Hashdex Director of Marketing Chris Glendening sat down with Head of Legal and Compliance, Julia Castelo Branco, to talk about recent developments regarding crypto regulation.
The conversation covered a wide range of topics, including how US investors are impacted by an unfriendly regulatory environment, the EU’s progress on the Markets in Crypto Assets (MiCA), and best practices for asset managers investing in this space.
Chris: There’s a lot of attention around crypto regulation this week, with SEC Chair Gensler testifying before the US House Financial Services Committee and a vote scheduled in the European Parliament to finalize the Markets in Crypto Assets (MiCA) regulation. The US and EU are obviously two hugely important markets for this industry, but the US continues to lag in terms of approving any sort of framework for crypto regulation. What do US investors need from regulators in terms of regulatory guidelines for the crypto industry?
Julia: The first and foremost need of US investors now is regulatory clarity through the approval of a comprehensive framework for crypto assets. We have been seeing a lot of activity from different US regulators around crypto in these last few years and some of them are somewhat contradictory, making the need for a framework even more urgent.
There are some important proposals currently being discussed by Congress, such as the Responsible Financial Innovation Act - RFIA, which would address important issues for the crypto industry, including the commodity status of certain crypto assets, a special category of CFTC registrant for Digital Assets Exchanges, and custody and segregation requirements.
The approval of the RFIA would give the industry and US investors much-needed clarity to continue developing this market, including clarity around whether ether (ETH) is a security, an issue we have seen recently in the suit brought by the New York Attorney General against KuCoin. Litigation like this pushes the crypto industry backwards, bringing instability to the market. Thus, there is a crucial need for a regulatory framework that can help resolve these uncertainties.
With regard to how the SEC has approached crypto, I believe there should be a shift. It is clear that many US investors want to have exposure to crypto—just look at the numbers of US investors on crypto exchanges. However, it would be much better from an investor protection standpoint for them to invest through a regulated vehicle with the green light of the SEC. We have seen some important developments with the approval of the bitcoin futures ETFs, but US investors should have access to a spot bitcoin ETF like in so many other regions. We are optimistic this will come sooner rather than later, and believe that a bitcoin futures ETF regulated under the Securities Act of 1933 may have the best chance for conversion to spot.
To sum up, US regulators seem to be more focused on enforcement actions than on approving guidelines that would foster the industry and protect investors. The events that shook the industry in 2022 had a great impact on how US regulators are looking into crypto, but the technology isn’t going anywhere and will continue to evolve at a fast pace in the near future. The focus now should be on how to regulate the industry to protect investors and avoid events like FTX, while also fostering innovation and giving US investors access to crypto exposure through regulated products.
Chris: In contrast to the US, the EU has created a regulatory framework that is set to be approved this week. What will the new MiCA regulation mean for the development of ETPs and other investment vehicles in Europe? Is anything similar planned in the UK?
Julia: The new Markets in Crypto Assets (MiCA) regulation will have a huge impact on the development of the global crypto industry. Like other EU rules that spearheaded regulations in their respective sectors, such as the General Data Protection Regulation (GDPR), MiCA will potentially become the world’s standard for the registering of crypto-asset service providers (CASPs) and the definitions of types of tokens, such as asset-referenced tokens (ARTs), e-money tokens (EMTs) and Utility Tokens (UTs). The strong regulation is very welcome as it brings traditional protections to this emerging market, helping to build the public’s trust in crypto, while both enabling innovation and technological development but also filtering out the bad apples that have caused turmoil in the industry.
As for the development of ETPs and other investment vehicles in Europe, on one hand MiCA will not cause a direct effect on them or their issuers, but on the other hand it will oblige CASPs used by the issuers of such products to meet strict criteria, have strong governance and compliance procedures, and step-up to the high standards that service providers in traditional financial markets must meet. These service providers, such as custodians, will need to comply with the MiCA regulation's requirements related to authorization, conduct of business, and prudential standards.
It is noteworthy that ETPs and other crypto investment vehicles are already subject to TradFi regulations, such as the Prospectus Regulation, Markets in Financial Instruments Directive (MIFID), Alternative Investment Fund Managers Directive (AIFMD) Transparency Obligations Directive (TOD), and Undertakings for Collective Investment in Tradable Securities (UCITS) Directive. Considering that issuers of financial products with indirect exposure to crypto are already regulated by the existing rules, it is clear that MiCA’s goal is to regulate the new players that have emerged within the crypto industry, as well as the tokens themselves, creating a regulatory framework that can allow investors and local lawmakers and authorities to have more clarity on this new emerging ecosystem, but not preventing or slowing its development.
Therefore, although ETP issuers themselves may not be directly subject to the MiCA regulation, they will need to ensure that their service providers comply with these requirements to operate in the EU. This will bring more clarity to due diligence and know-your-partner (KYP) procedures for ETP issuers when selecting and working with service providers, who will now have a more tangible framework to rely on.
Shifting to the UK, there is not yet a regulatory framework for crypto assets approved. The Financial Conduct Authority (FCA) has oversight to check whether crypto asset firms have effective anti-money laundering (AML) and terrorist financing procedures in place. Thus, if a crypto firm is registered with the FCA, it means that it complies with a certain level of AML requisites and does due diligence and background checks of its providers, giving a certain level of confidence to the market.
In February this year, however, the UK government released a consultation of an extensive regulatory framework for crypto assets with the objective of establishing an effective regulation which enables firms to innovate at pace, while maintaining financial stability and clear regulatory standards. This approach adopted by the UK government is welcomed by the industry as it intends to achieve strong regulation that will push the industry forward, allowing for innovation but protecting investors and the market from disasters as we have been seeing recently.
Also important to highlight is the format of this consultation, which calls for the participation of the public and crypto market experts. Given the technicity that comes with digital assets and blockchain technology, this participation and possibility of comments from the industry is extremely important to end up with a good framework.
Finally, the UK has other important initiatives currently under discussion by its Parliament, including the Financial Services and Markets Bill, which expressly includes crypto assets as financial instruments that can be sold in the UK. Upon approval of this and the regulatory framework mentioned above, the UK will certainly be in a good position to attract crypto players and help foster the growth of this industry.
Chris: Brazil has been a leader in giving investors access to this emerging asset class through regulated financial products. Are there lessons from Brazil that can be applied to the US, Europe, or elsewhere?
Julia: The Brazilian Securities Exchange Commission (Comissão de Valores Mobiliários - “CVM”) has been a leader since 2018 in allowing Brazilian investment funds to invest in cryptocurrencies. In 2018, this type of investment was indirect, through a foreign vehicle. In 2021, Brazil became one of the first countries to approve a crypto ETF and it is one of the few to approve crypto basket ETFs. In 2022, it approved a new framework for Investments Funds expressly including crypto assets as a financial asset class, similar to shares or notes.
What we have been seeing in Brazil is a recognition that crypto assets should be considered like more traditional financial instruments. The CVM understands that there is an appetite by investors to include this new asset class in their respective portfolios and that it is much better for investor protection to do this under a regulated environment. There are millions of people investing in cryptocurrencies through unregulated exchanges. Most of them do not fully understand the specifics of the industry and the ins and outs of regulatory and compliance standards. When you set up a regulatory framework with educated regulators that can differentiate between a serious player and a bad actor, setting up layers for the approval of a regulated financial instrument with exposure to the asset class but observing requirements such as money laundering prevention, liquidity, and licensing, among others, you mitigate many of the risks associated with the investments in crypto.
This is the main lesson from Brazil that other countries should follow, especially those still looking at crypto with suspicion and focusing on the negative side of history only.
Chris: Regardless of the region, we get many questions from clients about our compliance practices, especially following last year’s implosion of FTX and a number of the other centralized industry players. Are there best practices asset managers should follow given the unique nature of crypto assets?
Julia: Yes—asset managers that invest directly in crypto assets should follow several compliance and risk management procedures. A strong compliance and risk control team is key and should be considered from the start. This team should put together a robust policy framework to manage risk, private key handling, and storage of crypto assets, for example, in addition to the usual policies that asset managers have in place.
Moreover, the team should be prepared to execute detailed and careful due diligence on all partners, service providers, and crypto asset projects. This is what we call in the industry the “KYs.” We have the usual “Know your Partner (KYP),” “Know your Client (KYC),” and “Know your Employee (KYE)” procedures, but also “Know your Token (KYT)” that is specific to crypto. KYT involves the team conducting due diligence of all the tokens that will be included in the portfolio. This is extremely important to understand the risks associated with crypto assets and control what the manager may include in the portfolio.
One other practice asset managers should follow is the usage of a specialized software for transaction and wallet monitoring, and analytics using on-chain data for real-time monitoring. In other words, it’s important to use technology to follow the flow of the tokens in the blockchain, raising red flags when a crypto asset may be illicit in nature.
Lastly, it is also important for crypto companies to stay close to regulators worldwide and follow closely all frameworks of the countries where they do business. Regulation is developing at a fast pace and crypto companies need to stay up-to-date on the latest guidelines issued by authorities.
Chris: What can investors expect from regulators for the remainder of this year?
Julia: In general, we will see important movements from crypto regulators across the world this year. I like to say that 2023 is key for crypto regulation, with some important frameworks being approved and adopted—such as MiCA, the Brazilian Digital Assets Framework that will become effective in the next couple of months, and maybe UK developments as well, as we discussed. In late 2022, we saw important regulatory developments in Asia, especially in Hong Kong, and this trend will probably continue through the remainder of this year. Hopefully other governments will continue or even start discussions about regulatory frameworks for digital assets.
Finally, all eyes are on the US and how they will continue to approach crypto assets, especially after the Congressional hearing with Char Gensler this week and the results from the dispute between Grayscale and the SEC. We will probably see more enforcement actions from the SEC, but the industry is begging for regulatory clarity. If the US advances from a regulatory standpoint and approves a framework like what is under discussion by Congress, other countries will certainly follow, allowing this industry to meet its global potential.
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