Crypto View - June 2022

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Welcome to this June's Crypto View. There has been a slightly longer gap between issues this month as I took a couple of weeks' holiday following the successful launch of our new Crypto Reviewer platform. It would seem that the crypto market did not take a similar holiday (perhaps an understatement)! 

As a result, this month's issue is a bit of a bumper edition: We look at the consultation from HM Treasury on failures of systemic digital assets, which seems particularly relevant in light of the recent turmoil in the (algorithmic) stablecoin market; as well as statements, publications and announcements regarding CBDCs from around the world -- this is something that is really gaining traction. We also cover couple of Bank of International Settlements (BIS) papers on issues they are seeing in the crypto market which make for particularly interesting reading. We also saw HM Treasury's response to its consultation on amendments to the MLRs, which highlights proposed changes to the Travel Rule in the UK. From Ireland, we look at the view of the Irish Funds industry group. 

As from this month, we are introducing a regular section on Europe's important regulation., the Markets in Crypto-assets Regulation (MiCA) as the regulation progresses along the path to implementation.

Stablecoin Insolvency Regime

On 31 May, HM Treasury released a consultation on managing the failure of systemic Digital Settlement Asset (including stablecoin) firms. It is quite a brief consultation, and focuses on the way in which government can "create the conditions for issuers and service providers of stablecoins used as a means of payment to operate and grow safely in the UK." It references the consultation and response that it published in January 2021 and April 2022, respectively, that sought to introduce legislation to establish regulatory regimes for stablecoins that are used for the purpose of making payment transactions, but goes further in this consultation, referring to a "digital settlement asset" (DSA) to refer to stablecoin of the type consulted on previously, together with wider forms of digital assets used for payments/settlement.

HM Treasury proposes an amended Financial Market Infrastructure Special Administration Regime (FMI SAR) to address the risks posed by the possible failure of systemic DSA firms which are not banks (banks are catered for by separate pre-established regimes). The FMI SAR was established to address the risks posed by the possible failure of systemic financial market infrastructure such as payment systems (Faster Payments or Bacs) and securities settlement systems (Euroclear UK & International). A special regime is appropriate as the failure of such systems due to insolvency would cause such severe disruption to the public that the standard processes should not be followed. As such, the FMI SAR requires administrators to prioritise the continuity of a failed payment system's services over the interests of that firm's creditors.

HMT is proposing to introduce legislation to amend the current regime to address the financial stability risks associated with a systemic DSA firm's failure.

CBDCs in the News

There have been several developments in relation to stablecoins, specifically CBDCs:

• Jerome Powell of the Federal Reserve reconfirmed that the US is looking carefully at CBDCs, in the context of potentially improving the US's domestic payments system, while maintaining the dollar's international standing, given how the global financial system might evolve over the next 5 to 10 years.

• We also saw the ECB's Fabio Panetta discussing CBDCs in his introductory statement at the committee on Economic and Monetary Affairs of the EU Parliament. This was at far greater length than Mr Powell, and really highlighted the focus the EU is putting on CBDCs. Mr Panetta sees the digitalising of payments as being critical for two reasons -- preserving the role of public money as the "anchor of the payments system in order to ensure the smooth coexistence, the convertibility and the complementarity of the various forms that money takes", and further, that "a digital euro would contribute to [the EU's] strategic autonomy and economic efficiency by offering a European means of payment that could be used for any digital payment, would meet Europe's societal objectives and would be based on a European infrastructure." It does look as if the EU is more determined to bring a CBDC to the public than other jurisdictions.

• There was also news from India (in the Reserve Bank of India's Annual Report), confirming that the Reserve Bank is engaged in the introduction of a central bank digital currency, as well as that the Hong Kong Monetary Authority, Bank of Israel and the BIS had teamed up to research a retail CBDC. Project Sela, as it is known, will take a deep dive into cybersecurity issues in the context of retail CBDC.

• Finally, and not least, there was an announcement from Circle - the issuer of USDC, a fully backed USD denominated stablecoin -- that it is issuing EUROC, an EUR backed stablecoin, under the same full-reserve model. The press release flagged the interesting statistic that the total circulation of all euro-denominated stablecoins is just $129 million, compared to $156 billion in dollar-denominated stablecoins. It will be interesting to see how much this changes over the coming years.

Amendments to the MLRs

On 15 June, HM Treasury published a response to the consultation it published in July 2021 regarding proposed amendments to the Money Laundering, Terrorist Financing and Transfer of Funds (Information on the Payer) Regulations 2017 (MLRs). This covers the entirety of the MLRs, and is not restricted to crypto. However, Chapter 6 outlines the key changes that HM Treasury is considering in relation to the transfer of cryptoassets, and the so-called "Travel Rule". This aims to bring the UK in line with the FATF Recommendation 16, regarding information sharing requirements for transferring cryptoassets. HM Treasury is considering legislation that will require one of the originator's address, date and place of birth, and passport number to be provided with a cross-border transfer of cryptoassets above the de minimis threshold. Originally, the government had proposed the de minimis threshold to include linked transfers including both fiat and crypto. The consultation changes this so just, cryptoasset only transfers are in scope. The de minimis level is to be set at EUR 1,000, which deviates from the GBP 1,000 first proposed-- this is because the FATF's recommended threshold of EUR 1,000 is less than the GBP 1,000 the government had proposed (though given the trajectory of the pound, how much longer this will be the case remains to be seen...).

There will also be some relief for certain firms. In a welcome move, the collection of beneficiary and originator information for all unhosted wallet transfers will not be required -- with only those transactions identified as posing an elevated risk of illicit finance needing to have the details sent. Further, there is an exemption for transfers which involve only UK based cryptoasset firms (the full information need not be sent with the transfer, but must be provided to the beneficiary cryptoasset business on request). However, in light of the way in which the AML registration regime has been implemented, very few firms will benefit!

Happily, the government has decided to allow a 12-month grace period, to run from the point at which the amendments to the MLRs take effect until 1 September 2023 -- so firms have some time to look at how to go about implementing this. Firms should already considering the similar (though perhaps more strict) rules being introduced under the Transfer of Funds Regulation in the EU.

BIS

The BIS published two papers last week, which I found pretty interesting. The first looks at DeFi lending, and discusses the differences with traditional lending, and issues that arise due to the decentralised nature of the activity. In particular, it looks at the way in which the use of collateral as a substitute for credit ratings or other information on borrowers and lenders increases procyclicality, with appreciating prices increasing collateral values and falling collateralisation ratios, leading to relaxing borrowing constraints and increasing loan values -- which leads to further price appreciation. In busts, as we are seeing now, loans are liquidated as prices -- and hence collateral values -- decline sharply, suppressing lending activity.

The second paper looks at the potential risk from market manipulation in crypto and DeFi by miners. The issue that is explored is that validators or "miners" updating the blockchain can determine which transactions are executed and when, thus affecting market prices and opening the door to front-running and other forms of market manipulation. Generally, we would consider miners to select transactions based on the transaction fee and/or tip that they might receive to validate the transaction, but in practice, there may be more profit available by selecting a different order of validation -- this is referred to as "miner extractable value", or MEV. Worryingly, the BIS suggests that since 2020, total MEV has amounted to an estimated USD 550--650million on just the Ethereum network, according to two recent estimates. We seem to be some way off introducing insider-dealing style legislation in the UK or elsewhere, but it does seem that this is an issue that would need to be resolved, even if just to shore up the credibility of the industry. As the BIS notes, MEV stands at odds with the idea of decentralisation itself.

Irish Funds industry group publishes paper

In Ireland, the Irish Funds industry group has published a paper, entitled Crypto Assets -- Opportunities, risks and future possibilities for regulated investment funds in Ireland, which looks at the possible applications of cryptoassets to funds.

In short, the paper states that as regulated investment funds already incorporate the protections that cryptoasset investors are seeking, they could be the optimal vehicle to provide exposure to such assets. Among the steps put forward by the paper are:

• QIAIFs: clarification of the extent of acceptable indirect exposure within Qualifying Investor AIFs and the conditions required to increase such exposure;

• RIAIFs: clarification of any risk mitigation measures which would be necessary to allow Retail Investor AIFs to take direct or indirect exposure to cryptoassets;

• UCITS: Ireland to lead the discussion regarding the eligibility of cryptoassets within UCITS funds; and

• General: the CBI should engage with fellow regulators to ensure convergence of the regulatory approach to cryptoassets.

The paper also makes specific recommendations to the Irish Government, including the creation of a specific taskforce on tokenisation within the Fintech Steering Group, and the adoption of legislation on cryptoassets and decentralised finance platforms to match other EU Member States. If you have any questions on this, or on crypto regulation in Ireland more broadly, please get in touch with Derek Lawlor.

This month in MiCA

The third and penultimate political Trilogue on MiCA was held on the 14th June. There will be a fourth Trilogue at the end of June, with the aim being to reach an agreement under the French Presidency. It seems that there are several key topics where agreement is yet to be reached, including supervision, custodial liability, exchange's responsibility for whitepapers for non-EU tokens, environmental safeguards, the overlap with AML legislation, and whether or not NFTs will be brought into scope of the regulation. If agreement is not reached by the end of this month, the finalisation of MiCA will move into the Czech Presidency. We are keeping our eye on developments.