the Law Enforcement Branch recorded a total of 4,637 money laundering cases between July 2005 and November 2021, of which 769 related to money laundering through bank fraud. Decentralized finance will further complicate the nature of financial fraud, and the FSB is unlikely to propose a regulatory perimeter for this new market anytime soon. EMDEs therefore need to be very careful and allow decentralized finance to work only in sandboxed environments.

Over the past decade, technology has been a key enabler of financial inclusion, through fintech as we know it today. Crypto markets may represent the future of fintech, or at least give a glimpse of it. Therefore, the upcoming G20 Presidency will serve as a springboard for India to help shape financial regulation that is important from the perspective of EMDEs.

These are the personal opinions of the authors.

Arvind Gupta and Vivan Sharan are, respectively, Founder, Digital India Foundation, and Secretary, Esya Center

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