25.06.2019 | Cryptocurrencies: the next chapter lies in regulation

Improving checks and balances to make the sector thrive.

Click here to read the Alaco article in Investment Week. 

 

 

 

If nothing else the cryptocurrency sector has been a prodigious source of memes, hashtags and catchphrases, having spawned a unique subculture, writes Henry Burrows, co-founder of Alaco Analytics. Yet with greater investment, talent and expertise flooding the market, digital assets are being dragged into the mainstream.


What was once the domain of dark web marketplaces and cyberpunks is now firmly in the sights of big corporate firms; juggernauts such as Facebook, AT&T and Amazon now all have digital tokens firmly in their sights.

To (perhaps unfairly) borrow from Winston Churchill: this is not the end of crypto, this is simply the end of the beginning. The next phase of the evolution of all things blockchain is about to begin.

Crypto assets face EU-wide regulation

One of the more noticeable signs is the shifting nature of discourse since 2017. Famously castigated by JP Morgan CEO Jamie Dimon in 2017 as a "fraud" that would eventually blow up, digital assets are now being talked up as a game-changer for the world's leading banking institutions - seen, according to press reports, as a cheaper,

faster and lower-risk trading and settlement tool.

Government bodies and working groups are also being formed to devise 'best practice' guidelines, while institutions, exchanges and custodians are working to create more robust compliance architecture.

Eventually, even Dimon was forced to retract his remarks when JP Morgan announced the creation of its own settlement coin in February 2019.

Regulatory framework

This is a sign the sector is maturing. And yet, despite the progress, one essential part of the puzzle is yet to fall into place: regulation.

A persistent argument against investing in cryptocurrencies has been the heightened risk stemming from the lack of any unified regulatory government framework.

This view is not wrong; fraud remains and investors are being scammed in ever-increasing numbers. According to the Financial Conduct Authority (FCA), crypto-asset scams last year in the UK more than tripled, with total losses to retail investors exceeding £25m.

There are all manner of explanations for the high levels of fraud - from poor security to just plain bad luck, and even the fact that a transnational regulatory response is actually extremely tough to get right.

FCA: 'Get rich quick' crypto investors do not understand the asset

But in reality, what allows such schemes to go unchecked is a lack of any meaningful oversight.

An interesting but unfortunate offshoot to all of this has, in the past, been a lackadaisical attitude towards due diligence by some in the market, and a perception that basic compliance is an option rather than a necessity.

Of late, there have been moves to bridge this gap. Alongside the influx of new money since 2018 has come a push for more rigorous checks and greater transparency in the fundraising process.

This, coupled with a crackdown in the US on unregistered token offerings, has almost entirely scuppered the wild west of the Initial Coin Offering market.

Self-regulate

One reaction has been to devise new fundraising methods in the form of securitised token (and initial exchange) offerings.

Both, however, are in their infancy and have yet to be fully endorsed by regulatory authorities, who continue to sit on the sidelines formulating, writing and then rewriting their own game plans.

Nonetheless, the recent pivot towards more mainstream compliance practices has driven a broader awareness of the need for better scrutiny in crypto-assets.

In some corners, this appears to be a genuine effort to self-regulate while governments work out the best direction of travel; in others it has led to a proliferation of financial services buzzwords, with only scant thought for implementation or the bigger integrity picture.

One term being thrown around with abandon is KYC (Know Your Customer), a standard financial services acronym used to denote the need to identify a customer through verification of certain personal criteria.

Token white papers and initial offering documents brim with references to KYC, as well as AML (anti-money laundering) and CTF (counter-terrorist financing).

Keen to prove their legitimacy and compliance credentials, it has become the latest big thing in digital assets, often pitched as the answer to all your compliance issues.

KYC creates the critical foundations for robust compliance, but on its own it tackles only part of the problem.

Having someone's name, address and date of birth is not going to put the brakes on misconduct, nor can you set much store by it as an effective anti-corruption tool.

But what it can do is provide a level of comfort regarding counterparties, and afford some degree of recourse should things go wrong.

Due diligence

Where heightened risks are identified, however, the sector must ultimately turn to more robust methods of due diligence.

In some cases, firms are utilising global compliance databases to tackle those tricky AML issues. But these findings are often short on context, and can in some cases be proven through closer scrutiny to be incorrect.

In response to this, financial services long ago turned to enhanced due diligence (EDD), a well-trodden and critical part of pre-transaction criteria for banks and investment houses.

EDD, as it is commonly known, is deployed to obtain insight beyond the headline risks attached to a potential counterparty.

Essentially, it is used to gather intelligence on the veracity of an issue and its wider context - critical, some would argue, for appropriate risk assessment.

In other words, a red flag need not spell the end of a commercial relationship if you can demonstrate sufficient steps towards mitigating the concerns attached to it.

That is not to say that it is necessary for each transaction or customer onboarding. It should only be used in situations where a heightened risk is apparent, or where sizeable transactions require closer examination.

But deploying such measures has obvious benefits. ot only would it strengthen internal compliance controls.

Over the longer term, it would help to chip away at those negative perceptions of the crypto sector. More to the point, it would sit well with regulators when they eventually get their act together.

This is serious stuff and a far cry from where crypto started a decade ago.

However, it is of paramount importance for a sector that has - for better or for worse - found itself firmly in the spotlight, embraced not just by techies, but by those in financial services, shipping, manufacturing, real estate and beyond.

Setting the right tone in this new chapter for cryptocurrencies is critical for its long-term viability.