15 November 2023

SSM's Enria: Regulating crypto finance: taking stock and looking ahead

It is remarkable that the European Union is the first major jurisdiction in the world to introduce a regulatory framework for the crypto industry. The Markets in Crypto-Assets Regulation (MiCAR) entered into force at the end of June 2023 and will be applicable in its entirety by the end of 2024.

I am very grateful for the invitation to deliver the keynote speech at this conference, here in Venice. The theme is very topical and particularly timely, and I am sure that today we will be discussing many interesting aspects of financial innovation and the role of regulation.

It is remarkable that the European Union is the first major jurisdiction in the world to introduce a regulatory framework for the crypto industry. The Markets in Crypto-Assets Regulation (MiCAR)^[1] entered into force at the end of June 2023 and will be applicable in its entirety by the end of 2024.^[2]

I will first discuss how recent developments in the crypto-assets world have strengthened the case for directly regulating crypto-asset activities. I will then touch on some problematic aspects of MiCAR and explain how the most advanced forms of decentralised finance (DeFi) seem to pose a fundamental challenge to the very application of financial regulation and supervision. And I will conclude by outlining what I believe are the basic elements of a regulatory and supervisory framework which sets the boundaries and polices interactions between the crypto industry and the banking sector.

Regulating crypto-asset activities

The technical features of the crypto-assets framework can be hugely complicated, but its basic building block is the distributed ledger technology (DLT). In this environment, assets, both financial and non-financial, are encrypted in the form of digital tokens (tokenisation), and transactions and contracts are executed on the basis of permissionless and pseudonymous access, with no need for any intervention by centralised institutions, whether public or private, as intermediaries, custodians or guarantors of the final settlement.

Bitcoin and other native crypto-assets based on DLT and, more broadly, DeFi, a development of that original concept, seemed to provide the opportunity for a new structure of financial markets that could completely dispense with the need for financial intermediaries and public institutions. For many people, these innovations bring to mind radical proposals such as free banking^[3] or the denationalisation of money^[4], which gained greatly in popularity in the wake of the havoc wreaked by the banking and regulatory failures that led to the great financial crisis of 2007-08.

I initially advocated^[5] the segregation of the crypto-assets world, in particular cryptocurrencies, from the regulated financial sector, avoiding the need to directly regulate crypto-asset activities.

I thought at the time that prohibiting financial institutions, in particular credit institutions, from buying, holding or selling crypto-assets would avert the danger of contagion to the regulated financial sector and also dispel a potential perception among the general public that investments in highly speculative crypto-assets would enjoy the same level of protection as investments in traditional financial assets.

At the same time, I strongly argued for the full inclusion of crypto exchanges and crypto-asset providers under the remit of anti-money laundering and countering the financing of terrorism (AML/CFT) regulation and supervision. I was of the view that it was indeed possible to let new technologies and products develop outside the mainstream channels of banking markets under an approach that could be characterised as “let crypto experiment in a closed environment”.

However, the turbulence experienced in crypto markets since then, including recent instances of unsustainable business models and egregious fraud, makes a strong case for a tougher regulatory approach.

In fact, we have seen some crypto-asset projects that relied solely on expectations of ever-increasing prices and continuous inflows of capital from new investors (like a Ponzi scheme) with no intrinsic value whatsoever, no ability to generate cash flows and extreme price volatility^[6].

In the demise of the stablecoin TerraUSD, for instance, we had a clear case of a flawed business model coupled with misconduct. This shone a light on three extremely concerning aspects: the high vulnerability of the lending protocols; the extensive interconnections among crypto-asset players; and the unreliability of algorithmic stabilisation mechanisms. The same case revealed strong detrimental interconnections between crypto-assets (Luna, paired with TerraUSD) and crypto-asset firms (Lido, Celsius) which had a profound impact on public confidence in the entire sector.

The trading platform FTX also operated with a seriously flawed institutional and governance framework that was prone to conflicts of interest, fraud and misappropriation of client assets in order to cover losses incurred by other group entities. Indeed, the FTX case laid bare all the problematic aspects of an opaque corporate structure and an overly complex and vertically integrated crypto-related business model....

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