Mind the gaps

Many countries and legislators seem to agree that establishing clear, cohesive and comprehensive regulation of digital assets is of paramount importance due to far-reaching implications on financial stability, investor protection and the overall integrity of the financial system.

Advanced digital technologies, such as cryptocurrencies and tokenised securities, have gained significant prominence in recent years, attracting a broad spectrum of investors, researchers and market participants. Without effective (and one might argue coordinated) regulation, the inherent risks associated with these assets, including fraud, market manipulation and cyber threats, could continue to undermine investor confidence and lead to significant financial losses. Robust and tech-smart regulatory frameworks help mitigate these risks by imposing standards for transparency, security and accountability, thereby safeguarding both individual investors and the broader financial ecosystem.

The regulation of digital assets is crucial for ensuring compliance with anti-money laundering (AML) and know-your-customer (KYC) requirements. Cryptocurrencies, in particular, have been associated with illicit activities such as money laundering and the financing of terrorism due to their anonymous nature. Appropriate regulations compel digital asset service providers to implement AML and KYC measures, helping authorities trace and prevent unlawful financial activities.

In this context, legislative regulation supported by judicial interpretation strikes a balance between protecting the public interest and promoting responsible innovation in the rapidly evolving digital asset space. That said, it is important to implement regulations carefully to avoid stifling innovation and to ensure that they are effective in achieving their intended goals.

Global rules

The categories of digital asset regulations are broad and include the classification of digital assets, the regulatory framework, jurisdictional boundaries, taxation and investor protection. Each jurisdiction has implemented its own approach to regulation, prioritising certain areas over others. For example, a Financial Action Task Force (FATF) report from June 2023 reveals that 75 per cent of countries lack virtual asset AML regulations. Indeed, even for countries implementing rules, enforcement remains low at only 21 per cent.[1]

The FATF report also states that, as of April 2023, 58 jurisdictions have passed legislation or regulation to implement the ‘travel rule’ (the Rule), reflecting significant progress since 2022, although global compliance remains unsatisfactory. The Rule is a regulatory requirement that targets the anonymity of crypto transactions in order to prevent money laundering and terrorist financing.

The Rule specifically targets virtual asset service providers (VASPs). VASPs are companies able to conduct cryptocurrency transactions, including custodial services, the provision of crypto wallets and payments that dictate the level of cryptocurrency adoption within any country.[2] Companies known as money transmitters, some of which are able to transmit crypto, are not strictly speaking VASPs.[3] The personal data of the transacting parties ‘travels’ with their transfers, hence the name ‘travel rule’.

The Rule existed before the FATF’s 2019 Recommendations, which expanded the Rule to include the crypto industry. The Rule requires VASPs to communicate the information of the originators and beneficiaries of crypto transactions that exceed a certain threshold, which can differ by country. For instance, in Canada, the relevant licence allows for ‘dealing in virtual currencies’ and is issued by the Financial Transactions and Reports Analysis Centre of Canada to a subset of money transmitter service businesses. It requires VASPs to obtain and share ‘required and accurate originator information, and required beneficiary information’ with counterparty VASPs or financial institutions during or before the transaction.

In the US, the Rule is required for any transaction above USD3,000. The EU has also approved the Rule for crypto-assets, which will cover transfers of crypto-assets and will require information on the source of the asset and its beneficiary to ‘travel’ with the transaction and be stored on both sides of the transfer.[4]

Much of Europe has adopted the EU Fifth Anti-Money Laundering Directive, which requires VASPs to register with the relevant authorities and comply with AML/counter-financing of terrorism regulations. The Caribbean region has also been developing regulatory frameworks for VASPs, with the British Virgin Islands and the Cayman Islands among the countries that have adopted VASP legislation. The regulatory frameworks in the Bahamas, Bermuda and the Cayman Islands are considered leading global examples in this space.

The Virtual Asset (Service Providers) Act, 2020 (the Act) brought digital assets and related service providers under the Cayman Islands Monetary Authority’s (CIMA’s) remit. Entities engaged in or wishing to engage in virtual asset services must be registered with CIMA. The Act also prohibits natural persons from carrying on virtual asset services as a business or in the course of business in or from within the Cayman Islands.

Confusion and uncertainty

The current regulatory landscape for digital assets is fragmented and evolving quickly, with multiple regulators at the federal and/or state level having jurisdictional authority over a transaction. This can create gaps and overlaps as the market develops, leading to confusion and uncertainty for businesses and investors.[5] Moreover, existing property laws may not fully accommodate digital assets, which have unique qualities and features. This can make it difficult to provide a strong legal foundation for the digital assets industry and its users. For this reason, the EU’s adoption of the Markets in Crypto-Assets Regulation is especially welcome and introduces a harmonised regulatory framework for digital assets in the region. The new rules cover issuers of utility tokens, asset-referenced tokens and stablecoins.

The regulation is the first attempt at creating a comprehensive regulatory framework for digital assets in the EU and is expected to reduce fragmentation.[6] The International Monetary Fund has called for the harmonisation of digital asset regulation to address the challenges posed by the evolving crypto world.[7] UNIDROIT, an intergovernmental organisation, has adopted principles on digital assets and private law to provide legislative guidance and best practices in relation to transactions involving digital assets, such as cryptocurrencies.[8] The principles aim to promote legal certainty and predictability in the use of digital assets. Harmonisation could lead to standardisation of processes across the digital asset lifecycle, so reducing operating risk and costs and the complexities of navigating varying regulatory landscapes, making it easier for businesses to operate across borders and investors to access new markets and opportunities.[9]