The Need for a Designated Crypto Asset Regulator

In the aftermath of the global financial crisis, the G20 set out to implement reforms in the over-the-counter derivatives market aimed at introducing central clearing to minimize risk and counterparty credit exposures. 

The group also imposed a stricter regime for credit rating agencies, particularly for ratings used by regulators. Syren Johnstone, executive director at the Faculty of Law at The University of Hong Kong, says this precedent could serve as the future roadmap for crypto regulation.

Johnstone believes a new regulator should be created to oversee the treatment of crypto assets. But for this to happen, he says, a global forum such as the G20 needs to get involved. To back up his opinion, he’s written a paper—Inhabiting Different Realities: Incrementalism, Paradigms, and the New Prospect—that questions the current approach toward the regulation of crypto assets.

“Everybody knew that this was a massive, unknown risk in the system,” he tells WatersTechnology, referring to OTC derivatives and credit rating agencies leading up to the financial crisis. “But it wasn’t until we had the crash that the G20 woke up and said they’re going to do something about this, waved their hand and [said] everybody must implement [the reforms]. At some point, to deal with the powers that currently vest in some of these regulatory bodies, the only way is for the G20 to think that it’s important enough to say, ‘Guess what everybody, we’re going to need a new regulator to deal with this area of technology if we want it to evolve.’”  

He acknowledges that this isn’t likely to happen any time soon. “This paper is a 200-millimeter lens looking way out there as to where I think we need to be aiming ourselves. But I don’t think it’s going to change until we get something mandating it from a body like the G20, for example,” he says. 

In the paper, Johnstone, who previously held senior management roles at Banco Santander and Societe Generale, lays out several proposals for policy development aimed at crypto assets. 

Current regulation applies what Johnstone calls a ‘fit-to-existing-regulations’ taxonomy on crypto assets, which is characterised by an incrementalist approach that risks stifling innovation and damaging the potential of the underlying technology. 

The only way you’re going to deal with it is for the G20 to think that it’s important enough to say, ‘Guess what everybody, we’re going to need a new regulator to deal with this area of technology if we want it to evolve.’

Syren Johnstone, The University of Hong Kong

An example of this can be seen in the field of logistics management, says Paul Li, general counsel at OAX Foundation, which independently funded Johnstone’s paper. “VeChain has been trying to set up ways in which products can be tracked from creation all the way to the end-user. They’re doing this through a combination of Internet of Things, QR codes, smart lids, and smart tracking. Then all of the information links into the blockchain they’re managing, so that at every scan and every point, the information is validated.”

He continues: “There needs to be a way for the participants on the network to want to support the system. As it currently stands, anything that’s being used to remunerate them or help them in terms of giving them a reason to support that network could potentially fall into the realm of a security or a financial product. Does that mean that those people who are supporting the network could potentially be captured by some financial services regulation? That doesn’t seem appropriate—it doesn’t seem proportionate to what they’re doing or in any way fair.”

OAX was founded in 2017 to explore the future of decentralized exchanges and address their main shortcomings: speed, scalability, interoperability, and trust.

The notion of better classifying crypto assets is something that some regulators, including the European Commission, are also considering. The EC issued a consultation paper in December 2019 on a potential framework for crypto assets. It wanted feedback on crypto assets that fall under existing EU legislation such as Mifid II, as well as those that don’t. 

New Taxonomy 

One of Johnstone’s proposals is to develop a new taxonomy that interacts better with the DNA of cryptographic consensus technology. The “determined-by-architecture” (DBA) taxonomy he proposes is made up of three core building blocks: cryptographically secure technology; the ability to implement a consensus mechanism; and the ability to run across a decentralized network. 

Johnstone says a new taxonomy is needed to make predictions and figure out the correct regulatory treatment for any new “species” beyond the primary one—financial crypto assets.  

“The problem at the moment is that we have three basic boxes: money, securities, and something else. That’s an inadequate set of boxes to deal with all the different kinds of things we would like to do with this technology. So the taxonomy needs to be something which drives regulatory attitudes toward the future,” he says. 

The problem at the moment is that we have three basic boxes: money, securities, and something else. That’s an inadequate set of boxes to deal with all the different kinds of things we would like to do with this technology

Syren Johnstone, The University of Hong Kong

Johnstone says the first thing that should be done is to flesh out how the taxonomy might start to service that need, before getting into the nitty-gritty of how developers are thinking about moving the technology forward along the ideas of consensus, cryptography, and decentralization. 

“The point is, I know the EU is actively looking at this,” he says. “Okay, one doesn’t go and knock on the door of the G20—you try to make your way closer to the top of the mountain. So, hopefully by the end of this year, there’ll be a little more awareness, at least in Europe, that there might be alternative ways of looking at how to taxonomize this space. That might not be my DBA taxonomy, but the key point is that it identifies what we’ve got now, what I’ve called fit-to-existing-regulations. It doesn’t take too much thinking about to realize, ‘Hey, look—that’s a quick, cheap, and easy solution.” 

Often, says OAX’s Li, “something bad” needs to happen before regulators or international forums like the G20 take action. For example, Mark Carney, former chairman of the Financial Stability Board (FSB), said in March 2018 that “the FSB’s initial assessment is that crypto assets do not pose risks to global financial stability at this time.” 

Then Facebook came out with its Libra digital currency, and all of a sudden the regulators started to view crypto as a systemic risk.

“The potential for these products, and for the technology more generally, to have a significant impact very quickly is there. It just shows how ill prepared many of the globally responsible parties are for what is coming,” Li says. “So if you’ve got all of these large organizations like the G20, Iosco, and all of the privacy commissioners globally not looking at any of this with anywhere near the [right] level of knowledge or even concern, by the time they look at it, they could find themselves in a very precarious position where things have just gone a little bit out of control.”

Ahead of the Curve

Johnstone and Li stress that the industry needs to start thinking ahead of the curve. The financial crisis laid bare just how intertwined and complex the financial markets are, so adding crypto assets into that mix has the potential to be like throwing gasoline onto the fire.

Others, such as the Association for Financial Markets in Europe—have also called for the financial services industry to adopt a pan-European crypto asset taxonomy. But developing a taxonomy is one thing; it’s quite another to create an entirely new institution that will decide how crypto assets should be regulated. A designated crypto regulator might make sense given that the breadth of crypto assets could end up extending the reach of financial services rules, but a major obstacle could be the unwillingness of existing regulatory bodies to give up some of their power. 

Even if major institutions such the Financial Conduct Authority and Securities and Exchange Commission, along with their counterparts around the globe, agree to a new, crypto-focused regulator, it will take a long time to get off the ground. 

Quite frankly, sometimes it takes a touch of chaos to enact change. So expecting the G20 to throw its collective hat into the ring at this point might seem like wishful thinking. But Johnstone realizes that on the journey toward a ‘new prospect’ of more suitable crypto regulation, the first step is to show that there is a potential roadmap toward a solution before a disaster occurs that compels action.