How to (and not to) Regulate Crypto

Insights from 2023 McGill Desmarais Global Finance Lecture and Conference on Central Bank Digital Currency

Cryptocurrency can transcend borders. That’s part of its promise, and one reason it’s so challenging to regulate. But the notion that crypto is completely unregulated isn’t accurate either.

“Despite the rhetoric, most jurisdictions do somehow regulate crypto assets, though it’s not always clear how,” says Ananya Kumar, associate director at the Atlantic Council in Washington, DC.

“There are some glaring gaps, but experimentation with regulation is happening in real-time, and it’s happening everywhere.”

At the 2023 Cryptocurrency Conference at Desautels, Kumar led a session on the state of the regulatory landscape. The theme of this year’s event was ‘How to (and not to) regulate crypto’, and with the high-profile collapse of cryptocurrency exchange FTX still headline news, it spoke to the zeitgeist. Staged on September 29 and organized by Desautels professors Katrin Tinn and David Schumacher, the conference brought together participants from twenty-eight different organizations, including universities, regulatory public policy institutions, and the private sector.

Kumar’s team at the Atlantic Council’s GeoEconomics Center maintains the Cryptocurrency Regulation Tracker, which monitors regulations in sixty jurisdictions, including G20 countries and countries where adoption is especially high. Crypto is primarily regulated in four ways, through taxation, consumer protections, anti-money laundering rules, and disclosure and reporting requirements. But regulations are a patchwork, with some jurisdictions advocating for greater coordination, and others banning cryptocurrency outright–though this hasn’t had the intended effect.

“Banning crypto doesn’t stop people from using it. Adoption is highest in countries with bans,” says Kumar.  “People can always access crypto outside of a jurisdiction, and there is an enforcement lag. In countries with bans, there hasn’t been a drop in usage because of the lack of enforcement.”

Regulating crypto could provide a first-mover advantage for the next global financial hub

Singapore has long been considered a crypto haven, while Nigeria banned it altogether. And according to Franca Ciambella (BCom’84), the two countries offer lessons on how to regulate crypto—and how not to.

“Singapore has a robust legal regime,” says Ciambella, a lawyer and advisor at Global Law Alliance who participated in the ‘Global perspectives on regulating crypto panel’.

“But even in a such a sophisticated system, law enforcement doesn’t always understand cryptocurrency. Once, an exchange refused to release crypto to a client of mine, and we filed a police complaint about the misappropriation of property. It was not understood. The police did nothing. So, there are weaknesses, but Singapore is trying to balance investor protection with innovation.”

Nigeria is at the other extreme. It banned cryptocurrencies, though adoption is very high. One motivation for its use is the instability of Nigeria’s currency, the Naira.

“In the last year, the Naira has depreciated by 50%. If you have savings, you don’t want to keep it in Naira. There is also scarcity of US dollars,” says Ciambella. “Everything is stacked against crypto use in Nigeria, but there are reasons why it’s widely used. There’s a lot of peer-to-peer trading, and payment services providers set up exchanges outside the country that use intermediary bank accounts to receive payment and provide cryptocurrency.”

Recognizing these issues, the Central Bank of Nigeria is working toward a framework to regulate crypto, and expects it to be ready in 2025. In the long run, regulatory clarity about cryptocurrencies could provide a first-mover advantage that helps create a new global financial hub.

Regulatory competition is a real factor, and it’s a different kind of competition

“Regulatory competition is a real factor, and it’s a different kind of competition,” says Shaun Martinak, a portfolio manager at Coinbase Asset Management. “It might not be for the largest single capital market, but for creating a nexus of commercial activity in Asia Pacific, or the Middle East and North Africa—however you want to define a broader region that isn’t constrained by Western alliances and the progress of the regulatory frameworks there.”

This could be the impetus for a new major financial centre. Perhaps in an island nation like Singapore that wants to have an outsized global footprint, or a Middle Eastern emirate transitioning away from a commodity-driven economy. Specific jurisdictions have their own unique incentives. But ultimately, any kind of regulation will need to have some level of standardization across jurisdictions for any kind of international hub to take shape.

“Emerging markets are not currently coordinating, and we have seen this tendency among advanced countries in the past,” says Nobuyasu Sugimoto, the deputy division chief of the Financial Supervision and Regulation Division at the International Monetary Fund (IMF).  “Because of the great financial crisis, advanced economies are now talking to each other.”

But emerging economies are not as proactive. The IMF encourages them to coordinate when they seek support, and to exchange information with each other.

“We’re trying to provide knowledge about the most important topics,” says Sugimoto. “Often, regulators aren’t talking to the industry because they don’t feel confident to do so. Our effort has focused on providing the confidence to discuss regulation more openly and transparently.”

Canada and the United States are wrestling with fundamental questions about the nature of crypto

In Canada and the United States, the regulatory picture is beginning to take shape. Crypto exchanges are being regulated, and existing laws applied to the prosecution of white-collar cases like that of Sam Bankman-Fried. But outstanding questions remain, and there are some big ones—like whether crypto can be classified as currency at all.

Currency suggests that crypto is money, and that’s part of the reason regulators are moving toward more generic terms
“Currency suggests that crypto is money, and that’s part of the reason regulators are moving toward more generic terms,” says Elizabeth Côté, the director of the Digital Innovation Hub at the Office of the Superintendent of Financial Institutions.

Côté participated in a panel called ‘Regulating crypto in Canada and beyond’ with Pascale Toupin, the director of oversight of intermediaries at Quebec’s Autorité des Marchés Financiers (AMF); Laurent Féral-Pierssens, a managing partner at BlockZero Advisors; and David Adler, a partner at McCarter & English, a New York City law firm.

“In Canada, the Currency Act acknowledges legal tender as currency,” Côté continued. “But would crypto assets fall in that category? When it comes to defining it, we have to look case law about what money is. Probably back to the 1700s, when the goldsmiths of London were issuing deposit receipts, and whether those were considered money.”

Regulators need to be cautious about applying this term because it could be read as implying a move toward digital currency, but regulation is nevertheless underway. Toupin noted that Quebec’s AMF has been working with other provincial regulators to build harmonized regulations and securities legislation, and has so far registered twelve crypto asset trading platforms.

But just across the border in the United States, the legal picture looks somewhat different. There, some forms of crypto might fall under some definitions of currency, but even that is uncertain.

“The Uniform Commercial Code (UCC) applies to transactions involving sales or securitization, and it has a definition of currency,” says Adler. “It says a currency is any object that’s accepted as legal tender, anywhere in the world. And Bitcoin has been given status legal tender in El Salvador, so it is technically a currency under the UCC. But I’m not sure this issue has ever been put before the courts.”

Beyond currency: Crypto can open new asset classes to average investors

When crypto is interoperable, it enables entirely new investment products and can democratize collateralization.

“A piece of paper is fundamentally interoperable. I can have it, you can have it, and we can exchange it easily,” says Christine Parlour, the keynote speaker at this year’s conference and a professor at the University of California Berkeley’s Haas School of Business.  “But if you issue assets on a blockchain, it’s not so interoperable. There needs to be a regulatory push for this to happen.”

And this doesn’t only benefit assets issued on a blockchain, like Bitcoin. Real-world assets can be put on a blockchain too. This process is called tokenization, and it can allow for ownership of these assets to be fractionalized.

“We like to tell students to have exposure to an alternative asset class in a well-diversified portfolio, but these things tend to be sold in chunks– there’s only one of each Monet painting,” says Parlour. “Tokenization can tap a much broader audience. It allows people to buy a fraction of an alternative asset, and make investments they otherwise could not afford.”

The fractional ownership that tokenization enables could also catalyze entrepreneurial activity by facilitating collateralization of real-world assets like real estate.

“When real-world assets are moved on-chain, you don’t have to use an entire house as collateral, you can use a portion of it, says Parlour.  “That speaks to a more global community, and could increase trade.”

But while blockchain presents new possibilities, the differences in its structure also present novel challenges.

“A lot of regulation is based on what we’ve seen in the past. And that combines basic economic frictions and a market structure. As we move to new ways of putting markets together, how do we figure out the basic economic friction we want to regulate, or not?” says Parlour. “And what was only happening because of how the market was previously designed. That’s something regulators need to grapple with.”

Crypto regulations has begun, but many questions remain unanswered

Crypto regulation should not simply aim to adapt new assets to existing regulatory frameworks and, according to Katrin Tinn, one of the conference organizers, this is the key takeaway from the event.
Collaboration with academic researchers and the private sector can help identify market frictions, and help regulators to fix them
“Collaboration with academic researchers and the private sector can help identify market frictions, and help regulators to fix them,” says Tinn. “This would encourage innovation by providing companies with greater regulatory clarity, and ideally eliminate the need for jurisdiction shopping.”

Regulators in Canada and elsewhere are already enhancing their regulatory frameworks, and increasing their focus on custody, stablecoins, and the clarification of the legality of the ownership and trading of crypto-assets in decentralized spaces. But there are still many questions, centering primarily around the regulation of innovative financial assets that use digital ledgers and blockchain technology.

“Should the regulation of tokenized real-world assets favour native tokens issued on-chain, or require custody by regulated financial institutions? And what implications will these choices have for market concentration?” Asks Tinn.

“Should certain innovations in decentralized crypto-asset exchanges be integrated into mainstream stock exchanges? What are systemic risks associated with digital assets? These are some of the essential questions that were highlighted by speakers at this year’s  conference. Digital ledger technology holds the promise of improving financing contracts, making it easier for innovators to secure external funds and offering investors better choices. However, to witness real success, we need regulatory clarity. This conference aimed to move us closer to that goal.”