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FATF Updates Standards; Yellen Pushes for Stablecoin Regime; Bank of England Calls for Enhanced Reg

FATF Updates Standards for Virtual Assets & VASPs


What happened?


Late last week, the Financial Action Task Force (FATF) released its “Targeted Update on Implementation of the FATF Standards on Virtual Assets (VAs) and Virtual Assets Service Providers (VASPs).”


The report was published after the announcement that EU lawmakers had come to an agreement on the highly anticipated Transfer of Funds Regulation (TFR) and Regulation on Markets in Cryptoassets (MiCA), both of which aim to provide a comprehensive regulatory framework for crypto activities.


With respect to DeFi, the report said that “FATF’s recent outreach with industry suggests that ‘decentralised’ currently can be a marketing term rather than a technical description, and that even in so-called decentralized arrangements, often there continues to be persons and centralized aspects that may be subject to AML/CFT obligations.”


The report also built on FATF’s earlier guidance for enforcement and focuses on encouraging countries to implement and enforce its “Travel Rule” that requires VASPs to share information about their customers.

FATF expressed concern in the report over the fact that “of the 98 jurisdictions that responded to FATF’s March 2022 survey, only 29 jurisdictions have passed relevant Travel Rule laws, and a small subset of these jurisdictions have started enforcement.” FATF strongly urged jurisdictions to act quickly to plug this regulatory gap.


The report ended by outlining market developments and potential emerging threats. In this section, FATF specifically suggested the “continued need for FATF to monitor the growth of, and illicit financing risks associated with” DeFi and “unhosted wallets.”


What does this mean?


The FATF, along with the Bank of International Settlements, has long been skeptical of the idea that financial activities can be disintermediated at all, writing in an earlier report that “where customers can access a financial service, it stands to reason that some party has provided that financial service, even if the act of providing it was temporary or shared among multiple parties.” This is perhaps technically true, e.g. people are indeed involved in the processes of validation and mining. But those activities are not functionally equivalent in any way to the role of traditional financial intermediaries.


A footnote in the text underscores the contradiction in the FATF’s position. The report differentiates DeFi from “decentralized VAs such as Bitcoin, Ethereum, and Tezos… the term DeFi is used where ‘decentralised or distributed application (Dapp)’ offers financial services such as those offered by VASPs.” This differentiation raises several questions, such as whether the FATF considers a DeFi protocol without a governance mechanism running on the ethereum network to be likewise decentralized.


One positive take away from the report, on the other hand, is that it recognizes the potential for law enforcement agencies to achieve their AML/CFT policy objectives by novel tools like blockchain analytics and the comprehensive enforcement of KYC reporting at custodial financial institutions operating in crypto.


Treasury Secretary Yellen Reiterates Need for Stablecoin Regulation


What happened?


Again late last week, the Department of Treasury released a “readout,” or summary, of a meeting held between the members of the President’s Working Group on Financial Markets. This working group includes representation from Treasury, Federal Deposit Insurance Corporation, Office of the Comptroller of the Currency, and Consumer Financial Protection Bureau.


The readout emphasized Secretary Yellen’s own sense of urgency with respect to “the need to continue to constructively engage in serious legislative efforts to promptly put in place a regulatory framework for stablecoins[…].”


Secretary Yellen further highlighted the need to address stablecoin risks stemming from potential runs, a lack of soundness and transparency, and insufficient reserve backing. She wants to address these risks while also “complementing existing authorities with respect to market integrity, investor protection, and illicit finance.”


What does this mean?


Secretary Yellen’s urgency with respect to custodial stablecoin regulation is shared by most policymakers and regulators in Washington, and Treasury may be signaling a shift away from its current policy suggestion (restricting stablecoin issuance to chartered banks) in favor of more expedient options. While there is broad interest in regulating the crypto space as a whole, it is generally accepted that addressing the risks associated with custodial stablecoins is where policymakers should begin this incremental process.


This order of approach makes sense given that frameworks exist that are well-suited to address the risks associated with centralized financial service providers like stablecoin issuers, crypto exchanges, and the like.


The importance of regulating stablecoin issuers in particular became acute for regulators after the collapse of UST — an event which Secretary Yellen cited during the meeting as a reason to ensure that stablecoin issuers are subject to a federal framework.


Bank of England Calls for Enhanced Crypto Regulation


What happened?


On Tuesday, the Bank of England’s Financial Policy Committee released its Quarterly Financial Stability Report, within which they highlighted the need for enhanced regulation aimed at addressing the risks crypto markets pose to financial stability.

Digital policy and regulation.

A summary report on the meeting explained that, while crypto market volatility does not currently pose a threat to the broader financial system, it has the potential to in the future, if it continues to grow and integrate with mainstream financial institutions.


The Committee believes this potential threat “underscore[s] the need for enhanced regulatory and law enforcement frameworks to address developments in crypto asset markets and activities.”


This report built on a consultation paper released by the Bank of England in response to UST losing its dollar peg. The consultation paper outlined a strategy to reduce consumer risks associated with stablecoins, and suggested several requirements aimed at suring up reserve holdings, promoting transparency, and protecting consumers.


What does this mean?


Specifically, it seems the Bank of England is also interested in beginning the process of regulating crypto markets by devising a framework for stablecoin issuers to protect consumers.


On a more macro level, the UK government recently shifted to a much more positive approach to crypto and DeFi, and the collapse of Boris Johnson’s government may influence whether that trend continues or reverses.


ICYMI


On Friday of last week, we submitted comments to the Financial Services Regulatory Authority (FSRA) of Abu Dhabi Global Markets (ADGM) on its “Discussion Paper No. 1 of 2022: Policy Considerations for Decentralized Finance.”


While we agreed with the report’s suggestion that DeFi has the potential to increase the efficiency of financial services by reducing intermediation costs, we totally disagree with the discussion paper’s contention that financial policy objectives cannot be accomplished outside of a permissioned and centralized system.


You can find our full response to the FSRA’s discussion paper here.