crypto currency regulation / Rudzhan Nagiev

This article appears in the June 2023 issue of Investment Executive. Subscribe to the print edition, read the digital edition or read the articles online.

Regulators are preparing rules for the crypto industry that mimic regulations already in force in the traditional financial industry, signalling the end of the party for crypto bros.

The International Organization of Securities Commissions (IOSCO) launched a consultation in May on recommendations to guide the world’s securities regulators in overseeing crypto markets. The mantra is “same activity, same risk, same regulation.”

Regulators have been cautious about introducing requirements on crypto firms for fear of stifling innovation and growth. Regulators also have faced uncertainty about how novel assets, firms and business models fit into regulatory frameworks developed for traditional securities markets.

That’s changing with IOSCO’s consultation, which sets out recommendations for investor protection standards in the crypto industry that are the “same as, or consistent with” standards in traditional financial markets.

This new approach reflects the fact that many investors have replaced conventional saving and investing with speculating on unregulated crypto.

“Global retail investor exposure to cryptoassets has grown exponentially in recent years, as have retail investor losses due, not only to market conditions, but also financial crime, fraud, money laundering and other illegal cryptoasset market practices,” IOSCO said in its consultation. “The fragility and interconnectedness of the cryptoasset market continues to leave entities and investors exposed to significant losses triggered by all too frequent shock events.”

Those shocks include the collapse of the Terra/Luna stablecoins and the failures of several major crypto firms last year, including Celsius Network LLC, Voyager Digital LLC and FTX Trading Ltd.

While there has seemingly been little spillover from these events into mainstream financial markets, retail investors have experienced significant harm. Policymakers worldwide want to prevent future harm and head off possible financial stability risks that may arise if the industry is allowed to grow unchecked.

Beginning in 2025, global banking regulators will require an ultra-conservative capital treatment for banks’ crypto exposures. And the Financial Stability Board (FSB) is slated to issue high-level recommendations for regulating the crypto industry in July.

The IOSCO standards, which the organization aims to finalize by the end of the year, are intended to put the FSB’s principles to work in a practical way to address crypto’s market and conduct risks. Local regulators are expected to bring their rules in line with IOSCO’s final recommendations.

In the meantime, the regulators’ initial proposals, which are out for consultation until July 31, call for the crypto industry to face its own set of listing standards, order-handling requirements, market transparency rules (pre- and post-trade disclosure), and asset custody and segregation obligations.

The proposals also aim to tackle the conflicts of interest that regulators have observed at “vertically integrated” crypto firms such as FTX, which engage in activities including issuing assets, market-making, brokerage, proprietary trading, custody and asset lending. This structure carries a raft of potential conflicts, such as creating an incentive and opportunity for firms to manipulate asset prices, facilitate insider trading and front-running, and other forms of investor abuse.

IOSCO is calling for regulators to use tools such as disclosure, prohibitions on certain business structures, and conduct rules to bring conventional standards to the crypto industry.

While regulators previously were more concerned about driving crypto activity out of their jurisdictions with heavy-handed rules, they’re now proposing recommendations to “facilitate a level-playing field between cryptoassets and traditional financial markets and help reduce the risk of regulatory arbitrage.”

This marks a dramatic change and raises the hope that major securities markets will adopt common rules for the crypto industry. The proposals were crafted by a board-level fintech task force at IOSCO that included representatives from regulators in 27 jurisdictions, including Ontario and Quebec, and the world’s major regulators are all on board.

The U.K.’s Financial Conduct Authority heads the task force’s crypto regulation work and the U.S. Securities and Exchange Commission is leading a separate project focused on the decentralized finance (DeFi) industry. The DeFi working group is expected to issue its own report and policy recommendations later this year.

In addition to efforts from global policymakers, the Canadian government pledged to tackle risks posed by the crypto industry in the latest federal budget, promising further details in the fall economic update. And the Bank of Canada’s most recent financial system review called for accelerating the work of building a regulatory framework for crypto markets, such as implementing the forthcoming FSB principles and the global capital rules for banks’ crypto exposure.

Canadian regulators also have been at the forefront of tackling the challenges in the emerging crypto industry.

The Ontario Securities Commission (OSC) was one of the world’s first regulators to set rules for offerings of crypto-focused mutual funds and ETFs. The regulator brought some of the first enforcement actions against offshore crypto trading platforms that defied the OSC’s call to seek registration, and tackled massive wash trading at another firm. The OSC also unraveled the QuadrigaCX mystery, revealing an old-fashioned Ponzi scheme disguised as crypto innovation.

The Canadian Securities Administrators also set stringent expectations on crypto firms that now are pursuing registration.

However, given the borderless nature of the crypto industry, local efforts are undermined by a lack of global standards, which is why IOSCO is pursuing co-ordinated action.