Mechanism of Regulation

Behind the Headlines by HKU FinTech

Thailand's Securities and Exchange Commission announced the banning of cryptocurrencies as a means of payment for goods and services.

The country saw a dramatic rise of digital assets held by Thais - 114B Baht from 9.6B Baht in two years with daily average turnovers of 4.8B Baht (from 240M Baht) and active trading accounts at almost 2 million from around 170,000 before the pandemic, Bloomberg reported.

What is the mechanism behind such regulatory action? How do regulators approach such issues and where should it be headed?

Discussing how cryptocurrency regulation works, Douglas Arner, The University of Hong Kong Kerry Holdings Professor in Law and RGC Senior Fellow in Digital Finance and Sustainable Development, explains the regulators' playbook, focusing in on Stablecoins and the approach he called 'Proportional Graduated Approach'.

This transcribed discussion is an excerpt from a panel as part of the 'Crypto Regulation Asia Summit 2022' held on 24 February. He sets the discussion by describing the regulatory evolution as a balance between regulation and innovation.


It's over a decade, almost 15 years now, that we've been talking about these aspects of dealing with the balance between regulation and innovation. And I think it has been a really interesting evolution.

If we think about the first few years, we had a number of Central Banks, a number of banking regulators that took very restrictive approaches to Crypto digital assets.

We didn't see an early focus on a sort of criminal use, but we continue to see in many cases for an extended period of time across the last decade, many regulators actually kind of giving some distance and letting things develop.

Even we see the ICO bubble around 2018, in major jurisdictions we see some actions but still staying quiet back.

I think two things really triggered a shift from kind of focusing on the market integrity, the AML (Anti-Money Laundering) side, to something different. And the first was really (Facebook's) Libra.

If we think about the FSB (Financial Stability Board) global regulatory efforts, one has been with the FATF (Financial Action Task Force) in the context of AML in this setting that we've talked about a lot.

The second was really triggered by Libra and we see this global process to build a regulatory system for global Stablecoins.

The reality is so far, nothing like what was envisage, a sort of global Stablecoin - a Crypto currency issued by a global private tech giant - nothing like that exists.

Part of the reason is because there was a very heavy global regulatory response and now we have a system whereby essentially most regulators in G20 Financial Stability Board jurisdictions have built or are building a regulatory system to address global Stablecoins.

But the challenge is there aren't actually many of those out there.

What has happened over the past couple of years, is that the volume of other digital assets, including Stablecoins, has grown pretty dramatically.

And I think Stablecoins are interesting because of course if we go back to that original idea of Crypto as an alternative to government bank financial systems, we can see the CBDC as a response.

But the Stablecoin is actually something that market participants have wanted to be able to link Crypto and digital assets to Fiat currencies and the traditional monetary system. And so they've evolved essentially out of the demand side.

Now, so long as they weren't actually that big, regulators actually have kind of stayed back. But size-wise, scale-wise, and I think we really saw this in 2021, markets broadened very dramatically all across the world in the context of users and levels of sophistication and size and volatility.

And I think that that has triggered this high level focus at the global regulatory end, with this FSB paper, which highlights from the standpoint of regulators all over the world, they are looking for ways to rein things in but without causing a collapse of the market because if you cause a collapse of the market, you actually trigger the damage that you're trying to avoid.

So it's an escalation of regulation but trying to balance without crushing the market.

When we begin to think about what regulators should do, one aspect is very much around the question of what are you talking about? Is this a direct challenger to the monetary system as a Libra might be, or as an eventual global Stablecoin - potentially a global Stablecoin that is what we would call a synthetic CBDC which has direct access to the balance sheet of liquidity of a major Central Bank? And we can see discussions both in the context of China and the United States about this sort of model. This is something that would be a direct challenge to domestic currencies.

The second is from the standpoint of payment systems: Is it really a sort of monetary instrument? In which case you want it to be treated largely as other sort of payment instruments.

But the final one is a lot of Stablecoins are actually investments. In other words, the Stablecoin issuer says that it is linked to a pool of assets and the question is, is it really one-to-one-backed with safe assets? Or is there some amount of float going on? And the bigger the float the more risk.

And that's where our real concerns need to be: things that are actually trying to say that they are stable monetary instruments, when in reality they are leveraged investment products?

And that I think from the standpoint of regulators is why we are seeing this tendency to what I would call a Proportional Graduated Approach - which basically says you start with a functional activities-based approach - the smaller it is, the more you let it go, the bigger it gets, the more you need to pay attention. And at a certain level when it's big, you move from an activities-based approach to an entity-based approach where you regulate the large institution product infrastructure itself.

That is the direction where I think we are going and where regulators need to be going, but it's not easy to do.


Governing FinTech 4.0: BigTech, Platform Finance, and Sustainable Development by Douglas W. Arner (HKU), Ross P. Buckley (UNSW), Kuzi Charamba (HKU), Artem Sergeev (HKU), and Dirk A. Zetzsche (University of Luxembourg) | Fordham Journal of Corporate and Financial Law

After Libra, the e-CNY and COVID-19: The New World of Money and Payments by Ross P. Buckley, Douglas W. Arner, Dirk A. Zetzsche, and Anton Didenko | London School of Economics Business Review

Stablecoins: Risks, Potential and Regulation by Douglas Arner (HKU), Raphael Auer (BIS), and Jon Frost (BIS) | SSRN

Risk and Reward: An Outlook for CBDCs, Stablecoins and Settlement Coins | Regulation Asia's Youtube Channel
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