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FSR OUTLOOK 2023: Crypto Winter — Market downturn emboldens regulators to greater intervention

07 December 2022
Legal Briefings – By Marina Reason, David Wormley, Chris Ninan, Natalie Curtis, Hannah Cassidy, Ruth Overington, James Emmerig, Martin LeTouzé, Vincent Danton, Marc Gottridge, Pat Horton, Lydia Wong

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Explore our FSR Outlook 2023

As the crypto industry's troubles deepen, regulators around the world have been given political license to strengthen rulemaking and enforcement action

In a nutshell:

  • The latest "crypto winter" has given regulators political cover to pass or finalise rules designed during the latest run of growth, and for more aggressive intervention, enforcement action and rulemaking.
  • Both regulators and financial institutions appear to be more ready to engage with the potential of blockchain technology, at a time where a downturn in the tech industry's ability to hire is freeing up technical talent.

Rules expected in 2023

2022 has been a turbulent one for the crypto industry, with the latest "crypto winter" now likely to continue through 2023, as liquidity issues triggered by the recent collapse of FTX spread to other market participants, damaging investor trust in crypto, and prompting calls for swifter industry, regulatory and legislative intervention.

The EU's Markets in Cryptoassets in Regulation (MiCA) is set to become law in early 2023. MiCA will regulate issuing and offering most tokens to the public in the EU, also creating an EU-wide authorisation regime with prudential and conduct rules for cryptoasset service providers. MiCA carves out DeFi and NFTs, at which the EU is now looking more closely.

The UK's Financial Services and Markets Bill should become law in early 2023, bringing most cryptoassets (but not NFTs) into the recently-strengthened financial promotions regime for the first time. The Bill also lays the groundwork for the regulation of stablecoins used for payment and for the introduction of a "sandbox" to test the use of distributed ledger technology (DLT) and other technologies in financial markets infrastructure (FMI). A proposed amendment to the Bill would enable the UK regulators to make rules for cryptoassets more generally.

The Monetary Authority of Singapore (MAS) has proposed measures to reduce risks to consumers from cryptocurrency trading and enhance standards of stablecoin-related activities. MAS is also expected to consult on regulations (expected to come into force in 2023) implementing legislation expanding MAS-regulated cryptoasset services to include custody, among others.

Hong Kong's licensing regime for virtual asset service providers is expected to apply from 1 March 2023 and the Securities and Futures Commission (SFC) will consult on whether to allow access for retail investors. Hong Kong is also taking steps towards more mainstream adoption of cryptoassets and considering a risk-based regime for payment-based stablecoins. The SFC has issued guidance on authorisation requirements for ETFs offering exposure to cryptoassets and is signalling greater acceptance of more straightforward tokenised securities. Further guidance on, and a modified regime for, security token offerings is expected.

In the US, the White House released its comprehensive framework for responsible development of digital assets, and FSOC has recommended that Congress legislate to address regulatory gaps and risks to the financial system posed by digital assets. 

In Australia, a consultation on regulating virtual asset custodians and service providers stalled with the change in government and Treasury has announced that it would instead conduct a "token mapping" exercise to identify how crypto assets and related services should be regulated. A consultation paper will be issued by the end of 2022, with the work to continue in 2023. Treasury also plans to progress work on a licensing framework, review innovative organisational structures, look at custody obligations for third party custodians of digital assets and provide additional consumer safeguards. Currently, crypto-asset exchanges are regulated only in relation to anti-money laundering and, additionally, where there are certain retail products that have crypto as an underlying. The Reserve Bank of Australia is also piloting a wholesale CBDC and exploring the use cases for a retail CBDC.

Firms and regulators engaging on potential DLT adoption

Regulators and financial firms are co-operating to formulate use cases for DLT in traditional finance, recognising potential improvements to speed, cost, certainty of execution and other factors in certain areas. Several schemes are forthcoming or in place for this cooperation, which come at a time when engineering and product expertise is becoming more available in the market.

The EU finalised its pilot regime for market infrastructures based on DLT in June 2022. Eligible firms can, from 23 March 2023, apply to operate DLT trading facilities and/or settlement systems in a test environment for up to 6 years. The UK FMI sandbox mentioned above seems likely to follow a similar model. The Hong Kong Monetary Authority is working on a pilot project to tokenise Government green bond issuances to institutional investors, to test the use of DLT throughout the bond lifecycle and guide future issuances by other market participants. The Australian Securities Exchange undertook testing of a DLT-based replacement for its clearing and settlement system, but that project experienced technical challenges and has now been paused.

MAS' "Project Guardian" pilot is already operational, with Singapore leading many other jurisdictions in its attention to DeFi. The pilot had its first live trade on 2 November 2022: development is expected to continue through 2023 and beyond. Project Guardian aims to explore a range of concepts and may provide a model for similar initiatives elsewhere. 

More active enforcement

As regulation develops and regulators gain powers, enforcement under these new regimes is inevitable. Although the crypto winter may have caused a decline in new crypto scams, regulators will remain alert to scammers, targeting those most affected by the cost-of-living crisis and more susceptible to "get rich quick" scams. 

The increasingly long line of crypto exchange failures, including that of prominent, apparently sophisticated firms, is sure to bring added scrutiny from prosecutors and class action firms, as well as driving forward legislative and regulatory change. And banks that offer services for cryptocurrency investors and crypto businesses may also seize the opportunity to leverage their highly regulated status with investors seeking safer cold-storage solutions for their digital assets. For more on the legal and practical implications for users, lenders and other market participants of a crypto custodian falling into distress and even an insolvency process, click here.

The recent FTX collapse is a case in point. FTX is now under investigation in the Bahamas, and was being investigated by various US state and federal regulators before the collapse: commentators draw parallels with scandals such as Madoff or Enron, highlighting the alleged use of FTX customers' assets to shore up Alameda Research’s liabilities, the recruitment of prominent personalities (and some former US regulators) to lend credibility to the business, in addition to issues with leverage, liquidity and asset valuation. Whilst policymakers argue and regulators investigate, a class action suit allegedly worth $11bn has already been filed in Florida.

In the US, in spite of their ongoing turf war for jurisdiction over digital assets, both the Securities and Exchange Commission (SEC) and the Commodities Futures Trading Commission (CFTC) have been actively pursuing enforcement actions – a trend likely to continue into 2023. The SEC has launched a series of enforcement actions in relation to crypto Ponzi schemes and the promotion of cryptoassets, including high-profile endorsements by celebrities and influencers. This follows the near doubling of its crypto enforcement unit in 2022. The SEC has also brought a market manipulation case in relation to the alleged use of bots to create the (false) appearance of robust market activity, and a tippee has pleaded guilty in what the DoJ describes as the first ever cryptocurrency insider trading case. The CFTC has also "aggressively policed" digital commodity asset markets, filing 18 digital asset-related enforcement actions in Fiscal Year 2022. 

France shut down a crypto exchange after a regulatory audit revealed AML breaches and the exchange lost customer funds. The UK Financial Conduct Authority recently concluded its most active quarter of marketing-related enforcement, with this activity expected to continue and attention expected to pivot to crypto marketing upon the expansion of the financial promotion regime.

In Australia, ASIC's 2022-2026 Corporate Plan identifies cryptoasset regulation as a strategic priority, and ASIC has recently taken action against crypto firms said to have contravened Australian financial services laws, particularly for failure to comply with new product governance requirements. ASIC’s 2022 Enforcement Priorities includes an intention to focus on misconduct involving high risk products, including crypto-assets. 

 

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