Moves are underway in Europe and the US to regulate the volatile cryptocurrency markets. Global Insight investigates the road ahead.

It has been a torrid time for cryptocurrencies. During May, the collapse of the stablecoin Terra and its sister cryptocurrency Luna reopened unsettled questions about the future of the industry. Luna’s value plunged from $116 in April to zero by mid-May.

The crypto coin was pegged to the value of the stablecoin Terra, which was meant to be pegged to the US dollar. But unlike most stablecoins, its exchange value was not fixed one-to-one with the dollar. Instead, Terra was backed by an algorithm linked to Luna, so when Terra started to slide from $1 to 15 cents, Luna was doomed.

The news hit an already sliding crypto market. Ran Neuner, a crypto trader and enthusiast, reportedly told thousands of digital traders in an online broadcast that the collapse was ‘one of the greatest catastrophes crypto has ever seen’. Apart from the always-open question of how to realistically value cryptocurrencies, the event has shaken confidence that crypto can act as a hedge against inflation by creating something like a digital gold standard. The dream of a new global financial system built on crypto also took a huge step back.

Towards normalisation

The turmoil comes at a time when regulators have been looking more favourably at the sector. In March, US President Joe Biden appeared to open the door to the normalisation of the crypto markets when, in a widely reported executive order, he called for a co-ordinated effort by federal agencies to research and report back on digital assets within six months (see box: The US government’s key crypto objectives) . The order also urged the Federal Reserve to continue its work on the potential for creating a central bank digital currency.

While the executive order does not prescribe agencies to adopt particular policies, it does represent the first full-scale study of distributed ledger technology with a view to setting guidelines and regulation for its use. Key areas, of many, that are likely to come under scrutiny, include cybersecurity, securities law and anti-money laundering, as well as their impact on the environment in the context of the President’s climate agenda.

‘The executive order does not address questions regarding the role and jurisdiction of each of the executive branches of the US government and independent agencies that seek authority relating to digital assets’, says Anurag Bana, Senior Project Lawyer in the IBA Legal Policy & Research Unit. This means that, with so many agencies involved, the final recommendations are likely to be muddled about which bodies will regulate what – especially since the Federal Reserve and the Securities and Exchange Commission (SEC) need to remain independent.

Assessing risk

In addition, Bana says that while the executive order says that federal agencies need to ‘ensure that digital assets do not pose undue risks to consumers, investors, or businesses’, what counts as undue risk remains an open question.

‘At present, there is no one regulator in charge of determining the level of risk appropriate for digital assets’, Bana says. ‘So the order raises – without entirely resolving – the question of whether the level of risk permissible for digital assets should be commensurate with that of securities.’

If crypto were to be regulated in a similar way to that asset class, the SEC could establish distinct regimes for assets marketed only to accredited investors and those that can be marketed to the public.

That may make the US federal government happy, but people active in the market have reservations. While key crypto players cautiously welcomed the news, some believe that an SEC-style system would not work because crypto needs defining as a new asset class. That would result in better-tailored regulation, considering crypto is neither a traditional currency nor an equity (see box: A brief history of cryptocurrencies and their regulation).

And what about the crypto project’s wider libertarian ambitions of taking currency out of the hands of governments? Adam Blumberg, co-founder of PlannerDAO and Interaxis, a company that teaches financial advisers about crypto, welcomed the executive order but has said that ‘part of the idea of crypto and DeFi [decentralised finance] is taking some of the financial power out of the hands of government. Why would we expect anyone in the government to be saying, “Yes, we’ve been overdoing it for some time and we need to give up some trust to computer code that can process transactions for us?”’.

Crypto’s European journey

Meanwhile, cryptocurrencies enjoyed a reprieve from the European Parliament in March when the institution struck out a provision in its regulatory proposals that would have banned cryptocurrencies such as Bitcoin. Bitcoin and Ethereum 1.0 are designated proof-of-work currencies, which in layman’s terms means they consume huge amounts of energy. This is something the European Parliament objects to because their energy usage potentially contravenes the goals of the European Green Deal – which aims to ‘transform the EU into a modern, resource-efficient and competitive economy’.

The EU’s Markets in Crypto Assets Regulation (MiCAR) could now come into force in 2025, but the details of what that regulation will entail still need to be finalised. Even so, the eurozone is further ahead than the US – or anywhere else for that matter – in its efforts to regulate the market. Teunis Brosens, Head Economist, Digital Finance and Regulation, at financial institution ING, says that MiCAR is likely to introduce regulation in three main areas: consumer protection, financial market integrity and financial stability. Anti-money laundering is already included in the EU’s fifth directive on the issue, known as AMLD5.

One of the key tenets of the European approach is that it aims to be ‘technology neutral’, which means applying the same rules to future crypto developments, rather than having overly stringent categorisations that need to be constantly upgraded.

‘This principle sounds clear and sensible but is a lot harder to implement in practice’, Brosens says. ‘In fact, it is almost inevitable that regulation is always trailing behind developments in the field. Still, it is likely that a substantial part of cryptocurrencies and stable coins that we know today will move in scope of MiCAR, although it is much less clear to what extent decentralised finance will be in scope.’

New applications of the technology are likely to ensure that a clear definition of crypto and, therefore, how it should be regulated, remains elusive. At the same time, it looks likely that regulators in Europe and the US will play an increasingly significant role for a large part of the market.

Arthur Piper is a freelance journalist. He can be contacted at arthurpiper@mac.com

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