Crypto View - May 2022

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Welcome to this month's Crypto View.  It's an international issue!  First, we are delighted to announce the launch of our Crypto Reviewer Tool - see more details below.  Second, as for news, we cover a Discussion Paper on CBDCs in Hong Kong, the IMF's Global Financial Stability Report and start with a note from Rosali on her fireside chat on the Future of Crypto Regulation with Rostin Behnam, the chairman of the CFTC, at City Week 2022 in London, and the FTX application to the CFTC.   

Fireside Chat with Rostin Behnam and FTX application

I had a very enjoyable and fascinating discussion with Chairman Behnam. I specifically asked about the CFTC's history of regulatory aspects of crypto and its future.  As derivatives market regulator, the CFTC has some responsibility for underlying products, and this has for the last 6 years included crypto.  The CFTC has successfully prosecuted several crypto market participants for violations of the Commodity Exchange Act (CEA) and CFTC's regulations  and filed and settled charges against Tether and others.  Given this experience, Chairman Behnam repeated his previous suggestion that the CFTC would be well placed to regulate cash crypto (other than stablecoin, which is likely to be treated in the same manner as FX; and crypto linked to securities, which is likely to be a CFTC matter).  The Chairman also suggested that there is likely to be further convergence of the crypto market and traditional market infrastructure and pointed to the recent acquisitions by crypto firms of financial market infrastructure.  In particular, he mentioned the FTX application and suggested everyone takes a closer look at it.

The FTX application is indeed extremely interesting.  I can see that it could have profound implications for not just crypto markets but all financial market infrastructures in the US and beyond.  FTX, a crypto firm, bought Ledger X, a CFTC register derivatives clearing organisation (DCO).  This DCO does not use any FCM intermediaries (clearing members).  This non-intermediated DCO is available to retail participants. However, all FTX products are currently fully collateralised. FTX now wants to offer margined products to compete with the incumbent exchanges and clearing houses and this is the subject of its application for amendment of its registration with CFTC.

Traditionally, clients of FCMs have benefited from the extensive customer protection provisions in the US legislation. Clearing houses in turn have not to deal with end client credit risk, but could rely on the creditworthiness of their clearing members, margin posted, contribution to a guaranty or default fund, and ultimately, mutualisation of losses across the clearing membership.  FTX's proposal is novel in several respects:   like other crypto exchanges, FTX proposes to directly custody margin (which will include cash and crypto) from retail customers; offer real-time risk calculations by reviewing customer positions every 30 seconds and if appropriate, call for  margin.  No switch off for weekends or for non-business hours.  Further there will be no mutualisation of risk between intermediaries.   Instead, FTX proposes to manage risk by liquidating customers' positions; laying off positions with backstop liquidity providers and finally using its guaranty fund.  FTX proposes to contribute $250million of cash to allow the DCO to continue operations.  As all FTX participants will be able to process, clear and settle trades through the DCO they will all be "clearing members" under CFTC Regulations.

CFTC has invited public comment on the FTX proposal and the closing date for commenting is now 11 May 2022.   As of today's date, 09 May 2022, more than 1,000 responses have been submitted.  This is unprecedented.    Lawyers have responded saying that the FTX analysis is correct, intermediation, although common now, is indeed not required; and that the proposal although innovative, does indeed stick to well-established regulated principles.   Market participants' comments are more mixed.  Some query the use of liquidation as a risk management tool, suggesting it might be susceptible to manipulation.  Other welcome the technological developments contained in the FTX proposal, suggesting it could have prevented the recent LME nickel market crisis.

CFTC has announced it is holding a public roundtable on 25 May to discuss intermediation in derivatives trading and clearing. 

Hong Kong CBDC Discussion Paper

The Hong Kong Monetary Authority (HKMA) issued a discussion paper on 27 April seeking views regarding the retail central bank digital currency (rCBDC), e-HKD, from the public and from industry. The discussion paper focuses on issuance mechanisms, interoperability in addition to data protection and privacy. This paper forms the second part of the study into introducing e-HKD in Hong Kong and draws attention to the potential benefits and challenges to the digital currency. At present, the HKMA have not decided whether or not to introduce the e-HKD currency and are therefore seeking input to aid in this decision. We are very interested to see how this develops, both locally in Hong Kong but also in the global arena of central bank digital currencies. We will bring you further updates in due course.

IMF Global Financial Stability Report

The recent IMF Global Financial Stability Report, published last month made a number of Policy Recommendations. The paper, as you can imagine, is quite broad in scope, but does include thoughts on cryptoassets in a number of places. Firstly, it looks at the "Risks of Cryptoization and Sanction Evasion through the Crypto Ecosystem". Here it discusses the increase in use of cryptoassets throughout the pandemic, and also discusses the feasibility of using cryptoassets as a means of evading sanctions brought in as a result of Russia's war on Ukraine. Though it notes, as we have discussed before, that a lack of liquidity in the market for Ruble to crypto pairs means that large scale transfers of value are impractical. However, it does raise several concerns with the crypto ecosystem that regulators have:

1. the use of exchanges and other crypto asset providers that are noncompliant with sanctions and/or capital flow management measures;
2. poor implementation of adequate due diligence procedures by cryptoasset providers; and
3. the use of technologies and platforms that increase the anonymity of transactions (such as mixers, decentralized exchanges, and privacy coins - indeed, we saw the US Treasury announce action being taken against a cryptoasset mixer used by a North Korean state-sponsored hacking group).

The report also looks closely at cryptoassets under the lens of the challenges to financial stability that the rapid growth of FinTech brings. In particular, it draws attention to DeFi, which it says is at the frontier of technological advancement. While it acknowledges "the promise of reducing costs and frictions related to informational asymmetry, increasing efficiency and competition, and broadening access to financial services, especially in low-income countries and for underserved populations", the IMF is concerned that the "speed, reach, and depth of these changes give rise to systemic risks and pose challenges to financial stability."

The IMF calls for policy action to tighten and clarify fintech regulation, as well as enhanced monitoring of incumbents, which might be more vulnerable under pressure from rapid fintech development. It acknowledges that DeFi poses unique challenges to regulators, something that we definitely agree with. In particular the decentralised, global and potentially anonymous governance structures of DeFi protocols make regulators' lives extremely difficult. The IMF proposes a number of steps that it feels regulators should take to derisk DeFi.

1. Regulation should focus on elements of the crypto ecosystem that enable the development of DeFi. Specifically, the IMF calls out stablecoin issuers, centralised crypto exchanges, hosted wallet service providers, and reserve managers, network administrators, and market makers. It suggests that such entities would benefit from a clear, robust and, most importantly common global regulatory framework. Further, the IMF believes that engaging with these more centralised entities could be an effective access point for regulators.
2. Authorities could also directly regulate key functions within DeFi. Suggestions given include public-private collaboration on code regulation, through either ex ante guidelines on operational and risk parameters or ex post code reviews and audits that can identify areas vulnerable to risk and help deliver policy objectives.

At a general level, regulators should be encouraging DeFi platforms to adopt robust governance through industry codes and build effective public-private collaboration to establish self-regulatory organizations. The IMF notes that a transparent and credible governance system could improve risk management, facilitate good conduct of financial transactions, and eventually attract more users and capital to the platforms. Such a governance system could be a natural entry point for regulators to interact either directly or through the development of industry codes or self-regulatory organizations. Whether such a proposal is in line with the ethos of DeFi generally though, remains to be seen.

As the IMF is essentially focussed on the stability of the TradFi system, the alternative is of course restricting the exposure of regulated firms to DeFi markets -- and this is something that regulators do certainly have the power to do.

Crypto Reviewer Tool

Following a successful BETA phase and market testing exercise our new Crypto Reviewer platform will launch later this month. Covering over 25 jurisdictions the Crypto Reviewer product is our latest RegTech offering and delivers up to date legal & regulatory information for numerous crypto token types across multiple jurisdictions via an intuitive and easy to use digital platform. Crypto Reviewer is provided on an enterprise wide subscription basis and is updated monthly to reflect current market position.

Further information can be found on our website. To organise a demo and enquire about a trial of the platform please contact our Head of Sales, Lee Curtis.