Europe Establishes Cryptocurrency Framework. Part 2: Great Britain

We looked at two landmark documents pertaining to cryptocurrency legalization in Europe: the EU Markets in Crypto-Assets regulation (MiCA) and a similar paper from the central bank of Great Britain. These massive and extremely substantive pieces consist of hundreds of pages outlining the European vision of cryptocurrencies’ role and place in the modern world and the future European financial system.

Let’s turn to the UK. London has remained the world’s most respected financial center for centuries, still retaining this title despite the power of the United States, the Swiss banking traditions, the rise of Hong Kong, and other challenges. And since the United Kingdom left the European Union it needs to be considered separately from the rest of Europe with its policy (including financial) now being completely independent.

We have examined Financial Stability in Focus: Cryptoassets and decentralized finance – a March 24 document published by the Bank of England (BoE) Financial Policy Committee (FPC).

On the one hand, this voluminous paper is an outstanding mini-textbook on cryptocurrencies and DeFi. If you are new to the field, read it, and you will find answers to many fundamental questions. On the other hand, the most frequently used word in the document is “risks”. It indicates that the Bank of England still perceives the entire crypto industry as too precarious compared to regular finance.

FPC experts start by recognizing that the crypto sector is yet small and isolated relative to the fiat money sector. However, if the pace of growth seen in recent years continues, its ties to traditional finance will likely strengthen. The report’s authors admit that “the new technology has the potential to reshape activity currently taking place in the traditional financial sector.” They continue by listing the most well-known benefits of crypto: lower transaction costs, higher payment system interoperability, and more choice for users.

Despite that, one thing is repeated like a mantra throughout the piece: the Bank of England’s desire to squeeze cryptocurrencies and DeFi onto the Procrustean bed of conventional financial regulation. Here’s what it looks like: “Where crypto technology is performing an equivalent economic function to one performed in the traditional financial sector, the FPC judges this should take place within existing regulatory arrangement.” They seem to have missed the fact that cryptocurrencies were created precisely so that states and banks could not regulate them.

The report defines cryptocurrencies as “a digital representation of value or contractual rights that can be transferred, stored or traded electronically, and which typically use cryptography, distributed ledger technology (DLT) or similar technology.” Their share is estimated at about 0.4% of global financial assets, with more than 17,000 different cryptoasset tokens in circulation today.

“Currently, the vast majority of cryptoasset activity is driven by the use of highly volatile unbacked cryptoassets as speculative investment assets,” the authors note. “Large daily swings in value are common – Bitcoin prices have fallen by 10% or more in a single day around 25 separate times over the past five years, on one occasion falling 27% in a single day. This price volatility makes unbacked cryptoassets unsuitable to be widely used as money, for example as a means of exchange or a store of value.”

The general idea the experts are trying to convey in every way possible is that blockchain is good for finance, but independent cryptocurrencies are bad. But when they face new entities like stablecoins, DeFi, and crypto ETFs, you can almost see the fiat-centered worldview of the Bank of England specialists who wrote the report crumble. And as it is happening, they bring up some interesting facts: “Around 75% of cryptoasset trading on centralised exchanges involves a stablecoin, which are intended to act as a stable store of value relative to fiat currency and other assets. Stablecoins also play a key role in DeFi applications, with some DeFi applications issuing their own currencies.”

The authors also acknowledge that many of the services currently supported by crypto technologies are similar to those in conventional finance, including lending, exchange, investment management, and insurance. However, such services are now focused on the cryptoasset markets, which are tiny compared to the overall financial sector.

Still, cryptoassets and associated markets, including cryptoasset derivatives and cryptoasset funds, have been developing rapidly. This new technology may change the work of the traditional financial sector, either by migrating it or through broad adoption of the technology. Experts admit that the tech underlying cryptocurrencies and DeFi gives them noticeable advantages over the conventional financial system and, most importantly, removes the need for centralized intermediaries.

Presumably, that is why an entire third section of the report is devoted to what is then summed up in one sentence: “Direct involvement in cryptoasset and associated markets by UK banks has been limited to date, but further involvement could increase the risk of financial losses and operational disruption.”

The final sixth section then describes regulatory initiatives to mitigate the pitfalls associated with cryptoassets and DeFi. In short, the British will try to apply fiat regulation to cryptocurrencies as much as possible. And at this stage, this responsibility falls upon the banks.

Although perhaps the most important thing in this section is the statement: “The Bank and HM Treasury are also currently considering the case for issuing a UK retail Central Bank Digital Currency. In 2022, the Bank and HM Treasury will launch a consultation, which will set out their assessment of the case for doing so.”

It shows that the UK is still leaning towards creating its own CBDC, the digital pound.

The end of the extensive document consists of three separate parts. The first is dedicated to DeFi. The authors write: “DeFi is a collective term for a set of applications that seek to provide a range of financial services, including loans and exchanges, with the aim of reducing reliance on centralised financial intermediaries. These alternative financial applications are built on distributed ledger technology. Unlike traditional financial services firms that undertake these activities, DeFi applications are, at present, largely unregulated.”

That is about as precise of a definition as you will find. It is followed by a brief and quite accurate, textbook-like summary of the DeFi fundamentals.

Even with their biases, BoE experts concede: “Some technological features used in DeFi, such as smart contracts, have the potential to improve speed and efficiency in the wider financial system. The DeFi ecosystem is currently small, but has grown very rapidly and is likely to grow further.”

They also believe that the threat that DeFi poses to the broader financial system in the foreseeable future is minor. At the same time, DeFi apps can compete with traditional financial service providers by increasing economic activity outside the regulatory perimeter, which means that the continued growth of DeFi creates possible legislative issues.

The second part describes “Broader risks from cryptoassets and associated markets”. Here, the reader is told the familiar tale of cryptoassets impeding financial stability, consumer and investor protection, market integrity, and creating a potential for money laundering and terrorist financing.

But then comes an unusually sober thought: “Increased concerns about consumer protection or market integrity could lead to a loss of confidence in cryptoassets, which may in turn undermine financial stability by weakening broader trust and integrity in the financial system.”

The third part is about “Regulatory considerations for systemic stablecoins”. The point it makes is that some stablecoins may create risks that go beyond those associated with traditional payment systems. We are talking about the issue of new financial tools in the form of digital tokens, the value of which is still subject to fluctuations. “Absent additional regulation, some stablecoins held to be used for payments may not offer similar protections to central bank or commercial bank money,” the report authors state. “The FPC notes that systemic stablecoins issued by non-banks and backed with deposits at commercial banks would pose significant financial stability risks.”

In conclusion, the Bank of England proposes to regulate everything related to stablecoins to the highest degree.

Let’s summarize. The Bank of England (Britain’s central bank) has presented an approach to cryptocurrency regulation centered around minimizing the risks from assets new to the financial system, as well as upholding sanctions against Russia caused by their war against Ukraine. But though the document is quite cautious, it most importantly fully recognizes cryptoassets and DeFi’s “right to exist”. The Bank of England also notes that full economic integration of crypto requires changes in the country’s laws, and until those are made, the risks should be handled by the banking sector.