The cryptocurrency markets are witnessing the rise of a regulatory framework designed to boost institutional participation. On the surface, regulation and cryptocurrencies might seem contradictory. Bitcoin and other cryptocurrencies rose because of a desire to escape highly regulated, centralized regimes.
Ian Taylor, Executive Director of CryptoUK, a trade body representing the digital asset sector, believes a balance between regulation and decentralization is ideal.
“The philosophy of open source, decentralized systems that allow for anyone to participate at any time anywhere in the world with no fear of a single actor acting against your best interests, is and always will be a force for good,” he says. “However, when we observe poor practice that harms consumers it is the state’s responsibility to address this, whether counter to a certain ethos or not.”
MiCA implementation a positive
Sandra Ro, CEO of Global Blockchain Business Council (GBBC), firmly believes regulation is essential for institutional participation. “Many of GBBC’s financial institutions are already regulated and/or licensed by various entities,” she notes. “For those that are already regulated and expanding services into digital and crypto assets, prudent regulation and regulatory clarity are positive for scaling the industry.”
Ro also explains that unregulated entities offering crypto services routinely seek regulatory guidance and clarity. The European Commission (EC) made a significant move in defining a comprehensive regulatory framework in September 2020. Titled the Digital Finance Package, this framework aims to boost fintech competitiveness while maintaining stability.
The package included a proposal titled Market in Crypto Assets (MiCA) that targeted streamlining Distributed Ledger Technology (DLT) through virtual asset regulation in the EU. Current legislation excludes the Decentralized Finance (DeFi) and Non-Fungible Token (NFT) sectors. However, lawmakers have strongly hinted at future packages regulating these portions of the digital asset industry.
MiCA’s regulations regarding stablecoins offer an example of the security lawmakers seek to bring to the crypto markets. Stablecoin issuers whose market volumes exceed “significant” (emphasis from the MiCA document) thresholds will be subject to due diligence requirements. MiCA also regulates Crypto Asset Service Provider (CASP) activities.
“This policy is hugely complicated and overarching and ambitious in its scope,” Taylor explains. “Fair, balanced, and proportionate regulation takes time to design so as much as the industry has been asking for clarity, it’s important not to rush it to strike the right balance of protecting against harms whilst promoting innovation.”
Ro agrees with this view and believes the EU has gone about defining regulations the right way. She points out that authorities delivered MiCA after an analysis conducted by the EC with further analysis from the European Banking Authority and the European Securities and Markets Authority about the suitability of existing legislation for regulating the industry.
“This is the right approach to take to ensure that nascent technologies are not regulated out of existence but also that a tech-neutral approach is being taken and there are no inconsistencies with existing legislation,” she says. Taylor and Ro both believe that MiCA represents a trailblazing leap for regulation.
“What we know with traditional markets is that the greater the liquidity, the better price transparency, and a regulated transparent market results in reducing volatility or large price swings,”
Ian Taylor
“MiCA has been a long time coming,” Ro says. “Other jurisdictions will look to implement their own regime having looked at the outcome of MiCA. It was imperative that the right approach was taken.”
The framework currently prescribes a 12-month implementation period for stablecoin issuers and 18 months for CASPs. Some observers have noted that this period might be too long. Taylor disagrees with this view, given the ramifications successful MiCA implementation has.
“A piece of new regulation of this magnitude – you could call it MiFID for crypto – should be gently phased in with built-in flexible options to its design, as the nature of innovation is that it is fluid and dynamic,” he explains. “I hope this is achievable, especially considering potential political and economic headwinds in the eurozone. Regulatory clarity is vital for the ongoing advancement of this innovative space.”
Ro notes that while formal work surrounding MiCA will not begin until it enters official journals, issuers must conduct a lot of preparatory work. “There have been many comments on how long this (implementation period) is,” she says. “However, there is a lot of technical work that has been deferred to the European Supervisory Authorities (ESAs) via delegated and implementing acts. This period of time is necessary.”
Incentivizing institutional participation
A nascent asset class, the crypto markets are famous for their volatility. Regulation can temper some of the risks institutions face when entering, something that David Mercer, CEO, LMAX Group, is quick to point out.
“Security, regulatory clarity, the safety of funds, and liquidity are all mandatory requirements when it comes to institutional adoption,” he says. “At the moment, it’s bitcoin that has proven to be satisfying these needs for institutional investors dipping into the space, but we believe all of this will come with respect to other cryptos.”
Taylor echoes this view. “Regulatory clarity is vital for adoption,” he says. “The downside risk for a highly regulated financial institution in regard to compliant liquidity, for example, is an absolute priority. Banks, for example, have many considerations, including tax, legal, accounting, and risk capital, where the regulatory clarity is immature.”
Taylor also points out that regulation will have a positive effect on liquidity. “What we know with traditional markets is that the greater the liquidity, the better price transparency, and a regulated transparent market results in reducing volatility or large price swings,” he says. “Therefore, as regulatory clarity improves, so will institutional adoption, thus achieving greater liquidity.”
Ro notes that while regulatory adoption is good for the markets, some challenges exist. “A lack of alignment in approaches is a significant challenge,” she says. “These firms and this technology are global, and we need to ensure that standards are set with alignment between jurisdictions.”
The average startup’s ability to comply with MiCA (or any regulatory framework) while lacking resources is another challenge. Taylor believes these firms will need an adjustment period as they upskill to meet regulations.
Interestingly, despite the lack of firm regulatory authority and talk of crypto winter, institutional participation has remained steady and diversified. LMAX Group’s Mercer explains that while the macro downturn has affected crypto, the after-effects have been positive.
“We see no difference between the reaction to volatility in the crypto space and the reaction to volatility in traditional markets,” he says. “As far as volatility goes, bitcoin volumes are at their lowest since December 2020, while ether volumes are just off their lowest levels since January 2021.”
Ro notes that institutional participation has shown signs of diversifying and increasing in the medium term. “Over the past five years, we have seen an increase in institutional funds and investments from traditional firms going into crypto and crypto firms,” she says.
“Institutional participation takes many forms from investments in underlying crypto start-ups, to cryptocurrencies and NFTs, to structured products like ETFs and futures. Even in crypto winter, billions IN capital have been raised by new crypto funds to invest across an array of opportunities.”
“For those that are already regulated and expanding services into digital and crypto assets, prudent regulation and regulatory clarity are positive for scaling the industry.”
Sandra Ro
Opportunities abound for investors
Mercer believes sustained participation and existing market levels indicate the opportunities currently present. “Given the relatively low levels of volatility in crypto, and the sharp pullback already seen, we see risk/reward to building exposure at current levels as being highly compelling,” he says. “It would seem the balance of risk suggests that the next surge in volatility could very well be accompanied by a surge in price.”
Innovation is one of the primary reasons the crypto markets draw institutions. Every coin offers an interesting use case, with many promising to replace outdated traditional financial functions. However, CASP innovation also brings risks. Industry observers have pushed risk reduction as one of the primary reasons for regulation. However, will increased regulation stifle CASP innovation? Taylor believes the onus is on CASPs, irrespective of regulatory concerns. “Regulation does not always result in the stifling of innovation,” he says. “Innovation may slow as CASPs adapt to entirely new regulations. However, in keeping with their customer-centric ethos, they will no doubt be focused on ensuring they serve their customer needs – and part of that is delivering innovative new products and services.”
Mercer explains that innovation lies at the core of the crypto and DeFi industry. It is hard to legislate away. “When you have a market that promises to do most of the things that traditional financial institutions do, but doing it faster, round the clock, and without intermediaries, paperwork and bankers, there is no doubt that institutions will be drawn to this market,” he says.
“Applications include earning interest, borrowing, lending, buying insurance, and trading assets. We would also add that there is the advantage of enhanced credit risk management and higher returns than traditional bonds.”
The relatively young and immature nature of the crypto sector tempers all positive talk. Bitcoin is the most mature asset available to institutions, and even that experiences significant volatility. Mercer points out that while volatility is decreasing, these assets are perhaps not ready to assume central positions in investor portfolios quite yet.
“At the moment, we don’t believe crypto assets have fully matured to the point where they have proven themselves as attractive diversification assets,” he says. “Having said that, we believe the very real possibility that institutions will be drawn to trading crypto as an alternative asset class in response to macroeconomic pressures.”Current macroeconomic trends such as inflation and central banks raising interest rates in response led to notable fluctuations in the crypto market. Bitcoin and other cryptocurrency prices crashed from all-time highs; levels that market participants believed were unjustified.
Mercer believes in crypto’s long-term potential. “I am certain that LMAX Digital will have a large part to play as the crypto market moves into the mainstream and large institutional investors start trading digital currencies, bringing more liquidity to the market,” he says.
“Cryptocurrencies have the potential to transform capital markets. As we see more initiatives using blockchain technology itself, digital assets will need to be transferred on those blockchains.”
“..we believe the very real possibility that institutions will be drawn to trading crypto as an alternative asset class in response to macroeconomic pressures.”
David Mercer
What is in store?
As regulatory action and macroeconomic forces push institutions to engage with the cryptocurrency markets, viable DLT use cases are steadily emerging. For instance, CBDCs are a popular topic in central banking circles, with governments in Sweden, Singapore, and the EU trialling them.
DLT is also making its way in capital markets, reducing settlement risks, and offering greater visibility. These promising examples are countered by others, such as the price swings in the cryptocurrency markets, and the way bitcoin and ether dwarf other cryptocurrencies.
Ro explains that while regulatory action is on the right path, authorities worldwide must address common pain points to make a difference. “Some of the biggest challenges to scaling this industry and the global opportunity set are a lack of common definitions, global standards, consistent rules or guidance across sovereign borders around licensing, and global regulatory clarity,” she says.
While some countries such as Singapore, Switzerland, and the EU (via MiCA) have clarified definitions and services, others have not done so. Failure to achieve consensus will thus cripple growth. Taylor points out that designing such regulations is challenging.
However, a few gaps exist currently. “In the UK, there are some regulatory gaps I would like to see plugged – particularly around market integrity and on specific market participants when it comes to safeguarding clients’ funds,” he says.
Mercer believes crypto has long-term utility for institutions and decreasing volatility makes the market highly attractive. “We see a trend where smaller portfolio allocations from institutional investors will only become larger over time,” he says. “Crypto, particularly bitcoin, is here to stay, and we remain convinced that bitcoin will be as resilient as gold in capital markets within the next 10 years.”
While no one can accurately predict how institutional participation in crypto will evolve, there is no doubt that the market and regulatory action are headed in the right direction.