To boldly go where no regulation has gone before

With advertisements for cryptocurrencies adorning major sporting events alongside the gambling ads, art markets grappling with digital asset classes like NFTs and almost everything being “tokenised”, we are boldly going out into a DeFi/Web 3.0 universe.

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Yet the laws of economic physics continue to hold even as we rocket headlong into the outer rims of the financial galaxy.

“The crypto sector is largely unregulated and we need to do some work to get the balance right so we can embrace new and innovative technologies while safeguarding consumers.” - Jim Chalmers, Australian Federal Treasurer

The vast majority of these bold treks will fail. Some will be good ideas at the wrong time. Some will be flawed ideas. Some, too many, will be scams. But some ideas, some innovations, some companies, will persist and bring with them major transformations and guide us into a new era of financial services.

But these galaxies are largely uncharted and the history of exploration tells us hidden dangers lurk if we don’t understand what’s there. That’s why it is welcome for governments and regulators around the world to have eased back a bit from the – justifiable at the time – scepticism initially showed towards this new financial world.

Scepticism is certainly still the proper frame of mind but a proper scepticism, one that is prepared to understand the opportunity as well as the risk. Indeed, many regulators have moved further and are now perhaps more curious than sceptical.

Four years ago the Bank for International Settlements, known as the central bank for central banks, opined crypto was “a combination of a bubble, a Ponzi scheme and an environmental disaster”. Now the BIS is overseeing a range of fascinating projects, distributed ledger platforms supporting blockchain have found ways to consume far less energy and several of the Ponzi schemes have imploded.

The BIS has softened a bit: “(There) are deeper structural flaws that make crypto unsuitable as the basis of a monetary system: the lack of a nominal anchor, the fragmentation of the crypto universe and its reliance on speculation,” the bank’s head of Hyun Song Shin wrote in the BIS's Annual Economic Report.

“The future monetary system should build on more solid foundations, as the fusion of enhanced technical capabilities and the core of the trust provided by central bank money. Wholesale and retail central bank digital currencies and retail fast payment systems enable new capabilities such as programmability, composability and tokenisation.”

My colleague Robert Porter has provided an excellent explainer of the basic digital finance horizon:

Digital Finance - the use of decentralised networks built on distributed ledger technology that enable the tokenisation of real-world assets - is a fundamental protocol shift akin to the emergence of the internet and has the potential to disrupt banking.

Our working hypothesis is decentralised networks are an emerging form of Financial Market Infrastructure (FMI) with a new form factor (i.e. tokens) for transacting value. We foresee significant potential customer benefits in terms of lower costs, reduced settlement times, more resilient infrastructure and mitigation of counterparty risk.

Together with initiatives such an innovation hubs and the numerous, albeit low profile, commercial ventures transforming conventional banking via tokens, blockchain and AI, the world of DeFi is being mainstreamed.

Dozens of central banks have begun pilots on the use and utility of a central bank digital currency (CBDC).

In Australia, the Federal Government has announced plans to chart this new financial universe while the Reserve Bank of Australia has just launched a research project in collaboration with the private sector on where a CBDC could work.

The Australian Prudential Regulation Authority has released a policy road map for the evolution of crypto assets.

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The Australian government announced it will begin work on a “token map” of the cryptocurrency sector. Timely because, according to the Australian Tax Office, more than one million Australians have “interacted” with digital assets since 2018.

And that means a lot of people have made money but, if the normal patterns of frontier investments have held, a lot more have lost money.

“Token mapping” is an approach to describing the characteristics of the different digital tokens – tokens being digital representations of real world items - including the type of digital asset, its underlying code and other defining technological features. The initiative will be used to determine which crypto assets are already subject to financial services law and non-financial products that may need special legislation of their own.

According to the Australian Treasurer Jim Chalmers, “the crypto sector is largely unregulated, and we need to do some work to get the balance right so we can embrace new and innovative technologies while safeguarding consumers”.

Chalmers noted the “token mapping” proposal has not been tried elsewhere in the world but would help delineate where regulation was needed and would be affective.

“The aim will be to identify notable gaps in the regulatory framework, progress work on a licensing framework, review innovative organisational structures, look at custody obligations for third party custodians of crypto assets and provide additional consumer safeguards,” he said.

Meanwhile, the Reserve Bank of Australia is collaborating with the Digital Finance Cooperative Research Centre (DFCRC), which brings together industry, academic and regulatory stakeholders, to investigate “the opportunities arising from the transformation of financial markets through the digitisation of assets that can be traded and exchanged directly and in real-time on digital platforms.”

Key to that project will be to understand where the official and private sectors can play the most constructive role without crowding one another out and, again, what regulation is appropriate.

For example, CBDCs may well have an important role in cross border trade finance or in providing direct monetary benefits to some members of society. However, according to the BIS and many others, the state sector should not take over the financial system nor attempt to provide an extra level of deposit security. In an extreme case, if a central bank were to offer an ordinary deposit account, the danger is in times of financial stress there might be a run on commercial banks as depositors seek the ultimate security of a central bank.

We saw a version of this in the global financial crisis when governments and central banks were forced to institute emergency guarantees on deposits to prevent runs on those banks perceived to be smaller or more risky.

For an easily understood and very readable discussion of the many strands of central bank involvement have a look at the International Monetary Fund article “An IMF economist explains central bank digital currency to his mother.

The key concerns raised include not just the danger of a run but of privacy – can the state use the CBDC to spy on you? (They could, safeguards are important.) What are the implications for taxation? What if citizens of country X decided they would prefer to hold their deposits with a foreign central bank? Will the involvement of a central bank encourage or stifle innovation?

Those out-there pioneers of DeFi and crypto will lament the intrusion of the official sector into this new world but it is both desirable and inevitable if the innovation and transformation is going to win the trust of not just governments but everyday citizens.

The question is not whether the crypto world should be regulated at all but rather how it should be regulated. How invisible should the hand of the market be? What role should the state play and where can the private sector do a better job with less risk to the taxpayer?

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

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