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Digital Asset Regulations: A Catalyst for Institutional Adoption

February 17, 2023

Digital Asset Regulations: A Catalyst for Institutional Adoption

The digital asset industry continues to demonstrate characteristics of nascency. Despite the volatility, virtual assets remain attractive for traditional financial institutions. In fact, it’s been reported that, 70% of institutional investors expect to acquire cryptocurrency in the near future. 

This leaves lawmakers faced with the challenge of balancing innovation against consumer protections in a rapidly changing environment. In the wake of many high-profile insolvencies last year, the industry is keenly focused on regulatory movements in the U.K., Europe, Canada and the U.S.

What Issues Are Regulators Tackling Globally?

Bearing in mind that 51% of Americans who have never owned cryptocurrency would consider buying if they could store it in their primary bank, policymakers are striving to establish a framework that provides clarity to operators who are looking to serve these newcomers. 

For example, the U.K.’s financial regulator, the Financial Conduct Authority (FCA) has been engaging with industry representatives to define which tokens fall within its purview and to enforce Know Your Customer (KYC)/ Anti-Money Laundering (AML) requirements. The EU is focused on issues like Stablecoin reserves and disclosures for initial coin offerings. There is less clarity in the United States, but proposed legislation would classify digital assets as a mix of commodities falling under the purview of the Commodity Futures Trading Commission (CFTC) and securities regulated by the Securities and Exchange Commission (SEC). Canadian securities regulators require crypto exchanges to register with the applicable authorities and bring their operations into compliance with the rigorous risk management standards expected of traditional financial institutions. It’s worth noting that the general tone towards oversight has become more contentious in 2023.

While some guideposts have been placed, additional clarity around these issues would alleviate concerns which have kept many financial institutions from fully embracing digital assets. We believe clearer rules are forthcoming. 

Can Regulators Balance Innovation and Consumer Protection?

There was a record $760 million of digital asset exploits in October 2022 alone (with nearly $3 billion over the course of the year). We also saw several high-profile lender and exchange insolvencies, which led to significant losses at the retail and institutional level. These trends in conjunction with a rapidly innovating space requires swift action from regulators, setting up a scenario where regulatory efforts start out relatively heavy-handed, only to be walked back through later industry consultations. 

Will impending legislation add friction to the rapid pace of innovation in the space?

Crypto startups raised a record $29.2 billion in 2021 but so far only $21.5 billion in 2022. Early indications this year suggest a continued slowdown in venture funding. 

That’s a big gap – and while regulations pose a risk to the ecosystem’s development, a thoughtful implementation, can help the industry regain lost trust. This, in turn, could spark another phase of rapid growth and innovation.  

Many startups lack the knowledge of working in a highly regulated environment. However, incumbent financial services businesses maintain this acumen in-house. This may lead to a scenario where firms who are well-versed in oversight and have long-standing relationships with policymakers develop successful digital asset solutions for the next wave of growth. 

What’s Coming?

Traditional finance giants are making notable moves into digital assets. It takes deep conviction and significant buy-in for a well-established incumbent to enter an emerging asset class amidst challenging market conditions. Policymakers are trying to move fast enough, but many institutions remain sidelined due to a lack of clarity.

Can History Be Our Guide?

Lenders used to be as un-regulated and decentralized as digital assets are today. In the mid-1800’s Wildcat Banks operated outside of federal oversight. They issued notes as a medium of exchange, but they weren’t government-backed. These claims represented the liabilities of the institution and were redeemable for gold/silver. However, early lenders rarely maintained enough collateral to cover their debts, leading to bank runs similar to what we have seen recently in digital assets. The National Bank Acts of 1863 and 1864 established a federal financial system and brought commercial banks under the purview of the U.S. Government.

We consider banks to be reliable today because of centralized regulation. Mass adoption of digital assets will be challenged until the promise of blockchain technology is demonstrated responsibly. While sweeping regulations may serve as a short-term headwind for innovation, the long-term impact will be increased trust and institutional adoption. 

Aquanow and others across the ecosystem continue to participate in constructive conversations with policymakers to help inform the best way forward. Our hope is that lawmakers come to better understand this complex technology through industry engagement and education, we are striving for fair and balanced guidance that helps foster continued innovation. 

Want to learn more? We dive deeper into the trends driving digital asset adoption and everything financial institutions need to know about the growing market in our latest report.

Download our Digital Assets Primer for Institutions to learn how to get involved.

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