The need for a dialogue between crypto businesses and regulators

This year has been a strong one for digital asset markets, highlighted by growing institutional inflows and a propitious shift in the regulatory environment. Witness the U.S. Securities Exchange Commission’s September letter that says crypto exchanges that comply with SEC Rule 15c3-3 (the Customer Protection Rule) are free to trade digital asset securities. 

With more than 50 million people around the world investing and trading in crypto in meaningful volumes, Goldman Sachs has recently appointed a new global head of digital assets, as did JPMorgan in February. Goldman’s move was a noted reversal following a May earnings call in which one of its analysts questioned the legitimacy of Bitcoin (BTC) as an asset class.

The timbre of digital asset markets is changing from primarily speculative in nature, driven by high-frequency individual traders riding waves of volatility, to longer-term buy-and-hold activity. For instance, Yale and Harvard have both made waves in recent months with SEC filings revealing multi-million-dollar investments in crypto funds as the asset class continues to gain momentum.

Related: Ivy League universities set to boost the crypto industry with an injection of institutional investment

Visa, Mastercard and PayPal have made recent announcements that they, too, are embracing the digital asset markets, with Visa recently writing on its blog:

“Digital currencies have the potential to extend the value of digital payments to a greater number of people and places.”

Indeed, a growing number of organizations and governments around the globe are embracing digital assets for trading, investing and non-intermediated payments. As proof of this momentum, the World Economic Forum established a consortium to govern digital currencies this year, including government-issued stablecoins, which central bankers have increasingly embraced.

As of mid-July 2020, according to the Bank for International Settlements report, at least 36 central banks have published retail or wholesale central bank digital currency work. At least nine countries have undertaken CBDC pilots; 18 central banks have published research on retail CBDCs; and another 13 have announced research or development work on a wholesale central bank digital currency.

Regulatory clarity has been slow to materialize as a major impediment to adoption by traditional investors and service providers, however, change is undeniably underway.

In addition to the recent SEC move, the Office of the Comptroller of the Currency recently announced that national banks can provide crypto services, including holding private keys for customers and other custody solutions. And crypto businesses enthuse at the prospect of a harmonized patchwork of state and federal money transmitter rules. Such developments are making markets more palatable for participants entering this space.

Related: US banks get crypto custody nod, but instant demand surge is unlikely

According to a new report by Fidelity Digital Assets head of research Ria Bhutoria:

“The OCC’s July 2020 interpretive letter represents a major step forward in increasing the comfort of traditional institutions with digital assets. To the extent that institutions regulated by the OCC actually provide digital asset custody services, a greater number of investors and users may also be more comfortable trading, holding and engaging with digital assets via intermediaries held to the strict regulatory standards of a federal agency in charge of administering the banking system in the United States.”

That being said, it’s a chicken-and-egg quandary: Progress with the regulatory and infrastructure development required to support digital asset markets has not kept pace with activity in these markets.

Does regulatory uncertainty remain?

As rules and regulations continue to be introduced and refined, a host of questions remain:

1. Will banks store customers’ digital asset keys and facilitate transacting on crypto platforms, and, if so, how; or will they require customers to engage another provider to de-risk that function?
2. Particularly given the increase in crypto block trading, what prime service offerings can reduce or eliminate the potential for broken trades and theft of assets?
3. How can crypto businesses manage the fragmentation of instrument pricing and reporting?
4. How can crypto businesses navigate the rapidly changing and complex regulatory landscape?

The extent to which banks will custody private keys and act as fiduciaries or lay off the risks to other qualified providers is unclear. A growing number of crypto prime service providers have emerged to provide essential trading, lending, clearing and settlement functions, and the battle to compete in this underserved segment has ramped up significantly in recent months. The emergence of credible and capable prime service providers in the crypto world is critical.

As the market for digital assets grows, the number of trade breaks and security breaches may rise if the infrastructure doesn’t mature, making security and compliance existential priorities for trading venues. For instance, there was also a massive Bitcoin selloff on the BitMEX exchange in March: Nearly $200 million was chaotically liquidated with overleveraged traders unable to move money between networks in time to unwind their positions. And according to the Fidelity Digital Assets report, there were 11 exchange hacks in 2019 resulting in $283 million in digital assets stolen. While the total amount stolen has declined year over year, which indicates security improvements, the number of hacks has increased.

In the eyes of U.S. regulators, crypto businesses are virtual asset service providers that will soon be required to collect the names of transaction senders and receivers. They also must have AML policies and procedures in place. Indeed, crypto businesses have their work cut out to reconcile the morass of changing state, federal and cross-border rules. As market oversight remains fragmented and in flux, counterparties can be left holding the bag if a transaction goes awry.

Related: Slow but steady: FATF review highlights crypto exchanges’ struggle to meet AML standards

Other industry-wide issues remain sticking points for institutions on the sidelines.

For one thing, digital asset identifiers aren’t consistent across platforms and exchanges, and there are often different tickers for the same instrument. In the absence of a central crypto market-data repository, trying to process transactions in downstream systems for valuations, pricing, accounting and reporting can create a host of problems. Indeed today, it is virtually impossible for investors and other stakeholders to consistently and reliably calculate true realized crypto gains and losses.

What are the industry needs now?

As this market segment grows and bigger blocks need to move between buyers and sellers, market participants need, more than ever, accurate market data and quality prime services such as lending, custody, margin, clearing and settlement to ensure customers have a safe environment in which to do business. More financial institutions will become active in this space once such concerns about regulatory uncertainty, market transparency, execution quality and capital efficiency are addressed. Fortunately, we are seeing evolutionary forces in crypto data management, rulemaking and reporting.

A host of new providers are creating systems so consumers of decentralized crypto data, such as banks and other institutions, can more easily and accurately reconcile accounting and reporting. Additionally, watchdogs are beginning to apply traditional market protections to the digital asset ecosystem. For its part, the recent OCC guidance is a blueprint that other agencies can follow to usher standards and safeguards that will enable these burgeoning markets to thrive in the months and years ahead.

Crypto businesses can navigate the rapidly changing business and regulatory landscapes by joining a number of highly active trade associations that are now shaping policy and industry change.

It behooves market participants to become as active as they can in these associations as policymakers define digital assets and how they should be regulated. There’s strength in numbers, so engaging with other crypto businesses in dialogue with regulators affords the opportunity to make a meaningful impact on this rapidly evolving segment before a policy is set in stone.

Keeping tabs on the nuance of change underway not only makes markets safer for all but can help financial services firms roll out potentially lucrative lines of business competitors may be pursuing, such as stablecoins for cross-border payments and crypto trading services. Eventually, today’s steep curve of market structure evolution will flatten, and digital assets will be commonly embraced. When that happens, those of us working diligently together now will be gratified to look back as agents of change.

The views, thoughts and opinions expressed here are the authors alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.