It’s time to rationalize the disparate regulatory treatment of crypto

Easing inflation, a pause in interest rate hikes and a brief U.S. banking crisis have driven bitcoin prices to a record high, as investors see the digital currency as a safe haven.

New forms of digital money, such as fiat-backed stablecoins, central bank digital currencies and decentralized finance, or DeFi, could transform payments and financial services and improve efficiency in digitally native environments, such as the metaverse, without the costs of switching between digital and traditional financial activities.

Large banks are looking to use blockchain technology to tokenize deposits to support payments and tokenize real-world assets for clearing and settling transactions. While blockchain improves security, increases regulatory transparency and reduces concentration risk, it also brings new risks and mostly remains unregulated.

The volatility and recent failures in crypto exchanges, and among lenders and other digital-asset firms, jeopardize crypto’s standing as a safe haven, show the fragility of the digital asset ecosystem and make the case for a tougher and unified regulatory approach.

Despite its game-changing potential, crypto adoption has remained relatively low. Only 42% of institutional respondents to the 2023 ISG State of the Banking Industry Study said CBDC and digital assets will be a top priority over the next two years. Survey respondents ranked “enabling digital asset services” 13th out of 20 opportunities over the next two years, and “enabling digital currency transactions” 17th out of 20.

It’s clear that the high potential for fraud and the lack of regulations have hampered bank investments. Consumers are also wary of digital assets’ unsavory reputation and investor losses from high-profile collapses such as FTX, Celsius and Silicon Valley Bank.

There is an increasing view that crypto and digital assets must be subject to the same rules and regulatory compliance frameworks as traditional financial assets. Public/private collaboration among traditional financial firms, digital asset natives, virtual asset service providers, or VASPs, and regulators can help achieve better standards in regulating digital assets without inhibiting innovation.

Traditional banks need to evaluate the best approach to the digital asset ecosystem, perform due diligence on third-party vendors, implement an overarching digital asset strategy and integrate digital asset activities into their risk and compliance frameworks. This requires additional investments in people, processes and technology as well as adequate controls to protect consumers, operate safely and mitigate risks, including credit, market, liquidity, concentration, compliance, operational/cyber, technology and legal/regulatory challenges.

Regulatory sandboxes allow innovators and regulators to work toward responsible innovation and consumer protection by enabling digital asset products, services, solutions and business models to be tested before a full-scale launch. Responsible innovation, combined with technology, robust guardrails and proactive risk management and governance, has the potential to alleviate the frictions and inefficiencies in the digital asset landscape, so it seems worth the time and effort to achieve.

The global nature of digital assets requires coordination, but countries are taking wildly varied approaches, ranging from China’s attempts at a total ban to the United Arab Emirates’ partial ban on certain activities such as issuance of new stablecoins.

Furthering the patchwork approach, banks in some countries have imposed restrictions on certain activities or blocked crypto transactions. For instance, providers in the U.K. are prohibited from offering crypto-derivative products to retail investors. U.K. lenders including Chase, Santander, NatWest, HSBC, Barclays and Nationwide have restricted transactions with crypto exchanges or imposed limits on payments to crypto exchanges, citing an uptick in fraud, scams and volatility.

In June 2023, the European Union adopted the Markets in Crypto-Assets, or MiCA, regulation, a cross-jurisdictional regulatory and licensing framework for crypto assets across all member states. It aims to curb market abuse and will require service providers like crypto exchanges to comply with rules such as AML, market manipulation and insider trading, and make them liable in the event of loss of investors’ assets. The U.S. Securities and Exchange Commission has proposed extending custody rules to crypto assets to ensure investors are protected in case of a business failure.

Global regulatory coordination and cooperation will help financial institutions navigate digital assets’ opportunities and risks effectively and will promote strategic consistency. For example, it would be helpful if the Financial Stability Board’s recommendations for the regulation, supervision and oversight of crypto-asset activities and markets, as well as global stablecoin arrangements, were adopted and enforced in non-FSB jurisdictions.

The Basel Committee on Banking Supervision’s standards on banks’ crypto-asset exposures is a positive step in this direction. It mandates conservative capital requirements for unbacked crypto assets with a risk weight of 1,250%, as well as an exposure limit constraining the total amount of unbacked crypto a bank can hold to below 1% of Tier 1 capital.

Advancements and clarity in regulations and oversight could inspire growth in the digital asset market and deter illicit activity. Governance rules for exchanges promote transparency and reassure market participants of where their assets are at all times, and that confidence, in turn, fosters institutional adoption, which attracts participation, liquidity and long-term stability. A predictable legal framework would promote innovation and help attract necessary talent and capital.

Effective regulation would drive a new level of engagement (on both the demand and supply side) in an asset class that has enormous potential to drive new revenue streams for banks and additional choice for consumers.