• Will Regulation Catch Up With Innovation In Digital Assets?

Will Regulation Catch Up With Innovation In Digital Assets?

In this interview, our European head of business development for fund services, Karine Seguin, discusses the race between regulation and innovation in digital assets with Dan Smith, our head of US fund services, and Tony Carr, our head of Asia fund services. 

The article was originally published by WealthBriefingAsia, one of Asia's leading online publication for wealth managers and private bankers.

A head start
In the race between digital assets and regulation, the former was way out in front until turbulence hit the market this year. Crypto funds have had a big head start with the total global number of crypto funds having shot up by 800 per cent over the last five years, according to Coinbase’s 2021 Global Fund Management (GFM) report. 

But will the market upheaval we’ve seen in 2022 drive greater regulation?

“A few years ago, regulators thought they didn’t have to worry about crypto and it would be a flash-in-the-pan asset class,” said Carr. “Now, it’s more institutionalised than ever. People from banking backgrounds, such as traders, quants and hedge funds, are looking to get into this space. I think this asset class is here to stay. However, markets are being tested now and I believe that the turbulence will push for more regulation and for regulation to be put in place faster.”

Definitions and disagreements in the US
Right now, regulators need to gain a lot of ground, because the global picture is “a big hodgepodge,” said Smith. “Just within the US, there’s disagreement and confusion. Globally, all the different governments and regulators have different views too.”

“The US hasn’t even yet decided which regulator has the authority over which digital assets,” said Smith, “though legislation is currently being proposed which will clarify this. It could be the US Treasury Department – which the IRS is part of   which very broadly regulates virtual assets and actual currencies. But it could also be the SEC, which regulates securities, and the CFTC, which regulates futures exchanges.”

“Virtual assets are treated as securities,” Smith said, “hence are taxable.” But there's also legislation out there that's claiming Bitcoin and Ethereum are currencies and should be treated as commodities.”

Asia plays the waiting game
In Hong Kong, managers wanting to manage digital assets defined as securities can trade up to 10 per cent of their assets or apply for a special licence to trade more than 10 per cent. However, this solution isn’t that simple: only a handful of licences have been given out so far, after a long and costly process.

Managers in Asia want to be regulated as most of the industry in Hong Kong and Singapore has a background in finance and has already worked in regulated environments, but being slow at  authorising licensing can be frustrating for the managers.

Carr said “most managers that I speak with want to get licensed as that will give them access to institutional investors who will normally require the manager to be licensed in a FATF jurisdiction and follow KYC/AML procedures in recognised jurisdictions. Tax is a potential problem too: crypto funds are still not classed as a tax-exempt product. It’s a very grey area and tax advisors have different opinions on how to deal with this. Managers would like greater clarity from the tax authorities on this subject.”

The AML/KYC elephant
It remains to be seen how market turbulence will affect investor appetite in the longer-term, however, as more investors have access to crypto there is already higher demand from investors to be able to use that crypto to subscribe funds directly rather than converting back into fiat. This does present an AML problem, as it is difficult to be 100 per cent sure that the wallet belongs to that person when there is no name attached to the in-kind subscription. This is something fund administrators and technology providers will need to work on as a priority.

The US is considering imposing an obligation on the cryptocurrency recipient to get the sender’s name and tax ID number and file a report with the IRS. “Under this obligation, if you gave your Trezor to your friend and the friend wanted to make an investment into a fund, it would be up to the administrator to tell the friend of their obligation. If that was reported to the regulator, that would be a way of tracking that transaction,” Smith said. 

In Singapore and Hong Kong, however, there is no move towards this kind of AML process, primarily because for the individual in Singapore and Hong Kong there is no capital gains tax to be paid. There are, however, discussions taking place about regulations for receiving crypto or subscriptions in kind and carrying out AML processes on those transactions.

Towards the finishing line – and beyond
Both Carr and Smith agree that regulation is gathering pace as investors demand more certainty.

However, the problem is, Carr said, that the regulators need people who have experience of dealing with digital assets to advise them how to regulate digital asset funds. The only way to truly understand the asset class is to have worked in it.

Smith thinks that institutional investors with a lower appetite for risk will force managers to move towards a safer and more regulated environment. “That means the regulators in the jurisdictions that want to attract that capital will write the laws and regulations accordingly,” he said. But this is crypto – so the race is never likely to be over. “The next challenge for regulators will be Defi pools. Given that Defi pools are formed from source code, how do you regulate and ask for KYC on investors and AML from a piece of code?” he said.

Regulators, agreed Smith, will always be one step behind. “I think they'll get 90 per cent of the way there in the next few years. Then they’ll be doing constant catch-up on that last few percent, as this space continues to evolve.”