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Surfing the Regulatory Wave: Compliance Lessons From TradFi

Over the past year, there has been a swell of regulatory activity related to digital assets. To help organizations navigate this tricky landscape, we need to look back and apply the lessons from the Financial Crisis of 2008. How did large financial institutions respond to the legislative reaction of the Dodd-Frank Act and MiFIR? What are the concerns of global regulators now, and how can firms plan ahead?

At the recent Consensus conference, a panel session “Surfing the Regulatory Wave: Compliance Lessons From TradFi” examined these questions in detail. Moderated by Brock Arnason, our Founder and Chief Executive Officer at Droit, the panelists included Sandra Ro (CEO of GBBC), Usman Ahmad (Chief Executive Officer and Co-Founder of Zodia Markets) and Sarah Ward (Chief Legal Officer at Chainalysis).

What can we learn?
As the maturation of the digital asset ecosystem occurs, there are a number of lessons from TradFi particularly related to the transparency and customer protections. There are already rules in place for monitoring and managing market abuse, which will in time encompass digital assets. However, to get to this, a clear taxonomy around the digital assets space first needs to be defined and understood.

Further, blockchain technology stands to help with transparency because it can improve upon existing tracking and tracing of risk methods, thereby helping provide the right tools to mark-to-market and dynamically risk-manage portfolio positions. This level of tracking and tracing even applies to ‘Layer 2’, the name for a secondary framework or protocol that is built on top of an existing blockchain system. Information available on the blockchain is also available on Layer 2 and should inform how we think about what else may be required from a reporting perspective.

Regulation required
Yet despite the crypto financial system actively adopting new technology such as Layer 2, the overall position of digital assets remains uncertain, especially in the US. This is in most part due to mixed signals currently manifested by US regulators: while these rule-makers on the one hand seem eager to come to the table, on the other hand classifications of digital assets are unclear or left undefined, muddying jurisdictions amongst the different regulators.

In other areas of the world, regulators are taking a bolder stance. Asia has an early lead with both Hong Kong and Singapore creating regulatory frameworks. More recently we have seen progress in Europe as well with its prescriptive Markets in Crypto Assets (MICA) regulation. And in the UK, the FCA is currently consulting on new rules and is more in favor of adopting a risk-based regulatory approach.

One good example of such a risk-based approach would be the AML and KYC requirements of onboarding on Layer 2. Any controls should be proportionate to identified risks. This is especially relevant when one considers that criminals are still largely relying on centralized exchanges and fiat in order to cash out illicit funds. Controls focusing on AML/KYC should therefore focus on protection around these specific areas.

The need for regulatory clarity
The overriding message is that regulatory clarity is desperately needed. This is neatly illustrated by the current industry plight of crypto firms being unable to bank. This situation sits at odds with governmental regulatory goals of financial resilience and stability. By excluding crypto firms from the banking industry, what is actually being created is a concentration risk (seen most recently in the recent collapses of Silicon Valley Bank and Circle), which is clearly neither good for the crypto industry or the broader financial system.

Ultimately, blockchain technology and digital assets are here, and can bring value and benefits to traditional finance. But in order to be fully accepted and integrated into the financial system, regulators and the industry need to think retrospectively about where we’ve been and consider what appropriate controls need to be in place.

If you would like to watch the panel session “Surfing the Regulatory Wave: Compliance Lessons From TradFi” from the recent Consensus by CoinDesk panel, please click here.