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September 23, 2022

Digital asset regulation, explained

Learn the basics of digital asset regulation, from how effectively digital assets are being regulated to why legislators want to regulate them in the first place.

Is 2022 the year of digital asset regulation? Some might think so, with global regulation of digital assets quickening its steps to keep up with the explosive growth in digital assets–including everything from cryptocurrency to tokenized securities to non-fungible tokens or NFTs. 

But blockchain regulation is only in its infancy. To date, the majority of digital asset regulation has focused on anti-money laundering, anti-terrorism funding, and know-your-customer obligations. Many important elements have yet to be figured out, beginning with how to treat digital assets–which are inherently global and decentralized–within independent, pre-existing judicial frameworks. 

Below we offer a brief explainer on digital asset regulation, from how effectively digital assets are regulated to why legislators are concerned with the regulation of cryptocurrency in the first place.

Who controls cryptocurrency?

With fiat money, it’s clear who controls the currency; the government does. But it’s a little more complicated for crypto. 

Most cryptocurrencies run on globally decentralized networks. These are public peer-to-peer networks that operate without the control or oversight of a central authority. Instead, the system and its data are distributed across a number of independent nodes, creating an unbreakable ledger that can track transactions and ownership without relying on one central entity. 

This disbursement of control differs vastly to fiat currency such as the US dollar or British pound, which are issued by national banks. Acting under the federal government, these banks have the power to control the currency’s value by issuing new currency, setting interest rates, and managing foreign currency reserves.

By contrast, crypto is largely uncontrolled; that is, if we’re talking about control in the sense of concentrated power. But there are other ways to examine the question ‘who controls cryptocurrency?’.

Who’s controlling crypto? Nobody, everybody

You can say that cryptocurrency is controlled both by nobody and the entire network–at least in theory. This is because just like in a truly democratic political system, each node in a truly decentralized network has equal voting power and thereby equal influence on the chain. 

In practice, of course, it’s possible for an entity or cartel of entities to gain undue influence on a chain. While a chain is based on consensus among distributed nodes, this consensus can be compromised through a hack or manipulation; blockchain isn’t invincible. This is why it’s extra important to choose a blockchain such as Polymesh that’s purpose-built to reduce the risks of consensus-based attacks.

Crypto creators

Of course, there’s an element of control in crypto’s creation; before a network can achieve sufficient decentralization, it has to be created by somebody. This creator could be an individual, a small startup with a few developers, or a huge multinational company with hundreds of employees; there’s no rule as to who can construct crypto. Hence the thousands on the market.

It’s important to note that there are many different types of blockchains and levels of decentralization, and some are better fits for certain use cases than others. Polymesh is public permissioned, so it has some level of centralization although the chain’s information is transparent. This offers a range of benefits necessary for meeting the needs of financial institutions, particularly around identity and compliance.

Investors and economic participants

Economically, we can also say that investors partly control crypto since they have potential to impact the crypto market. This includes both ‘whales’ (powerful investors who can invest and trade hundreds of millions of dollars, influencing the market on their own) and the smaller fishes who have little impact individually but collectively can make or break a crypto token. 

Often the two interact. Just look at Dogecoin as an example: the cute Shiba-Inu themed meme coin gained cult status on Reddit around the same time as retail investors on the same subreddit r/WallStreetBets triggered the GameStop short squeeze - see Graeme Moore’s op-ed in Fortune on GameStop and security tokens here. But multi-billionaire Elon Musk is partially responsible for this, having tweeted about the coin regularly since 2019, pushing its value up each time. 

Valued at just less than $0.01 USD at the beginning of 2021, Dogecoin rose to a record high of $0.68 USD by May 2021 and consistently polled among the top five cryptos by total market cap; it’s still among the top 20 cryptocurrencies by market cap today. Overall, Dogecoin is a great example of how the world of investing is changing as it collides with the world of technology (including the world of social media virality and meme lords). 

Government regulations

Finally, while the government may not control cryptocurrency to the extent that it controls a national currency (with the notable exception of a central bank digital currency), its influence on crypto can’t be dismissed. Crypto doesn’t operate in a vacuum; crypto companies need to comply with national legislation or face potential punishment or fines, which includes everything from existing compliance rules for securities to crypto token promotion/marketing. 

Below we’ll touch on how international relations might impact crypto activity, but let’s focus for a moment on crypto marketing. Many governments have been quick to push legislation to restrict crypto advertising and marketing to retail consumers, claiming the majority of ads are misleading–the United Kingdom, Singapore, and Spain are three examples. 

For the UK and Spain, crypto promotion needs only to be fair and disclose risk; third-party advertising including through social media is allowed. But in Singapore, advertising is restricted solely to digital asset providers’ own platforms. 

Tying this to the above section about investors, we can get a picture of how crypto promotion might interact with market influence through social media: if sponsored crypto marketing is allowed, crypto companies can tap into the potential for influencers to affect the market by directly utilizing an influencer’s fame and following to promote their products. But if there are limits to paying crypto influencers to promote cryptocurrency platforms, companies will need to attract online attention more organically. 

Luckily, the crypto space is one in which marketing primarily tends to be word-of-mouth. That said, a few interesting questions arise when we consider how digital asset regulation for advertising might affect influencers. Things like: should crypto influencers be liable for losses from their followers? (And if yes, why shouldn’t they then have a stake in their followers’ gains?). Or should the government create guidelines for crypto influencers to adhere to as well? 

Looking at it this way, you can see how crypto has the potential to disrupt social media advertising ethics and the way we view and treat personal responsibility on social media. 

It isn't black or white

For crypto, there’s no central authority with direct control over the network or the coin’s value. As a result, cross-border transactions can flow more easily and there’s less risk of having your assets frozen by the state. 

The recent war in Ukraine thrust crypto into the limelight for exactly this reason. While many feared Russian oligarchs would take to using crypto to evade international sanctions (seemingly forgetting the blockchain is traceable), the Ukrainian government looked to crypto to raise funding while its central bank froze the exchange rate and banned digital money transfers in response to martial law.

Clearly, the issue of control in crypto isn’t black-or-white. It also can’t be assumed that just because crypto itself is decentralized and uncontrolled, cryptocurrency companies will ‘let anything fly’. 

In fact, crypto companies like Binance have been adamant about global compliance being a priority. Binance CEO Changpeng Zhao, for example, issued a statement in March 2022 clarifying that Binance does comply with the same international sanctions as banks, and that it would be improper to freeze populations of users’ assets in the face of war as those populations also represent regular citizens.

So, what should companies worried about regulatory compliance requirements do to ensure they meet them? It’s simple: work with a blockchain that’s built for this purpose.

Compliance is ultra important for Polymesh as it’s one of the qualities that makes Polymesh the best fit blockchain for regulated assets. In fact, Polymesh has the most sophisticated compliance engine on the market–you can customize an array of attestations at both the individual and entity level, and complex requirements can be automated efficiently at scale. 

Are digital assets regulated?

Digital asset regulation is complex primarily because financial laws pre-date the technology. For many cases, it’s not exactly clear how to regulate digital assets because they aren’t always homogenous with existing legal items (usually financial instruments). 

Take cryptocurrency. For many countries, cryptocurrency regulation is largely in its infancy because regulators haven’t yet figured out how to legally classify decentralized virtual currencies. Most won’t classify cryptocurrency or consider it legal tender (or ‘money’) if it isn’t issued by the government or the nation’s central bank, but this means cryptocurrency will be largely unregulated unless there’s a specific cryptocurrency act or framework put in place.

Legislators are faced with a choice: figure out where these blockchain-based assets line up with existing legal definitions and regulate accordingly, or create new fit-for-purpose blockchain regulation laying out new criteria. Neither is an easy option: those who pick the former have to work with legislation that was never designed to accommodate digital assets, while those who pick the latter have to chart consensus on terminology. 

Once there’s terminological clarity, regulators can begin to craft policies making it clear what crypto projects will be expected to comply with and the relevant regulatory body to oversee them, if applicable. But it’s not an easy feat: crafting legislation for an emerging industry requires a careful balance between consumer protection and industry innovation. Too much regulation, and innovation can be severely hindered; too little regulation, and you have the “wild west”, with projects opening and closing overnight often with consequences to consumers.

Given this difficulty, it’s no wonder that digital asset regulation hasn’t received much urgency in regulators’ eyes until now; a slow approach as the industry unfolds is better than something rushed and overly restrictive. After recent events like the crypto crash this past June, however, it’s clear regulators are keen to up their efforts–this summer has already seen major crypto-based legislation either proposed or passed in the US, UK, EU, and Singapore. 

Who regulates digital assets in the US?

In the US, there are multiple federal regulators battling for authority over digital asset regulation. We get into this in more detail in a blog spotlighting the US regulatory landscape, but to cover the basics, the main fight for supremacy over digital assets in the US is between the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC).

However, this past June saw a recent bipartisan proposal introduced that would bring the majority of digital assets within the control of the CFTC, offering terminological clarity and ending the war between the two on the issue of digital asset regulation once and for all. We’ll have to see how it unfolds! 

Why do governments want to regulate digital assets?

The reason we’re witnessing regulators focus increasingly on digital asset regulation is the same reason regulators put in place rules for more traditional financial assets: bad actors. We can think of bad actors as individuals or entities who act on their own self-interests even when it harms others or the system. 

Regulation of cryptocurrency and other digital assets is in large part a way to prevent economic innovation from upending the financial system and stem from long-held concerns related to bad actors. These include:

  • Protecting consumers from manipulation
  • Perceived abuses in reporting for tax purposes
  • Fears that digital tokens are conduits for criminal activity
  • Concerns about participants circumventing sanction regimes 

Imposing digital asset regulation– whether through existing or new legislation–is just a way for jurisdictions to ensure the stability of the global financial system in response to these concerns.

But these threats aren’t anything new; the traditional financial world also experiences front running, rug pulls, tax evasion, and undisclosed unlawful trades. The game of trying to obtain money from investors and avoid compliance requirements has been playing for a while– it’s just that now there are two playing fields: traditional finance and decentralized finance (DeFi).

What is the current global regulatory landscape for digital assets?

Globally, digital asset and cryptocurrency regulation remains highly fragmented and continuously in flux. In September 2021, El Salvador made headlines for becoming the first country to make bitcoin legal tender at the same time as China declared cryptocurrency illegal altogether in a bid to eliminate competition for the digital yuan. 

Even within nations, opinion on blockchain regulation is divided. In May 2022, France granted Binance a Digital Asset Service Provider (DASP) registration, welcoming the crypto exchange–the largest by volume–to French markets after it was rejected by the US and the UK. Yet France’s decision was met with shock and disapproval from neighboring states and French ministers alike.

The changing landscape of digital asset regulation is partly due to market changes, technological innovation, and emerging threats–but it’s also because there’s no jurisdictional body to oversee a truly international effort. 

Most world banking regulators agree on policies under the Basel Committee on Banking Supervision, but digital assets have no equivalent. It’s not even clear whether a financial board is the best forum for globally managing digital assets; it might not be broad enough as digital assets are inherently decentralized and extend into fields beyond finance. 

The intertwining of finance with technology is an obvious example of the interdisciplinary nature of digital assets. A less obvious–but equally worthy–example is the potential for digital assets to engage wider society within such spaces (e.g. by reducing barriers to investing in certain asset classes). But digital assets even have the potential to restructure socio-political spaces altogether through decentralized autonomous organizations or DAOs.

Currently, DAOs are the most decentralized form of organization conceivable. They work by utilizing blockchain infrastructure to create user-driven ecosystems which flip traditional fiat-based organizations on their head by avoiding information asymmetry and fostering equality among members. This has the potential not only to create more democratic decision-making and foster deeper interpersonal connectivity than currently present with technology (which is already huge!) but also dramatically disrupt the social impact space.

For the sake of space in this article, we won’t go into a detailed comparison of digital asset regulation around the globe. Still, we should mention that this summer alone has seen major developments– see our spotlight blog series for specifics on the US, UK, and Singapore (among others).

How are digital asset companies responding?

The response across the industry is varied: some companies fear regulation will severely dampen innovation; others want current loopholes to remain; and still others embrace it, recognizing that a regulatory framework ultimately fosters greater credibility as long as it’s not overly restrictive or rushed.

So, how might these attitudes affect how digital asset companies respond?

There’s three core options which we can predict digital asset services providers to take in response to increased digital asset regulation:

  1. Ignoring global regulatory trends: Participants can choose to put their head in the sand at their own risk, although at best they are likely to become subject to a myriad of conflicting regulations, while at worst they’ll be subject to enforcement actions and face severe monetary and other consequences. 
  2. Creating self-governing organizations: Participants can choose to copy other sectors and seek to create self-governing organizations, similar to FINRA in the US, and persuade regulators to let that body enact applicable regulations– perhaps ultimately subject to the oversight of higher regulators. 
  3. Appealing directly to global regulatory organizations: Through traditional methods of public commentary on proposed regulations, lobbying, and other acts of political participation, entities in the space can seek to influence global regulators to promote consistent and reasonable regulations. 

Evidently, digital asset companies who choose options 2 or 3 do so because they recognize how they can play a role in the changing regulatory landscape and potentially benefit from new regulations.

How might Polymesh users approach the changing landscape? 

Firstly, security token issuers and other market participants should prepare themselves for increased tax, AML, KYC, security, custody, and marketing regulations for digital assets. 

Rules and regulations will differ depending on jurisdiction, so it’s up to each individual or entity to ensure they stay up to date on what’s relevant and applicable to them. In general, we can expect larger digital asset exchanges to cope with these demands easier than newer companies owing to greater market size and cash flows. 

For digital asset issuers and investors– including artists minting NFTs and the common public who purchase them, or decentralized exchange operators and the retail investors utilizing them–the picture is less clear. What is clear, however, is that most will lack the financial resources, knowledge and experience, or personnel required to perform the necessary reviews and reporting for complex compliance requirements. 

That’s why you need to ensure that you have a blockchain built for that exact purpose.

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