15 December 2023
The International Organization of Securities Commissions (IOSCO) wants to support jurisdictions seeking to establish compliant crypto assets trading markets in the most effective way possible. Understandably, their solution mirrors certain existing market regulation on the trading of crypto assets. IOSCO’s goal is laudable but as with all regulatory initiatives, the devil is always in the detail.
IOSCO's recently published final report introduces principles-based and outcomes-focused recommendations for the wide-ranging regulation of crypto assets. These recommendations specifically target the activities performed by crypto asset service providers (CASPs), with the overarching goal of achieving regulatory convergence among jurisdictions implementing crypto assets regulation. In this blog we use crypto assets as a concept which encompass tokens issued on public permissionless blockchains.
Regulatory development milestone
The report is a true milestone in the development of governance and regulation of the global crypto ecosystem. Historically, regulatory authorities have adopted diverse approaches to crypto assets regulation, ranging from innovation-friendly to the outright dismissive. This scattered approach has created uncertainty and has hindered the sustainable and responsible growth of crypto markets. IOSCO advocates for a more coordinated approach at the global level, with an emphasis on principles and outcomes. Addressing concerns about investor protection and market integrity, the report sets a direction for robust baseline regulatory responses.
Inspiration from MiCAR
Flow Traders has long embraced the innovation and emerging opportunities in the crypto assets markets. This is why we also see the approach adopted in Europe via the EU’s Markets in Crypto Assets Regulation (MiCAR) as a valuable guide for other regulators. The new IOSCO report echoes significant elements of MiCAR, bolstering the view that this EU-regulation will indeed enhance transparency, expansion, and resilience in the crypto-assets ecosystem. MiCAR's potential contributions include promoting institutional adoption, activating innovative protocols, and improving investor protection.
Global tradfi standards setting is one such environment where market participants can positively influence the behavior and development in the crypto assets’ ecosystem. As the market expects IOSCO to publish their other report focused on defi later this year, the current crypto assets recommendations already provide an insight into what we can expect.
Big challenges await in implementing the recommendations
The most far-reaching and significant of IOSCO’s recommendations are on aligning regulation of crypto assets with more traditional securities regulation in areas such as disclosure, insider dealing, market abuse and custody. If implemented, these would have direct implications for crypto market participants in terms of establishing systems and controls, and compliance monitoring in these areas. This requires market-wide cooperation involving all relevant stakeholders to thoroughly assess how these principles will provide effective regulation while also ensuring the ecosystem has the regulatory clarity to thrive and innovate.
We note three specific examples of the potential challenges arising from IOSCO’s recommendations.
A. Disclosures (recommendation Three)
IOSCO recommends accurate disclosure by CASPs of each role and capacity in which it is acting at all times, in all jurisdictions where the CASP operates and provides services. Currently, it is not uncommon for a service provider to engage in different activities and functions in crypto asset trading environments, in different jurisdictions at the same time. The continuous operation of the global crypto asset market, coupled with potentially varying disclosure requirements across jurisdictions, raises concerns about information overload and potential loss of oversight. Consequently, harmonizing disclosure formats across jurisdictions becomes even more crucial for maintaining transparency.
B. Abusive market behavior (Recommendations Eight to Ten)
Secondly, IOSCO sets out the critical expectation that there should be effective systems and controls in place to identify and monitor for manipulative market practices and to prevent leakage and misuse of inside information. Fortunately, IOSCO itself also foresees that this will not be an easy task. Implementing these recommendations requires improved data availability (both ‘on-chain’ and ‘off-chain’), consistent reporting standards, and international data standards for enhanced market transparency. The question remains open as to whether established institutions such as the International Organization for Standardization (ISO) should also provide these standards.
C. Custody and Safeguarding client assets (Recommendations Twelve to Sixteen)
A third example relates to the custody of client monies and assets. The current setup of the crypto asset market structure puts heavy responsibility on crypto exchanges to maintain an orderly market. It is this concentrated risk which is permeating into the traditional financial markets and has grabbed IOSCO’s attention. IOSCO is, therefore, linking the crypto exchange market structure with safeguarding client monies and crypto assets. A key component here is the proof of reserve of client assets which can be verified on a continued basis, is free of colluding risks, and is clean from liabilities or vague commingling protocols. If the developments of non-native custody solutions deliver within these recommendations, it might be possible to extract wallets from the crypto exchanges into a separated custodian. That would decrease inherent liquidity risk for users of crypto exchanges but potentially create other liquidity and funding concerns for the crypto ecosystem. Flow Traders believes custody providers should make it possible for users and other market participants to validate their relevant data. It is important that this data shows the fair value positions in the wallets. It should exclude any lending, borrowing or collateralization of client deposits to third parties and safeguard the users’ assets from comingling with other funds at the crypto asset exchange.
Closing the gap and moving forward
In conclusion, regulating entities offering crypto asset trading is seen as a crucial step toward maturing the overall digital assets ecosystem. Bridging the gap between tradfi and defi is essential for attracting individuals, organizations, institutional investors, and corporates to the crypto markets. IOSCO's efforts certainly are a welcome contribution to this goal, but the path forward involves addressing the challenges posed by the recommendations. IOSCO's approach calls for collaboration among stakeholders to ensure effective regulation and to foster innovation in the ever-evolving crypto assets ecosystem.
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The IOSCO recommendations, which can be read in full here, cover six key areas:
- Conflicts of interest arising from vertical integration of activities and functions
- Market manipulation, insider trading and fraud,
- Cross-border risks and regulatory co-operation,
- Custody and client asset protection,
- Operational and technological risk, and
- Retail access, suitability, and distribution.
In line with IOSCO’s established approach for financial market regulation, the recommendations are addressed to the relevant international and local competent authorities.