Cryptocurrency industry regulation proposals by the market players

In view of the recent publishing by the Financial Stability Board (FSB) of the report on the proposed framework for international regulation of the cryptocurrency industry, which was a result of FSB’s research of the topic as was mandated by the G20, some market players also have expressed their thoughts on this hot topic.

The FSB’s proposes that “effective regulatory and supervisory frameworks should be based on the principle of ‘same activity, same risk, same regulation’”. This approach would mean that regulations applicable to traditional financial institutions shall be also applicable to companies that operate in the cryptocurrency industry and provide similar services with equivalent economic functions. However, certain special features relating to the operation of the cryptocurrency industry must certainly be addressed as well.

On 19 October 2022, the Chief Executive Officer of one of the largest cryptocurrency exchanges, FTX, Sam Bankman-Fried (SBF), published his view on possible regulation of the cryptocurrency industry, together with some suggestions on how to make it effective.

The proposal by SBF focused on seven fundamental aspects of the industry:

1. Cybersecurity and accountability.
2. Asset listing and recognition of certain cryptocurrencies as securities.
3. Tokenization of traditional equities.
4. Customer protections, disclosures, and suitability.
5. Sanctions, allowlists, and blocklists.
6. DeFi.
7. Stablecoins.

Below is a summary of each of the proposed cryptocurrency industry regulation categories.

1. Cybersecurity and accountability. It is suggested to create a special list of blockchain wallets that are associated with security breaches and add them to a public list of suspicious addresses. Customer protection in case of hacks must be a priority. The balance between bug bounty programs and real hacks can be found in a standard called “5-5”, where the hacker has to return 5% of the stolen assets to the victim within 24 hours of the breach. The remaining funds are to be considered a generous bug bounty.
2. Asset listing and recognition of certain cryptocurrencies as securities. Cryptocurrency platforms have to conduct the Howey Test (a test from the U.S. Supreme Court case that is used to determine whether an instrument qualifies as an “investment contract” for the purposes of the U.S. Securities Act) over cryptocurrencies. If the result is negative, the cryptocurrency can be considered to not be a security, unless there is an opposite decision by an appropriate court of jurisdiction. Cryptocurrency exchanges may also publish an overview of the assets traded on the platform, where the status of tokens will be indicated.
3. Tokenization of traditional equities. Traditional equities market bear settlement risk that results from a long chain of entities being involved in the securities market transaction. This poses a threat that certain brokers that have low regulatory capital buffer may fail to settle the gains of a large number of retail investments in similar cases that took place during AMC Entertainment Holdings, Inc. (AMC) or GameStop Corp. (GME) stock rallies in 2021. Tokenized stocks may settle almost instantaneously essentially removing the settlement risk from the transaction. However, regulations on its issuance, registration, disclosure, clearing, and custody have to be drafted.
4. Customer protections, disclosures, and suitability. SBF calls for the customer knowledge test procedure to be implemented by the cryptocurrency service providers with regard to a particular product the customer wants to interact with. Only customers who pass the test on the mechanics of the product must be allowed to access it. Centralized cryptocurrency service providers shall have various disclosure and transparency regimes in place for the products and services they are offering. Wealth-based tests for customer suitability are seen by the author as discriminatory and not practically effective enough.
5. Sanctions, allowlists, and blocklists. The strategy around sanctions compliance shall be built around blocklists (block transactions that are associated with sanctioned addresses), instead of allowlists (processed only allowed transactions while blocking all others). It is suggested that a responsible actor like the Office for Foreign Asset Control (OFAC) of the U.S. Department of the Treasury maintain an on-chain list of sanctioned addresses that can be accessed by market participants. Wallet holders must have the ability to whitelist their addresses if the illicitly sourced funds were transferred to them without their knowledge. Such funds may be sent by a victim to a special address maintained by a responsible actor for further burn or custody.
6. DeFi. There should not be licensing or registration procedures for codes on a blockchain, with blockchain validators, also being outside the scope of financial regulation. Certain permissions or licensing procedures may be considered for centralized platforms that solicit and market DeFi protocol to retail clients since this activity is somewhat correlated with broker-dealing or futures commission merchant business. Writing a code for a decentralized exchange, trading there, and doing peer-to-peer transfers must be not subject to regulation.
7. Stablecoins. Regulation of stablecoins must be supportive in nature, mainly protecting the digital economy from system risks. Stablecoins must be in fact supported by the pegged currency or government securities. Issuers of stablecoins must publish up-to-date public information, including audit reports, about the underlying assets of the token. In case of minting or redeeming a stablecoin (token on-ramp/off-ramp process), the issuer company must conduct a Know Your Customer (KYC) procedure similar to the one required under the Bank Secrecy Act (BSA) for the individual or entity that initiates the process.

SBF already had experience in publicly discussing cryptocurrency regulation. In December 2021 he was summoned, together with other executives representing digital currency companies (CEOs of Circle, Bitfury Group, Paxos Trust Company, Stellar Foundation, and Coinbase Global Inc. have been participating in the hearing) to the U.S. Congress to testify before the House Financial Services Committee for the hearing on “Digital Assets and the Future of Finance: Understanding the challenges and benefits of financial innovation in the USA”.

There are no guarantees that the suggested regulatory ideas will be implemented in practice, however, some of the points from them might as well make to the cryptocurrency industry regulation not only in the U.S., but also in other countries and jurisdictions.