Despite its meteoric rise, the cryptocurrency market operates within a regulatory grey area in many jurisdictions. The decentralised and borderless nature of cryptocurrencies poses significant challenges for regulators, who must grapple with issues ranging from investor protection to money laundering and financial stability. James Burnie, a partner at legal firm Gunner Cooke advising on financial services regulation says: “The nature of the Web3 industry has been intrinsically global, as it is easier than ever for a company based in one jurisdiction to sell to clients in another. As regulation has come in, originally this meant that companies were able to engage in regulatory arbitrage as they could structure their setup to avoid more onerous regimes. Such companies could offer cheaper products; however this was often by having lower standards than companies within a jurisdiction would have to abide by.”
To counteract this outcome, regulators have started to take a more expansive approach to their jurisdiction, meaning that the offering of a product into a country is seen as an activity that can be regulated. “The consequence of this has been to drive up the cost of compliance for the Web3 industry, making it harder for the industry to thrive. The key issue in the next few years is therefore how to balance the cost of compliance with ensuring proper standards and it is clear in this respect that the global regulatory system is far from settled as to how to handle this issue,” Burnie adds. Jill Wong, a Partner at international law firm Reed Smith, agrees that there are intricate legal challenges associated with regulating cryptocurrencies. Wong, based in Hong Kong, highlights the difficulty of fitting cryptocurrencies into traditional financial laws, leading to regulatory gaps.
“In Hong Kong, as in other jurisdictions, it has not been straightforward to fit cryptocurrencies into traditional securities and banking laws or other existing regulations in relation to money services,” she says.
“As Hong Kong has functional regulation, the regulator may be different depending on the activity being carried out. It can get complicated. However, with recent new regulatory initiatives aiming to fill regulatory gaps, the regulatory landscape is becoming clearer; crypto-exchanges should now apply for a licence and in the near future, stablecoin issuers and OTC crypto-fiat conversion businesses are likely to be regulated.”
The decentralised nature of cryptocurrencies complicates enforcement and investor protection efforts, highlighting the need for cross-jurisdictional collaboration among regulators. Wong’s colleague Brett Hills, also a Partner at Reed Smith, says: “There are huge challenges to legislators and regulators in designing, implementing and enforcing effective and proportionate regulatory regimes governing cryptocurrencies and indeed other digital assets. And it is therefore not surprising when regimes have not been effective and proportionate.”
Categorising cryptocurrencies
Cryptocurrencies present several regulatory challenges. They have some similar and some different features to existing financial assets. Questions arise as to whether particular digital assets fall into existing categories (securities, commodities and so on) or new categories need to be developed to appropriately cater for them.
Cryptocurrencies are also owned, bought and sold on a global basis; regulators operate within jurisdictions. That then raises the question of how a local regulator deals with offshore activity. Regulators are generally more protective of retail customers and investors, many of whom have bought cryptocurrencies.
Regulators worldwide are grappling with defining cryptocurrencies and determining their regulatory status, often resulting in fragmented and inconsistent regulatory approaches. Research from the Financial Conduct Authority highlights the complexity of the situation. While 90 percent of crypto users understood what cryptocurrency was, only 58 percent claimed they had, “a good understanding of how cryptocurrencies and the underlying technology works.”
A further 12 percent of crypto users falsely believed that crypto investments have some sort of financial protection. This lack of consistency can be confusing for businesses and investors alike, as they navigate a landscape where rules may differ significantly from one jurisdiction to another.
Implications of regulatory decisions
Recent court rulings and legislative changes have profound implications for cryptocurrency regulation. In jurisdictions like the EU and the UK, efforts are underway to craft specific regulatory frameworks for digital assets. The EU’s Markets in Crypto-Assets Regulation (MiCA) is an example of this. The UK is following a similar path but phasing in the introduction of its regulatory regime so that it can build upon and learn from previous phases.
In the US, regulators have sought to apply existing regulatory categories to digital assets and related firms such as exchanges resulting in regulation driven by enforcement. MiCA in the EU and the new UK regime aim to provide clarity and predictability for businesses and customers, fostering a conducive environment for industry growth.
However, challenges persist, particularly in jurisdictions where regulation is driven by enforcement actions, such as the US. The lack of clarity stemming from enforcement-driven regulation creates uncertainty for businesses and investors, hindering industry development and innovation. Hill says: “In most jurisdictions, the view was that most cryptocurrencies fall outside the traditional categories of financial products such as securities and electronic money. As a result, in some of those jurisdictions, legislators have been able to design regulatory regimes that specifically apply to cryptocurrencies and other digital assets.”
Wong adds: “In Hong Kong, cryptocurrencies have been recognised by the courts as ‘property’ which can be the subject of a trust in a liquidation context. Hong Kong courts have also on multiple occasions granted freezing injunctions over cryptocurrencies as asset preservation measures. These provide welcome certainty for traders and investors.”
The impact of regulatory clarity
Regulatory clarity plays a pivotal role in shaping the development of the cryptocurrency industry. Uncertainty leaves businesses and investors grappling with regulatory risks, impeding investment and innovation. Conversely, clear and transparent regulatory frameworks provide certainty, fostering trust and confidence in the market.
Jurisdictions that offer regulatory clarity and certainty attract businesses and investment, positioning themselves as preferred destinations for cryptocurrency-related activities. As the industry matures, stakeholders increasingly prioritise jurisdictions with robust regulatory regimes, conducive to sustainable growth and innovation.
Regulators worldwide are grappling with defining cryptocurrencies and determining their regulatory status
Burnie says: “The problems of uncertainty generally leave firms with the choice of either ignoring the regulatory risk, meaning that there is a greater chance of repercussions should it materialise, or to spend on contingencies designed to reduce the risk, which may or may not be successful.
“As such, the preference will always be for greater clarity and certainty and indeed we have seen firms actively move into those jurisdictions which provide certainty. This has been a selling point for regulators seeking to promote their jurisdiction and indeed we have assisted both the Mauritius FSC and the Kazakhstan AFSA with developing regulatory frameworks for cryptoassets, designed to give certainty and thereby attract business to the regions.”
Advice for businesses and investors
Navigating the regulatory landscape of cryptocurrencies requires strategic foresight and careful consideration of legal and regulatory risks. Experts advise businesses to seek professional legal guidance early, understand target markets and prioritise regulatory compliance. Moreover, businesses must adapt to regulatory changes and proactively engage with regulators to shape the evolving regulatory landscape.
Investors should conduct thorough due diligence, focusing on regulated exchanges and service providers with reputable credentials. Understanding the risks associated with cryptocurrency investments is paramount and investors should exercise caution while navigating the volatile market.
Hill says: “Businesses and investors navigating the regulatory landscape of cryptocurrencies will need to think through their product offering clearly and produce a document setting out its key features for their advisors. They would be wise to take professional legal and regulatory advice early to stay ahead of any potential pitfalls or risks.
“It is also important to consider and demarcate what are the must-haves and the nice-to-haves for a product or service. Changing a product’s design can result in a very different regulatory outcome so knowing where to be flexible can go a long way to achieving the desired result.”
Burnie adds: “Often we see businesses implode either because they seek to achieve too much (spreading resources too thin), or there is poor execution (for example a lack of understanding of the target market for the product). For example, different marketing rules exist in different jurisdictions, so simply seeking to be ‘global’ is generally less successful than targeting resources in a particular jurisdiction. Given the sometimes fickle nature of the markets, it is also worth building a funds war-chest in case of another crypto-winter.”
The future of cryptocurrencies
Cryptocurrency regulation remains a complex and evolving domain, shaped by technological innovation, market dynamics and regulatory scrutiny. While challenges persist, regulatory clarity and collaboration offer a path forward for industry stakeholders, and as Burnie outlines, this has been achieved in Mauritius and Kazakhstan. By navigating the regulatory landscape with diligence and foresight, businesses and investors can unlock the full potential of cryptocurrency while ensuring responsible growth and innovation in this transformative space.
